Ch. 16-20

What is fiscal policy?

Fiscal policy is the use of government spending and taxation to influence the economy, particularly aggregate demand. It aims to stabilize economic fluctuations and promote growth.

What are the two main types of macroeconomic policy? How do they differ?

Fiscal Policy: adjusts government spending and taxes. Monetary Policy: adjusts the money supply and interest rates via central banking actions.

What triggered the use of fiscal policy during the Great Depression?

A collapse in aggregate demand caused unemployment to soar above the natural rate. Keynes advocated short-term government intervention to revive demand.

What was the fiscal response to the COVID-19 pandemic?

Stimulus checks, expanded unemployment compensation, and aid to businesses and hospitals to support demand during shutdowns.

What is expansionary fiscal policy?

Policy used during recessions to increase economic activity by increasing government spending or decreasing taxes.

What are the consequences of expansionary fiscal policy?

Budget deficits and increased national debt, especially during downturns like COVID-19.

What is contractionary fiscal policy?

Used during economic booms to reduce inflation by decreasing government spending or increasing taxes.

What is the formula for Aggregate Demand (AD)?

AD = C + I + G + NX, where C is consumption, I is investment, G is government spending, and NX is net exports.

How does a change in taxes affect AD?

Lower taxes increase disposable income, boosting consumption and shifting AD right; higher taxes reduce consumption and shift AD left.

What is the marginal propensity to consume (MPC)?

The fraction of an additional dollar of income spent on consumption. MPC = ΔC / ΔY.

What is the formula for the spending multiplier?

1 / (1 - MPC). It shows how initial spending leads to a greater increase in GDP.

What is countercyclical fiscal policy?

Fiscal policy that offsets business cycle fluctuations: stimulus during recessions, restraint during expansions.

What are the 3 time lags in fiscal policy?

Recognition lag (identifying the issue), implementation lag (passing policy), impact lag (policy taking effect).

What are automatic stabilizers?

Policies like unemployment insurance and progressive taxes that automatically adjust with economic conditions.

What is mandatory federal spending?

Spending required by law, such as Social Security and Medicare, which makes up ~70% of the federal budget.

How do AD-focused and AS-focused fiscal policies differ?

AD-focused policies work short-term to boost demand; AS-focused (supply-side) policies work long-term to increase potential output.

What is supply-side fiscal policy?

Policy that aims to grow the economy’s productive capacity (LRAS) through investment in resources, technology, and institutions.

What are some tools of supply-side policy?

R&D credits, business loans, education subsidies (positive); tariffs (negative effect on LRAS).

What is "crowding out"?

When increased government spending raises interest rates, reducing private investment and consumption.

Why is crowding out less of a concern in recessions?

Private demand for funds is already low, so government borrowing is less likely to raise interest rates significantly.

What is the Laffer Curve?

A graph showing the relationship between tax rates and tax revenue; high rates can reduce revenue beyond a certain point.

What is the optimal tax rate according to the Laffer Curve?

The rate that maximizes government revenue without discouraging work or investment.

What are current U.S. marginal tax rate ranges?

Between 35% and 40%.

What is the primary source of U.S. federal tax revenue?

Payroll taxes, which account for about 50

What is money?

Money is anything widely accepted for the purchase of goods and services and functions as a medium of exchange, unit of account, and store of value.

What are examples of money in the modern economy?

Currency (paper bills and coins), checkable deposits (bank accounts), and digital transfers (online/mobile payments).

What is a medium of exchange?

A function of money that allows people to trade without a barter system; eliminates the need for a double coincidence of wants.

What is the \"double coincidence of wants\"?

A situation in barter where both parties must want what the other has at the same time; money eliminates this problem.

What is the unit of account function of money?

Provides a common standard to measure and compare the value of goods and services.

What is the store of value function of money?

Allows money to retain its value over time and be saved for future use.

What is commodity money?

A physical good with intrinsic value (e.g., gold); tied to real value but hard to transport.

What is commodity-backed money?

Money exchangeable for a commodity at a fixed rate (e.g., one dollar in silver payable to bearer on demand).

What is fiat money?

Government-issued money with no intrinsic value; relies on trust and legal decree for its value.

What is cryptocurrency?

A digital, decentralized form of money secured by encryption; speculative and not universally accepted.

How is the money supply measured?

M = Currency + Deposits; M1 includes currency and checkable deposits, M2 includes M1 + savings and money market funds.

What are commercial banks?

Private firms that accept deposits and make loans; they act as intermediaries and channels for monetary policy.

What is a bank run?

A sudden withdrawal of funds by many depositors, threatening the bank’s ability to stay solvent under fractional reserve banking.

What is FDIC insurance?

Federal insurance for deposits up to $250,000, designed to prevent panic but may increase moral hazard.

What is moral hazard in banking?

When banks or depositors take more risk because they are protected from losses, e.g., by FDIC insurance.

What are bank reserves?

Funds held in the vault or at the Federal Reserve, used to meet withdrawal demands and provide liquidity.

How is the reserve ratio (rr) calculated?

Reserve ratio = Reserves / Deposits; e.g., 300M reserves ÷ 1000M deposits = 30%.

What is Interest on Reserve Balances (IORB)?

The interest rate the Fed pays to banks on their reserves; used as a tool to influence bank lending behavior.

How does lowering IORB affect the economy?

Encourages banks to lend more, increasing the money supply and stimulating economic activity.

How does raising IORB affect the economy?

Encourages banks to hold reserves, reducing lending and shrinking the money supply to slow inflation.

Why do banks hold reserves?

To meet withdrawals, follow regulations, and maintain liquidity in uncertain conditions.

What are key bank assets?

Reserves, loans (main income source), and securities like government bonds.

What are bank liabilities?

Customer deposits, savings and time deposits, and borrowings from other banks or the Fed.

What is owner's equity in a bank?

The difference between assets and liabilities; represents the bank's net worth or capital.

How do banks create money?

By holding a fraction of deposits in reserve and lending the rest, which gets redeposited and re-loaned repeatedly.

What is the simple money multiplier formula?

m^m = 1 / rr; e.g., if rr = 10%, multiplier = 10.

What are the main responsibilities of the Federal Reserve?

1. Conduct monetary policy, 2. Act as a central bank, 3. Regulate banks and ensure financial stability.

What is the federal funds market?

A market where banks lend reserve balances to each other overnight.

What is the federal funds rate?

The interest rate charged on loans between banks; targeted by the Fed to influence the money supply.

What are discount loans?

Loans directly from the Fed to banks; the interest rate charged is called the discount rate.

How does IORB help conduct monetary policy?

Adjusting IORB influences how much banks lend or hold in reserves, controlling the money supply.

What is the relationship between lending and reserve policy?

Lower reserves → more lending → increased money supply; higher reserves → less lending → reduced money supply.

Why is bank equity important?

Equity acts as a buffer against losses; negative equity indicates insolvency risk.

What are key takeaways about how banks operate

Banks pay low interest on deposits and lend at higher rates, only hold a fraction of deposits as reserves, and can become insolvent if loans default or too many depositors withdraw.

What happens to the money multiplier when people withdraw cash from banks?

The multiplier decreases because there's less money left in the banking system to be multiplied through lending.

What happens to the money multiplier when banks hold more reserves voluntarily?

The multiplier decreases because banks lend out less money, reducing the overall amount of money created.

What are Open Market Operations

The Fed buys or sells Treasury securities to adjust the money supply; a traditional, short-term, and flexible monetary policy tool.

What happens when the Fed buys Treasury securitites

It increases the money supply by injecting liquidity into the banking system.

What happens when the Fed sells Treasury securitites

It decreases the money supply by pulling liquidity out of the system.

What is Quantitative Easing

A non-traditional form of OMO where the Fed buys long-term bonds and troubled assets to stimulate the economy.

What happens when the Fed buys assets through QE?

t injects liquidity and increases the money supply.

What happens when the Fed sells assets through QE?

It tightens liquidity and decreases the money supply.

What is monetary policy?

The use of central bank tools to influence the money supply, interest rates, and macroeconomic conditions such as inflation, unemployment, and GDP growth.

What are the main tools of U.S. monetary policy?

1. Open Market Operations (OMO)
2. Quantitative Easing (QE)
3. Interest on Reserve Balances (IORB)
4. Lending Facilities

What is the federal funds rate?

The interest rate on overnight loans between private banks, targeted by the Federal Reserve to influence short-term interest rates and monetary policy.

What is expansionary monetary policy?

When the central bank increases the money supply to stimulate the economy, typically by lowering IORB, buying bonds, or opening loan facilities.

What are the short-run effects of expansionary monetary policy?

• Decrease in interest rates
• Increase in investment and consumption
• Increase in AD → Higher real GDP and lower unemployment
• Modest increase in the price level

What is contractionary monetary policy?

When the central bank reduces the money supply to combat inflation, often by raising IORB or selling bonds.

What is the loanable funds market?

A model showing how savings are loaned to borrowers, with interest rates balancing supply and demand for funds.

What happens in the long run after expansionary monetary policy?

Prices fully adjust, SRAS shifts left, real GDP and unemployment return to natural levels, and only the price level increases.

What is money neutrality?

The idea that changes in the money supply only affect nominal variables (like prices) and have no impact on real variables (like real GDP or employment) in the long run.

Why doesn’t monetary policy always work?

• It’s ineffective if inflation is expected.
• Doesn’t solve recessions caused by supply shocks.
• Can overstimulate or misfire if poorly timed.

Who is harmed by unexpected inflation?

Workers and suppliers with sticky prices or wages, as they suffer losses in real income or purchasing power.

What is the Phillips Curve?

A model showing a short-run inverse relationship between inflation and unemployment.

Who first identified the Phillips Curve relationship?

A.W. Phillips, observing UK wage inflation and unemployment.

What did Samuelson and Solow contribute to the Phillips Curve?

They popularized the concept in the U.S., suggesting policymakers could choose a tradeoff between inflation and unemployment.

What is the long-run Phillips Curve (LRPC)?

A vertical line at the natural rate of unemployment, indicating no long-run tradeoff between inflation and unemployment.

What is adaptive expectations theory?

The idea that people predict future inflation based on recent past inflation, leading to predictable errors when inflation changes.

What is rational expectations theory?

The idea that people use all available information to forecast future inflation, making monetary policy less effective unless it surprises.

How does inflation affect unemployment if it is expected?

If fully expected, inflation does not reduce unemployment; the real effects are neutralized.

What is stagflation?

A situation with both high inflation and high unemployment, typically caused by supply shocks.

What is active monetary policy?

The deliberate use of monetary tools to counteract macroeconomic fluctuations.

What is passive monetary policy?

A hands-off approach where the central bank focuses on maintaining stable money supply and prices

What is the Effective Tariff Rate (ETR)?

The total tariff revenue as a portion of all merchandise imports. Formula: ETR = Tariff Revenue ÷ Value of Imports.

What was the \"Liberation Day\" tariff policy?

A policy imposing a 10% tariff on nearly all imports and up to 145% on many Chinese goods.

What is absolute advantage in trade?

The ability of a country to produce more of a good using the same quantity of resources.

What is comparative advantage?

The ability to produce a good at a lower opportunity cost than others.

Can trade be beneficial if one country has an absolute advantage in everything?

Yes. Even with absolute advantage, trade is beneficial due to comparative advantage.

What is the opportunity cost of a good?

What is sacrificed or forgone to produce one unit of that good.

What is the key principle behind specialization in trade?

Countries gain by specializing in goods with low opportunity costs and trading for others.

What are the gains from international trade?

Comparative advantage, Economies of scale, Increased competition, Greater variety of goods, Fostering peace through interdependence

What are natural trade barriers?

Barriers like language and geography that naturally limit trade between countries.

What are man-made trade barriers?

Government-imposed restrictions like tariffs (taxes on imports) and quotas (quantity limits on imports).

What is a tariff?

A tax imposed on imported goods to make them more expensive and protect domestic industries.

What is a quota?

A legal limit on the quantity of a specific good that can be imported.

What effect does a tariff have on a market?

It reduces supply, increases prices, and lowers the quantity consumed.