Part I Unit 5 – Consequences of Policy

Federal budget deficit:

• Is the amount by which annual government spending exceeds tax revenues 

  • If the Government increases spending without increasing taxes they will increase the annual deficit and the national debt will increase

Federal budget surplus:

• Is the amount by which annual tax revenues exceed government expenditures 

• When a government receives more in taxes than it spends in a given fiscal year, resulting in a positive balance.

Crowding Out Effect:

• Government spending might cause unintended effects that weaken the impact of the policy 

  • The Gov’t may “crowd out” consumers and producers from the loanable funds market if they borrow in a deficit

Influence on Real Interest rates -

→The relationship between government borrowing and real interest rates is usually positive. 

When the government runs a budget deficit, it enters the loabable funds market…

increasing the total demand for credit  [ Increased Demand for Loanable Funds ]

If the supply of saving does not rise to meet the increased demand…

the competition for funds forces real interest rates up [ Higher Interest Rates ]

With rates increasing, it makes borrowing more expensive…

which causes private firms/bussiness to not invest and decreases household spending. [ Higher Cost of Borrowing ] 

What is implied by the Phillips curve?

Inflation rate and unemployment rate are inversely related

What 3 things change/affect the SRPC?

• A change in AD will cause movement along our SRPC

• A change in SRAS will shift our SRPC

• A change in expected inflation rate shifts SRPC

Where is the LRPC drawn?

Drawn at NAIRU [ Non-accelerating rate of unemployment ], which is demonstrated as a vertical line down the middle of the graph

What does LRPC imply about the relationship between inflation and unemployment in the long-run?

It implies that there’s not relation between inflation and unemployment

Disinflation:

Decrease in inflation

Deflation:

Negative inflation ( prices are falling )

What is the Quantity Theory of Money and the Equation of Exchange?

The amount of money in circulation is equal to the total value of all goods and services sold ( Nominal GDP )

Equation of Exchange:

MV = PY

Money Supply (M) x Velocity of Money (V) =

• Price Level (P) x Real GDP (Y)

Velocity of money

How many times a particular a particular dollar is used in a transaction in a given year

Why does this matter?

Is into that changing money supply only really changes inflation rate

If Money Growth > Output Growth

Inflation results ( Causes P rise ) 

If Money Frowth = Output Growth

Price levels remain constant ( P is stable )

What does the aggregate production function show us?

Shows that productivity is tied to the quantities of capital per worker as well as changes in technology

When you improve technology…

the aggregate production function grows

What is economic growth?

• An increase in real GDP per capita over time 

• Allows for permanent changes in output and productivity

 Economic growth [ Illustrated on graph ]

An outward shift of the PPC and LRAS

What causes economic growth?

Increase in productivity

Examples of causes of economic growth

Capital Stock

Increased use of new and better tech

Investment Spending is spending by business on capital, thereby increasing capital stock

What policies can the government use to try and encourage it?

• Human Capital per worker

• Technology

• Physical Capital per worker