Midterm 2 - Monetary & Fiscal Policy

What is monetary policy?

Setting interest rates to influence economic conditions

What is fiscal policy?

Using government spending and taxation to influence economic conditions

What is the fed’s dual mandate?

1. Maintain Stable prices

2. Promote maximum sustainable employment - low interest rates —→ increase GDP —→ more employment

What is the zero lower bound?

Nominal interest rates can’t go below o

Demerits of increased government spending

1. Crowds out private spending

2. Investment is particularly vulnerable because increased gov spending —→ higher interest rates —→ harder for businesses to take out loans

What is the fiscal multiplier?

Measure of how much GDP changes as a result of both direct and indirect effects flowing from an extra dollar of spending. It captures both the increase in GDP as well as crowding out effects

Why is LRAS vertical

If price doubles, in the long run, input prices also double so firms don’t want to produce more or less than before

Classical Dichotomy

Purely nominal changes (like inflation) won't have any effect on real variables in the long run

why is there no long run aggregate demand?

it doesn’t matter how much people want because it is limited by how much we can produce

Long run output

in the long run, real GDP will return to potential GDP

SRAS basically shifts back until it reaches the LRAS

if LRAS rises so does SRAS

What shifts the LRAS

1. More workers (population)

2. Capital Stock (machines)

3. Technology

4. Discover more natural resources

Natural recovery long run

recession —→ high unemployment —-→ wages fall —→ SRAS shifts right

Where does the majority of federal spending go?

social insurance programs and national defense

Discretionary spending

spending that the fed decides on annually (military)

Mandatory spending

Spending set by law (social security, SNAP, farm subsidies)

What are payroll taxes for?

fixed tax on earned income

fund social security

what are income taxes?

progressive tax

tax on all money regardless of the source

Standard deduction

first bit on income that the government doesn’t tax

What is a budget deficit

When the government spends more than it earns; accumulation of budget deficits is known as debt

business cycles create deficits even if spending doesn’t change

How does the government fund a deficit

by borrowing money via bonds

How can we think about government debt

1. debt to gdp ration

2. How is debt vs gdp growing

3. Compare to other contries

4. Compare to history

Why shouldn’t we worry about US debt?

1. most of it is owed by Americans (more than half is owned by investors)

2. Future generations can repay it

3. Wouldn’t take big adjustment to repay the debt (small decrease in spending per person)

4. Gov can roll over debt via new bonds

5. raise taxes, print money, etc.

Why should we worry about US debt?

1. higher debt = slower growth

2. future fiscal stimulus is constrained

3. Risk a confidence crisis

4. at some point too much debt leads to debt crisis