Macroeconomics Unit 4

Why doesn’t monetary policy work as well as fiscal policy to offset real (supply) shocks?

If the Fed targets inflation, unemployment will drop too much. If the Fed targets unemployment, inflation will rise too much.

Why shouldn’t the Fed ever target unemployment instead of inflation?

This could create “runaway inflation” where aggregate demand continues to rise as the Fed tries to keep unemployment in check, thus expectations rise and so does inflation with no plans of stopping because it doesn’t actually move the LRAS curve.

What types of variables should the Fed target?

Nominal variables (price level, inflation, NGDP, Nominal Wage).

What are the Fed’s two primary goals?

Keep employment maximized and inflation at approximately 2%.

Explain the two main difficulties faced by the Fed.

1. Time lags: the Fed is dealing with policies that take a very long time (6 months to a year and a half) to take effect, meaning their adjustments may be rendered null by changes in the economy since the time they put their adjustments into place.

2. Imperfect information: similar to time lags with policy efficacy, the Fed is getting information from months in the past, meaning they are trying to make policies based on old information (they never have any idea what the current economy is doing).

What are some rules and some discretions that the Fed has?

1. Discretion: the Fed has the freedom to use any means possible to achieve their dual mandate, making them flexible for addressing new scenarios.

2. Rules: the biggest two rules is that first they have to target their dual mandate, and second the Taylor Rule.

What is the Taylor Rule?

Interest on federal funds = neutral real interest rate (economy at full capacity) + current rate of inflation + 0.5 (inflation - 2%) + (output -2%).

What are the two largest costs of reducing inflation?

1. Higher unemployment.

2. Lower GDP growth.

What is the budget deficit?

How much the government collects per fiscal year vs. how much they spend per fiscal year. Government spending - government revenue (taxes).

What is the government debt?

The total amount of money the government owes to other countries, a sum of all deficits run by a government over the years - the total payments the government has made to pay some of it off.

What is the relationship between the federal budget deficit and debt?

New debt = previous debt + budget deficit OR (- budget surplus).

What are marginal tax rates?

The rates you pay on whatever money is in the different tax brackets (i.e., $10,000 - $30,000 = 10%, so you would pay 10% of that $20,000 whereas perhaps $30,000 - $60,000 = 15%, so then you would pay that first thing and then added onto it you would pay 15% of $30,000.

What are average tax rates?

The sum of all the taxes paid on income divided by the total income. This gives the total tax rate a person can expect to pay based on their income and can be used to calculate what you might expect to pay on total income.

How to calculate basic income tax?

1. Subtract either standard deduction or itemized deductions (whichever one is larger) from total income.

2. Multiply each tax bracket by the amount of income you have in each of the tax brackets, then add them up and that is your final tax amount.

What is the difference between itemized and standard deductions and when would someone choose to have itemized deductions instead?

Standard deduction is just the normal amount that would be deducted from a person, no paperwork required. Itemized deductions are interest on mortgages, medical expenses, state and local taxes, or charitable donations. Typically very rich families use itemized deductions because the interest on their mortgages combined with state and local taxes are higher than the standard deductions.

What are the three main categories of federal spending and a few specific examples of each?

1. Mandatory spending:

   1. social security

   2. medicare and medicaid

   3. unemployment benefits

2. Discretionary spending

   1. defense and military

   2. education

3. Net interest on debt (this portion continues to rise as the US goes into more debt)

What are transfer payments in federal spending?

Social security, medicare, unemployment benefits, etc.. These payments are made without any return, which is why they are called transfer payments because essentially the government sends the money we pay on taxes straight over to these programs. These make up around 60% of federal spending and growing as the population ages.

What is the single largest government program in the world?

Social Security (US).

What are payroll taxes?

Taxes that fund Social Security and Medicare, automatically taken out of our paychecks.

How does Alternative Minimum Tax (AMT) work?

Used for higher income people, AMT tax means you have to do your taxes two different ways:

1. Regular tax system

2. AMT system:

   1. Disallows many deductions/exemptions.

   2. Has a flat rate of 26% on first portion of AMT income.

   3. Has a rate of 28% on income above $232,000.

What types of income are taxed using investment taxes?

Capital gains (profit from selling stocks, real estate, etc.), interest, and dividends.

What are the three bad effects of fiscal policy?

1. Crowding out

2. Too small

3. Timing difficulties

How does crowding out work?

1. Government issues tax cuts to help stimulate growth.

2. Government is forced to spend more.

3. Government has to issue more bonds to gain more money.

4. Greater demand for loanable funds pushes up interest rates.

5. This makes borrowing more expensive for people and businesses.

6. Investment falls, making it more difficult for growth to occur.

How is fiscal policy too small sometimes?

With such a high US GDP, if there is any significant drop in AD, fiscal stimulus needs to make up far more ground than it can without doubling its discretionary spending almost.

What is the difficulty with timing with fiscal policy?

Recognition lag, legislative lag (time to get the laws passed) and implementation lag or the idea that the policy won’t actually begin to take effect until much later.

When is Fiscal Policy the right option?

When the federal funds rate is 0.

What is the spending multiplier and how does it work? When is it most effective?

The spending multiplier is the change in GDP per dollar of government spending (1 / 1 - MPC). It is most effective when the MPC (marginal propensity to consume) of a population is large.

What is the tax multiplier?

Tax multiplier is how much GDP will change for every $1 change in taxes: MPC / 1 - MPC.

Does the Fed “undo” fiscal policy?

Yes. Sometimes the Fed may undo fiscal policy because, while their goals are the same, fiscal and monetary policy take different approaches and react to different signals. For example, if fiscal policy cuts tax rates to try to stimulate growth, the Fed may see an increase in the monetary base and raise IORB’s, thus making interest rates grow and putting the economy into a recession, counteracting the fiscal policy.

Can fiscal policy help with supply shocks?

Yes, it is better equipped to do this than monetary policy because it is capable of making work force participation groups, making tax cuts, funding government programs, etc.

What are the three main components of the current account?

1. Trade balance

   1. Exports

   2. Imports

2. Income

   1. Income from investments held abroad

3. Net transfer payments

   1. Foreign aid, gifts to other countries, etc.

What are the three main components of the financial account?

1. Foreign direct investment

   1. Investments in physical assets or business operations in another country.

2. Portfolio investment

   1. transactions in stocks, bonds, or other assets.

3. Other investments

   1. Typically bank loans or foreign deposits.

What is a financial account surplus/deficit? What is a current account (trade) surplus/deficit?

Financial account surplus is when foreign deposits in the US are greater than US investments abroad and vice versa. Current account (trade) surplus is when foreign purchases of US assets are greater than US purchases of foreign assets and vice versa.

What is the relationship between financial account and current account?

When one is positive, the other must be negative (add them = 0). If one is running a deficit, the other must be running a surplus.

What is the interpretation of the fact that the US runs a constant trade deficit?

That the US is a really good place to invest in.

What is the equation for national savings?

GDP - consumption - government spending (Y - C - G)

What is the equation for GDP regarding net exports?

GDP = consumption + investment + government spending + net exports (Y = C + I + G + NX)

What is nominal exchange rate?

The amount of one currency it takes to have one of the other, for example Japan is 143 yen per dollar.

What is real exchange rate?

Real exchange rate = nominal exchange rate x (domestic price level / foreign price level), where nominal FX is foreign currency price of domestic currency.

How to find how much a of one good would be relative to that of the domestic good?

Amount of foreign good to buy same home good = (1 foreign currency / amount of home currency per 1 foreign currency) x (domestic units needed to buy home good) x (1 / foreign units needed to buy foreign good).

What happens when there is suddenly more/less demand for a type of currency?

1. More

   1. Currency appreciates

   2. Other countries want to sell to them to get more high powered currency

   3. Imports rise

   4. Exports fall

   5. Dynamic aggregate demand falls

2. Less

   1. Currency depreciates

   2. Other countries want to buy from them since it is cheaper

   3. Exports rise

   4. Imports fall

   5. Dynamic aggregate demand rises

To what value should the purchasing power parity approach?

1.

Why does the PPP always approach 1?

People will buy goods in the place where they are cheaper, increasing the demand for the cheaper country’s currency and causing their currency to appreciate, bringing the equation closer to 1.

Why would PPP deviate? List 3 reasons.

Transaction costs (shipping/contracts), non-tradable goods and services (haircuts), and tariffs and quotas (legal barriers to trade).