ECON 2020

Fiscal Policy

government utilizes spending tools (taxes and government spending) to influence macroeconomy

Expansionary Fiscal Policy (EFP)

government stimulates economy towards expansion by increasing G (increases I) or decreasing T (increases C)

Obama Fiscal Policy

Done to increase AD through government spending and tax cuts

Cons of EFP

Can lead to higher budget deficits and national debt during recessions

Contractionary Fiscal Policy

Government reduces G or increases T to decrease aggregate demand and slow expansion, decreases budget deficit

Countercyclical Fiscal Policy

Fiscal policy that aims to counteract the business cycle

Spending Multiplier

As new income generates additional spending, there’s a multiplier effect; spending becomes income to another; process leads to small increases in AD

Spending Multiplier Formula

1 / (1 - MPC)

Marginal Propensity to Consume (MPC)

Portion of additional income spent on consumption; formula is (change in consumption / change in income)

Time Lags in Fiscal Policy

Delays in the effects of fiscal policy due to various factors; include Recognition, Implementation, and Impact Lags; risk magnifying the business cycle

Recognition Lag

time it takes to identify a recession or expansion in the economy

Implementation Lag

Time taken needed to enact fiscal policy

Impact Lag

Result of time needed for multiplier to have full impact

Automatic stabilizers

Government programs that automatically implement CFP in response to economic conditions

Crowding Out

When private spending and investment falls in response to increases in G; results of higher interest rates due to government borrowing

New Classical Critique of Fiscal Policy

Increasing G and decreasing T are offset by increases in savings since people know they’ll have to pay higher taxes eventually; savings will then lead to less consumption

Saving Shifts

reallocation of funds to savings due to fiscal policy; if savings increases by entre amount of stimulus, its effects are negated

Supply-side fiscal policy

Involves use of government spending and taxes to affect supply side of the economy

Supply-Side fiscal policy during the Covid Recession

Involved aid to small businesses, loans to large corporations, hospital aid, and state/loval government aid

AD fiscal policy during the Covid Recession

Included tax rebates and unemployment compensation

Other policies of Supply Side Fiscal Policy

R&D tax credits, Education Policies, Lowering corporate/marginal income tax rates

Laffer Curve

illustrates relationship between tax rates and tax revenue (y axis is revenue, x axis is rate) two regions for below and above efficient rates

Money

Any generally accepted means of payment

Functions of Money

Medium of Exchange, Unit of Account, Store of Value

Types of Money

Commodity, Commodity-Backed, Fiat, Crypto

Commodity Money

Use of an actual good for money

Pros/Cons of Commodity Money

Pro: Value of money tied to something real

Con: Transportation Costs

Commodity-Backed Money

Represents ownership of a commodity and can be traded for it

Pros/Cons of Commodity-Backed Money

Pro: Value tied to something real

Con: Changes in commodity price affect all prices

Fiat Currency

Money issued by a government, valued by public trust but not tied to a commodity

Pros/Cons of Fiat Currency

Pro: Does not fluctuate with commodity values

Con: Governments often tempted to misuse discretionary powers

Pros/Cons of Crypto

Pro: Limited in Quantity

Con: No intrinsic value

M1

Money supply measure composed of currency and checkable deposits

Checkable deposits

deposits in back accounts from which depositors may make withdrawals by writing checks (In 2020, savings deposits also counted)

M2

M1 + Money market mutual funds + small-denomation time deposits (CD)

Purpose of Banks

Middlemen in the Loan Market, channel for monetary policy

Bank’s Balance Sheet

Includes Liabilities (Deposits, Borrowings, Assets (Reserves, Loans, Treasury securities), and Owner’s Equity

Reserves

Portion of bank deposits that are set aside and not loaned out

Fractional Reserve Banking

Banking system where banks hold a fraction of deposits in reserve (usually 15 to 25%)

Bank Run

Where many depositors attempt to withdrawal funds at the same time; follows when confidence in bank’s ability to meet withdrawal requests falls

FDIC

Insurance on deposited money from the Fed if bank goes under; up to 250k; leads to moral hazard

Moral Hazard

Lack of incentive to guard against risk where one is protected from its consequences (FDIC and Banks making risky investments)

Process of Banks creating Money

Based on lending activities; loans find their way back into system which is turned into more deposits

Assumptions of Money Creation Process

Fixed Reserve Ratio, all currency deposited in Banks

Reserve Ratio (rr)

Portion of deposits that banks keep on reserve

Simple Money Multiplier

Rate at which banks multiply money when all currency is deposited into banks; m^m = 1/rr

Responsibilities of the Federal Reserve

Monetary Policy, Central Banking, Bank Regulation

Federal Funds

Deposits that private banks hold on reserve at the Fed; fed pays interest and loans them out to other banks

Federal Funds Rate

Interest rate om loans between private banks; can be controlled by Fed

Discount Loans / Discount Rate

Loans from the Fed to private banks and the rate of interest paid on them

Monetary Policy Tools

IORB, Open Market Operations, Quantitative Easing, Lending Facilities, Discount Window, Reserve Requirements

Interest on reserve balances (IORB)

interest rate paid by the Fed on bank reserves deposited with the Fed; increases lead to fewer loans, decreases lead to more loans

Open Market Operations (OMO)

Involve purchase of sale of bonds by a central bank (usually short-term treasury bonds); done to increase money supply by putting money into the LFM or decrease by selling them

Quantitative Easing

Targeted use of OMO in which fed buys securities specifically targeting certain markets; usually non-traditional

Discount Window

Fed’s tool for extending loans to private banks; increasing and decreasing discount rate to discourage or encourage borrowing from the Fed

Lending Facilities

Fed’s tool for issuing loans to firms in targeted at-risk industries; used during COVID Recession to stabilize endangered firms

Reserve Requirements

Required percentage of deposits banks must keep in reserve, effect money multiplier

Monetary Policy in the Short Run

Increases AD, which in turn increases output and lowers unemployment; due to increased M lowering interest rates and encouraging investment

Expansionary Monetary Policy (EMP)

When central banks increase money supply in effort to stimulate economy; increases S of LF and lowers interest rates, leading to increased AD, Y, and P and decreased u

EMP in the Long Run

All prices adjust, real value of the dollar decreases, Y and u don’t change

Unexpected inflation hurting people

When inflation is greater than expected, workers with sticky wages, input suppliers with sticky prices, and lenders are harmed due to long-term contracts

Contractionary Monetary Policy (CMP)

Occurs when Fed acts to decrease the money supply; lowers supply in the LF and decreases AD through higher interest rates in short run

Why Doesn’t Monetary Policy Always Work?

Long-Run Adjustments, Adjustments in Expectations, Aggregate Supply Shifts

Long-Run Adjustment with MP

As prices adjust, economy returns to equilibrium, but this time with increased P

Money Neutrality

Idea that money supply does not affect real economic variables

Adjustments in Expectations with MP

When inflation is expected, Monetary policy does not work since SRAS will shift with AD; no real effects even in the short run

Aggregate Supply Shifts and MP

When supply shifts cause downturn, MP is less likely to work; happened with Great Recession where LRAS, SRAS, and AD shifted inward

Phillips Curve

short-run negative relationship between inflation and unemployment (more inflation, less unemployment); assumes inflation is always unexpected; developed by Samuelson and Solow

Long-run Phillips Curve

Straight vertical line where u = u*, since economy adjusts to natural rate

Adaptive Expectation Theory

Developed by Friedman; expectations of future inflation are based on most recent experience (tomorrow looks like today)

Stagflation

High unemployment and High inflation

Rational Expectations Theory

expectations are the result of all available information; does not imply predictions will always be correct

When inflation is predicted incorrectly

If overpredicted, unemployment rises; if underpredicted, unemployment falls

Active MP

strategic use of MP to counteract expansions and contractions; assumes Phillips curve is long run (which it is not, so caution is advised

Passive MP

When the Fed chooses only to stabilize money and price levels through MP; more common today

Trends in US Trade

Exporting more services, importing more goods, generally more imports than exports

Trade Balance

Difference between nation’s total exports and imports

Trade surplus

Positive net exports

Trade deficit

Negative net exports

Absolute Advantage

One party is able to create more with the same resources

Comparative Advantage

One is able to produce a good at a lower opportunity cost than someone else

Labor Intensive

Good that requires more labor-hours to make than another

Capital Intensive

Good that requires more capital investment to produce than another

Result of specialization in trade

Both countries’ PPF extend outward

Additional advantages to trade

Economies of Scale, Increased Competition, Trade Agreements

Protectionism

Blanket term for government policies that restrict international trade

Effective Trade Rate

Total tariff revenue as a portion of all merchandise imports; tariff revenue / imports

Natural vs. Manmade Trade Barriers

Language and Geography vs. Tariffs and Quotas

Tariff

Tax levied on imported goods; results in higher domestic prices, lower quantity of imports

Quota

Limit on quantity of products that can be imported into a country, results in same efficiency loss as tariffs

Reasons for Trade Barriers

National Security, Infant Industrie, Retaliation for Dumping, Favor to Special Interests

Infant industry argument

Domestic industries need trade protection until they are established and able to compete internationally

Dumping

Occurs when foreign supplier sells a good below the price it charges in its home country; done to gain foothold in foreign market

Balance of Payments

Record of all payments between one nation and the rest of the world

Current Account

Tracks all payments for goods and services, current income from investments, and gifts (US has deficit)

Capital Account

tracks payments for real/financial assets between nations and extensions of international loans (US as surplus)

Identity of Balance of Payments

Current account + Capital Account = 0

Causes of Trade deficits

Strong economic growth, Lower Personal savings rates, Fiscal Policy

Strong Economic Growth and Deficits

Domestic buyers purchase more imports (Current Deficit), foreign funds increase due to high return rates (Capital Surplus)

Lower personal savings rates and Deficits

falling domestic savings leads to widened finance gap, which is filled with foreign funds, leading to capital surplus