econ unit 5

What are the two broad goals of macroeconomic policy?

Low and stable inflation; unemployment at or close to the supply

What are the two main components of macroeconomic policy?

Fiscal policy (government spending, transfers, taxes) and Monetary policy (central bank setting interest rates).

What does fiscal policy refer to?

Government decisions on spending, transfers, and taxation that influence aggregate demand.

What does monetary policy refer to?

Central bank actions aimed at influencing aggregate demand through interest rates.

How does fiscal policy impact aggregate demand?

Directly via government spending; indirectly via taxes and transfers affecting household disposable income.

How does monetary policy impact aggregate demand?

By changing borrowing costs, savings returns, and investment decisions through interest rates.

What are the three main tools of fiscal policy?

Government spending, government investment, and taxes/transfers.

What is government investment?

Spending on infrastructure and fixed assets, which contributes to aggregate investment (I).

What is a budget deficit?

When government spending exceeds tax revenue.

What is a balanced budget?

When government revenue equals government expenditure.

What is the central bank’s main monetary policy tool?

The nominal interest rate (policy rate, such as the SARB repo rate).

What is the Fisher equation?

Real interest rate = Nominal interest rate – Inflation.

What happens if policymakers do not respond to a negative demand shock?

Risk of deflation, falling inflation expectations, downward shift of the Phillips curve.

How do fiscal and monetary policies respond to a negative demand shock?

Both can stimulate AD, boost output, reduce unemployment, and push inflation back to target.

Why should there be a division of labour between fiscal and monetary policy?

To prevent overshooting; monetary policy focuses on inflation, fiscal on long

What is the limitation of fiscal and monetary policy in supply

side shocks?

What is inflation targeting?

Policy of using interest rates to keep inflation within a set target range (e.g., SARB 3–6%).

Why target inflation?

People dislike high or volatile inflation; low and predictable inflation stabilizes the economy.

What is the zero lower bound?

Nominal interest rates cannot fall below 0% because people would hold cash rather than pay banks.

Why is the zero lower bound important?

In deep recessions, policy rates may not be low enough to stimulate demand unless inflation is positive.

What is quantitative easing (QE)?

Central bank purchases of long

When was QE widely used?

During the global financial crisis (2007–2009) when short

What determines the long

run inflation rate?

What does it mean for inflation expectations to be anchored?

Wage

Why is anchored inflation important?

It reduces the cost of bringing inflation back to target during shocks.

How does monetary policy affect investment decisions?

Lower rates reduce discount rates, raising NPV of projects and encouraging more investment.

What is the investment decision rule?

Invest if Net Present Value (NPV) > 0, where NPV = Expected return ÷ (1+r) – cost.

What is the role of risk premium in investment?

Risky projects require higher returns; higher risk premiums reduce investment.

How do lower real interest rates affect asset prices?

They raise the present value of future returns, boosting demand and asset prices.

What is the effect of interest rates on exchange rates?

Higher rates → appreciation → reduced exports, increased imports → lower AD.

What is a nominal exchange rate?

The market rate at which one currency is exchanged for another.

What is a real exchange rate?

The relative price of foreign goods/services compared to domestic goods/services.

What happens when the real exchange rate rises?

Domestic goods become cheaper (real depreciation), boosting exports and output.

What are the four main transmission channels of monetary policy?

Market interest rates, Asset prices & confidence, Exchange rate & net exports, Import prices.

How does an appreciated exchange rate affect inflation?

It reduces import prices, raising real wages, and lowering inflation.

How can fiscal policy dampen fluctuations?

Through government spending, automatic stabilizers, and discretionary changes in taxes/spending.

What are automatic stabilizers?

Tax and transfer systems that automatically offset booms and recessions (e.g., progressive taxes, unemployment benefits).

What is discretionary fiscal policy?

Deliberate government actions (tax cuts or spending increases in recessions, contraction in booms).

Why is fiscal policy less frequently used than monetary policy?

Fiscal policy is constrained by annual budgets and slower implementation.

What is crowding out in fiscal policy?

Government spending displaces private spending when the economy is at full capacity.

What is psychological crowding out?

Households save more if they expect future tax hikes from higher government spending.

What is the paradox of thrift?

Collective attempts to save more during recessions reduce aggregate demand and worsen downturns.

What is the fallacy of composition?

What is true for individuals (saving more) may harm the whole economy by lowering AD and jobs.

What is austerity policy?

Cutting spending and raising taxes to reduce deficits; harmful if applied during recessions.

What is the alternative to austerity in recessions?

Allow automatic stabilizers to operate and provide fiscal stimulus until private demand recovers.

What is the main tool of monetary policy?

The short

Summary: What do fiscal policies affect?

AD directly via government spending and indirectly via taxes/transfers.

Summary: What do monetary policies affect?

Real interest rates, AD via consumption and investment, and exchange rates via net trade.