econ midterm 2

What is the big picture of monetary and fiscal policy?

Both are tools policymakers use to influence aggregate demand (AD), helping stabilize the economy during recessions or periods of high inflation.

Monetary policy is conducted by the Federal Reserve through interest rates and money/credit conditions; fiscal policy is conducted by Congress and the President through government spending, taxes, and transfers.

What are the Federal Reserve's main macroeconomic goals in this unit?

Promote economic stability, especially keeping inflation controlled and supporting employment/output near its potential. The Fed uses monetary policy to influence borrowing, spending, investment, and therefore aggregate demand.

What is the federal funds rate (FFR)?

The interest rate banks charge one another for overnight loans of reserve balances. The Fed sets a target range for it; changes in this rate influence other interest rates and spending throughout the economy.

What is expansionary monetary policy, and when is it used?

The Fed lowers its target for the federal funds rate to encourage borrowing and spending, especially during a recession or when output is below potential. Lower rates tend to increase consumption (C), investment (I), and net exports (NX), shifting AD right.

What is contractionary monetary policy, and when is it used?

The Fed raises its target for the federal funds rate to cool spending and reduce inflationary pressure, often when output is above potential or inflation is too high. Higher rates tend to decrease C, I, and NX, shifting AD left.

How do interest rates affect household consumption?

Lower rates make borrowing cheaper and saving less rewarding, encouraging households to spend more. Higher rates make borrowing costlier and saving more attractive, so consumption tends to fall.

How do interest rates affect business investment?

Lower rates reduce the cost of financing equipment, buildings, and projects, so investment tends to rise. Higher rates make projects more expensive to finance, so investment tends to fall.

How do interest rates affect net exports through the exchange rate?

Higher U.S. interest rates can attract foreign investment, increasing demand for dollars and causing the dollar to appreciate. A stronger dollar makes U.S. exports more expensive to foreigners and imports cheaper to Americans, so exports fall, imports rise, and NX falls. Lower rates tend to reverse this.

What is the basic chain from a Fed rate change to aggregate demand?

Fed changes its rate target → market interest rates/borrowing costs change → C, I, and sometimes NX change → aggregate demand shifts. Lower rates generally shift AD right; higher rates generally shift AD left.

Which curve shifts directly in this unit's monetary-policy framework?

Aggregate demand (AD). A monetary-policy change affects spending demand. It does not directly shift SRAS or LRAS in the immediate model used in this unit.

What is the Taylor Rule, and what is it used for?

A rule-of-thumb formula for an appropriate federal funds rate based on inflation and the output gap. It provides a benchmark for whether policy might be too loose or too tight; it is an approximation, not a rule the Fed must mechanically follow.

What is the Taylor Rule formula used in class?

FFR = inflation rate + neutral real interest rate + ½(inflation rate − 2%) + output gap. Use the class's assumed neutral real rate (about 1% in the review material).

What is the output gap?

The percentage difference between actual real GDP and potential real GDP. Positive output gap: actual output is above potential (economy running hot). Negative output gap: actual output is below potential (slack/recessionary conditions).

How does the output gap affect the Taylor Rule recommendation?

A positive output gap adds to the recommended rate, suggesting tighter policy; a negative output gap lowers the recommended rate, suggesting easier policy.

How does inflation affect the Taylor Rule recommendation?

Inflation above the 2% target raises the recommended federal funds rate, suggesting contractionary policy. Inflation below target lowers the recommended rate, suggesting expansionary policy.

What is the neutral real interest rate?

The real interest rate consistent with the economy operating around potential output and inflation stable. In the class review's Taylor Rule examples, use approximately 1%.

Taylor Rule example: inflation 3%, neutral real rate 1%, output gap +1%. What FFR is suggested?

3% + 1% + ½(3% − 2%) + 1% = 5.5%. The rule suggests 5.5%; compare this with the actual rate to determine whether it suggests raising or lowering rates.

What is the Fed's interest-rate corridor?

The discount rate is generally the ceiling, the federal funds rate is the market overnight rate targeted by the Fed, and the ON RRP rate serves as a floor. Interest on reserve balances (IORB) helps anchor rates near the upper part of the corridor.

What are the discount rate, interest on reserve balances, and Overnight reverse repurchase agreement rate?

Discount rate: rate banks pay to borrow directly from the Fed.

IORB: interest the Fed pays banks on reserve balances. ON RRP: rate the Fed offers eligible institutions for overnight reverse repurchase agreements, helping establish a floor for short-term rates.

Why is the Federal Reserve considered independent?

Monetary policy is insulated from day-to-day political pressure. Board governors are appointed by the President and confirmed by the Senate for fixed terms; the FOMC makes monetary-policy decisions.

What is fiscal policy?

Changes in government purchases, taxes, and transfer payments intended to influence aggregate demand and economic activity. It is set through the political process, involving Congress and the President.

What is expansionary fiscal policy, and when is it used?

Increase government purchases (G), cut taxes, and/or increase transfers to boost AD, often during a recession or when output is below potential.

What is contractionary fiscal policy, and when is it used?

Decrease government purchases, raise taxes, and/or reduce transfers to slow AD, often when the economy is overheating and inflationary pressure is high.

How do government purchases affect GDP directly?

Government purchases of goods and services are directly included in GDP's expenditure formula: GDP = C + I + G + NX. Increasing G therefore directly raises aggregate demand.

How are transfer payments different from government purchases?

Transfers (such as SNAP, Social Security, unemployment benefits, or stimulus checks) are payments to people, not purchases of currently produced goods/services, so they do not directly count as G in GDP. They can raise GDP indirectly when recipients spend them, increasing C.

What are automatic stabilizers?

Policies that automatically cushion the business cycle without a new legislative vote. Examples include progressive income taxes and unemployment insurance. During a downturn, tax payments tend to fall and benefits tend to rise, supporting disposable income and spending.

What is discretionary fiscal policy?

Deliberate new government action, such as a stimulus package, a change in tax rates, or an infrastructure spending bill. It usually requires legislation and can be slowed by legislative and implementation lags.

Why can fiscal policy be slower than monetary policy?

Fiscal changes often require Congress and the President to agree on legislation, and programs take time to implement. The FOMC can adjust monetary policy at its scheduled meetings without passing a new law.

What is the government purchases multiplier?

Multiplier = 1/(1 − MPC). It measures the total change in real GDP caused by a change in government purchases, including successive rounds of spending.

What is the tax multiplier?

Tax multiplier = −MPC/(1 − MPC). A tax increase reduces disposable income and spending, so the multiplier is negative; a tax cut raises GDP. Its absolute value is smaller than the purchases multiplier because households save some of a tax change.

What is the marginal propensity to consume (MPC)?

The fraction of an additional dollar of disposable income that a household spends. If MPC = 0.75, a household spends 75 cents and saves 25 cents of an extra dollar.

If MPC = 0.75, what are the government purchases and tax multipliers?

Purchases multiplier = 1/(1 − 0.75) = 4. Tax multiplier = −0.75/(1 − 0.75) = −3.

If MPC = 0.75, what happens to real GDP after a $100 billion increase in government purchases?

ΔGDP = ΔG × purchases multiplier = $100 billion × 4 = +$400 billion.

If MPC = 0.75, what happens to real GDP after a $100 billion tax cut?

Tax cut means Δnet taxes = −$100 billion. ΔGDP = tax multiplier × Δnet taxes = (−3) × (−$100 billion) = +$300 billion.

Why is the government purchases multiplier larger than the tax multiplier in absolute value?

Government purchases directly add to aggregate demand. A tax cut first increases disposable income, but households spend only the MPC share and save the rest, so the initial boost is smaller.

What are progressive, proportional, and regressive taxes?

Progressive: average tax burden rises as income rises (e.g., progressive income tax). Proportional: same tax rate across incomes. Regressive: lower-income people pay a larger share of their income (often illustrated by sales taxes).

What is a marginal tax rate, and how do tax brackets work?

The marginal rate applies to the next dollar earned, or income within that bracket—not to all income. With progressive brackets, only the portion of income in a higher bracket is taxed at that higher rate.

What is the difference between a budget deficit and a budget surplus?

Deficit: government spending exceeds revenue during a period. Surplus: revenue exceeds spending. A deficit adds to the accumulated national debt; a surplus can help reduce it.

What is the national debt, and how is it different from the deficit?

The national debt is the accumulated amount the federal government owes. The deficit is a yearly (or period) shortfall of revenues relative to spending; repeated deficits add to the debt.

What is crowding out?

When government borrowing to finance deficits pushes interest rates up and reduces some private investment. It is a possible longer-run concern of expansionary fiscal policy, depending on economic conditions.

How do monetary and fiscal policy differ at a glance?

Monetary policy: Fed/FOMC; changes interest-rate conditions; influences C, I, NX; generally quicker to adjust.

Fiscal policy: Congress and President; changes G, taxes, transfers; can directly change G; often slower because legislation is needed.

What is the main exam strategy for identifying the policy direction?

First decide the economic condition: recession/negative output gap → expansionary policy (AD right);

overheating/positive output gap or excessive inflation → contractionary policy (AD left).

Then identify whether the prompt is about Fed interest rates (monetary) or government spending/taxes/transfers (fiscal).

Reserve requirements

the minimum amount of liquid assets or cash that commercial banks and other depository institutions must hold in reserve rather than lend out or invest (set by the Fed)