Key Concepts in Fiscal and Monetary Policy, Unemployment, and Inflation

Fiscal policy

The government using spending and taxes to affect the economy.

Expansionary fiscal policy

When the government increases spending or cuts taxes to boost the economy.

Contractionary fiscal policy

When the government decreases spending or raises taxes to slow the economy.

Fiscal stimulus

Government action meant to increase aggregate demand during a weak economy.

Aggregate demand

Total spending in the economy.

AD formula

AD = C + I + G + NX.

Consumption (C)

Spending by households on goods and services.

Investment (I)

Spending by firms on projects, equipment, or buildings.

Government spending (G)

Spending by the government on goods and services.

Net exports (NX)

Exports minus imports.

Countercyclical fiscal policy

Policy that goes against the business cycle to smooth out recessions and booms.

Automatic stabilizers

Policies that automatically help stabilize the economy without new laws.

Examples of automatic stabilizers

Unemployment benefits and proportional tax rates.

Paradox of thrift

When everyone saves more during a recession, total spending falls and the economy can get worse.

Fallacy of composition

What is true for one person is not always true for the whole economy.

Budget balance

Government receipts minus government outlays.

Budget surplus

When government revenue is greater than spending.

Budget deficit

When government spending is greater than revenue.

Balanced budget

When government revenue equals spending.

Federal debt

The total amount owed by the federal government.

Deficit vs. debt

Deficit is yearly overspending, while debt is the total amount owed.

Austerity policy

Cutting government spending or raising taxes to reduce deficits.

Inflation

An increase in the overall price level.

Deflation

A decrease in the overall price level.

Disinflation

A decrease in the inflation rate.

CPI

Consumer Price Index, a measure of consumer prices.

GDP deflator

A measure of the overall price level compared to a base year.

Recession

The period from a peak in GDP to the next trough in GDP.

Structural unemployment

Unemployment caused by changes in the economy or mismatch of skills.

Frictional unemployment

Unemployment from people searching for jobs.

Cyclical unemployment

Unemployment caused by a recession or weak economy.

Natural rate of unemployment

Frictional unemployment plus structural unemployment.

Labor force

Employed people plus unemployed people.

Unemployment rate

Unemployed divided by the labor force times 100.

Labor force participation rate

Labor force divided by working-age population times 100.

Discouraged workers

People who stop looking for work and leave the labor force.

Monetary policy

Policy controlled by the Federal Reserve that affects interest rates and money.

Who controls U.S. monetary policy

The Federal Open Market Committee, or FOMC.

Expansionary monetary policy

Lowering interest rates to increase borrowing and spending.

Contractionary monetary policy

Raising interest rates to reduce borrowing, spending, and inflation.

Inflation hawks

Central bankers who worry more about inflation and raise rates sooner.

Inflation doves

Central bankers who are more patient about inflation and worry more about unemployment.

Federal funds rate

The interest rate banks charge each other for short-term loans.

Positive bargaining gap

Inflation pressure is rising because workers/firms are pushing wages/prices up.

Negative bargaining gap

Inflation pressure is falling.

Phillips curve

The relationship between unemployment and inflation.

Stagflation

High unemployment and high inflation at the same time.

Debt

to-GDP ratio - Government debt compared to the size of the economy.

MPC

Marginal propensity to consume, or the fraction of extra income spent.

MPS

Marginal propensity to save, or the fraction of extra income saved.

MPC plus MPS

MPC + MPS = 1.

Multiplier

The amount GDP changes after a change in spending.

Basic multiplier formula

Multiplier = 1 / (1 - MPC).

Detailed multiplier formula

Multiplier = 1 / [1 - c1(1 - t) + m].

Higher MPC effect on multiplier

Higher MPC makes the multiplier bigger.

Higher tax rate effect on multiplier

Higher taxes make the multiplier smaller.

Higher imports effect on multiplier

Higher imports make the multiplier smaller.

Leakages

Saving, taxes, and imports that reduce the multiplier.

Equilibrium output

Where output equals aggregate demand.

Autonomous consumption (c0)

Spending that happens even if income is zero.

Change in GDP formula

ΔY = multiplier × ΔG.

New GDP formula

Ynew = Yold + ΔY.

Investment decision rule

A firm does a project if the expected rate of return is greater than the interest rate.

Present value decision rule

A firm does a project if the present value of benefits is greater than the present value of cost.

Normative statement

A statement based on opinion, values, should, ought, or more important.

Positive statement

A factual statement that can be tested or proven true or false.

Ceteris paribus

All else equal.