5.2 The role of government: Introducing fiscal and monetary policy

how do the decisions and choices made by gov policymakers affect the macroeconomy?

• changes in gov spending directly affect aggregate demand

• taxes and gov transfers affect household incomes which affect demand too

fiscal policy

policies around taxes, gov transfers, and gov spending

**bc it also affects AD, it can be used by gov to stabilize AD, in this case called discretionary fiscal policy

monetary policy

central bank or government actions aimed at influencing economic activity through changes in interest rates

if gov can control or influence AD, what else can it influence?

levels of employment, unemployment, and inflation

demand shock

exogenous change to demand

government budget deficit

if gov spends more in total than it receives in tax revenue, gov budget is in a deficit

**sometimes they do this on purpose in order to stimulate spending

spending on goos and services + government fixed investment + transfers + interest payments - taxation

fiscal policy affects aggregate demand in 3 ways…

(1) government spending on G+S

(2) government investment (part of aggregate investment, I)

(3) taxes and transfer payments which affect aggregate demand indirectly by affecting household incomes

inflation target

government typically requires central bank (we assume central bank is in charge of controlling inflation) to keep inflation as close to a certain rate as possible

policy interest rate

changes in this interest rate affect changes in market interest rates i..e morgage interest rates - this is what central banks use to influence inflation

**this is a nominal interest rate that don’t change

real interest rate

the nominal interest rate adjusted for expected inflation

fisher equatoin

equation for the real interest rate

r = i - pi^E

real interest rate = nominal interest rate minus inflatoin expected over the year ahead

i = nominal interest rate

if pi^E = positive, that means inflation reduces the real interest rate

if pi^E = negative, that means inflation increases the real interest rate