Monetary and Fiscal Policy

Laissez-Faire Debate

  • All proponents agree less government intervention in the free market, the better the economy

Should the Government Intervene?

  • Fiscal policy is the change the government makes in spending or taxation, so as to achieve full employment and stable growth.

  • Pres and congress determine fiscal policy

Pros and cons

  • Some say that political officials may trad-off bad times now for better times in the future to advance their positions

Philip’s Curve

  • The idea that unemployment and inflation were directly correlated

  • This, however was proven wrong by the stagflation in the ‘70s

  • 3 other theories emerged:

  • Adaptive Expectations

  • Rational Expectations

  • Natural rate hypothesis

Natural Rate Hypothesis

  • There’s a natural rate of growth for real variables, like unemployment, RGDP, and real interest rates

  • it says these variables have a natural value, and the economy will readjust to put them back at their normal levels

  • Some believe that the philip’s curve is still useful in the short run because lower inflation will lead to higher unemployment.

  • So a politician can use expansionary fiscal policy during a recessionary gap to increase his odds of capturing his position

  • However, if the natural rate hypothesis is true, then the politician using expansionary fiscal policy may accelerate inflation without necessarily achieving lasting reductions in unemployment, as the economy adjusts back to its natural levels over time.

Monetary Policy

  • Changes in money supply designed to achieve full employment without inflation

  • Though, those at the FED are not as susceptible to the political arena, they do not congressional and presidential support

  • increasing money supply increases output in the short run, but in the long run results in inflation and contractionary gaps

Adaptive Expectations

  • People base their expectations of the economy’s performance on the recent past

Rational expectations

  • People make decisions on information they gather, so they make predictions based on how they know the economy works

Other implications

  • The 2 ‘80s recessions could have been less severe if the public had more trust that the FED could carry out its policy

  • A lot of inflation in the ‘70s was stopped through tight monetary policy, which caused many recessions in the early ‘80s

  • Many times the FED tried to enact a contractionary policy to decrease inflation, but the policy leaders would not allow for more unemployment

  • A contractionary policy increases interest rates, decreases investments, and the economy contracts, but the interest does lower as wells as the price level and RGDP

  • Fiscal and monetary policy both rely on the publics expectations

  • Permanent income theory: people spread their income over their lifetime

  • If the gov decreases taxes to stimulate the economy, households have more money, but will only spend it if they believe the tax cut is permanent, then fiscal policy is effective, but if they believe it is not permanent, then they will save it

Supply-side economics

  • production drives the economy, so making it easier on firms stimulates the economy

  • AKA Trickle-down economics

  • It did not work, but is related to fiscal policy