Fiscal Policy and Money

Module 10 - Fiscal Policy:

• Business cycle: the short-term fluctuations experiences in the economy due to changes in levels of economic activity

• Recession: a decline in real output for at least 2 consecutive quarters

• Expansion: a phase of the business cycle characterized by increasing rGDP, income, and unemployment

• Full-employment rGDP: the level of rGDP produced in an economy when it's operating at the natural rate of unemployment. Also, the level of rGDP when the economy is in a long-run equilibrium

  • Time on the horizontal and rGDP on vertical axis

  • Real GDP Expenditures: Y = C+I+G+NX

  • NX: X-M

  • DI: Y-T

• Fiscal Policy: changes in govt. Purchases/ taxes designed to achieve full employment/ low inflation. Sometimes called discretionary fiscal policy or activist fiscal policy

  • Elected federal govt.

• Expansionary Fiscal Policy: the application of fiscal policy to increase aggregate demand; involves increasing govt. purchases / decreases in taxes

  • When Y < Yfe

  • Increase in AD
    Expands rGDP

  • Reduces unemployment

  • shifts the AD curve to the right.

  • Govt purchases increases as taxes decrease

  • To calculate how much you need to increase: figure out MPC and then use equation (same for contractionary)

    • △AD = Multiplier e x △G

  • If the economy is experiencing a recession, the govt. May want to use expansionary fiscal policy to help the economy recover more quickly

• Short-Run Eq: AS=AD

• Long-run Eq: Y=Y full-employment

• Contractionary Fiscal Policy: the application of fiscal policy to decrease aggregate demand; involves decreasing govt. purchases / increasing taxes

  • If the economy is experiencing rising inflation, the govt. May want to use contractionary fiscal policy to help lower inflation

    • Controls Inflation

    • Contracts AD

    • Contracts rGDP

    • Because you don't was AS to decrease (leads to increase in prices, lowers GDP and ultimately stagflation) → use contractionary policy to decrease AD

  • Govt purchases decrease as taxes increase

    • If Y increases above Y* (full-employment level) - too much (Y is above Y*) = inflation so govt may reduce purchases - eventually getting closer to/reaching Y* due to multiplier effect

    • A small increase in Govt purchases can cause a large increase in rGDP

    • Or decrease taxes for same effect

    • The increase in taxes slightly shifts the AD curve to the left but the multiplier effect does the rest

• rGDP: Y* | horizontal line on business cycle (time on x and rGDP on y) 

• Decrease in taxes increases disposable income which increases consumption which then increases rGDP (Y) and then due to the multiplier effect consumers save more money and spend the rest (consumption continues to rise) and you eventually reach LREq

  • Y = C+I+G+NX
    NX=X-M

• Fiscal Policy Tools: changes in govt purchases and/or taxes designed to achieve full employment and low inflation. Sometimes called discretionary fiscal policy or activist fiscal policy

• Multiplier effect: the concept that an additional dollar of expenditures will result in the creation of more than 1 dollar’s worth of rGDP

  • Govt. Purchases (G)

  • Taxes (T) - more effective when they are below Y* (i think lol)

• Expenditures Multiplier: the effect that a $1 change in expenditure has on rGDP; calculates as the ratio of the total change in rGDP due to a change in initial expenditure

  • MultiplierE = change in Y / change in expenditures

  • MultiplierE = 1/ 1-MPC

  • MultiplierE = 1 / MPS

• MPC: the fraction of each additional dollar of income that is spent on consumption

  • Change in C (consumption) / Change in Y (corresponding change in income)

• MPS: the fraction of each additional dollar of income that is saved

• Using fiscal policy can reduce or eliminate negative effects of economic downturn such as rising unemployment

  • Change in savings / change in income

• Aggregate demand and Expenditures: change in AD = Multiplier x change in expenditures

• Cost-push inflation:  inflation that occurs due to a decrease in aggregate supply

• Demand-pull inflation: inflation that occurs due to an increase in aggregate demand

• Taxes (T): Revenues collected by the government. From individuals and firms

• Tax Multiplier: the effect that a $1 change in taxes has on real GDP; in the aggregate expenditure model, calculates as the change in output divided by an initial change in taxes

  • MultiplierT = Change in rGDP / Change in Taxes

  • MultiplierT = ΔY / ΔT

  • MultiplierT = - MPC / 1-MPC

• Not intervening when AD increases can cause inflation prices rise and purchasing power of savings decreases reducing wealth real value of wages fall in standards of living decrease

• If the economy is experiencing inflation the govt may want to use contractionary fiscal policy to help lower inflation

• Raising taxes and avoid demand-pull inflation - taxes can smooth the business cycle

• Automatic Stabilizers: a feature of existing government policy that automatically steadies the economy by decreasing government spending/ increasing taxes as an economy grows, or by increasing govt. spending / reducing taxes when an economy contracts

  • During a recession, automatic stabilizers cause average tax rates to fall, the amount of transfer payments to rise, helping to make the recession less severe, even without any directional govt. action . During expansion the exact opposite occurs

• Taxes: revenues collected by the government. From individuals and firms

• Transfer payment: a payment made by the government. That does not require an exchange of economic activity in return. Transfer payments often take the form of payments to households

• Progressive tax: a tax in which the average tax rate increases as taxable income increases (and decreases as taxable income decreases). 

• Limitations of Fiscal Policy:

• Recession: a decline in real output for at least 2 consecutive quarters

  • Have lasted about 12 months on average

  • Need time to collect and analyze data

• Legislative Lag: the time it takes for policy makers to pass legislation authorizing a new fiscal policy 

  • Political processes take time

• Implementation Lag: the time between when a policy is enacted and when it has its full effect on the economy

  • govt. Still has to spend money and needs time to work its way through the economy

• Recognition Lag: the time between when an event affects an economy and when we recognize that effect in the data collected

• Pro-cyclical: makes the business cycle worse

• Loanable Funds: Money that is available in an economy for the private sector and government to borrow

  • Lend money out on interest

• Crowding Out: the process by which an increase in government borrowing results in less borrowing by businesses and consumers for private investment

  • Increase in government spending financed by borrowing might be partially offset by lower investment spending in the private sector

  • Due to this, the net effect of fiscal policy on rGDP may be diminished making fiscal policy less effective

• Decrease in taxes: less tax revenue means govt may have to borrow money to fund its operations

• Interest rate: the payment made or agents that lend or save money, expressed as an annual percentage of the monetary amount or lent or saved. Sometimes called nominal interest rate or price of money

  • Higher interest rate affects gross investment

• Investment demand curve slopes downward:

• Expansionary fiscal policy government to borrow

Module 11 - Money: 

• Money: any item that both buyers and sellers will generally accept in exchange for goods and services

• Medium of exchange: any item used to facilitate trade between buyers and sellers; one of the functions of money

  • Using money in our economy makes it easier for people to make transactions with each other. Money is a medium of exchange; people do not have to try to find someone who want  what they have and who ahs what they want

• Unit of account: a measurement unit that allows buyers and sellers to easily compare the value of different g/s/r; one of the functions of money

  • Using money in our economy makes it easier for people to make transactions with each other. Money is a unit of account; the value of goods and services is expressed in monetary units (dollars, euros, of goods and services) making it easy to compare the prices of 2 different items 

• Store of value: a characteristic of certain assets that enables them to transfer wealth from the present into the future; one of the functions of money

  • Using money in our economy makes it easier for people to make transactions with each other. Money is a store of value; when a farmer sells his entire crop in 1 month, he can use the money he receives in exchange many months later t buy goods his family wants and needs

• Almost anything can be money

• Paper money was first created in the 11th century - in China

  • Functions of Money

  • Medium Exchange

  • Unit of accounts

  • Store of Value

• The Federal reserve tracks the money supply

• Liquidity: the degree to which an asset can be readily converted into currency

• Certificates of Deposit (CD): A common type of small-denomination time deposit in which savings are generally held for a fixed term before money can be withdrawn

• Currency: physical units of money, such as cash and coins

  • how easy it is to convert any asset (like a savings account into currency to keep in your pocket)

• Currency in circulation: currency held outside of banks that is in use by people and businesses.

• demand deposits: money held in an account that can be converted to currency on demand. often called checkable deposits or checking accounts. 

• Federal Reserve System: the central bank of the United States, consisting of 12 regional banks and the Board of Governors. The Federal Reserve System conducts monetary policy, supervises and regulates banks, monitors the stability of the financial sector, and provides financial services to the US government

• Traveler’s check: a certificate, or check, that can be converted to currency

•  M1: the most liquid measure of the money supply; includes currency in circulation, demand deposits, and other liquid assets

  • M1 = Currency in circulation + Demand deposits + Other checkable deposits + Traveler’s checks

  • Components of M1

    • Currency in circulation: very liquid

    • Demand deposits (checkings accounts)

    • Other Liquid Deposits

• M2: A broader measure of the money supply that includes M1 and adds ibn other, less-liquid forms of money like small-denomination time deposits and money market mutual funds

  • M2 = M1 + Savings Deposits + Time Deposits + Money Market Mutual Funds

• Components of M2: represents the total supply of money in the U.S.

  • M1

  • Small-Denomination Time Deposits: Certificate of deposit (CD)

  • Money Market Mutual Funds

• Time deposit: Money held in an account that cannot be converted to currency, without penalty, before a specified time

• Money Market Mutual Fund: a demand deposit that accepts deposits and purchases short-term bonds and commercial debt in order to pay interest on the deposited funds

• Equation of Exchange: a mathematical identity, MV=PY, which states that the money supply (M) times velocity (V) is equal to the price level (P) times output or rGDP (Y). The eq of exchange implies that nominal purchasing power (MxV) = expenditure (PxY)

  • Equation of Exchange: M x V = P x Y

• Nominal variables: Variables measures n the monetary units, or prices

• Real variables: variables measures in numerical units, or units of output

• Classical dichotomy: the idea that real variables such a employment and output are independent from nominal variables like money

• Velocity of money: the number of times, on average, and in a given time period that each dollar in a nation's money supply is used to make purchases

President Woodrow Wilson signed the Federal Reserve Act (1913) - established the Federal Reserve System: the central bank of the US consisting of 12 regional banks and the board of governors. The Federal Reserve System conducts monetary policy, supervises and regulates banks, monitors the stability of the financial sector and provides financial services to the US govt.