UNIT 5- Fiscal & Monetary Combinations

Review of Fiscal & Monetary Policy

• Long Run Effects of Policies:

  • have to take a look at interest rates

  • high interest rates aren’t good for investment

  • low interest rates promote investment

Effects of Expansionary Fiscal Policy

1. Deficit Spending

   • government spending is greater than tax revenue

   • government must borrow money to finance the deficit

     • government issues bonds → supply of bonds increases which decreases the price of bonds and increases interest rates

2. Crowding Out

   • the budget deficit causes interest rates to rise, which hurts private investment

     • private investment gets crowded out by government borrowing

   • hurts the economy in the long run

   • reduces effectiveness of an expansionary fiscal policy

   • aggregate demand will increase, but not by as much as you would want it due to high interest rates

3. Monetizing the Deficit

   • Fed will increase money supply to keep interest rates from rising

     

Trade Off Between Inflation and Unemployment

1. Philips Curve - a graph relating to the rate of inflation to the unemployment rate

   • Short Run

     

     • A = high inflation, low unemployment

     • B = high unemployment, low inflation

     • short run Philips Curve works mostly when changes come from the demand side

       • demand-pull inflation

       • when changes come from the demand side you move along an existing short-run Philips Curve

     • Shifts in short-run Philips Curve:

       • cost-push inflation → shifts SRPC to the right

       • inflationary expectations → if we expect higher prices, we increase our demand today, which shifts SRPC to right

       • when AS decreases → SRPC shifts right

       • when AS increases → SRPC shifts left

   • Long Run Philips Curve

     

     • vertical at full employment level

Economic Growth

• An increase in the productive capacity of the economy

• Measured as a percentage change in Real GDP or per capita Real GDP

  • per capita = per person

• Growth is important to improving our state of living

• Evolving technology is part of growth

• Rule of 70/72 = divide the rate of growth into 70 or 72 → gives you the number of years it will take the economy to double its capacity

• shifts to right → economic growth

• Factors to Economic Growth:

  1. Productivity - key to economic growth

     • amount of output per unit of input

  2. Increase in real capital

     • interest rates go up → less real capital

     • interest rates go down → more real capital

  3. Improvement in worker skills (human capital)

     • education, training, etc.

  4. Improvement in technology

  5. Natural resources

     • abundance of natural resources increases growth

  6. Economic system to provide incentives to work, save, and invest

• Differences between Potential GDP and Actual GDP

  • Potential GDP is real GDP that the economy would produce if all of its resources were fully employed

  • Actual GDP is real GDP, that doesn’t necessarily mean you’re at full employment