Topic 5.1 Fiscal and Monetary Actions Study Guide

Review of Fiscal Policy Actions

Fiscal policy involves adjustments made by the government to taxes and spending levels to influence the aggregate demand ($AD$) of the economy. The specific actions depend on the nature of the economic gap:

• Inflationary Gap:     * To combat an inflationary gap, the government implements contractionary fiscal policy.     * Taxes: The government will Increase taxes to reduce disposable income and consumption.     * Government Spending: The government will Decrease expenditures to reduce the direct demand for goods and services.
• Recessionary Gap:     * To combat a recessionary gap, the government implements expansionary fiscal policy.     * Taxes: The government will Decrease taxes to boost disposable income and consumer spending.     * Government Spending: The government will Increase expenditures to directly stimulate economic activity and shift the $AD$ curve to the right.

Review of Monetary Policy Actions by Reserve Environment

Monetary policy tools utilized by the central bank differ depending on whether the banking system operates with scarce reserves or ample reserves.

• Monetary Policy with Scarce Reserves:     * Open Market Operations (OMO):         * Inflationary Gap: The central bank will Sell government securities to decrease the money supply.         * Recessionary Gap: The central bank will Buy government securities to increase the money supply.     * Reserve Requirement:         * Inflationary Gap: The central bank would increase the reserve requirement to limit lending.         * Recessionary Gap: The central bank would decrease the reserve requirement to encourage lending.     * Discount Rate:         * Inflationary Gap: The central bank would increase the discount rate to make borrowing from the Fed more expensive.         * Recessionary Gap: The central bank would decrease the discount rate to make borrowing from the Fed cheaper.
• Monetary Policy with Ample Reserves:     * Interest on Reserves (IOR):         * Inflationary Gap: The central bank would increase the Interest on Reserves to discourage banks from lending and keep money in the Fed.         * Recessionary Gap: The central bank would decrease the Interest on Reserves to encourage banks to lend to consumers and businesses.     * Administered Rates:         * Inflationary Gap: The central bank would increase administered rates (such as the Interest on Reserve Balances or the ON RRP rate) to raise the federal funds rate.         * Recessionary Gap: The central bank would decrease administered rates to lower the federal funds rate.

Impact of Policy Actions on AD and Interest Rates

The following reflects the movement of the Aggregate Demand ($AD$) curve and interest rates based on the type of policy applied:

• Expansionary Monetary Policy:     * AD Curve: Shifts to the right ($\uparrow$).     * Interest Rates: Decrease ($\downarrow$).
• Expansionary Fiscal Policy:     * AD Curve: Shifts to the right ($\uparrow$).     * Interest Rates: Increase ($\uparrow$) (typically due to the crowding-out effect or increased demand for loanable funds).
• Contractionary Monetary Policy:     * AD Curve: Shifts to the left ($\downarrow$).     * Interest Rates: Increase ($\uparrow$).
• Contractionary Fiscal Policy:     * AD Curve: Shifts to the left ($\leftarrow$).     * Interest Rates: Decrease ($\downarrow$).

Analysis of Combined Expansionary Fiscal and Monetary Policy

When both expansionary fiscal policy and expansionary monetary policy are implemented simultaneously, the following outcomes occur:

• Real Output: Increase (Both policies stimulate production).
• Price Level: Increase (Both policies are inflationary by nature as they increase $AD$).
• Unemployment: Decrease (Due to the increase in real output and demand for labor).
• Interest Rates: Indeterminate (Expansionary fiscal policy pushes rates up, while expansionary monetary policy pulls them down; the net effect depends on the relative magnitude of each policy).
• Investment: Indeterminate (Since the interest rate effect is indeterminate, the impact on gross investment is also unknown).
• Growth: Indeterminate (Economic growth is tied to investment; because investment is indeterminate, the long-term impact on the growth of the capital stock is indeterminate).

Analysis of Combined Contractionary Fiscal and Monetary Policy

When both contractionary fiscal policy and contractionary monetary policy are implemented simultaneously, the following outcomes occur:

• Real Output: Decrease (Both policies reduce overall spending and production).
• Price Level: Decrease (Both policies serve to lower inflationary pressure by reducing $AD$).
• Unemployment: Increase (Due to the decline in production and demand for labor).
• Interest Rates: Indeterminate (Contractionary fiscal policy reduces rates, while contractionary monetary policy increases them).
• Investment: Indeterminate (The path of investment depends on the indeterminate movement of interest rates).
• Growth: Indeterminate (Long-term economic growth remains uncertain based on the indeterminate level of investment).

Analysis of Contractionary Fiscal and Expansionary Monetary Policy

When contractionary fiscal policy is combined with expansionary monetary policy, the macroeconomic variables react as follows:

• Real Output: Indeterminate (Contractionary fiscal policy decreases $AD$, while expansionary monetary policy increases $AD$).
• Price Level: Indeterminate (The opposing forces on $AD$ make the final impact on the price level uncertain).
• Unemployment: Indeterminate (Because the impact on output is unknown, the effect on employment is also unknown).
• Interest Rates: Decrease (Both policies—reduced government borrowing/spending and increased money supply—work together to lower interest rates).
• Investment: Increase (Lower interest rates lead to a definitive increase in gross investment).
• Growth: Increase (Increased investment in capital goods promotes long-term economic growth).