Untitled Flashcards Set

stabilization function – attempts by government to minimize fluctuations in

overall macroeconomic activity.

• Fiscal Policy – Government policies related to spending and revenue generation.

• Monetary Policy – Government policies which determine a nation’s Money Supply.

• “The General Theory of Employment, Interest and Money” (1936) by John Maynard

Keynes – a book, written against the backdrop of the Great Depression, which was

in many ways an assault on “traditional macroeconomic thought” (previous

argument was for direct control of the macroeconomy)

▪ central argument of “The General Theory...”: markets are volatile and might

not result in “full employment”

▪ observed outcomes during Great Depression:

- people don’t have jobs/incomes

- without income people don’t buy output from firms

- firms can’t make profits, so they shutdown and layoff workers

- stable state with low resource use and low output

▪ low output equilibria caused by too little spending => recall, from our

discussion of GDP that: Y = C + I + G + NX => a low value of C can bring

down Y

- solution: replace missing private spending with government spending (i.e.,

offset the low value of C with a higher value of G ) => deficit spending as an

economic stimulus during downturns [a budget deficit occurs when

government spending exceeds revenues]

- corollary: government should cut back spending and run a surplus during an

expansion (this has often been overlooked) [a budget surplus occurs when

government revenues exceed spending]

- Key implication: Fiscal Policy can indirectly stabilize macroeconomic activity

(“spending against the wind”)

• Expansionary Fiscal Policy – increases in government spending or decreases in taxes

with the aim of stimulating overall economic activity

• Contractionary Fiscal Policy – decreases in government spending or increases

in taxes with the aim of dampening overall economic activity

• Crowding Out – decreases in private spending that occur following increases

in government spending

▪ as G is increased, does C remain constant or decrease? => a decrease in C

reveals “crowding out”

▪ If a significant amount of crowding out occurs, then the effectiveness of

stimulative Fiscal Policy will be reduced, since the government spending does not

create any new economic activity, but rather replaces private economic activity

with government economic activity (in a likely inefficient way)

▪ However, if instead productive resources are not fully employed, then government

spending will use otherwise idle resources and thus will generate new economic

activity => could lead to a significant short term increase in overall economic

activity as desired

• money supply – the amount of money in circulation in an economy (denoted M )

• velocity of money – the number of times that a typical dollar is used in market

transactions in a single year (denoted V )

• overall price level – the “average” of all the prices of goods/services traded (denoted

P )

• aggregate level of output – a measure of the real quantity of goods/services produced

(denoted Q )

• Equation of Exchange – an identity which relates the money supply, velocity of

money, overall price level, and aggregate level of output to each other: MV = PQ

• “A Monetary History of the United States, 1867-1960” (1963) written by Friedman and

Anna Schwartz – provided strong evidence to support a claim that the money supply

has a direct impact on short run levels of income, employment, and inflation

▪ In the decades following WW-II “Monetarism” emerged as an alternative to

“Keynesianism” => Monetarism argued that economic fluctuations depended

more on Monetary Policy than on Fiscal Policy

▪ Milton Friedman (1912-2006; Nobel Prize in 1976)

• loanable funds market – the collection of all markets in which lenders and borrowers

interact (e.g., mortgage markets, auto loan markets, consumer credit markets, business

loan markets)

▪ when loanable funds are more readily available, interest rates decrease =>

businesses are more inclined to build factories, expand production, and hire

workers, while households are more inclined to make major purchases

▪ starting at a point where Q is below its maximum, increasing the money supply

can lead to a real increase in economic activity (i.e., in Q )

• expansionary monetary policy – an increase in the money supply which provides

a short term stimulus to the macro-economy, resulting in higher levels of output,

employment, and incomes

• contractionary monetary policy – a decrease in the money supply which dampens

overall economic activity, resulting in lower levels of output, employment, and

incomes in the short term (but greater stability in the long term)

• central bank – entity which has the ability to alter the money supply of an economy

▪ Primary task is to control the nation’s money supply.

▪ U.S.: Federal Reserve (created in 1913)

▪ U.K.: Bank of England (created in 1694)

▪ Federal Reserve is an independent central bank, in that its actions are not

directly dictated by the legislative or executive branch

▪ experience suggests that independent central banks are better at promoting stable

economic growth and maintaining the value of a country’s currency => an

independent central bank is less vulnerable to short term political pressures

• fractional reserve banking system – a system in which at any point in time a

commercial bank is only required to retain a portion of the money it has accepted as

deposits

• Three policy tools of the Fed to alter the money supply:

1. open market operations – buying and selling of U.S. Treasury debt securities

to and from the public

o buying bonds puts more money in circulation (increases money

supply); selling bonds takes money out of circulation (decreases money

supply)

2. setting of reserve requirements – minimum restrictions on the amount of money

that a bank must keep on hand at any point in time, in the form of either cash in its

vault or deposits with the central bank

o lowering the reserve requirement increases the money supply; raising

the reserve requirement decreases the money supply

setting of discount rate – setting the interest rate that the Fed charges banks

on short-term loans

o lowering the discount rate increases the money supply; raising

the discount rate decreases the money supply

• So, why not always increase the money supply in order to stimulate economic

activity? Monetarist’s answer: In the long run, changes in the money supply have no

impact on the overall level of real economic activity, but rather only have an impact

on price

▪ in the long run, an efficient market economy will tend toward a situation in which

all resources are being used and society is producing close to its maximum level of

output (i.e., Q is at its maximum value)

▪ recalling MV = PQ , the only possible consequence of an increase in M is

ultimately a corresponding increase in P => an increase in the money supply will

not alter total output in the long run but will only increase prices in the long run

▪ Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”

• Inflation and Money Supply in Peru (1979-1991) => annual inflation rates of

3,398% in 1989 and 7,482% in 1990

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