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Unit Five Stabilization Policies

Unit Five Stabilization Policies. Fiscal and Monetary Policies Demand-Side Effects Supply-side Effects Policy Mix Government Deficits and debt The Phillips Curve Short-run and long-run Phillips curves Demand-pull versus cost-push inflation Role of Expectations. Stabilization Policies.

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Unit Five Stabilization Policies

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  1. Unit Five Stabilization Policies

  2. Fiscal and Monetary Policies Demand-Side Effects Supply-side Effects Policy Mix Government Deficits and debt The Phillips Curve Short-run and long-run Phillips curves Demand-pull versus cost-push inflation Role of Expectations Stabilization Policies

  3. Government’s manipulation of taxing and spending Fiscal Policy

  4. Any change in government spending or taxation that increases aggregate demand 1. Reduction in taxes 2. Increase in government spending Expansionary Fiscal policy

  5. Households disposable income is increased, leading to more consumption Firms have a greater incentive to expand output because they get to keep a greater percentage of their profits. Reduction in taxes

  6. G is a component of AD so money spent on public goods (schools, bridges) contributes directly to total demand for output in nation G leads to new household income which leads to further increases in consumption and investment by firms Increased government spending

  7. Global Government Spending

  8. Effect of Expansionary Fiscal Policies

  9. Shift AD to the right (increasing output, employment, and price level The degree to which a particular cut in taxes or increase in G depends on The size of the tax multiplier (in the case of a decrease in taxes) The size of the spending multiplier (government spending) Effect of expansionary fiscal policy

  10. The degree to which a cut in taxes will increase total spending in a nation Depends on the marginal propensity to consume (MPC) and the marginal propensity to save (MPS) Tax multiplier: t = -mpc/mps Tax Multiplier

  11. In Country A, the marginal propensity to consume equals 0.8. the MPS is therefore equal to 1-MPC=0.2. The tax multiplier in this country, t= -0.8/0.2=-4 The Tax Multiplier = -4 A particular decrease in taxes will lead to an increase in spending 4 times the initial cut in taxes Tax Multiplier Example

  12. Assume Country A (MPC= .8) reduces taxes on households by 10 billion Using t of -4 We can conclude that the tax cut will increase total spending by 40 billion dollars (-4 X -10 billion) Using MPC to tax multiplier

  13. The degree to which an increase in government spending will increase total spending in a nation Depends on the marginal propensity to save (MPS) Spending multiplier: k = 1/mps The Spending Multiplier

  14. Country A (MPC = .8) decides to increase government spending by 10 billion Spending multiplier (k) = 1/.2 K = 5 Increase in government spending of 10 billion will increase AD by 50 billion. Example

  15. The tax multiplier will always be less than the spending multiplierAn increase in spending of a certain amount will always have a greater effect than a tax cut of the same amount

  16. Government spending is a direct injection into circular flow whereas a tax cut is indirect because the money spent in the economy depends on the decisions of the household. WHY Will G always have a greater impact (when the amount is the same)

  17. Country M reduces taxes by 20 million dollars. It has a MPC of 75% Total spending will increase by how much???? Instead of cutting taxes by 20 million, the government of country M spends the 20 million. Total spending will increase by how much? ..

  18. Italy reduces taxes by 50 million euro. If Italy’s marginal propensity to consume is .75. How much total spending is projected to take place? What would be the projected aggregate spending in Italy if the government invested 50 million euro in the Italian healthcare system? Question of the day

  19. For your homework, please draw A correctly labeled AS/AD curve at equilibrium Show a shift that would result from an increase in GDP A correctly labeled money market graph Show a shift that would result from an increase in GDP A correctly labeled loanable funds market Show a shift that would result from an increase in GDP Homework: Due 2.27Nine points

  20. Any change in government spending or taxation that reduces aggregate demand -lead to lower price levels reduce output reduced employment Contractionary Fiscal POlicy

  21. Increased Taxes Decreased Government Spending Contractionary Fiscal POlicy

  22. Households will less disposable income (consumption will decrease) Firms will be able to keep less of their profits (investment will decrease) Increased taxes

  23. Fewer employment opportunities in the public sector – reducing demand for goods and services Households will experience lower incomes Decrease in Government SpenDing

  24. Decrease output, PL, and employment. Why do this??? If the nation is producing beyond full employment with high inflation rate Raising taxes will have a weaker effect on AD than cutting spending by the same amount (same as expansionary) Effect of contractionary fiscal policies on economic activity

  25. The nation of Eyepatch has a marginal propensity to save of 20%. If Eyepatch increases taxes by 10 million, how much will spending decrease? If Eyepatch cuts spending by 10 million, how much will spending decrease? Tax multiplier and Spending multiplier with contractionary fiscal policy

  26. Following any change in fiscal or monetary policy, AD will either increase or decrease. When expansionary policies should be used . Periods of high unemployment Periods of deflation Short-Effects of fiscal and monetary policies on demand

  27. Expansionary policies should be used only during recessions. In the short run, expansionary policies will lead to Increase in AD Increase in PL Increase in employment Increase in total output

  28. Expansionary policies should not be used when an economy is already producing at or beyond its full employment level. If a government does use expansionary policies in this situation: An increase in AD Little or no increase in employment Little or no increase in output A large increase in the price level

  29. Contractionary policies should be used only during periods of high inflation, when unemployment is already at or below the NRU. In the short run, contractionary policies will lead to A decrease in AD A decrease in the level of national output A decrease in employment A decrease in the PL (or inflation rate) Contractionary policies

  30. Contractionary policies should not be used when an economy is already producing at a level of output below its full-employment level or when an economy is in a recession. If these policies are used during a recession” AD will decrease Unemployment will increase National output will decrease The PL will slightly decrease

  31. Fiscal and monetary policies are almost always demand-side policies in that they change aggregate demand. In summary

  32. What would happen if policy makers put expansionary policies into place when they were not needed? What would happen of policy makers put contractionary policies into place when they were not needed? Questions of the Day

  33. Supply-Side economics

  34. The Crowding-out effect of expansionary fiscal policy How fiscal policy can affect AS Expansionary Monetary policy’s effect on Aggregate Supply How monetary policy can affect AS Short run effects of fiscal and monetary policies on AS

  35. Government borrows from private sector to finance a budget deficit resulting from a tax cut or government spending Interest rates may be driven up in private sector (remember the loanable funds FRQ) Lead to a reduction in private investment Reduces the expansionary effect of the fiscal policy Crowding out can increase the costs faced by private firms The crowding-out effect of Expansionary fiscal policy

  36. The Effect of Crowding Out (higher interest rates and reduced private investment caused by government borrowing) Reduction in aggregate supply Reduction in output Reduction in employment Increase in price level The crowding-out effect of Expansionary fiscal policy

  37. Expansionary Fiscal Policy can cause crowding out from government borrowing which can lead to higher IR and a reduction in AS. Expansionary Fiscal – reduce AS Expansionary Monetary Policy can cause a decrease in the interest rate which will reduce firms’ costs and may increase aggregate supply. Expansionary Monetary – increase AS

  38. Central banks expands money supply Firms find it cheaper to borrow funds for investment Firms hire more workers and may pass their savings onto consumers Expansionary Monetary Policy’s Effect on AS

  39. Expansionary Monetary Policy can have positive supply-side effects: An increase in aggregate supply An increase in output An increase in employment Expansionary Monetary Policy’s Effect on AS

  40. Draw two comic strips depicting The crowding-out effect on AS The effect of expansionary monetary policy on AS Homework: Due 3.1

  41. P.S. Expansionary Monetary Policy is most often considered a demand-side policy.

  42. Question of the Day The government borrows 10 billion dollars from the private sector to finance a new drone project. If the MPC = 75%, how much total spending will take place in the economy? Please draw an AS/AD curve that shows the effect of the government’s investment on AD and on AS.

  43. Long-run Effects of Fiscal and Monetary Policies

  44. Prices and wages are taken into account In periods of high inflation and low unemployment Workers’ real wages will decline as prices rise In the long run, workers will demand higher wages This will increase costs to firms When we move from short-run to long-run

  45. Prices and wages are taken into account In periods of deflation and high unemployment Workers’ real wages will increase as prices fall In the long run, workers will be willing to accept lower wages (because of high unemployment) This will decrease costs to firms When we move from short-run to long-run

  46. In the wake of any expansionary demand side policy, there will be A short-run increase in AD A short-run change in output, price level, and employment BUT . . . In the long run 1. Output will always return to its full-employment level Expansionary Demand-side policies and long-run output

  47. Assume that the government or central bank undertakes expansionary policies to increase AD AD, output, prices, and employment will increase Greater demand for the limited amount of output will increase PL (demand-pull inflation) In the short run, wages are fixed so higher PL will reduce real wages As unemployment falls below the natural rate, increased competition for jobs puts upward pressure on wages Nominal wages will rise as increasingly scarce workers demand higher wages The higher wage rate raises the costs of hiring workers, forcing a reduction in employment, and higher prices for consumers In the long run, output and employment will return to full-employment level, and PL will increase.

  48. Increase in ADDecrease in ASOne LRAS

  49. Expansionary demand-side policies by themselves will have no effect on the long-run level of full employment output. Effect of expansionary policies on long-run output

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