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ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-10

ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-10. Fiscal Policy & Monetary Policy. What is Fiscal Policy? Fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full-employment, control inflation and encourage economic growth.

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ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-10

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  1. ECN 202: Principles of MacroeconomicsNusrat JahanLecture-10 Fiscal Policy & Monetary Policy

  2. What is Fiscal Policy? • Fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full-employment, control inflation and encourage economic growth. • Fiscal policy influences saving, investment, and growth in the long run. • In the short run, fiscal policy primarily affects the aggregate demand. • Fiscal policy includes • Changes in Government Purchases • Changes in taxes

  3. Fiscal Policy Choices: • Expansionary Fiscal Policy- When recession occurs expansionary fiscal policy can be implemented to prevent economic downfall. • Contractionary fiscal policy- When demand-pull inflation occurs, a restrictive or contractionary fiscal policy can be implemented to control it.

  4. Expansionary Fiscal Policy • During recession investment↓ as a result AD curve shifts to the left. • Expansionary fiscal policy can be taken 3 ways- • Increased Government Spending (G)- An increase in government spending shifts the AD to the right. • Tax reduction(T)- A decrease in taxes (raises income and consumption rises by MPC times the change in income). AD shifts to the right. • Combined Government spending increases and tax reductions

  5. Contractionary Fiscal Policy • When demand-pull inflation occurs, the demand for goods & services ↑ as a result investment↑ which shifts the AD curve rightwards. • Contractionary fiscal policy can be taken in 3 ways- • Decreased government spending- A decrease in G shifts the AD curve back to left. • Increased taxes- An increase in the tax will reduce income and thereby decrease consumption which shifts the AD curve to the left. • Combined government spending decreases and tax increases

  6. Effects of Fiscal Policy • There are two macroeconomic effects from the change in government purchases or taxes: • The Multiplier Effect: • Each dollar spent by the government or cut in taxes can raise the aggregate demand for goods and services by more than a dollar. • The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. • The formula for the multiplier is: • Multiplier = 1/(1 - MPC) Price level AD’’ AD’ AD GDP

  7. What is Monetary Policy • It consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy to achieve and maintain price-level stability, full employment and economics growth.

  8. Impacts of Monetary Policy on Aggregate Demand • Expansionary Monetary Policy: • Central bank lowers the interest rate • This in turn stimulates investment which increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. • Contractionary Monetary Policy: • Central bank raises the interest rate • This dampens investment which reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.

  9. The Tools of Monetary Control • The Central Bank has three tools in its monetary toolbox: • Open-market operations • Changing the reserve requirement • Changing the discount rate

  10. The Tools of Monetary Control • Open-Market Operations • The Central Bank conducts open-market operations when it buys government bonds from or sells government bonds to the public: • When the CB buys government bonds, the money supply increases. • The money supply decreases when the CB sells government bonds.

  11. The Tools of Monetary Control • Reserve Requirements • The CB also influences the money supply with reserve requirements. • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

  12. The Tools of Monetary Control • Changing the Reserve Requirement • The reserve requirementis the amount (%) of a bank’s total reserves that may not be loaned out. • Increasing the reserve requirement decreases the money supply. • Decreasing the reserve requirement increases the money supply.

  13. The Fed’s Tools of Monetary Control • Changing the Discount Rate • The discount rate is the interest rate the CB charges banks for loans. • Increasing the discount rate decreases the money supply. • Decreasing the discount rate increases the money supply.

  14. Problems in Controlling the Money Supply • The CB’s control of the money supply is not precise. • The CB must wrestle with two problems that arise due to fractional-reserve banking. • The CB does not control the amount of money that households choose to hold as deposits in banks. • The CB does not control the amount of money that bankers choose to lend.

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