Comparing Fiscal & Monetary Policy

1. Comparing Fiscal & Monetary Policy

2. Fiscal Policy and the Budget Balance • The budget balance is the difference between the government’s tax revenue and its spending SGovernment = T – G – TR • Expansionary policies reduce the budget balance; contractionary policies increase it • However, budget balance is not the result of fiscal policy alone

3. Cyclically Adjusted Budget Balance • There is a strong relationship between the budget balance and the business cycle • Tax revenues and transfers are the greatest reason for this • Business cycle effects on the budget balance are temporary – eliminated in the long run • Cyclically adjusted budget balance is the estimate of the budget balance if GDP = YP so it is less volatile than actual budget balance • Removes effects of business cycle

4. Should the Budget Be Balanced? • Economists believe the budget should be balanced on average = deficits in bad years offset by surpluses in good ones • Persistent deficits raise public debt Problems posed by public debt • “Crowding out” • Interest payments put pressure on future budgets…

5. Deficits, Debt, & Implicit Liabilities • To assess the ability of governments to pay their debt, we use the debt-GDP ratio • As long as GDP outpaces debt, there is no concern about government’s ability to pay • Implicit liabilities are spending promises made by the government that are effectively a debt, though not included in current debt statistics • Cause the greatest concern about future debt & ability to pay

6. Monetary Policy and Interest Rate Fed Open Market Committee sets a target federal funds rate Fed expands money supply through open-market operations (oversimplified…) Lower interest rate results from increased money supply Leading to more investment spending Resulting in a higher GDP and higher consumer spending (The opposite for contractionary monetary policy)

7. Monetary Policy in Practice • Expansionary in times of negative output gap • Contractionary in times of positive (inflationary) gap • Taylor rule for setting federal funds rate takes into account both inflation and output gap FFR = 1% + (1.5 X inflation rate) + (0.5 X output gap %) • Fairly accurate predictor of Fed actions, though the fed funds rate can’t be negative even when there is a large negative output gap

8. Monetary Policy and the Long Run • Self-correcting economy means that demand shocks caused by monetary policy only have temporary effects Shift in AD as a result of money supply increase New output above YP, so wages rise Decrease in output in response to rising cost of inputs (AS shift) Return to equilibrium output, but at higher price level (Opposite effect for contractionary policy)

9. Monetary Neutrality • Monetary neutrality means that changes in the money supply have no real effect on the economy in the long run (though they have powerful effects in the short run) • Change in price level is proportional to change in money supply

10. Monetary Neutrality and Interest Rate Rise in money supply pushes down interest rate Greater demand causes aggregate price level to rise Raises demand for money Return to original interest rate

11. Final Thoughts on Fiscal & Monetary Policy Lags • Fiscal policy – Greatest lag is government choosing and implementing response • Monetary policy – Greatest lag is economy responding to policy • Our government does not set an inflation target, though we want low – but positive – inflation