REV - Stabilization Policies

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Stabilization Policies

Fiscal Policy

The government has two tools for regulating fiscal policy: a change in government spending or changes in taxes. The government can also use both if it thinks the economy needs it.

Inflationary Situation

1. The government has two tools for regulating fiscal policy: a change in government spending or changes in taxes. The government can also use both if it thinks the economy needs it.

2. If the inflation is demand-pull inflation, the government should use a Contractionary fiscal policy.

3. It can decrease government spending, increase taxes, or both.

4. The government is aiming for a budget surplus, where tax revenues are larger than government spending. Both

5. Increased taxes and decreased government spending reduces consumption spending, which causes a decrease in aggregate demand.

6. Then, if prices are flexible downward, the decrease in aggregate demand causes the equilibrium price level to decrease, ending the inflation.

7. If prices are not flexible downward, the policy will stop price level from increasing. Since inflation usually occurs in the vertical range of the aggregate supply curve, GDP shouldn’t decrease by much.

Recessionary situation

1. The government now needs to use an expansionary fiscal policy. The aim of the policy is to increase aggregate demand, which shifts the AD curve to the right and will cause an increase in real GDP.

2. The government has two tools to use: it can increase government spending or decrease taxes (or both). Increasing government spending will increase aggregate demand (since AD=C+Ig+G+Xn). Decreasing taxes will increase consumption spending (it increases it by the tax increase times the MPC), which will also increase aggregate demand.

3. Then, since aggregate demand is increased (rightward shift of AD curve), equilibrium GDP will either increase (if the economy is in the horizontal or intermediate ranges) or stop declining (if the economy is in the vertical range).

4. If the economy is on the horizontal range, the full effect of the multiplier will be felt: when AD increases by an amount, GDP will increase by the multiplier times that amount.

5. The final equilibrium will have a higher GDP and the same or slightly increased price level since recession usually means the horizontal range of the AS curve.

 

Phillips Curve

  • Philips curve: a curve showing the relationship between the unemployment rate and the inflation rate. In the short run it shows a negative (inverse) relationship. In the long run there is no relationship.

The main concept of this is a stable, inverse relationship between inflation and unemployment. The short-run Phillips curve has a negative slope; the long-run Phillips curve is vertical. The Adaptive Expectations Theory predicts that there is a short-run tradeoff between inflation and unemployment but there is no long-run tradeoff. In the short run, the inverse relationship works, but in the long run, it seems that the graph will always shift back to a vertical line.

 

Inflation & Taxes

Inflation: a rise in the general level of prices in the economy (percentage change in either the CPI or the GDP deflator)

Both fiscal and monetary

Summary: recessionary
  • Fiscal policy: increase government spending, decrease taxes
  • Monetary policy: loose money policy – buy government securities, lower reserve ratio, lower discount rate
Summary: inflationary
  • Fiscal policy: decrease government spending, increase taxes
  • Monetary policy: tight money policy – sell government securities, raise reserve ratio, raise discount rate

The Federal Government (Washington DC) can alter its taxes and spending to try and stabilize the economy – this is called “fiscal policy”. Some fiscal policy takes place automatically (called automatic stabilizers) and some requires acts by Congress and the President (discretionary).

  • Automatic include:welfare payments, unemployment compensation, progressive tax structure
  • Regulations can also influence the economic situation, but regulations are not normally changed to change the economic situation

Cyclical unemployment: Unemployment caused by insufficient AD.

 

Government Debts and Deficits

Deficit spending is expansionary, and it counters recession. There’s two ways of financing a deficit. The government can enter the money market and borrow, competing with private business borrowers for funds. This might cause a crowding- out effect, “taking up” some space for investment spending and consumer spending.

The crowding-out effect reduces the expansionary impact of the deficit spending. The government can also make more money, making spending increase without any harm done to investment. However, making more money can have an inflationary effect too.

To counter demand-pull inflation, fiscal policy has to involve making a budget surplus. However, a surplus can do one of two things: debt reduction (paying off debt, but then it might offset the anti-inflationary impact because the government is putting money back into circulation), or impounding (keeping the surplus funds, doing nothing with them; this way, the full extent of the anti-inflationary policy will be met). Debt can actually be inflationary because if the government tries to pay it off quickly, there will be inflation because the money supply increases.

 

Impact of policies on AS/AD

Impact of policies on AD/AS equilibrium

1. An expansionary fiscal policy shifts (or tries to shift) the Aggregate Demand curve to the right. This will shift the equilibrium GDP up (as long as the economy isn’t in the vertical range) and shift the price level up (as long as the economy isn’t in the horizontal range).

2. Usually, the government uses an expansionary fiscal policy when the economy is in the horizontal range, so the policy only shifts equilibrium GDP up.

3. A Contractionary fiscal policy shifts the Aggregate Demand curve to the left. This will lower equilibrium price level (when it’s not in horizontal range) and lower equilibrium GDP (when it’s not in vertical range). However, the economy is usually in the vertical range when the government uses this policy, so the policy usually only shifts price level down.

4. G vs. C, I G can be directly changed “on whim”, since fiscal policy can quickly be enacted to change government spending. However, C and I are much more uncontrollable, since they both depend on confidence, which is a hard thing to change.

5. They both, however, increase aggregate demand, and increase GDP by the amount times the multiplier. 

 

Monetary Policy & M1 , M2

Monetary Policy

1.Who controls? The Board of Governors of the Federal Reserve System (“Fed”) is responsible for controlling the U.S banking system (and the money supply). The Board of Governors has seven members, appointed by the President with confirmation of the Senate. It directs the activities of the 12 Federal Reserve Banks, which then control the nation’s banks.

2.The Federal Open Market Committee (FOMC) is made up of the 7 members of the Board of Governors plus 5 of the presidents of the Federal Reserve Banks. It sets the Fed’s monetary policy and directs open-market operations.

3.Required reserve ratio This is how much percent of a bank’s reserves must keep on deposit with the Federal Reserve Bank or as vault cash.

4.Money multiplier - since banks lend their excess reserves, a system of banks will “magnify” original excess reserves into a larger amount of new demand-deposit money, causing the money supply to grow by more than the original excess reserves. MM = 1/RRR

5.The maximum demand-deposit creation (money created) equals the excess reserves that can be lent out by commercial banks times the money multiplier.

6.For example, if someone deposited $100 into a bank, and the required reserve ratio was 0.2, then the bank’s excess reserves would increase by $80, and since the money multiplier is 1/0.2=5, the money supply will be increased by 80*5=400.

7.If the Fed buys or sells securities to the public, the money supply will increase/decrease less than if the Fed buys or sells them to banks. This is shown in the following examples:

  • Let’s assume that the required reserve ratio is 0.2. The money multiplier is then 5. If the Fed buys $1000 worth of securities from commercial banks, the excess reserves will increase by $1000. Then, the money supply will increase by $1000*5=$5000. If they buy securities from the public, the public gets more money, and when they deposit it into banks (whether directly or indirectly), bank reserves increase. However, since the required reserve ratio is 0.2, the bank needs to put $200 of the money in the Federal Reserve Bank, and so excess reserves only increase by $800. Then, the money supply will increase by $800*5=$4000.
  • If the Fed sells $1000 worth of securities to commercial banks, then excess reserves will decrease by $1000, so the money supply will decrease by $1000*5=$5000. If the Fed sells $1000 of securities to the public, then after the transaction is cleared, the bank will have $1000 less in securities. $200 of that money can be taken from Federal reserves, and so excess reserves only decrease by $800, causing the money supply to decrease by $800*5=$4000.
  • Checking account money Most of it comes from demand deposits, which are deposits in commercial banks that are meant to be checkable.

M1, M2

1.M1 is the narrowest definition of money supply. It includes currency (coins + paper money) and checkable deposits (demand deposits in banks or thrifts).

2.M2 includes M1 plus near-monies (highly liquid financial assets which do not directly function as a medium of exchange but can be readily converted into currency or checkable deposits without risk of financial loss). Near-monies are noncheckable savings accounts, money market deposit accounts, small time deposits, and money market mutual funds.

 

Balanced Budget Multiplier

1.Equal increases in government spending and taxation increase the equilibrium GDP.

2.If G and T are both increased by an amount, the equilibrium GDP will rise by the same amount, regardless of what the multiplier is.

3.This happens because a change in government spending has more of an impact on AE than a tax change.

4.This is because government spending has a direct effect on AE, i.e. a $20 increase in government spending will result in a $20 increase in AE.

5.However, since if people are taxed, their consumption only decreases by a fraction of the tax (since the tax affects both savings and consumption).

6.For example, a $20 increase in taxes in an economy with a MPC of .75 only results in $15 added to AE. Then, let’s look at how much these values affect equilibrium GDP. Since the multiplier is 4, the $20 increase by GDP results in a $80 increase in GDP. Also, the $15 decrease by taxes results in a $60 decrease in GDP. Therefore, the net increase in GDP is 80– 60 which is $20, the same as how much G and T were changed. 

 

 

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