Modern Macroeconomics: Fiscal Policy


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CFA Ll Economics

Modern Macroeconomics: Fiscal Policy

Explain how fiscal policy affects aggregate demand and aggregate supply.

Fiscal expansion: An increase in government spending or a decrease in taxes (i.e., a budget deficit)
leads to an increase in GDP and an increase
in prices. Fiscal restriction or contraction: A decrease
in government spending or an increase in tax leads to lower prices and lower output/GDP. (The
aggregate demand curve shifts left.) Counter cyclical: Change in policy (i.e., budget deficit or

by government will offset changes in aggregate spending by consumers and investors and
lead to smooth fluctuations in the business cycle. For example, if an economy is in recession then
plan a budget deficit.

Describe why fiscal policy should be timed p
roperly and why timing is difficult.

There's usually a time lag between when policy is needed and when its recognized by policy
makers; there's also a lag between when the need is recognized and when its instituted, and a lag
between when policy is adopted

and when its impact is felt. The use of fiscal policy to calm the
business cycle is very difficult; it may accentuate the corrective action of the economy rather than
correct the problem for which it was intended. Automatic stabilizers are built in fiscal

which ensure deficits in a recession and surpluses during a boom. Three types: unemployment
compensation; corporate profit taxes and progressive personal taxes (e.g. In a recession, when tax
receipts are low, increasing transfer payments and reduc
ing tax revenue will cause an automatic
deficit to occur and therefore help to alleviate high unemployment).

Discuss the impact of expansionary fiscal policy based on:

The basic Keynesian model

An increase in government spending and/or a decrease in ta
xes (i.e.,
a budget deficit) will be magnified by the multiplier process and lead to an increase in aggregate
demand. If the economy is operating below full capacity, this will lead to an increase in GDP and

The Crowding
Out model

The effect
of an increase in the budget deficit will be dampened as
borrowing for the deficit will increase interest rates and crowd out private spending and
investment, leading to a decrease in investment. In an open economy the increase in interest rates
leads to a
n increase in foreign investment
capital inflow
and an increase demand for domestic
dollars, producing an increase in exchange rates
currency appreciation
and a decline in net
exports and a decrease in aggregate demand.

The New Classical model

The eff
ect of an increase in the budget deficit will be dampened
because households will anticipate higher future taxes implied by the debt and reduce their
spending and increase their saving to pay for them; this will crowd out private spending. An
alternative e

an increase in government spending leads to increase in aggregate
demand, which is crowded out by a decrease tax effect. A decrease in taxes leads to an increase in
savings (as consumers expect tax to increase) and therefore leads to a decreas
e in consumption. A
decrease in taxes leads to an increase in loanable funds, leading to an offset government demand
for money. A decrease in taxes leads to unchanged aggregate demand and interest rates.

The Supply
Side model

A decrease in marginal tax ra
tes leads to increase in investment and
savings, an increase in work and productivity, a decrease in leisure, and a decrease in tax sheltering,
leading to an increase in aggregate supply in the long run (LR), an increase in GDP, a decrease in
and a decrease in prices.

Keynesian model:

Increase in government spending or decrease in taxes will be magnified by the
multiplier and lead to an increase in aggregate demand.

Crowding out model:

Effect of increase government spending is dampened because

borrowing to
finance the budget deficit will push up interest rates and crowd out private spending and

New classical model:

Effect of increase government spending is dampened because households


CFA Ll Economics

anticipate higher future taxes implied by the deb
t and reduce their spending to pay for them, which
will crowd out private spending.

side model:
A decrease in marginal taxes will increase the increase the incentive to earn
and improve the efficiency of resource use, leading to an increase in outpu
t in the long run.

Identify the relationships among budget deficits, inflation, and interest rates.

An increase in government spending (i.e., a budget deficit) leads: (1) to an increase in the
demand for loanable funds, placing upward pressure on the re
al rate of interest (according to
crowding out model) and (2) with higher expected taxes, to a decrease in spending and the
stimulation of savings, thereby permitting government to expand its borrowing at an unchanged
interest rates (according to New Class
ical model). There is a mixed opinion on the relationship
between a budget deficit and interest rates.

Money and the Banking System

: Medium of exchange; measure of value and store of value.

money supply

M1=Currency in circulation+de
mand (checkable) deposits+traveller's cheques. M2=M1+savings
deposits+time deposits<$100K+money market mutual fund shares. M3=M2+time
deposits>$100K+big mutual funds+overnight loans from customers+ eurodollar deposits of US

Describe the frac
tional reserve banking system.

For each USD deposited at a bank a small percentage is held as reserves and the rest is lent as
loans. Money is created when banks make loans.

The Deposit Expansion Multiplier = 1/Required Reserve Ratio.

If banks are required

to hold 25% of deposits as reserves, then a new deposit of $1,000 will
potentially expand the money supply by (1/0.25) x $1000 = $4000. If excess reserves are increased
by $1000 (when there were no existing excess reserves) then the money supply could inc
rease by a
maximum of $4000.

Question: Reserve Requirement is 10%. Say banks currently have (1) cash (and deposits with the
Fed of) $25 million (mn); (2) loans and securities equal to $175mn; (3) demand deposits equal to
$200mn. How much more can the bank
s legally lend?

Answer: Deposit of 200mn x reserve requirement of 10% = required reserves of $20mn.

Actual reserves are currently $25mn, minus required reserves of $20mn = excess reserves of $5mn.
Therefore the bank can loan out its excess reserves, or a f
urther $5mn.

Explain how a central bank can use monetary tools to effect monetary policy.

A central bank (e.g. the FED) (1) regulates banks and (2) implements monetary policy via the use
of tools:


The Required Reserve Ratio allows the FED to increase the

money supply by a decrease of
this ratio.


Open Market Operations. The FED buys/sells treasury bonds/notes/bills to control the
monetary base

this is the FED's main avenue for control of the money supply (e.g. FED sells
bonds which decrease the money sup


Discount Rate. The rate it charges banks for loans (e.g. a decrease in the real rate of interest
leads to cheaper money and an increase in the money supply).

Expansionary monetary policy can be produced: Lower the discount rate or lower the required
reserve ratio or buy bonds. Restrictive monetary policy is caused by the reverse of the above.


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Modern Macroeconomics: Monetary Policy

Identify the determinants of the demand for and supply of money.


Desire of people to hold wealth in cash, check
ing account, highly liquid asset

determined by the cost of money. The demand for money is inversely related to the real rate of
interest. The supply of money is determined by monetary authorities and unrelated to the real rate
of interest.

The Quantity
Theory of Money suggests that a change in the money supply will cause a
proportional change in the price level because velocity and real output are unaffected by the
quantity of money. A change in the money supply leads to a proportional change in prices.
velocity of money is the average number of times per period (years) a dollar is used to buy goods
and services (G&S).

Nominal GDP = M x V=P x Q => MV=PQ: Money(M) times Velocity(V) equals Price(P) times
Quantity of G&S(Q). V and Q are determined by fa
ctors other than the (fixed) money supply. E.g.
If M increase then P increase.

Explain how monetary policy affects interest rates, output, and employment.

Expansionary MP

implemented by the FED by Open Market Operations (OMO), i.e., buying
bonds, which

in the short run (SR) will force the price of bonds up and their rate of return down.
Therefore the expansionary policy results, first, in a lower real rate of interest. This lower rate will
spur investment and consumer demand. Thus aggregate demand will
increase and cause the
aggregate demand curve to shift to the right resulting in higher prices and increased output at least
in the SR, and an
increase in employment

if expansionary MP was unexpected.

Factors which lead to an increased aggregate demand (GD

The decrease in the real rate of interest produces an increase in consumption and investment now,
compared to the future.

A lower the real rate of interest lead to a depreciation of the dollar which make exports more
attractive to foreigners (i.e., a
n increase in net exports).

A lower real rate of interest cause asset prices to increase, leading to an increase in wealth and
purchasing power of households holding those assets.

An increase in bank reserves make more loans available to small businesses

If the increase in the money supply was unexpected then in the SR it brings output back to full
employment (as mentioned above). This is because costs rise less than prices in the SR.

N.B. for the exam: A restrictive MP or tightening of the money supply
will have the opposite SR

Discuss whether anticipating the effects of monetary policy affects the policy.

When monetary policy (MP) changes are anticipated beforehand both the SR and long run (LR)
effect will be higher prices and wages and highe
r nominal interest rates (to their LR equilibrium);
it has no impact on real economic activity, i.e., GDP output is unchanged and unemployment is
unchanged. (i.e., wages increase due to inflation).

Describe the short
run and long
run effects of expansion
ary and restrictive monetary
policies on the inflation rate, interest rates, real output, and employment.

In the SR an unanticipated increase in the money supply will reduce the real rate of interest and
increase the availability of credit, thereby trigger
ing an increase in the demand for goods and
services. This will increase aggregate demand which will expand real output and employment.

In the LR the major effects of an unanticipated increase in the money supply are inflation and
higher nominal interest

rates. Rapid monetary growth will neither reduce unemployment or
stimulate real output in the LR. Alternatively, in the LR an increase in the money supply will


CFA Ll Economics

result, in the LR, in (1) higher prices, and (2) higher nominal interest rates. Also, an expec
tation of
an increase in future inflation, leads to an increase in nominal interest rates. The SR effects on
GDP and employment are reversed in the LR, hence in the LR neither real output nor
unemployment are effected. (The real rate falls in the SR and no
minal rate rises in the LR.)

Nominal interest rate equals the real rate plus expected inflation. With inflationary expectations the
real interest rate falls in the SR and the nominal rate rises in the LR.

Short run


Short/long run


Impact of expansionary MP



Inflation rate

Only a small increase


Real output & employment

Temporary increase unless
excess capacity exists

No change

Money (nominal) interest rate

Probably decline


Real interest rate


No change

Impact of restrictive MP



Inflation rate

Small decrease


Real output & employment


No change

Money (nominal) interest rate

Short term rates probably


Real interest rate


No change

ions, Inflation, and Unemployment

Explain the role expectations play in determining the effectiveness of fiscal and monetary

If an increase in the growth rate of the money supply is fully anticipated, then prices, wages and
interest rates will ris
quickly in response and there will be no change in output (GDP) or
unemployment. If the increase in the money supply is unanticipated, there will be a temporary but
real increase in output and a decrease in unemployment, as the increase in money

supply will at
first be thought of as an increase in demand.

Identify how individuals form expectations.

Adaptive Expectations

people base their future expectations on actual outcomes observed
during recent periods. Using
Rational Expectations

ople weigh all available information about
the probable effects of current and future economic policy when they make decisions about future
economic events

given all available data today, individuals will make rational decisions
regarding the future base
d on today's information, and sound economic reasoning, not historical

Discuss the trade
off between unemployment and inflation in view of expectations.

The Phillips curve shows an inverse relationship between the inflation (prices and money wages)

and unemployment rates.

Under adaptive expectations changes in policy (e.g., expansionary MP) leading to inflation will be
unanticipated so inflation (an increase in prices) will reduce workers' real wages, causing an
increase in the demand for labour and

a reduction in the unemployment rate. Under rational
expectations changes in inflation will be fully anticipated so there won't be a inflation and
unemployment trade

inflation will be expected and nominal wages will rise along with prices;
ent and output won't change.

An unanticipated increase in inflation:
Adaptive expectations:

SR: Demand and production


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increase and unemployment decreases. LR: Prices increase and unemployment and production
revert back to their original level.
Rational ex

In the SR and LR prices increase and
production and employment are unchanged.

The LR results are
the same

in both adaptive and rational expectations.

The natural rate of unemployment (NaRU) is the LR average unemployment rate due to frictional

and structural conditions in the labour market. It is influenced by: unemployment compensation;
the minimum wage and job training opportunities. Demographics also affect NaRU.