Using Policy to Affect the Economy

Fiscal Policy  Government efforts to promote full employment and maintain prices by changing government spending and/or taxes  Congress/President is in charge of fiscal policy

Monetary Policy  Central bank (Federal Reserve) efforts to promote full employment, maintain prices, and encourage long-run economic through control of the money supply and interest rates.  This is done through:  Open market operations  Reserve ratio  Discount rate

Expansionary Policy  (Easy Money Policy)  Used to counteract a recession  Expansionary Fiscal Policy:  Cut taxes  Raise spending  Expansionary Monetary Policy  Buy bonds  Decrease reserve ratio  Decrease discount rate

Contractionary Policy  (Tight Money Policy)  Used to fight inflation  Contractionary Fiscal Policy:  Raise taxes  Lower government spending  Contractionary Monetary Policy  sell bonds  Increase reserve ratio  Increase discount rate

Using Fiscal Policy to Affect Aggregate Demand  Using fiscal policy to increase AD will have 2 effects:  Multiplier effect  Crowding-out effect

Multiplier Effect  When the government spends more & taxes less, people & businesses have more money, so they spend more too.  So, AD increases by MORE than just what the government spends

Multiplier Effect  We can estimate how MUCH AD increases by first determining the “marginal propensity to consume”  What fraction of income is spent vs. what fraction is saved  (only income that is spent will increase demand  MPC of ¾ means that for every dollar, 75 cents is spend

Multiplier Effect  Spending multiplier = 1/(1-MPC)  If MPC=3/4, then Spending Multiplier = 4  The higher the MPC, the higher the spending multiplier, the greater increase in AD  EX: If the government spends $1,000 and the MPC is ¾, then $1000 will cause an increase of $4,000 in AD  (multiplier applies to increases by all components of GDP)

Crowding-Out Effect  Counter-force to multiplier effect  Increased spending by the government will cause at least some decrease in AD

Crowding-Out Effect  When government spends money, they increase interest rate in loanable funds graph  This increase in interest rates causes a DECREASE in investment spending

 Crowding Out & Multiplier Effects are opposing forces  Both happen when the government spends money, the degree of each determines how much AD increases (it usually does).

Using Monetary Policy to Affect Aggregate Demand  Federal Reserve can use three tools of monetary policy to affect the money supply

Theory of Liquidity Preference  When the money supply increases, interest rates decrease (money market graph)  When money supply increases, people have lots of money to deposit, so banks decrease interest rates to bring supply & demand in money market into balance

Using Monetary Policy to Affect Aggregate Demand  This causes higher investment spending which causes AD to increase, leading to higher prices & higher output  So, Federal Reserve can increase/decrease money supply to affect price levels and output

 Congress/President & Federal Reserve use their tools of fiscal & monetary policy to effect change in the economy.