Unit 5: Monetary and Fiscal Policy Combined

Goals of Economic Policy Stabilizing the economy Keeping employment high Price level stable –If aggregate demand is too low, there will be unemployment –If aggregate demand is too high, there will be inflation

Try to think of TWO fiscal policy tools Could you remember any??? Government spending Taxes Income tax brackets Unemployment compensation Stock and bond returns

Fiscal policy is one of the two demand management policies available to policy makers. Government expenditures (i.e. government spending) Level and type of taxes Both are considered discretionary fiscal policy tools

Basically….. This is how the government can increase aggregate demand in an effort to increase our productivity (or real GDP) Also a way to increase employment during a recession

Government Spending: Affects the economy directly by increasing the demand for goods and services When the government increases spending, it initiates a multiplier process that results in a greater increase in total spending than the initial increase Will increase aggregate demand (AD), shifting it to the right In the short run, this will result in an increase in real GDP and the price level –Considered expansionary if the change increases AD and/or real GDP Examples: $700 billion Wall Street buy out

Changes in Taxes: Does not directly change real GDP Changes in taxes affect the disposable income of households or businesses The changes are felt through consumption spending and investment spending An increase in taxes will decrease disposable income A decrease in disposable income will decrease consumption (but by less than the increase in taxes) ---- some of the additional cost of taxes will come out of their savings

Automatic Stabilizers There are many tools embedded in the economy that respond to the different phases of the business cycle: automatic stabilizers Called automatic b/c they adjust without an action by Congress or the President They limit the increase in real GDP during expansions and reduce the decrease in real GDP during recessions

Income Tax System As your nominal income increases, you move into a higher tax bracket and pay more taxes This limits the increase in disposable income and consumption Vice-versa, if you take a pay cut you move to a lower bracket and therefore have lower taxes

Unemployment Compensation As the economy slows and unemployment increases, the income of the unemployed does not fall to zero Unemployment comp. provides a base level of income and the negative impact on real GDP is lessened

Stock and Bond Returns Many corporations establish the dividends they pay on shares of stock and maintain this payout for several years Thus, dividends do not follow swings of the business cycle Bond payments maintain their value throughout their “lifetime”

Three Monetary Tools 1. Open Market Operations: buying and selling bonds 2. Reserve Requirements: changing the reserve ratio at banks 3. The discount rate

How much time do these policies take to get initiated??? Inside lag: the time it takes for data to be collected, policy makers to recognize that policy action is necessary, the decision about which policy should be taken and the implementation of the policy In Washington that could take FOREVER!

How much time does it take these policies to actually impact the economy? Outside lag: the time it takes the economy to respond to the new policy *** it takes a varying amount of time for the different policies***