1. Lecture 11: Monetary & Fiscal Policy
Influencing the state of the economy

2. Purpose of the lecture Briefly review the main macroeconomic models
Bring together the main macroeconomic models to show the effect of selected macroeconomic policies
Briefly discuss the trade-off between employment and inflation

3. The purpose of policy Maintain long-term growth Stabilise the economy
Moderating the business cycle
Maintain employment levels where possible
Control inflation

4. Policy options for recessions
Do nothing
Lower costs and wages will result in an eventual increase in output.
Stimulate aggregate demand with monetary policy
Stimulate aggregate demand with fiscal policy

5. Do nothing (market correction)
Price
Level
Long-run AS
AS1
AS2 P1 A P2 B P3 C
AD1
AD2 Y2 Y1
Quantity of
Output

6. The limits of self-correction
Hardship for some households
Adds to long-term unemployment
Adds to consumer & producer pessimism
Political unrest

7. Monetary Policy and Aggregate Demand

8. The process of monetary policy Expansionary & Contractionary
Central bank buys securities
O’night cash rate increases
Interest rates increase
Increase in consumption & investment
Increase in aggregate demand
Central bank selld securities
O’night cash rate decreases
Interest rates decrease
Decrease in consumption & investment
Decrease in aggregate demand

9. The result of expansionary monetary policy
Price
Level
Long-run AS
AS1 P2 B P1 A
AD2
AD1 Y1 Y2
Quantity of
Output

10. When to use expansionary policy
Growth rate is low; and
Consumer and investor sentiment is pessimistic; but
Inflation should also be low
Stimulation increases prices

11. Fiscal Policy & Aggregate Demand

12. Fiscal Policy
Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.
Fiscal policy influences saving, investment, and growth in the long run.
In the short run, fiscal policy primarily affects the aggregate demand.

13. Fiscal Policy
The Federal government’s control of the economy is both direct and indirect.
Its expenditures have a direct effect on aggregate demand.
Taxes and tax policy have an indirect effect on consumer spending.

14. The Multiplier Effect of Government Purchases
Government purchases are said to have a multiplier effect on aggregate demand.
Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.
The total impact on the quantity of goods and services demanded can be much larger than the initial change in government spending.

15. The Multiplier Effect of Government Purchases
Price
Level
2. …but the multiplier effect can amplify the shift in aggregate demand.
AD3
1. An increase in government purchases of $5 billion initially increases aggregate demand by $5 billion…
AD2
AD1
Quantity of Output

16. A Formula for the Government Purchases Multiplier
The formula for the multiplier is:
Multiplier = 1/(1 - MPC)
An important number in this formula is the marginal propensity to consume (MPC).
It is the fraction of extra income that a household consumes rather than saves.
eg if households spend 80 cents out an extra $1 they earn, then the MPC is 0.8

17. An Example of the multiplier effect
MPC = 0.9
Multiplier = 1/(1-0.9) = 1/0.1 = 10
Government spends $200,000
Extra activity = 10 x $200,000 = $2,000,000
NB same mathematical principle as the money multiplier
Size of increase is determined by how much is ‘kept back’

18. Changes in Taxes
When the government cuts taxes, it increases households’ take-home pay.
Households save some of this additional income.
Households also spend some of it on consumer goods.
Increased household spending shifts the aggregate-demand curve to the right.

19. Changes in Taxes
The size of the resulting shift in aggregate demand is also affected by the multiplier and crowding-out effects.
The size of the shift in the aggregate demand is also determined by the households’ perceptions about the permanency of the tax change.

20. Automatic Stabilisers
Automatic stabilisers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

21. Examples of automatic stabilisation
Taxes automatically decline in a recession
Helps maintain disposable income
Government welfare payments
Increase in total in recessions

22. The Crowding Out Effect

23. The Crowding-Out Effect
Fiscal policy may not affect the economy as strongly as predicted by the multiplier.
An increase in government purchases causes the interest rate to rise.
A higher interest rate reduces investment spending.

24. The Crowding out effect of fiscal stimulation
Price
Level
2. …but higher interest rates lead to a decrease in investment and a decrease in aggregate demand.
1. An increase in government purchases initially increases aggregate demand
AD2
AD3
AD1
Quantity of Output

25. The Employment/Inflation Trade-off
Society faces a short-run trade-off between unemployment and inflation.
If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.
If we reduce aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

26. The Phillips Curve
The Phillips curve illustrates the short-run relationship between inflation and unemployment.
It shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

27. Aggregate Demand, Aggregate Supply, and the Phillips Curve
The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.
A higher level of output results in a lower level of unemployment.

28. Phillips Curve Inflation Rate (percent per year) 6 B A 24 7
Unemployment Rate (percent)

29. Policy Impact
Monetary and fiscal policy can shift the aggregate demand curve, thus moving the economy along the Phillips curve.
The Phillips curve illustrates the trade-off between inflation and unemployment faced by policymakers.

30. The employment growth trade-off
(b) The Phillips Curve
(a) AD/AS Model
3. …Unemployment decreases but inflation increases.
Inflation rate
Price level (deflator)
2. Demand increases to output of $6b
AS1
1. Output = $5 b & Unemployment = 8 percent * 6
106 * *
102 2 *
AD2
AD1 5 6 3 8
Output ($b)
Unemployment rate (%)

31. The Phillips Effect in Australia 1960s-1990s

32. The Phillips Curve in the 1960s
Include figure 18.8 here
Generally low inflation rate and low unemployment rate

33. The Phillips Curve in the 1970s and early 1980s
Include figure here
Generally high inflation and medium to high unemployment rate

34. The Phillips Curve in the late 1980s and early1990s
Insert Figure 18.12
Generally low inflation rate and medium to high unemployment rate

35. Policy trends Growth a priority in the 1960s
Wage control in the mid-1980s reduced supply-side wage pressures on inflation.
Restrictive monetary policy in the late 1980s
Inflation fell but unemployment rose.
Current RBA policy is generally keeping inflationary expectations low.
Medium unemployment rate

36. MACROECONOMIC POLICY DEBATES

37. Should Policymakers try to stabilise the economy? YES Vs NO
The economy is inherently unstable.
Monetary and fiscal policy can influence aggregate demand and offset this.
No reason for society to suffer through the booms and busts of the business cycle.
Stabilising aggregate demand will boost production and employment.
There are time lags between decision & response for both monetary & fiscal policy
This means intervention will be largely ineffective in the short run and may be harmful by exacerbating downturns or upswings

38. Monetary Policy Rules’ vs ‘Discretion
The problems of discretionary policy are not proven
Need flexibility for changing circumstances
Leave it to the experts
What rules are valid anyway?
Discretionary policy can easily be mismanaged
Policy is manipulated in the political business cycle
Policy makers don’t follow through on announcements
Economic actors are sceptical about announcements
Need moderate and steady growth of the money supply to limit the problems

39. The central bank should aim for zero inflation YES Vs NO
Zero inflation is probably unattainable and output and unemployment costs from policy are too high.
Instead aim for a low inflation.
Policymakers can reduce many of the costs of inflation without actually reducing inflation.
No benefits but many costs to inflation
eg shoeleather, menu, etc
Reducing inflation is a policy with temporary costs and permanent benefits.
Once the disinflationary recession is over, the benefits of zero inflation would persist.

40. The Government should balance the budget YES Vs NO
The problem of deficits is often exaggerated.
Current govt spending may produce benefits well into the future.
Need flexibility in spending for emergencies etc
Govt debt can increase because population growth and technological progress increase the nation’s ability to pay the interest on the debt.
Deficits are a burden on future generations
Need more taxes or less spending
Deficits reduce savings & therefore investment in capital & therefore lower growth

41. Tax laws should be reformed to encourage saving YES
A nation’s productive capability is determined largely by how much it saves and invests for the future.
A nation’s saving rate is a key determinant of its long-run economic prosperity.
When the saving rate is higher, more resources are available for investment in new plant and equipment.

42. Tax laws should be reformed to encourage saving YES
We heavily tax the income from capital and reduce benefits for those who have accumulated wealth.
This reduces saving, capital accumulation, lower labour productivity and economic growth.

43. Tax laws should be reformed to encourage saving YES
An alternative to income tax policies advocated by many economists is a consumption tax.
With a consumption tax, a household pays taxes based on what it spends not on what it earns.
Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods.

44. Tax laws should be reformed to encourage saving No
Such changes in tax laws would primarily benefit the wealthy.
High-income households save a higher fraction of their income than low-income households.
Any tax change that favours people who save will also tend to favour people with high incomes.

45. Tax laws should be reformed to encourage saving No
Reducing the tax burden on the wealthy would lead to a less egalitarian society.
Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving.

46. Conclusion
The study of economics does not always make it easy to choose among alternative policies.
Few if any policies come with benefits but no costs.
The study of economics should make you a better participant in our national debates.

47. Self-Test (Hakes & Parry): Chapter 17
Match all Terms & Definitions
Answer questions 2 & 3 of the Practice Problems
Answer Short Answer questions 6, 8 & 10
Do all True/False Questions
Answer Multiple Choice Questions 6, 8, 9, 10, 15, & 18
Check answers in guide and revise accordingly

48. Self-Test (Hakes & Parry): Chapter 18
Answer question 3 of the Practice Problems
Answer Short Answer question 7
Answer Multiple Choice Questions 1, 2, 4, 5 & 8
Check answers in guide and revise accordingly

49. Self-Test (Hakes & Parry): Chapter 19
Match all Terms & Definitions
Answer question 1 of the Practice Problems
Answer Short Answer questions 1, 3, 5 & 8
Do all True/False Questions
Answer Multiple Choice Questions 1, 2, 3, 5, 7, 8 & 11
Make notes on the Advanced Critical Thinking questions 1 & 2
Check answers in guide and revise accordingly

50. Reading
This week: Text and Study Guide Chapters 17 & 19 and the main points from 18
Revision