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.