ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-11

1. ECN 202: Principles of MacroeconomicsNusrat JahanLecture-11 Fiscal Policy & Monetary Policy

2. What is Fiscal Policy? • Fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full-employment, control inflation and encourage economic growth. • Fiscal policy influences saving, investment, and growth in the long run. • In the short run, fiscal policy primarily affects the aggregate demand. • Fiscal policy includes • Changes in Government Purchases • Changes in taxes

3. Fiscal Policy Choices: • Expansionary Fiscal Policy- When recession occurs expansionary fiscal policy can be implemented to prevent economic downfall. • Contractionary fiscal policy- When demand-pull inflation occurs, a restrictive or contractionary fiscal policy can be implemented to control it.

4. Expansionary Fiscal Policy • During recession investment↓ as a result AD curve shifts to the left. • Expansionary fiscal policy can be taken 3 ways- • Increased Government Spending (G)- An increase in government spending shifts the AD to the right. • Tax reduction(T)- A decrease in taxes (raises income and consumption rises by MPC times the change in income). AD shifts to the right. • Combined Government spending increases and tax reductions

5. Contractionary Fiscal Policy • When demand-pull inflation occurs, the demand for goods & services ↑ as a result investment↑ which shifts the AD curve rightwards. • Contractionary fiscal policy can be taken in 3 ways- • Decreased government spending- A decrease in G shifts the AD curve back to left. • Increased taxes- An increase in the tax will reduce income and thereby decrease consumption which shifts the AD curve to the left. • Combined government spending decreases and tax increases

6. Effects of Fiscal Policy • There are two macroeconomic effects from the change in government purchases or taxes: • The Multiplier Effect: • Each dollar spent by the government or cut in taxes can raise the aggregate demand for goods and services by more than a dollar. • The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. • The formula for the multiplier is: • Multiplier = 1/(1 - MPC) Price level AD’’ AD’ AD GDP

7. The crowding-out effect: • Fiscal policy may not affect the economy as strongly as predicted by the multiplier. • An expansionary fiscal policy creates budget deficit which causes the interest rate to rise. • A higher interest rate reduces investment spending. • This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. • The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

8. What is Monetary Policy • It consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy to achieve and maintain price-level stability, full employment and economics growth.

9. Impacts of Monetary Policy on Aggregate Demand • Expansionary Monetary Policy: • Central bank lowers the interest rate • This in turn stimulates investment which increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. • Contractionary Monetary Policy: • Central bank raises the interest rate • This dampens investment which reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.