ecn 202 principles of macroeconomics nusrat jahan lecture 10 n.
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ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-10. Fiscal Policy & Monetary Policy. 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.

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slide2

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
slide3

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.
slide4

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
slide5

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
slide6

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

slide7

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.
impacts of monetary policy on aggregate demand
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.
the tools of monetary control
The Tools of Monetary Control
  • The Central Bank has three tools in its monetary toolbox:
    • Open-market operations
    • Changing the reserve requirement
    • Changing the discount rate
the tools of monetary control1
The Tools of Monetary Control
  • Open-Market Operations
    • The Central Bank conducts open-market operations when it buys government bonds from or sells government bonds to the public:
      • When the CB buys government bonds, the money supply increases.
      • The money supply decreases when the CB sells government bonds.
the tools of monetary control2
The Tools of Monetary Control
  • Reserve Requirements
    • The CB also influences the money supply with reserve requirements.
    • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.
the tools of monetary control3
The Tools of Monetary Control
  • Changing the Reserve Requirement
    • The reserve requirementis the amount (%) of a bank’s total reserves that may not be loaned out.
      • Increasing the reserve requirement decreases the money supply.
      • Decreasing the reserve requirement increases the money supply.
the fed s tools of monetary control
The Fed’s Tools of Monetary Control
  • Changing the Discount Rate
    • The discount rate is the interest rate the CB charges banks for loans.
      • Increasing the discount rate decreases the money supply.
      • Decreasing the discount rate increases the money supply.
problems in controlling the money supply
Problems in Controlling the Money Supply
  • The CB’s control of the money supply is not precise.
  • The CB must wrestle with two problems that arise due to fractional-reserve banking.
    • The CB does not control the amount of money that households choose to hold as deposits in banks.
    • The CB does not control the amount of money that bankers choose to lend.