Fiscal Policy & Monetary Policy I do not set interest rates! I’m in charge of Taxes & Gov’t Spending Fiscal Policy & Monetary Policy Government Test Review

Business Cycle Both Fiscal Policy & Monetary Policy attempt to “smooth” the “ups & downs” of the Business Cycle

AD/AS Model AD3 = UNEMPLOYMENT below You draw the AD curve on 1-section of the AS curve based on the economic situation AD3 = UNEMPLOYMENT below Full employment level (less than 4.5%) GDP above speed limit Inflation AS1 AD1 AD3 AD2 AD2 = UNEMPLOYMENT 5% GDP MODERATE Not yet at “full employment” Real GDP AD1 = RECESSION

Government Budget Know how the Government raises money for spending which taxes supply the most money Know top 4 major spending areas Why entitlement spending is so dangerous Why the Gov’t can’t balance the budget The long term danger of a growing national debt

2-Types of Deficits Structural deficit: a deficit which occurs with the economy at full potential output (very high GDP) Cyclical deficit: Portion of deficit attributable to a slowdown in the business cycle (during recession) Conclusion: Structural Deficits are significantly more problematic than Cyclical Deficits

Analyzing Deficits Summary Debt & Deficit should be viewed as % GDP This allows you to compare past deficits Deficits can place upward pressure on long term interest rates This is known as crowding out The current Federal Deficit is a structural deficit Entitlement spending must be addressed to correct it TARP & Federal Stimulus will add 2 Trillion to our debt during 2009! Debt could approach 100% of GDP in the next few years

FISCAL POLICY Monetary POLICY RECESSION FISCAL POLICY Monetary POLICY Expansionary Contractionary Loose Tight 2 Types 2 Tools Discount Rate Open Market Operations Taxes Gov’t Spending Recession = shift AD right Too fast GDP = Shift AD Left Goal For both:

PROGRESSIVE U.S. Income Tax System Understand the logic behind this cartoon and what it leaves out!

GDP What creates Economic Growth? INCENTIVES MATTER!!! GDP GDP Classical, Keyensian and Supply Side Economists all solve economic problems in different ways (understand the key differences!)

Practice Free Response

Free Response Economic Scenario: GDP growth is +6.0%, Unemployment 2%, Inflation is rising Solve the economic problem using Monetary Policy: Draw the graph of the current economy (AD/AS Graph) Explain the type & details of Monetary Policy you would use Graphically show the effect of your policy in the Money Market Modify your AD/AS graph as a result of this change Explain the effect of your policy on Employment Explain the effect of your policy on Inflation

GDP growth at 6.0%, Inflation rising, Unemployment 2.0% Economic Situation: GDP growth at 6.0%, Inflation rising, Unemployment 2.0% Solution: Tight Monetary Policy MS1 MD Interest Rate Qty of $ MS2 Inflation Real GDP AS1 AD1 Affects AD AD2 --------- i2 --------------- i1 End Result: Lower GDP & less inflation!

Use Fiscal Policy to improve the economy Economic Situation: GDP growth at -1.0%, Inflation falling, Unemployment 8% Use Fiscal Policy to improve the economy Inflation Real GDP AS1 AD2 AD1 What type? What Changes: Taxes? Gov’t Spending? End Result: higher GDP & same inflation!