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.  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

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

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

 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- o Decreased government spending- A decrease in G shifts the AD curve back to left. o Increased taxes- An increase in the tax will reduce income and thereby decrease consumption which shifts the AD curve to the left. o Combined government spending decreases and tax increases

 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 GDP AD AD’’ AD’

 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  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 Central Bank has three tools in its monetary toolbox: – Open-market operations – Changing the reserve requirement – Changing the discount rate

 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 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 Control Changing the Reserve Requirement – The reserve requirement is 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 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 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.