1. ECON 102 Tutorial: Week 21 Ayesha Ali www.lancaster.ac.uk/postgrad/alia10/econ102.html a.ali11@lancaster.ac.uk office hours: 8:00AM – 8:50AM tuesdays LUMS C85

2. Today’s Outline  Week 21 worksheet – Fiscal Policy & Monetary Policy:  This weeks material is very math-heavy. Make sure you also revise definitions, diagrams, and explanations from the book/lecture slides. Some things the worksheet doesn’t cover that I think are of interest:  Definitions of Fiscal & Monetary Policy  Goals of Fiscal & Monetary Policy  How do Fiscal & Monetary Policy work to meet these goals  Are there particular strenghts & weaknesses of Fiscal & Monetary Policy?  What affects the effectiveness of Fiscal & Monetary Policy?  If you’re unsure of any solutions here, please read Chapters 25 and 26 in your textbook – they provides detailed explanations and examples.  Exam 3 will be available at the end of class today.

3. Question 1

4. Question 2

5. How Governments Use Discretionary Fiscal Policy to Stabilize the Economy In a recessionary gap (Y* > Y), The gov’t wants to increase PAE, or decrease the gov’t deficit. To do so, they have two options:  Increase Gov’t Spending or  Decrease Net Taxes In an expansionary gap (Y* < Y), The gov’t wants to do the opposite:  Decrease Gov’t Spending or  Increase Net Taxes Questions 3 - 6 look at how we do this mathematically.

6. Question 3

7. Question 4

8. Question 5

11. Question 6

12. How Central Banks Use Monetary Policy to Stabilize the Economy To get rid of a recessionary gap (Y* > Y), A central bank will increase the money supply. Doing so will have two effects:  Reduce Interest Rates  Stimulate consumption and investment spending Conversely, to close an expansionary gap (Y* < Y ), the central bank will do the opposite – reduce the money supply. Questions 7-11 look at how this works.

13. Question 7

14. Question 8

15. Question 9 Draw an IS-LM diagram to show how the equilibrium values of the level of output and the rate of interest change when the central bank increases the money supply. When the money supply is increased, the LM curve shifts to the right. The new equilibrium is given by the intersection of the existing IS curve and the new LM curve and is characterised by a lower interest rate and a higher output level.

16. Question 9 Draw an IS-LM diagram to show how the equilibrium values of the level of output and the rate of interest change when the central bank increases the money supply. When the money supply is increased, the LM curve shifts to the right. The new equilibrium is given by the intersection of the existing IS curve and the new LM curve and is characterised by a lower interest rate and a higher output level.

17. Question 10 Draw a diagram which illustrates money market equilibrium when the economy is in a liquidity trap situation. An economy is in a liquidity trap if money demand is perfectly elastic with respect to interest rate changes, i.e. the money demand curve is horizontal. Even if the whole money demand is not horizontal it might be for a certain range of interest rates. For example, the money demand curve could be downward-sloping curve at higher interest rates, but horizontal at lower interest rates that are close to zero. If the money supply curve intersects the money demand curve in the horizontal section of the money demand curve, the economy is in a liquidity trap. In this case an increase in the money supply has no effect on the interest rate (the interest rate does not fall), because the public is willing to hold the additional money supply at the existing interest rate. So Monetary policy becomes powerless to lower the interest rate further – and hence powerless to shift the LM curve (see Figure 26.3) and to increase output. Only an expansionary fiscal policy can increase the equilibrium output level. First, let’s define what is a liquidity trap:

18. Question 11

19. Next Class  Week 22 Worksheet: IS-LM and Aggregate Demand  Gerry Steele posts materials & slides on Moodle – use these to help get through the tutorial worksheet.  The worksheet has a link to a spreadsheet you’ll need to use to answer the last question. I think that all you have to do in the spreadsheet is change the value of G and write down what happens as G changes.