COMPARING FISCAL & MONETARY POLICY

FISCAL POLICY AND THE BUDGET BALANCE

The budget balance is the difference between the government’s tax revenue and its spending

SGovernment = T – G – TR Expansionary policies reduce the budget balance;

contractionary policies increase it However, budget balance is not the result of fiscal

policy alone

CYCLICALLY ADJUSTED BUDGET BALANCE

There is a strong relationship between the budget balance and the business cycle Tax revenues and transfers are the greatest reason

for this Business cycle effects on the budget balance are

temporary – eliminated in the long run Cyclically adjusted budget balance is the

estimate of the budget balance if GDP = YP so it is less volatile than actual budget balance Removes effects of business cycle

SHOULD THE BUDGET BE BALANCED?

Economists believe the budget should be balanced on average = deficits in bad years offset by surpluses in good ones Persistent deficits raise public debt

Problems posed by public debt1. “Crowding out”2. Interest payments put pressure on future

budgets…

DEFICITS, DEBT, & IMPLICIT LIABILITIES

To assess the ability of governments to pay their debt, we use the debt-GDP ratio

As long as GDP outpaces debt, there is no concern about government’s ability to pay

Implicit liabilities are spending promises made by the government that are effectively a debt, though not included in current debt statistics Cause the greatest concern about future debt &

ability to pay

MONETARY POLICY AND INTEREST RATE

Fed Open Market Committee sets a target federal funds rate

Fed expands money supply through open-market operations (oversimplified…)

Lower interest rate results from increased money supply

Leading to more investment spending

Resulting in a higher GDP and higher consumer spending

(The opposite for contractionary monetary policy)

MONETARY POLICY IN PRACTICE

Expansionary in times of negative output gap Contractionary in times of positive (inflationary)

gap Taylor rule for setting federal funds rate takes

into account both inflation and output gap

FFR = 1% + (1.5 X inflation rate) + (0.5 X output gap %)

Fairly accurate predictor of Fed actions, though the fed funds rate can’t be negative even when there is a large negative output gap

MONETARY POLICY AND THE LONG RUN Self-correcting economy means that demand shocks

caused by monetary policy only have temporary effects

Shift in AD as a result of money supply increase

New output above YP, so wages rise

Decrease in output in response to rising cost of inputs (AS shift)

Return to equilibrium output, but at higher price level

(Opposite effect for contractionary policy)

MONETARY NEUTRALITY

Monetary neutrality means that changes in the money supply have no real effect on the economy in the long run (though they have powerful effects in the short run)

Change in price level is proportional to change in money supply

MONETARY NEUTRALITY AND INTEREST RATE

Rise in money supply pushes down interest rate

Greater demand causes aggregate price level to rise

Raises demand for money

Return to original interest rate

FINAL THOUGHTS ON FISCAL & MONETARY POLICY

Lags Fiscal policy – Greatest lag is government

choosing and implementing response Monetary policy – Greatest lag is economy

responding to policy Our government does not set an inflation target,

though we want low – but positive – inflation