ECN 202: Principles of MacroeconomicsNusrat Jahan

Lecture-11

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- 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.

Expansionary Fiscal Policy

During recession investment↓ as a result AD curve shifts to the left.

Expansionary fiscal policy can be taken 3 ways- oIncreased Government Spending (G)- An increase in government spending shifts the AD to the right.

oTax reduction(T)- A decrease in taxes (raises income and consumption rises by MPC times the change in income). AD shifts to the right.

oCombined 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-

oDecreased government spending- A decrease in G shifts the AD curve back to left.

oIncreased taxes- An increase in the tax will reduce income and thereby decrease consumption which shifts the AD curve to the left.

oCombined 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)

Pricelevel

GDPAD

AD’’

AD’

The crowding-out effect: Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An expansionary fiscal policy creates budget deficit which causes the interest rate to rise. A higher interest rate reduces investment spending. This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

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.