4 Fluctuations & Stimulus Flashcards
Productivity
A measure of how efficiently inputs like labor and capital are used to produce outputs, often calculated as output per worker or per hour worked. Productivity grows through investments in technology, education, and infrastructure, but can decline due to ageing populations, underinvestment, or economic disruptions
Recession
A significant decline in economic activity, often defined as two consecutive quarters of negative GDP growth.
Characterized by falling GDP, rising unemployment, and reduced investment. Recessions occur when aggregate demand (AD) falls below aggregate supply (AS), leading to unused resources and idle labour
Inflation
persistent increase in the general price level, reducing purchasing power and potentially destabilizing economic growth
Stagflation
Economy experiences stagnant growth, high unemployment, and high inflation simultaneously. Stagation is particularly challenging for policymakers because traditional measures to reduce inflation (e.g., raising interest rates) can exacerbate unemployment and slow growth further. Big example: Argentina.
Fiscal policy
Uses tax incentives (supply-side) and government spending (demand-side) to stimulate the economy by facilitating investment
Expansionary: Increases spending or reduces taxes to stimulate demand during recessions.
Contractionary (Austerity): reduce spending/raise taxes to control inflation
Monetary policy
Central bank actions to manage money supply and interest rates to achieve macroeconomic stability (expansionary vs contractionary)
Uses the relationship between interest rate, investment and output for economic recovery
Policy rate
interest rate set by the central bank to influence the economy. For example, the Federal Reserve’s federal funds rate or the European Central Bank’s refinancing rate determines borrowing costs for commercial banks and indirectly impacts overall economic activity
Marginal Propensity to Consume (MPC)
The fraction of additional income that households spend on consumption rather than saving. For example, if MPC is 0.8, households spend 80 cents of every additional dollar earned
Multiplier effect
Amplified change in GDP resulting from initial change in spending or taxation.
Multiplier = 1 / (1-MPC)
Multiplier process: mechanism through which the changes in spending affect aggregate output
Zero lower bound
where nominal interest rates are at or near zero, limiting the central bank’s ability to stimulate the economy using traditional rate cuts
Quantitative easing (QE)
unconventional monetary policy where the central bank purchases financial assets (usually government bonds) to inject liquidity into the economy.
Aggregate demand/supply
Total demand/ supply for goods and services in an economy at a given price level
Demand: signals an overall appetite for spending (Y = C + I + G + X − M)
Automatic stabilizers
Economic policies or programmes that counteract fluctuations in the economy without additional government intervention.
Eg. unemployment benefits (which increase during downturns) and progressive taxation (which collects more revenue during booms)
Consumption smoothing
Households usually maintain stable consumption levels over time even when income fluctuates eg. saving during high-income period and spend during low-income to stabilise consumption
Supply vs demand-side crises
A supply-side crisis occurs when production capacity is reduced due to factors like supply chain disruptions or increased input costs (e.g., oil shocks). A demand-side crisis results from a decrease in aggregate demand, such as reduced consumer spending or investment during a recession
Inflationary boom
Rising prices, eroding purchasing power, and overheating the economy.
Excessive AD relative to AS pushes prices upward and creates inflationary pressure.
Monetary policy and transmission mechanism
transmission mechanism describes how changes in the policy rate affect borrowing, spending, and investment.
Eg. lowering interest rates reduces borrowing costs, encouraging businesses to invest and households to spend more, thereby boosting AD. BUT at the ZLB, the effectiveness of rate cuts diminishes, and central banks may resort to QE to ensure liquidity
Transmission mechanisms
1. Market interest rate
2. Asset prices
3. Expectations
4. Exchange rate
Pareto efficiency
A state where no individual can be made better off without making someone else worse off
eg. in labour market, efficiency requires wages to reflect workers’ marginal productivity
Effects of fiscal stimulus (AD-AS)
Expansionary fiscal policy shifts the AD curve rightward, increasing output (GDP) and price levels. This raises employment but may lead to inflationary pressures if the economy is near full capacity.
Supply or demand shock
unanticipated shock to the demand/ supply side of the economy that affects production
Eg. energy prices, discovery of the internet, technological innovations to production processes
OR increase in online grocery shopping post-pandemic or war/pandemic which decreases AS
How does the private sector stabilise/amplify shocks?
Stabilise: consumption smoothing
Amplify: credit constraints, rising value of collateral
How does the government stabilise/amplify shocks?
Stablise: automatic stabilisers eg. taxes on corporate benefits during boom/ welfare benefits, also fiscal/monetary stimulus
Amplify: limit autonomatic stabilisers
Consequences of high debt
- rise in borrowing cost, decreased investment and decreased growth
- inflationary pressure - inflation makes it easier for governments to service debt obligation (seigniorage)
- decreased confidence in economy and ability of government to pay back debt
- increased uncertainty in economy, perhaps hurting exchange rate and preventing the government from further borrowing
Ricardian equivalence
Timing of tax cuts don’t matter, only the present discounted value does, because households will save during tax cuts to pay back for it in the future
Examples of supply-side fiscal stimulus
- Tax rate deductions
- Depreciation of currency
- Privatisation and deregulation
- Flexible labour markets
Does supply-side fiscal policy work?
Depends; the literature shows that temporary stimulus can work, but have limited effects in time of high uncertainty
MPC
Change in consumption / change in income
Negative fiscal multiplier
Happens more in LDCs, when gov spending
1. Crowds out private consumption
2. When debt levels are already very high (high debt countries have close to zero or even negative fiscal multipliers)
3. High degree of substitutability between private and public consumption
Why does government stimulate private investment?
Long run - technological growth and innovation create growth. Short run - created by expansion and job creation
How to deal with political inflationary pressure?
- Central bank independence, which historically lowered inflation in many countries
- Inflation targeting - publicly announcing target inflation rate and “price stability” as goal
Time consistency problem
Central bank can exploit expectations - an unexpected decrease in interest rate can stimulate spending and investment. But over time, this creates inflation expectations and overly high inflation without any benefit to output
