7. Fiscal and Monetary Policies Flashcards
what are the 2 types of fiscal policy
fiscal policy= taxations and gov spending
*Automatic fiscal policy: Responds to economic conditions without direct government intervention (e.g., tax revenues changing with GDP, unemployment benefits increasing during a downturn).
-> Unemployment benefits: Automatically increase during recessions, helping to stabilize incomes.
-> Progressive taxation: As incomes rise, people pay higher taxes, which helps moderate inflation.
*Discretionary fiscal policy: Active government decisions to adjust spending or taxation.
def receipts; outlays; Budget Balance; Supply-side effects
*Government income (taxes, fees, etc.).
*Government expenditures.
*Surplus (receipts > outlays), deficit (outlays > receipts).
*The impact of policies, innovations, or external factors on the production side of an economy, influencing the availability of goods, services, and productive resources
Effects of fiscal policy on Aggregate Supply & Demand (AS-AD Model)
Tax cuts boost supply (incentivize work and investment).
Government spending increases demand but may crowd out private investment.
what is monetary policy
Central bank actions to control money supply and interest rates.
-> Objectives: Price stability, high employment, stable economic growth.
what tools are used in monetary policy + how do they handle recession and inflation
*Bank rate (interest rate): Lower rates make borrowing cheaper, increasing spending and investment.
*Monetary base (money supply): Includes cash in circulation and bank reserves.
*Inflation: Central bank raises interest rates to cool down demand.
*Recession: Central bank lowers rates to stimulate borrowing and investment.
def comparative advantage
Countries or individuals should specialize in producing goods where they have a lower opportunity cost.
Trade allows both to consume beyond their individual production possibilities.
def absolute advantage
If one country/person is more productive at producing a good, they have an absolute advantage.
-> more efficient at producing a good BUT doesn’t determine whether trade is beneficial (comparative advantage)
what is specialization
Countries specialize in what they do best and trade with others, expanding the Production Possibility Frontier (PPF) beyond what they could achieve alone.
Why Currency Exchange is Necessary in financing international trade
When countries trade, they often use different currencies. This requires converting currencies in the foreign exchange market, where the price of one currency relative to another is determined.
-> exchange rate= the value of one currency for the purpose of conversion to another
what are the exchange rate movments while financing international trade
Appreciation: If a currency’s value increases compared to another, its exchange rate rises. This makes exports more expensive and imports cheaper (inflation bcs when purchasing power decrease so real value of money decreases)
Depreciation: If a currency’s value decreases, its exchange rate falls. This makes exports cheaper and imports more expensive.(deflation)
what is a balance of payments (BoP)
A country’s international financial transactions are recorded in it
-> consist of 3 key accounts:
1. Current Account (CA)
-Tracks exports (X) and imports (M) of goods and services, transfer and income flow.
-trade surplus (X > M) has a positive CA and trade deficit (X < M) has a negative CA.
2. Capital Account (KA)
-Records private financial transactions, such as foreign investments, loans, and business purchases.
-If foreign investors buy assets in a country, KA increases.
-If a country’s businesses invest abroad, KA decreases.
3. Reserve Assets (RA)
-official borrowing/lending by central banks to influence exchange rates and stabilize the economy.
-Central banks may buy or sell foreign currency reserves to adjust the exchange rate.
BoP equation
BoP must always balance:
CA+KA+RA=0
-> bcs of double bookkeeping
-> If a country runs a trade deficit (negative CA), it must borrow from abroad (positive KA or RA) to cover the gap. Conversely, a trade surplus leads to financial outflows.
give the equation of current account balance
GDP=Y=C+I+G+(X−M)
and GDP=Y=C+S+T where S (private saving), T(taxes)
-> exports-imports+net income-net transfer
Government budget balance in current account
T-G: taxes collected by the government- gov expenditure
If T > G (budget surplus), the government is saving money, which can contribute to a current account surplus.
If T < G (budget deficit), the government is borrowing, which may lead to a current account deficit.
Private sector balance- current account surplus or deficit?
S-I: personal saving-investment
If S > I, households and businesses are saving more than they invest, contributing to a current account surplus.
If S < I, the country is borrowing from abroad to finance investment, leading to a current account deficit.
in the short run, how to fix current account deficit?
in the short run,
-current account deficit (importing more goods and services than it is exporting)
to correct: increase exports or reduce imports.
->through currency depreciation: a fall in the value of the country’s currency relative to others:
1. exports cheaper for foreign buyers → Demand for exports increases.
2. Imports more expensive for domestic consumers → Demand for imports decreases.
long run effects of exchange rates (import and exports)
In the long run, the real exchange rate (adjusted for inflation) remains stable.
As prices and wages adjust, the temporary boost to exports fades, and depreciation no longer improves net exports.
how does Fiscal policy influence the economy’s long-term productive capacity and economic growth
*Taxes on income and consumption impact labor supply decisions: Higher taxes-> reduce the incentive to work, affecting total labor supply and productivity.
*Production function: Fiscal policy can shift the production function by influencing labor, capital, and technology, which are key determinants of economic growth.
what are the effects of taxes on capital income (if high inflation)
*Nominal interest rate dependency: Since taxes on capital income are based on the nominal interest rate (which includes inflation), high inflation can increase the tax burden, even if real returns remain the same.
*Lower saving and investment: Higher capital taxes discourage savings and investment, slowing capital accumulation and reducing the long-term growth rate of real GDP.
The AS-AD model helps analyze how fiscal policy affects economic growth, employment and inflation:
*Economic growth: Government spending or tax cuts can shift AD, influencing short-run output.
*Inflation: If expansionary fiscal policy increases AD too much, inflation rises.
*Employment: Fiscal stimulus can reduce unemployment, but excessive intervention may lead to overheating and inflation.
def automatic stabilizers
mechanisms built into government budgets, without any vote from legislators, that increase spending or decrease taxes when the economy slows.
-Tax Revenues: When real GDP decreases, wages and firm profits fall, reducing tax revenues (T↓). During economic booms, tax revenues rise.
-Means-Tested Spending: When real GDP declines, government spending on welfare programs (e.g., unemployment benefits, food stamps) increases, helping stabilize incomes.
what are the 2 key mechanisms of discretionary fiscal policy
*Government Expenditure Multiplier
When the government increases spending (G), it raises AD, leading to more consumption (C) and possibly boosting GDP.
However, increased government spending can raise real interest rates, leading to the crowding-out effect, where private investment (I) declines because borrowing becomes more expensive.
- Tax Multiplier
A tax cut (-T) increases disposable income, leading to higher consumption and demand.
However, not all of the tax cut gets spent—some of it is saved, so the tax multiplier is smaller than the government expenditure multiplier.
The crowding-out effect still applies here, as more demand can push up interest rates, discouraging investment.
def tax/ fiscal* multiplier
measures the change in real GDP resulting from a change in taxes (T).
what are the supply effects of discretionary fiscal policy
*Tax cuts (-T) → Higher GDP & Employment: Lower taxes encourage work and investment, increasing both AS and AD.
*Government spending (+G) → Higher real interest rates → Lower investment (-I): More spending can stimulate demand but may not always boost production and job creation effectively.
