7 Monetary And Fiscal Policy Flashcards
What does a contraction in AD followed by an expansion in SRAS cause?
Output is back to equilibrium but prices are lower so it is deflationary
What does a contraction in SRAS cause
Lower output and higher prices, stagflation
Monetary policy
A change in money supply that shifts the AD curve
How do banks typically increase the money supply
Adjust the refinancing/ discount rate to directly change the interest rates which changes the money supply
Fiscal policy
Changes in gov spending or taxation which effects AD
Multiplier effect
Amplifies the effect of government spending on AD
Crowding out effect
Diminishes the effect of government spending on AD
How does the multiplier effect work?
Increase in gov spending of £20bn causes initial increase in AD of £20bn. Because of the increase in confidence, consumers buy more and firms invest more so there is a further increase in AD.
How does the crowd big out effect work?
When AD increase, income increase and so does money demand which increases the interest rate and therefore reduces investment, shifting AD left
Active stabilisation policy
The use of monetary or fiscal policy to stabilise the economy in the face of shocks
How do Keynesians feel about active stabilisation policies?
They stress the role of AD in explaining SR economic fluctuations. The government should actively stimulate AD to maintain production at its full employment level
Arguments against active stabilisation policies
- AD is hard to control since policy affects the economy with long and variable lags
- it is better to leave the market alone to deal with SR fluctuations than base policies on incorrect forecasts
- policies should be used to achieve long run goals
Polices used in the recession to stimulate AD
- interest rates cut to zero
- bought government bonds, mortgage backed securities and other private loans
- the Congress appropriated $700bn for the treasury to use to save the financial system, provide equity injections into banks and make loans easier to obtain
In LR what does inflation depend on?
Money supply
Describe SR Phillips curve
Downward sloping curve, as unemployment increases, inflation decreases
Describe LR Phillips curve
Vertical, change in inflation doesn’t effect unemployment as it stays at the natural rate
Why does the SR Phillips curve slope downwards?
Because actual inflation is different from expected inflation
Describe how there could be increased inflation in the LR
Expansionary policy causes actual inflation to rise whilst expected inflation stays low in SR. In LR expected inflation adjusts to higher actual inflation so there is now higher inflation with natural rate of unemployment
Equation linking unemployment, natural rate and inflation
Unemployment rate= natural rate -a(actual inflation - expected inflation)
When does lower unemployment occur?
When actual inflation> expected inflation
Sacrifice ratio
% of annual output lost in the process of reducing inflation by 1%. A typical estimate is 3-5%
Rational expectations
People optimally use all information they have available when forecasting the future. If so disinflation would be costless
What must there be for costless disinflation to occur?
The government must commit to a policy of low inflation so that people lower their expectations of inflation, so we stay on the LR Phillips curve
What is the benefit of an inflation target
People are more likely to believe politicians when they introduce policies to reduce inflation
