7 Monetary And Fiscal Policy

Question 1

What does a contraction in AD followed by an expansion in SRAS cause?

Answer 1

Output is back to equilibrium but prices are lower so it is deflationary

Question 2

What does a contraction in SRAS cause

Answer 2

Lower output and higher prices, stagflation

Question 3

Monetary policy

Answer 3

A change in money supply that shifts the AD curve

Question 4

How do banks typically increase the money supply

Answer 4

Adjust the refinancing/ discount rate to directly change the interest rates which changes the money supply

Question 5

Fiscal policy

Answer 5

Changes in gov spending or taxation which effects AD

Question 6

Multiplier effect

Answer 6

Amplifies the effect of government spending on AD

Question 7

Crowding out effect

Answer 7

Diminishes the effect of government spending on AD

Question 8

How does the multiplier effect work?

Answer 8

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.

Question 9

How does the crowd big out effect work?

Answer 9

When AD increase, income increase and so does money demand which increases the interest rate and therefore reduces investment, shifting AD left

Question 10

Active stabilisation policy

Answer 10

The use of monetary or fiscal policy to stabilise the economy in the face of shocks

Question 11

How do Keynesians feel about active stabilisation policies?

Answer 11

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

Question 12

Arguments against active stabilisation policies

Answer 12

• 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

Question 13

Polices used in the recession to stimulate AD

Answer 13

• 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

Question 14

In LR what does inflation depend on?

Answer 14

Money supply

Question 15

Describe SR Phillips curve

Answer 15

Downward sloping curve, as unemployment increases, inflation decreases

Question 16

Describe LR Phillips curve

Answer 16

Vertical, change in inflation doesn’t effect unemployment as it stays at the natural rate

Question 17

Why does the SR Phillips curve slope downwards?

Answer 17

Because actual inflation is different from expected inflation

Question 18

Describe how there could be increased inflation in the LR

Answer 18

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

Question 19

Equation linking unemployment, natural rate and inflation

Answer 19

Unemployment rate= natural rate -a(actual inflation - expected inflation)

Question 20

When does lower unemployment occur?

Answer 20

When actual inflation> expected inflation

Question 21

Sacrifice ratio

Answer 21

% of annual output lost in the process of reducing inflation by 1%. A typical estimate is 3-5%

Question 22

Rational expectations

Answer 22

People optimally use all information they have available when forecasting the future. If so disinflation would be costless

Question 23

What must there be for costless disinflation to occur?

Answer 23

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

Question 24

What is the benefit of an inflation target

Answer 24

People are more likely to believe politicians when they introduce policies to reduce inflation