Fighting Recessions with Monetary and Fiscal Policy

Question 1

What does Monetary policy focus on?

Answer 1

Monetary policy works by manipulating the money supply in order to change the price of borrowing, which is the interest rate, in order to stimulate the economy.

The key to maing making policy work is the fact that the demand for money depends on the interest rate.

Question 2

What does Fiscal policy focus on?

Answer 2

Fiscal policy uses government spending and the tax code to stimulate the economy.

Question 3

Regarding politically biased economists who may be trying to pull a fast one, what did Joan Robinson say? (one of the greatest economists of the 20th century)

Answer 3

“The purpose of studying economics is not to acquire a set of ready made answers to economic questions, but to learn how to avoid being deceived by an economist”.

Question 4

What are Real wages?

Answer 4

Real wages are wages that are not measured in terms of money, but in terms of how much stuff workers can buy with the money they’re paid.

Question 5

Why are Real wages crucial to understanding how government stimulus affects the economy?

Answer 5

Real wages crucial to understanding how government stimulus affects the economy, because people don’t work hard for money in and of itself - they work hard for the things that money can buy.

This distinction is important because as the economy reacts to the gov’s shifting of the aggregate demand curve to the RIGHT, real wages only increase temporarily.

When real wages are higher, workers supply more labour. But when they fall back down to their original levels, workers go back to supplying their original amount of labour.

Question 6

Show on a graph, the results of a government run stimulus programme increasing AD.

Answer 6

Question 7

Explain the concept of Real wages using an example.

Answer 7

Ralph is a worker who loves Bananas. When the economy is at point A, he is paid £10 per hour, and his favourite food, bananas, cost £1 per kilo. This situation implies that his real wages - his wages measured in terms of what they can buy - are 10 kilos of bananas per hour. At that real wage, Ralph is willing to work full-time.

Question 8

What happens to workers like Ralph when the gov stimulates the economy and shifts the AD curve from AD₀ to AD₁ ?

Answer 8

When the gov stimulates the economy and shifts the AD curve from AD₀ to AD₁ , workers like Ralph benefit at first because real wages initailly rise.

That’s because in order to produce more output than Y^* , firms have to raise nominal wages (wages measured in money terms) on order to get workers to produce more.

Because prices are initially sticky at price level P₀ , the increase in nominal wages means an increase in real wages.

Question 9

How do Ralph’s real and nominal wages change as a result of this?

Answer 9

In Ralph’s case, suppose that the price of bananas remains at £1 per kilo because of sticky prices, but Ralph’s nominal wages rise to £12 per hour because the company he works for needs more labour.

Ralph’s real wage increases from 10 kilos of bananas per hour to 12 kilos of bananas per hour.

Question 10

What is the effect of an increase in real wages?

Answer 10

The increase in real wages motivates workers to supply all the extra labour that’s required to produce higher levels of output.

Question 11

What is the effect of nominal wages increasing but prices remaining the same?

Answer 11

Because nominal wages have gone up but prices haven’t, the resulting increase in real wages causes workers to supply more labour, which in turn allows firms to produce an output level greater than Y^*.

Question 12

How do firms deal with the costs of increased wages and what is the affect on real wages?

Answer 12

Unfortuantely, as frims begin to pass on the costs of increased wages as higher prices, real wages begin to fall.

i.e. suppose that because of the hihger labour costs, prices of bananas rise to £1.10 per kilo. At that price, Ralph’s real wage falls from 12 kilo of bananas per hour down to 10.91 kilos of bananas per hour. (To get 10.91, divide ralph’s £12 per hour money wage by the £1.10 per kilo price of bananas).

Question 13

How long will prices continue to rise?

Answer 13

Prices are going to conitnue to rise until they reach the point where real wages return to where they orignally where at point A before the gov stimulated the AD.

In Ralph’s case, the price of bananas continues to rise until they cost £1.20 per kilo. At that price, his higher nominal wage of £12 per hour again buys him 10 kilos of bananas per hour; his real wage is back where it started.

Question 14

Why do Real wages have a boomerang effect?

Answer 14

Becasue the economy returns to producing at Y^* , you only need to motivate workers to supply enough labour to produce Y^*, not anything extra.

Question 15

What are the downfalls of gov stimulus policies which shift AD to the RIGHT?

Answer 15

• they can’t permanently increase the amount of labour being employed by firms.
• they can’t permanently increase workers’ real wages.

These effecrs are at best temporary; they last only as long as the economy takes to adjust from A to B to C.

Question 16

What does the lack of upward price stickiness of prices/wages imply for any gov attempting to stimulate the economy into producing more than the full output emplyment level, Y^* ?

Answer 16

If prices and wages can rise quickly, the economy produces more than Y^* only very briefly. That is, it moves from A to B to C very quickly - so quickly that the stimulus causes output and employment to rise above Y^* only very briefly.

Question 17

What else does a lack of upward price stickiness imply for the gov attempting to stimulate the economy into producing more than the full-employment output level, Y^* ?

Answer 17

I people can see a stimulus coming, that stimulus (which attempts to increase output beyond Y^* ) is likely to generate only inflation and no increwse in output whatsoever.

In other words, if people can anticipate an increase in AD, the economy may jump directly from point A to point C, so that the price level rises without even a temporary increase in ouput.

Question 18

If the gov preannounces a big stimulus package that is going to shift AD to the RIGHT in a few months time, what will firms realise?

Answer 18

Because workers and businesses can find out about macroeconomics just as well as the politicians running the gov, they realise that the only long-run effect of upcoming stimulus will be for prices to rise from P⁰ to P¹.

Question 19

What do workers understand will happen to their real wages in the long run?

Answer 19

Workers understand that real wages will remain unchanged in the long run, because both their nominal wages and their cost of living (given by the price level)will increase by equal amounts.

As a result, they know that in the long run, the stimulus isn’t going to help them at all.

Question 20

What do firms anticipate?

Answer 20

Firms aren’t stupid.

They don’t want ot have their profits reduced becasue wages are rising while prices are fixed.

so they simply anticipate everything. Because prices eventually have to rise from P₀ to P₁ and wages eventually have to rise by an equal amount, firms get ahead of the wage increases by raising prices as soon as they can.

Question 21

What do economists mean by the term, Rational expectations ?

Answer 21

Rational expectations is one of the most important ideas in macroeconomics because it tells you that strong limits constrain the gov’s ability to control the economy.

People don’t just sit around like potted plants when the gov announces a policy change. They change their behaviour. And someitmes, their behaviourial changes completely ruins the gov’s ability to achieve its objective of stimulating the economy.

Question 22

What are the two ways in which Fiscal policy concerns itself with how govs tax and spend?

Answer 22

1. Increasing AD INDIRECTLY by lowering taxes so that consumers have larger after-tax incomes to spend on buying more goods ans services.
2. Increasing AD DIRECTLY by buying more goods and services.

Question 23

How are both of these types of Fiscal policy likely to affect gov budget deficits?

Answer 23

Because the gov’s budget deficit is defined as tax revenues minus spending, both types of fiscal policy are liekly to increase gov budget deficits.

This fact is very important because large and ongoing gov bedget deficits may lead to many economic problems, including inflation.

As a result, the fear of large budget deficits constrains the magnitudde of fiscal policy initiatives.

Question 24

How do govs spend money to help end recessions?

Answer 24

If people are unemployed and unsold goods are lying around gathering dust, the gov can come in with a lot of money and buy up a lot of the unsold goods.

The result of this action is that the gov generates so much demand that businesses start hiring the unemployed in order to increase output to meet all the new demand.

Question 25

What happens when formerly unemployed people start getting paid again?

Answer 25

When formerly unemployed people start getting paid again, they start spending more money, which means that demand rises.

When this happens the economic recovery should be self-sustaining so that the gov doesn’t need to continue to spend so much money.

Question 26

Why do politicians like suggesting increases in gov spending?

Answer 26

Because it makes them look good, especially if they can get some of the new spending earmarked specifically for their own constituents

Question 27

What are the three ways in which an increase in gov spending can be paid for?

Answer 27

1. The gov can lower the interest rate to expand the money supply.
2. The gov can raise taxes.
3. The gov can borrow more money.

Question 28

From the perspective of the gov, what are the advantages of selling bonds?

Answer 28

1. The gov can redirect some of the savings that people are making away from purchases of other assets and into purchases of gov-issued bonds.
2. The gov can get hold of lots of money to spend on goods and services, thereby turning what would have been private spending on assets into public spending on goods and services.

Question 29

What is the national debt?

Answer 29

Any current budget deficit adds to the national debt, the cummulative total of all the money that the gov owes lenders.

Question 30

What is meant by the process of, rolling over the debt ?

Answer 30

Future tax revenues secure all gov borrowing.

But the link between taxes and bond repayments isn’t direct. In other words, just because the gov has a lot of bonds coming due doesn’t necessarily mean it has to raise taxes suddenly to get the money to pay off the bonds.

Instead, govs will simply issue new bonds to get enough cash to pay off the old bonds.

This process is referred to as, rolling over the debt, and is routinely practised by govs everywhere.

Question 31

Why do people worry when they see the gov running large deficits or piling up a very large debt?

Answer 31

The worry that the gov may find itself in a position in which it can’t raise taxes high enough to pay off its obligations (or is unwilling to anger voters by raising taxes that high).

Investors worry that if this situation occurs, the gov may resort to printing money to pay off its debts. And doing so ruins the economy.

Question 32

How does the gov hurt bondholders by printing money to pay its debts?

Answer 32

Printing money to pay gov debts badly hurts bondholders because most of them get their cash after prices have gone up, meaning that their cash doesn’t buy much stuff.

Consequently, when people really start to worry that a gov may start to print more money to pay off its debt, the gov finds getting anyone to buy its bonds harder and harder.

Question 33

What might the gov do to get anyone to buy its bonds?

Answer 33

The gov offers higher and higher interest rates to compensate for peoples worries that the money they’re eventually going to get back isn’t going to be worth as much.

This makes the gov’s situation even worse, because any debt rollovers have to be done at the higher interest rates.

Question 34

What are the economic effects of higher interest rates?

Answer 34

Higher interest rates dissuade consumers from buying things like houses and cars and also discourage firms from borrowing money to buy new factories and equipment.

Consequently, just the expectation that a gov may print money at some point in the future to pay off its bonds can cause immediate harm to the economy.

Question 35

Does ‘money’ just mean the cash and coins in circulation?

Answer 35

No. Money has a wider definition that includes cash deposits in banks, credit and loans, and gov bonds of varying degrees of tradeability.

As a result, expanding the money supply, means doing something that increases the supply of all of the above.

Question 36

What are the drwabacks of using a metallic standard?

Answer 36

Using a metallic standard causes the supply of money to be pretty much fixed over time.

This means even if the economy needs a little bit more or a little bit less money to make it work better, the gov can’t do anything because the supply of moeny is fixed by the amount of gold the gov has in its vaults.

Question 37

Suppose you’re given £1mil to do whatever you want with. You choose to save every last penny for at least a year, beacuase after a year you think you’ll know how to spend it.

Should you keep all your new wealth in cash?

Answer 37

NO!

Holding your wealth in cash is, really stupid because cash earns no interest.

Even if you put the cash into a standard current account and earn a tiny perecent of interest, say 1%, thats still £10,000. Why would you give that up?

Or use the cash to buy gov bonds, you may get 5 or 6% = £50,000 or $60,000 more.

Question 38

What stops people from converting all their wealth to other assets and never holding cash?

Answer 38

What stops people from converting all their wealth to other assets and never holding cash is the fact that money lets them buy things.

Beyond that function, money is no better than any other asset; in fact, it’s worse in terms of rate of return becasue the rate of return on cash is always zero.

Question 39

Graphically demonstrate how much money people demand to hold at any particular interest rate.

Answer 39

As you can see from the downward slope of the money demand curve, the higher the interest rate, the less money people want to hold.

This graph simply demonstrate, the higher the interest rates on other assets, the more you’re going to want to economise on your cash holdings.

Question 40

Why is Money supply curve, M^S vertical?

Answer 40

Because the gov can decide how much money it wants to print and circulate without reagard to the interest rate.

Question 41

Why do the Money demand, M^D and Money supply, M^S curves intersect at interest rate i^* ?

Answer 41

This interest rate is the equilibrium interest rate, because it’s the only rate at which the total amount of money that people want to hold is equal to the total amount of money that the gov has circulated.

Also, i^* is a stable equilibrium meaning that if interest rates ever deviate from it, market forces are going to push them back to i^*.

Question 42

What are the two types of ways one can pay for a bond?

Answer 42

1. The face value payment is printed on the face of the bond certificate and comes on the date the bond expires.
2. The coupon payments are typically made twice per year until the bond expires. They’re called coupon payments, because before conputerised recordkeeping, you literally clipped a coupon off the bottom of the bond certificate and mailed it in to receive your payment.

Question 43

Why do the rates of return on a bond vary inversely with how much you paid for it?

Answer 43

Because the amount of money you get in the future is always fixed, the more you pay for it right now, the less your rate of return. Higher bond prices imply lower rates of return.

Question 44

What happens when interest rates are higher than i*?

Answer 44

When interest rates are higher than i*, the amount of money supplied exceeds the amount of money demanaded.

This situation means that people have been given more of the asset called money than they want to hold. So they try to reallocate their portfolio of assets by using the excess money to buy other assets.

Question 45

What happens when people start to buy bonds using this excess money?

Question 46

What happens when interest rates are lower than i*?

Answer 46

The amount of money demanded exceeds the amount of money supplied. Because people want more money than they have, they’re going to try to get it by selling non-cash assets like bonds in order to convert those assets into the cash they want.

Question 47

Graphically depict an increase in the money supply and its consequent lowering of the nominal interest rate.

Answer 47

Question 48

Why does Monetary policy work?

Answer 48

Monetary policy works because gov’s know that interest rates adjust in order to get people to hold whatever amount of money the gov decides to print.

The interest rate is, in some sense, the price of money, and it reacts in a way similar to other prices.

That is, if the money supply suddenly increase, the price of money falls, and vice versa.

Question 49

How does the UK system work?

Answer 49

The BOE controls the money supply because it has a legal monopoly to do so.

Until 1997 it was up to the Chancellor of the Exchequer, but the labour gov made the Bank independant.

The Bank doesn’t change the supply of money by telling the mint to print more or less but by using the base rate, which is the lowest possible interest rate that commercial banks can use to borrow money from the gov.

Question 50

What does the term open market operations mean?

Answer 50

The term open market operations refers to the central bank’s buying and selling of gov bonds. That is, open-market operations are transactions that take place in the public, or open, bond market.

Question 51

What will the bank do if it wants to increase the money supply?

Answer 51

It buys bonds because in order to buy bonds the gov must pay cash, which then circulates throughout the economy.

Question 52

What will the bank do if it wants to decrease the money supply?

Answer 52

It sells bonds because the people to whom the bank is selling the bonds have to give the gov money, which reduces the amount in circulation.

Question 53

What happens when interest rates are lowered through monetary policy?

Answer 53

Both consumption and investment increasde, shifting the aggregate demand curve to the right.

1. Lower interest rates increase consumer consumption spending by making it more attractive to take out loans i.e. for cars and homes.
2. Lower interest rates stimulate investment spending by businesses because at lower interest rates, a larger number of potential investmnet projects become profitable.

Question 54

What is the very simple 3 step process behind monetary policy?

Answer 54

if a Bank wants to help increase output, it initiates the following chain of events:

1. The bank buys gov bonds in order to increase the money supply.
2. The increased money supplycauses interest rates to fall because the prices of bonds get bid up.
3. Consumers and businesses respond to the lower interest rates by taking out more loans and using the money to buy more goods.

Question 55

Graphically depict how the result of increasing the money supply depends on inflationary expectations.

Answer 55

Question 56

Regards people’s inflationary expectations, what happens if people believe that the price level is going to remain fixed at P₀ ?

Answer 56

The rightward shift in AD moves the economy’s equilibrium rightward along the SRAS₀ curve from point A to B.

Question 57

Regards people’s infllationary expectations, what happens if people believe that the price level is going to jump in response to the increase in the money supply?

Answer 57

The SRAS shifts up vertically by the amount that the price level is expected to increase. Therefore, the economy’s equilibrium moves form A to C, where AD₁ intersects the new short-run aggregate supply curve, SRAS₁.

Question 58

In terms of how inflationary expectations affect interest rates, what is the underlying problem regarding the Bank?

Answer 58

The underlying problem is that the bank only has partial control over interest rates. In particualr, the bank controls money supply but not money demand.

Problem is - if people think that an increase in the money supply is going to cause inflation, they increase their money demand because they’re expecting to need more cash to buy things at higher rates.

Question 59

Why doesn’t the big shift in AD shift the economy back to producing at Y^* ?

Answer 59

The increase in money demand caused by inflationary fears tends to increase interest rates.

Higher interest rates tend to decrease investment. Any increase in interest rates caused by inflationnary fears decreases the effectiveness of the monetary stimulus which is why the big shift in AD doesn’t shift the economy all the way back to producing at Y^*.

With people expecting inflation, part of the stimulus ends up causing inflation rather than stimulating the economy to produce more output.

Question 60

What are the two hidden mechanisms which are at play when the Bank sets Monetary policy?

Answer 60

1. Precommitment: the bank establishes a credible commitment to a monetary policy. As a result, people will factor the bank’s policy into their decisions and act as though the Bank had already done so.
2. Advantage: The Bank knows what it may do when we can only guess, so if it thinks our expectations are out of line with policy, it can pull a surprise move and generate either a short-run stimulus or contraction before we know it.

Question 61

Graphically represent Stagflation.

Answer 61

Question 62

What is Stagflation?

Answer 62

Stagfation is when the economy simultaneously has a stagnant output level coupled with inflation.

(In detail) Output remains unchanged at the resessionary level Y_LOW, despite an increase in the money supply that causes AD to shift to the right.

Higher inflationary expectations cause the SRAS curve to shift vertically to SRAS₁, fully offsetting the increase in AD.

The short run equilibrium shofts from A to B, but the only effect is a higher price level with no increase in output.

Question 63

What did the stagflation experience of the 1970’s teaxh the BOE?

Answer 63

It taught the BOE (and its equivalent in other countries) that monetary policy works best if people believe that the Bank is not going to cause inflation.

Consequently, the banks these days only make moderate increases in the money supply when it wants to stimulate the economy.

These increases end up being more effective than the larger increases because they don’t trigger inflationary fears.

Question 64

What are inflation targets ?

Answer 64

Most central banks (esp in Europe) have inflation targets. Meaning they are required by law, to keep inflation within a certain range, and are therefore circumspect about increasing the money supply.