Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Economics 202Principles Of MacroeconomicsProfessor Yamin AhmadLecture 11• Economic Policy:Fiscal PolicyMonetary Policy• Supplemental (Background) Notes (accompanies this set of lecture notes)Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesBig Concepts• Fiscal Policy– Effects of Fiscal Policy on Economy– Multipliers• Monetary Policy– Effects of Monetary Policy on Economy– Demand/Supply of Money• Short Run vs. Long Run Effects: Crowding OutProfessor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Federal Budget• The federal budget is the annual statement of the federal government’s expenditures and tax revenues.• Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Federal Budget• The federal government’s budget balance equals tax revenue minus expenditure. If tax revenues exceed expenditures, the government has a budget surplus. If expenditures exceed tax revenues, the government has a budget deficit. If tax revenues equal expenditures, the government has a balanced budget.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesFiscal Policy Multipliers• Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.• Discretionary fiscal policy is a policy action that is initiated by an act of Congress.• To enable us to focus on the principles of fiscal policy multipliers, we first study discretionary fiscal policy in a model economy that has only lump-sum taxes. • Recall: Lump-sum taxes are taxes that do not vary with real GDP.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Government Purchases Multiplier• The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on equilibrium aggregate expenditure and real GDP.• A multiplier exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesFiscal Policy Multipliers• Figure 1 illustrates the government purchases multiplier in the aggregate expenditure diagram.• The government purchases multiplier is 1/(1 – MPC) where MPCis the marginal propensity to consume (absent induced taxes and imports).Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesThe Lump-Sum Tax Multiplier• The lump-sum tax multiplier is the magnification effect a change in lump-sum taxes has on equilibrium aggregate expenditure and real GDP.• An increase in lump-sum taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesFiscal Policy Multipliers• The amount by which a tax increase lowers consumption expenditure is determined by the MPC.• A $1 tax increase lowers consumption expenditure by $1 ´ MPC, and this amount gets multiplied by the standard autonomous expenditures multiplier.• The lump-sum tax multiplier is –MPC/(1 – MPC).• It is negative because an increase in lump-sum taxes decreases equilibrium expenditure.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesFiscal Policy Multipliers• Figure 2 illustrates the effect of an increase in lump-sum taxes.• The lump-sum transfer payments multiplier and the lump-sum tax multiplier are the same except for their signs—the transfer payments multiplier is positive.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesInduced Taxes and Entitlement Spending• Taxes that vary with real GDP are called induced taxes.• Most transfer payments are entitlement spending, which also vary with real GDP.• During a recession, induced taxes fall and entitlement spending rises; and during an expansion, induced taxes rise and entitlement spending falls.• Both effects diminish the size of the government purchases and lump-sum tax multipliers.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesFiscal Policy Multipliers• The extent to which induced taxes and entitlement spending decrease the multiplier depends on the marginal tax rate, which is the fraction of an additional dollar of real GDP that flows to the government in net taxes.• The higher the marginal tax rate, the larger is the fraction of an additional dollar of income that flows to the government and the smaller is the induced change in consumption expenditure.• The smaller the induced change in consumption expenditure the smaller are the government purchases and lump-sum tax multipliers.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesInternational Trade and Fiscal Policy Multipliers• Imports decrease the fiscal policy multipliers. • The larger the marginal propensity to import, the smaller is the magnitude of the government purchases and lump-sum tax multipliers.Professor Yamin Ahmad, Principles of Macroeconomics – ECON 202Note: These lecture notes are incomplete without having attended lecturesAutomatic Stabilizers• Automatic stabilizers are mechanisms that stabilize real GDP without explicit action by the government.• Income taxes and transfer payments are automatic stabilizers.• Because income taxes and transfer payments change with the