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UConn ECON 1202 - Monetary and Fiscal Policy

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Econ 1202 1st Edition Lecture 22 Outline of Lecture 21 (Monetary and Fiscal Policy (continued))I. Money DemandII. Shifts in the Money Demand CurveIII. Money SupplyIV. Equilibrium in the Money MarketV. Expansionary Monetary PolicyVI. Contractionary Monetary PolicyVII. Policy TargetsVIII. Taylor RuleIX. Fiscal PolicyX. Expansionary Fiscal PolicyXI. Contractionary Fiscal PolicyXII. Multiplier: How Much Bang for each Buck of Expenditure?XIII. The “Math” Behind the MultiplierXIV. Simple MultiplierOutline of Lecture 22 (Monetary and Fiscal Policy (continued))I. Crowding Out EffectsII. Empirical WorkIII. Supply Side of Fiscal PolicyIV. Fiscal and Monetary Policy: Is It Too Good To Be True?V. LagsVI. The Philips CurveVII. AD and ASVIII. The Long-Run Philips CurveIX. Does the Long-Run Philips Curve Ever Change?X. What is the Impact of Policy Changes Reducing Structural Unemployment?XI. Recent DevelopmentsXII. Supply Shocks and the Philips CurveMonetary and Fiscal Policy (continued)I. Crowding Out Effectsa. Short-Run Crowding Out-an increase in government purchases, whether it increases the demand for money or if expenditures financed by debt, may increase interest ratesi. If so, the higher interest rate will reduce consumption, investment, and net exportsii. So the initial increase in spending is partially offset b the crowding out1. G increases, but C and I decreaseb. Long-Run Crowding Out-the increase in government purchases wil have no effect on real GDP i. The reduction in consumption, investment, and net exports will exactly offset the increase in government purchases1. Why? Because in the long run, the economy returns to potentialGDP even without the government’s interventionii. The long run effect is simply to increase the size of the government sector within the economyII. Empirical Worka. How big is the Multiplier?i. Many studies have been done, but generally less than 2 (some studies show less than 1)ii. It is certainly a lot less than we originally thoughtIII. Supply Side Effects of Fiscal Policya. Role of Taxesi. Reform (tax and other) that create greater incentives to capital formation and the like have the potential to significantly increase real GDP in the long run beyond the increases that otherwise occur1. Don’t forget the reverseIV. Fiscal and Monetary Policy: Is It Too Good To Be True?a. Kind of or at least, there are a few things we need to be mindful ofi. Qualifications or limitations regarding fiscal and monetary policyV. Lagsa. Recognition Lag-there is a problem, how long will it take for the policymakers to recognize it?b. Implementation Lag-once a problem is recognized, how long will it take to implement it?c. Effectiveness Lag-once you recognized a problem and implemented a policy to fix it, how long will it take to start working?i. Monetary and Fiscal Policy have different lags, but the potential economic impact is the same: acerbating the business cycleVI. The Philips Curvea. 1958-A.W. Philipsi. “The relationship between unemployment and the rate of change of money wages in the UK” 1861-19571. Negative correlation between the rate of unemployment and the rate of inflationb. Philips Curve-chows the short-run trade-off between inflation and unemploymentc. Many policymakers in the 50s, 60s, 70s and possibly today, believed that you could use/select monetary and fiscal policy to influence aggregate demand in such a way that they could choose any point on the Philips Curvei. A little bit of menu with a certain tradeoff:1. High unemployment and low inflation or2. Low unemployment and high inflationVII. AD and ASa. An increase in AD in the short-run:i. Higher outputii. Higher price leveliii. Lower unemploymentiv. Higher inflationb. Lower AD:i. Lower outputii. Lower price leveliii. Higher unemploymentiv. Lower inflationVIII. The Long-Run Philips Curvea. Is verticalb. Unemployment rates tend toward its normal leveli. Natural rate of unemploymentc. Unemployment does not depend on money growth and inflation in the long rund. Example: if the Fed increases the money supply slowly, then the inflation rate is low and unemployment is at its natural rate or if the fed increases the money supply quickly, then the inflation rate is high and unemployment is still at its natural ratei. When we are at the natural rate, there is no tendency or economic forcecausing inflation or deflationIX. Does the Long-run Philips Curve Ever Change?a. Natural Rate of Unemploymenti. Unemployment rate toward which the economy gravitates in the long runii. Not necessarily socially desirableiii. Not constant over timeb. Labor market Policiesi. Effect the natural rate of unemploymentii. Shift the Philips CurveX. What is the Impact of Policy Changes Reducing Structural Unemployment?a. Natural Rate of Unemployment Fallsi. Long-run Philips Curve shifts to the leftii. Long-run AS curve shifts to the rightiii. For any given rate of money growth and inflation1. Lower unemployment 2. Higher outputXI. Recent Developmentsa. There is no stable short-run Philips Curveb. Each short-run Philips Curve reflects a particular expected rate of inflationi. Expected inflation changes when short-run Philips Curve shifts XII. Supply Shocks and the Philips Curvea. Supply Shocki. Event directly alters firms’ costs and pricesii. Shifts economy’s AS curveiii. Shifts the Philips Curveb. Stagflation in the 1970s i. AS curve shifts left as the economy faces an abrupt increase in oil pricesii. Stagflation1. Lower output2. Higher prices3. Short-run Philips Curve shifts righta. Higher unemploymentb. Higher


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