ECO2013 Katie Sherron Final Exam Study Guide Chapter 11 Fiscal Policy The Keynesian View and Historical Perspective Fiscal Policy Changing taxes or government spending with the purpose of achieving macroeconomic goals Classical economists believe equilibrium is present when the expected price level is the actual price level Resource prices will adjust to restore full employment o Thought recovery from recession would occur without fiscal policy and they would happen quickly o Thought economy can self heal Great Depression 1929 1939 GDP fell over 30 Keynes believed equilibrium is present when the total spending in the economy equals total output Resource prices may never adjust to restore the economy toward full employment o Changes in output direct the economy toward equilibrium NOT changes in prices o Small changes have a BIG impact o Output Prices Keynes Expenditure Multiplier o Builds on point that One individual s expenditure becomes the income of another o Total Income Expands by a Multiple of the Initial Increase in Spending o MPC is the marginal propensity to consume It refers to the amount of income that you would spend vs save if you earned a little extra o Multiplier 1 1 MPC o The multiplier times the amount of additional spending equals the amount of income that Keynes thought would be generated by government spending Paradox of Thrift The idea that when many households try to increase saving actual saving may not increase Countercyclical Policy A policy that tends to move the economy in an opposite direction from the focus of the business cycle Keynesian view of fiscal policy Recession o Government should run a budget deficit Increase spending and or Cut taxes o This will stimulate AD and shift it right to restore full employment Keynesian view of fiscal policy Expansion o Government should run a surplus Decrease spending and or Raise taxes o This will dampen AD and shift it left to fight inflation Restrictive Fiscal Policy must be used to fight inflation Keynes thought wages and other resource prices are sticky and the economy will be very slow to correct itself if it ever corrects Most economists believe it is difficult to time fiscal policy accurately and that automatic stabilizers help mitigate booms and busts Automatic Stabilizers o Tend to lead to a budget deficit during a recession and a surplus during a boom o Require NO congressional Action Chapter 12 Fiscal Policy Incentives and Secondary Effects Many economists have issues with Keynes ideas about expansionary policy This chapter considers some arguments against countercyclical policy Crowding out theory o Increasing government spending by running budget deficits won t shift AD o This is because the spending will be financed by government borrowing which will shift the demand for loanable funds to the right and drive up interest rates o The result will be a decline in consumer spending business spending and net exports offsetting any change that would have occurred from increasing government spending An increase in government borrowing will result in higher interest rates which will crowd out private investment and consumption New classical economists o Increasing government spending by running budget deficits won t shift AD o This is because consumers know that the deficits will eventually have to be paid off o When the government increases its borrowing consumers will save to pay off future taxes reducing consumer spending o The result will be no change in interest rates and no shift of the AD curve Ricardian Equivalence The theory that raising taxes and running a budget deficit are essentially equivalent and will have NO impact on consumption or AD Supply side economics o Keynes argued that cutting taxes and increasing government spending would have the same expansionary effect on AD Supply side economists disagree o Supply side economists argue that a tax cut is far superior to an increase in government spending o The reason is that high tax rates reduce an individual s incentive to work hard be productive and increase GDP Chapter 13 Money and the Banking System The three functions of money o Medium of exchange an asset that is used to buy and sell goods or services Without a medium of exchange barter Barter Trading for something else not using money o Store of value an asset that will allow people to transfer purchasing power from one period to the next Ex Putting money aside each month to save for spring break o Unit of account a unit of measurement used by people to post prices and keep track of revenues and costs When you use dollar prices to compare costs Defining the word money It s not just currency o Fiat money money that has neither intrinsic value or the backing of a commodity with intrinsic value currency is an example U S Currency is fiat money Has value because We trust it s valuable It is scarce o Liquid asset an asset that can be easily converted to money without loss of o M1 money supply the sum of currency in circulation checkable deposits maintained in depository institutions and travelers checks Currency medium of exchange made of metal or paper o Demand deposits non interest earning deposits that can be either withdrawn or made payable on demand to a third party Like currency these deposits are widely used as means of payment o Other checkable deposits interest earning deposits that are also available for value checking o M2 money supply equal to M1 plus savings deposits time deposits accounts of less than 100 000 held in depository institutions and money market mutual fund shares o Money market mutual funds interest earning accounts that pool depositors funds and invest them in highly liquid short term securities Because these securities can be quickly converted to cash depositors are permitted to write checks which reduce their shareholdings against their accounts Credit and credit cards are never money Credit means funds acquired by borrowing Banks Banks include Savings and loan associations Credit Unions Commercial Banks o Depository institutions businesses that accept checking and savings deposits and use a portion of them to extend loans and make investments Banks savings and loan associations and credit unions are examples o Federal Reserve System the central bank of the U S it carries out banking regulatory policies and is responsible for conducting monetary policy Monetary Policy one of the ways that the U S government attempts to control the economy If the money supply
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