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Chapter 16: Fiscal Policy Expansionary fiscal policy: occurs when the government increases spending or decreases taxes to stimulate the economy toward expansion Contractionary fiscal policy: when the government decreases spending or increases taxes to slow economic expansion Countercyclical fiscal policy: fiscal policy that seeks to counteract business-cycle fluctuations Marginal propensity to consume (MPC): the portion of additional income that is spent on consumption Spending multiplier (M^s): formula to determine the total impact on spending from an initial change of a given amount (1/1-MPC) Automatic stabilizers: government programs that automatically implement countercyclical fiscal policy in response to economic conditions Crowding out: private spending falls in response to increases in government spending New classical critique: of fiscal policy asserts that increases in government spending and decreases in taxes are largely offset by increases in savings, but if savings increases, then consumption falls, and this outcome mitigates the effects of the government spending Supply side fiscal policy: involves the use of government spending and taxes to affect the production (supply) side of the economy Laffer curve: illustration of the relationship between tax rates and tax revenue Fiscal Policy I ● Keynesian: all about AD, start spending, revolutionized modern Macro Fiscal Policy ● The use of government budget tools to affect macroeconomy ● Change G and T to shift AD ● Initial spending changes multiply through the economy ● Ex. Great Recession, 2008 Bush’s Economic Stimulus Act of 2008, send tax break checks to increase consumption, did not work so when Obama came into power, he expanded the government spending part of real GDP to increase aggregate demand ● Expansionary fiscal policy: leads to increases in budget deficits and the national debt during economic downturns Spending Multiplier: MPC ● What one person spends becomes income to others ● Increases in income generally lead to increases in consumption ● Each time people earn new income, they spend part of it ● Stage 1: increase spending ● AD= C+I+G+NX ● Stage 2: let spending multiply ○ Recall: Spending= GDP= Income ○ Spending by one becomes income to another...part of this will be spent ○ Boost aggregate demand, government spending ○ Each round of spending shifts aggregate demand to the right ● Result: Total spending generated will be a multiple of the initial change ● Multiple depends on how much people spend, depends on MPC

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Marginal Propensity to Consume (MPC): the portion of additional income that is spent on consumption ○ MPC= △ consumption/△income ○ Ex. MPC= ½ or .5 ■ Round 1: $100 billion, increases G ■ Round 2: $50 billion ■ Round 3: $25 billion ■ Round 4: $12.5 billion ■ Total: $200 billion ● m^s= spending multiplier, Keynesian Multiplier, Fiscal Multiplier ● m^s= 1/(1-MPC)= 1/(1-.5)=1/.5= 2 Summary and Implications ● Fiscal policy is typically focused on AD ○ Use G and T to shift AD ○ Multiplier power ○ Keynesian roots ● Countercyclical ○ Smooth out the business cycle ○ Using expansionary policy during economic downturns and contractionary policy during economic expansions ○ When GDP is going up, we pay off debt ○ When GDP is going down, we increase spending ● Budget implications: ○ Deficits during contractions (retail therapy, pull the economy back up) ○ Surpluses during expansions ○ Obama’s plan: enact recovery plan to decrease unemployment but what happened was that the recovery plan went up higher and didn’t go down for several years Critiques and Shortcomings of Fiscal Policy ● Lags ○ A. Recognition: Difficult to tell if we are on the way down or not, growth is not constant and one bad quarter does not always signal a recession, one good quarter does not signal an expansion ○ B. Implementation: takes a long time to implement policy because Congress has to agree on them ○ C. Impact: time lag between when a corrective action is taken and when the corrective action is felt, takes time for policy to work ○ There is a risk that the policy can actually magnify the business cycle because if it lags for a year to 18 months, expansionary fiscal policy could hit when the economy is already expanding, resulting in excessive AD and inflation (vice versa) ○ Keynesian reply: Automatic Stabilizers ■ Progressive income taxes: tax rates are already in place, already countercyclical, guarantee that individual tax bills fall when incomes fall

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(during recession) and rise when incomes rise (during expansions) Corporate profit taxes: go up and down against the business cycle, lower total tax bills when profits are lower (during contractions) and raise tax bills when profits are higher (expansions) Unemployment insurance: goes up automatically during a downturn because there is more unemployment, automatically more government spending Welfare payments: changes in G that are countercyclical

■ Crowding Out ○ Government spending crowds out private spending ○ Private spending falls in response to increases in government spending ○ Government increases their spending and private parties reduce their spending at the same time ○ G substitutes for C and I that would have taken place otherwise ○ Offsets ○ “Every dollar borrowed requires a dollar saved” ○ EX. 2015, economy is doing fine (S= $200, I= $200) ■ 2016, increase G by $100 billion, no new taxes, new deficit, new demand for loans ■ Parallel shift in demand, Quantity demanded increases so R increases ■ S= $250, I= $150 for private investment ● Net changes ○ G= +100 ○ I= -50 ○ C= -50 ○ Total= 0 ○ G might increase but it just offsets a decrease in I and C ● Savings Shifts ○ New spending today has to be paid for someday, taxes must rise sooner or later ○ New classical critique of fiscal policy asserts that increases in government spending and decreases in taxes are largely offset by increases in savings, but if savings increases, then consumption falls, and this outcome mitigates the effects of the government spending ○ Effects of the stimulus are negated Fiscal Policy II ● Back to the Great Recession ○ Why didn’t fiscal policy work as expected? ○ Combination of ■ Three critiques (crowding out) ■ Supply also shifted ● Supply Side Fiscal Policy ○ Focus on institutions that create incentives to innovate and work/produce/supply more ○ Using budget tools (taxes and government spending) to affect the ●

macroeconomy Demand: Spending v. Supply: Producing ■ How fiscal policy can affect LRAS (Resources, Technology, Institutions) ■ Shift to a new level of full employment output ■ Use of government spending and taxes to affect the production (supply) side of the economy ■ Government can implement fiscal policy and use tax code to encourage technological advancement Supply-focused Policy: ○ Tax credits for R&D spending ■ A firm builds a new lab, very costly, but government will incentivize them to do that by giving them tax breaks ○ Education subsidies ■ Can help build human capital ○ Lower corporate profit tax rates ○ Lower marginal income tax rates ■ Primary means by which we fund the government activities ■ Why is this a supply side policy? Tax Rates and Tax Revenue ● Income Tax Revenue= Tax Rate x Income ● Two relationships between tax rates and tax revenue ○ When rates are low (+) ■ When tax rates go up, tax revenue goes up ○ When rates are high (-) ■ Government is taking everything, no incentive to produce and people starve ■ Tax revenue is low because no one wants to produce anything ● Increase in tax revenue= decrease in tax rate x increase in income ○ Would decrease tax rate if it is too high in order to increase income to increase tax revenue ○ Incentives affect behavior ● Conservatives: argue for tax cuts, want a downward sloping relationship between tax rate and revenue ● Liberal: upward sloping relationship ● Depends on where you start, difficult to tell what will happen if you reduce all the rates ● Laffer Curve ○

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1980’s Experiment ○ All tax rates fell ■ What happens to tax revenue? ■ Total tax revenue fell! ■ No Laffer curve? ■ Among the wealthy, what happened? For the top 1%, tax revenue rose ■ Since 1980, top marginal tax rate went from 70 to 30 to 40 back to 35 ■ Share paid by top 1% has increased since then 2008 Tax Reductions (Bush) ○ CQ: the 2008 tax rate cuts applied to both future tax rates and past tax rates (from 2007), these tax cuts should be considered: both demand and supply side tax cuts ○ A. Reductions of future rates ■ Forward-looking: primary focus is on changing incentives for production and innovation, shift LRAS ● B. Reductions on past taxes (already paid): cannot change your behavior because it is always done ○ Backward looking: give refunds

Chapter 17: Money and the Federal Reserve Currency: the paper bills and coins that are used to buy goods and services Medium of exchange: what people trade for goods and services Barter: involves the trade of a good or service without a commonly accepted medium of exchange Double coincidence of wants: occurs when each party in an exchange transaction happens to have what the other party desires Commodity money: involves the use of an actual good in place of money Commodity- backed money: money that can be exchanged for a commodity at a fixed rate Fiat money: money that has no value except as the medium of exchange, there is no inherent or intrinsic value to the currency Unit of account: the measure in which prices are quoted Store of value: means for holding wealth Checkable deposits: deposits in bank accounts from which depositors may make withdrawals

by writing checks M1: the money supply measure that is essentially composed of currency and checkable deposits M2: the money supply measure that includes everything in M1 plus savings deposits, money market mutual funds, and small-denomination time deposits (CDs) Balance sheet: an accounting statement that summarizes a firm’s key financial information Assets: the items that a firm owns Liabilities: the financial obligations a firm owes to others Owner’s equity: the difference between a firm’s assets and its liabilities Reserves: the portion of bank deposits that are set aside and not lent out Fractional reserve banking: occurs when banks hold only a fraction of deposits on reserve Bank run: when many depositors attempt to withdraw their funds at the same time Required reserve ratio (rr): the portion of deposits that banks are required to keep on reserve, required reserves= rr x deposits Excess reserves: any reserves held in excess of those required (total reserves-required reserves) Moral hazard: occurs when a party that is protected from risk behaves differently from the way it would behave if it were fully exposed to the risk Simple money multiplier (m^m): the rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves, represents the maximum size of the money multiplier Federal funds: deposits that private banks hold on reserve at the Federal Reserve Federal funds rate: the interest rate on loans between private banks Discount loans: loans from the Federal Reserve to private banks Discount rate: the interest rate on the discount loans made by the Federal Reserve to private banks Open market operations: involve the purchase or sale of bonds by a central bank Quantitative easing: the targeted use of open market operations in which the central bank buys securities specifically targeted in certain markets Lecture 21: Money and Banking ● CQ: If the quantity of money in the economy doubled tonight, the result for the economy would be mixed, a boost in the short run but inflation in the long run. ● Money ● Medium of Exchange ○ What we normally trade for goods and services ○ Ex. Gold, silver, tobacco, paper currency ● Unit of Account ● Store of Value ● Three Types of Money ○ Commodity Money: ■ A physical good is used as money, hard to carry, hard to divide (makes transactions harder and less frequent) ● Commodity-Backed Money

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○ A certificate that represents a physical good Problem: changes in price of one commodity affect entire economy ○ Fiat money ■ No inherent value, gets its value because we agree it has value, official medium of exchange of the US ■ Meaningless paper, somebody is going to have to print this paper, Problem: discretion can be abused Currency: 1,271.9 Billions of Dollars (printed money) ○ M1: Currency + everything in your checking account and traveler’s checks (1,271.9+1,717.4, 2.9= 2,992.2) ○ M2= M1+ everything in your savings account, small time deposits, and retail money funds (2,992.2, 7,708.4, 502.3, 623.3= 11,826.2) ○ M= Currency + Deposits Commercial Banks ○ Basic Functions: ■ Accept deposits and extend loans ■ Inputs (Deposits) -> Firm -> Output (Loans) ○ Two Macroeconomic Roles ■ Middlemen in Loan Market- indirect finance ■ Channel for Monetary Policy ● Balance Sheet ○ Assets (uses of funds)= Liabilities + Owner’s Equity (sources of funds) ○ Liabilities + Owner’s Equity ■ Deposits ■ Borrowings: (other banks, from the fed) ■ Owner’s Equity ○ Assets ■ Loans ■ Reserves ■ US Treasury Securities ■ Other (Stocks, Bonds, Real Estate etc.) ○ Bank Reserves: vault cash or deposits at the central bank (fed) ○ Why hold reserves? ■ Reduced risk: you don’t know for sure that someone will pay back a loan ■ Reserve requirements ○ Why not have 100% reserves? Opportunity cost ● Fractional Reserve Banking ○ Required Reserve Ratio (rr) ■ The portion of deposits banks are required to hold on reserve ■ rr= 10% ■ Required Reserves= rr x deposits ■ Excess reserves: reserves held in excess of those required by the Fed

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CQ: if the required reserve ratio (rr) is 10%, how much excess reserves does Wahoo Bank have? 800 million in total deposits, 80 million worth of cash in their vault, and 20 million in their account ● 20 million CQ: Maximum loan Wahoo Bank can extend while still maintaining their required level of reserves ● 20 million Banks can create money by multiplying deposits ● M= Currency + Deposits ● Allows banks to create money ● Ex. New $1000, rr= 10%, Assume: no excess reserves, all currency deposited at banks ○ Round 1: Deposits $1000, M: $1000 ○ Round 2: $900, M: $1900 ○ Round 3: $810, M: $2710 ○ Round 4: $729, M: $3439 ○ It keeps going! ○ Sum: $10,000 ○ Simple money multiplier: (m^m= 1/rr)= 1/(1/10)= 10

Chapter 18: Monetary Policy Expansionary monetary policy: occurs when a central bank acts to increase the money supply in an effort to stimulate the economy Contractionary monetary policy: occurs when a central bank acts to decrease the money supply Monetary neutrality: the idea that the money supply does not affect real economic variables Phillips curve: indicates a short-run inverse relationship between inflation and unemployment rates Adaptive expectations theory: holds that people’s expectations of future inflation are based on their most recent experience Stagflation: the combination of high unemployment rates and high inflation Rational expectations theory: holds that people form expectations on the basis of all available information Active monetary policy: involves the strategic use of monetary policy to counteract macroeconomic expansions and contractions Passive monetary policy: occurs when central banks purposefully choose to only stabilize money and price levels through monetary policy Lecture 24: Monetary Policy ● Fractional Reserve Banking ○ Works well until...a bank run! ○ Solution: government-backed insurance: FDIC ○ New Problem: moral hazard ■ Lack of incentive to guard against risk where one is protected from its consequences

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The Federal Reserve System (Fed) ○ Central bank of the US (institution that fosters economic growth) ○ Major Duties ■ Central Banking: a bank for commercial banks ● Federal funds: deposits that private banks hold on reserve at the Fed ● Discount loans: loans from the Fed to private banks ■ Regulate Banks ● Monitors balance sheets of banks, monitor overall risk ■ Monetary Policy Monetary Policy Tools ○ Required Reserve Ratio (rr), can change the money supply ■ Fed sets the ratio of deposits that banks must hold on reserve, this ratio is the required reserve ratio ■ m^m= 1/rr ■ Decrease in rr-> increase in m^m -> increase in M ■ Increase in rr -> decrease in m^m -> decrease in M ○ Open Market Operations (OMO) ■ Central bank going out into the open market, buying and selling ● Purchase or sale of bonds by a central bank ■ Buy securities-> increase in M ■ Sell securities-> decrease in M ■ Typical OMO: buy and sell short-term Treasury securities ■ OMO Notes: ● Small changes multiply ● OMO= trades with financial institutions in the loanable funds market ● First effect of OMO: change supply of loanable funds, injecting funds into the loanable funds market, and let the banks multiply this by lending out loans ○ Quantitative Easing (QE) ■ A new type of OMO ■ Targeted use of OMO in which the central bank buys securities specifically targeted in certain markets ■ QE: buy other securities ■ When Fed buys securities in a particular market, the action leads to lower interest rates in that market ● A. Longer-term treasury securities ● B. Targeted purchases in troubled markets ○ Mortgage-backed securities Effects of Monetary Policy ○ CQ: expansionary monetary policy reduces unemployment in the short run because some prices are sticky ○ CQ: When all prices fully adjust, an increase in the money supply: has no real

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effects on the macroeconomy Historical Macroeconomics ○ Great Depression: starts Macro, fiscal policy is the primary response, Money supply contracted ○ 1950’s: monetary policy gains popularity, increase in M-> short run increase in inflation, decrease in unemployment: tradeoff between inflation and unemployment Phillips Curve: inverse relationship between inflation and unemployment, short run ○ A.W. Phillips (1958) ○ Samuelson and Solow (1960) ■ U.S. inflation and unemployment rates, 1948-1959 ■ “In order to have zero inflation, the American economy would seem on the basis of twentieth century and postwar experience to have to undergo something like 5 to 6 percent of the civilian labor force being unemployed” ■ “In order to achieve the non perfectionist's goal of high enough output to give us no more than 3 percent unemployment, the price index might have to rise by as much as 4 to 5 percent per year” ■ Tradeoff between i and u in the short run (Phillips Curve) ■ Implicit Assumption ● Inflation always unexpected ● i^e= 0

Adaptive Expectations: people expect the future to look like today ○ Milton Friedman & Edmund Phelps ■ A. Inflation is powerful when it is a surprise ■ B. Surprise inflation harms some people ■ C. People have incentives to adjust expectations ■ D. If inflation is fully anticipated… ● It should NOT affect unemployment ● Phillips Curve may not always work ● When inflation is expected, unemployment is not affected ○ Example: ■ Time

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i^e

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u=u*

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u specialization, trade -> Produce none of what you consume ● Why trade? ○ Why trade for a sandwich? ○ Production costs are too high ○ Opportunity costs ● When does international trade make sense ○ Trade when opportunity costs of production are high ○ Produce when opportunity costs of production are low Comparative Advantage ● Absolute advantage: the ability to produce more with the same quantity of resources ○ Here, trade is intuitively beneficial ● We use comparative advantage to show: specialization and trade is beneficial even if a nation enjoys absolute advantage in everything ● Ex. 2 nations US and China ○ 2 goods: food (wheat) and textiles (shirts) ○ Assume: U.S. has absolute advantage in production of both ○ Output per worker day

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Food

Textiles

U.S.

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3

China

1

2

What happens if they decide to trade an...