Chapter 21- Monetary and fiscal policy

What are automatic stabilizers? Give some examples of automatic stabilizers during a recession.

Automatic stabilizers are a form of fiscal policy that do not require the passage of a new law. For example, during a recession, tax collections decrease since people are making less money and government spending on programs such as unemployment insurance, food stamps, and other welfare programs increases because more people become eligible for them.

If a government wants to implement a contractionary fiscal policy, what are the two broad options that they can choose from?

Increase taxes and/or decrease government spending

What are some less controversial uses of deficit spending?

Spending on capital projects and wars are viewed as not very controversial uses of deficit spending because the benefits last for years after the expenditure has been made, so it makes sense for future generations to pay since they are also receiving the benefits. Also wars have traditionally been viewed as an appropriate use of deficit spending since future generations will benefit from national security.

If your goal is to implement fiscal policy that will take effect quickly, should you choose tax cuts or increased government spending during a recession?

Tax cuts will take effect more quickly

What does it mean to say that the Federal Reserve has a dual mandate?

The Fed is supposed to use monetary policy to affect the country's economy in order to maintain maximum employment (low unemployment) and stable prices (low inflation).

Give two examples of the Federal Reserve's actions during the Great Recession, above and beyond the usual monetary policy tools. Fully explain each of your examples.

The Fed made loans to primary dealers including investment banks and other that purchase bonds from the FOMC; usually these loans are only available to commercial banks. The made loans of treasury securities to banks in return for mortgage-backed securities. The mortgage-backed securities were almost worthless, so this lending process made the bank's balance sheets a lot healthier. The Fed helped to negotiate Bear Steans' acquisition by JPMorgan Chase and guaranteed a portion of potential losses

Would you describe the actions of the federal government during the 2008 recession as classical or Keynesian? Why?

The government implemented tax cuts and government spending increases (the stimulus), so these would be Keynesian policies.

Could a government proceed in debt forever? Explain why or why not.

Theoretically, since a government does not die or retire and live off of savings like an individual person does, it is possible that a government could be in debt forever so long as there are people willing to lend to the government.

Is the US currently in debt? Do we currently have a budget deficit?

Yes and yes.

a. If the MPC is .8, what is the spending multiplier? b. By how much would GDP increase if government spending increased by $5 million?

a. 5 b. $25 million

How are crowding out and the multiplier effect similar and different?

Crowding out and the multiplier effect both affect the aggregate demand curve. The multiplier effect shifts AD further to the right after an increase in AD, whereas crowding out decrease AD after its initial increase.

If a government wants to implement an expansionary fiscal policy, what are the two broad options that they can choose from?

Decrease taxes and/or increase government spending

During the 2007 recession, the Fed used monetary policy to reduce interest rates in the economy. Use what you have learned to give a possible explanation as to why this failed to restore the economy to a long-run equilibrium

Interest rates fell to zero. After that, traditional monetary policy cannot have any further effects. Everyone who is willing to take out a loan at close to zero percent, has already done so and interest rates can't be negative.

How do Keynesian economists differ from classical economists? What do they believe the government should do in times of recession?

Keynesian economists believe that short-run fluctuations are harmful to economies and their citizens. Classical economists believe that we should only be concerned with the long-run health of an economy. Keynesian economists would advocate for the government to use fiscal and monetary policies.

Can fiscal policy decrease both inflation and unemployment at the same time?

No. An expansionary fiscal policy will decrease unemployment, but increase inflation. A contractionary fiscal policy will decrease inflation and increase unemployment.

Explain why fiscal policy does not always shift the AD curve by the exact right amount to reach a new long-run equilibrium.

Potential output must be correctly estimated to determine if the economy is in a short-run or long-run equilibrium. We must also be able to calculate the spending multiplier correctly. Various government entities must coordinate to spend the government's money. The shape of the SRAS curve must be known and SRAS must not be affected be the policy change.

List the 2 monetary policy goals. Does the Fed have to choose between each of these?

Stable prices and high employment. Yes, monetary policy involves a tradeoff between either increasing unemployment or inflation. This is because monetary policy shifts the aggregate demand curve.

What is the debt ceiling? How did congress' debt ceiling debate in 2011 affect the United States' ability to borrow money?

The debt ceiling is a cap on how much debt the country can have. The debt ceiling debate led to the US government bonds being downgraded by credit rating agencies. This could create a problem where purchasers of US government bonds would not trust that they will be paid back. So far, this has not happened.

Suppose that taxes are decreased by $100 million and output increases by $125 million. Does this number indicate whether there is crowding out or a multiplier effect?

There are always multiplier effects and crowding out if the government finances the spending with a deficit. This number indicates that in this case, the multiplier effect is larger than crowding out.

In what situations would contractionary fiscal policy be recommended? How might you implement this type of policy? Why would you implement this policy --- what are the reasons why it might make sense to slow the economy through government policy?

A contractionary fiscal policy would be used when the economy is experiencing an expansionary gap. An indication of this would be high inflation. Government spending could be decreased and/or taxes could be increased. This could be to try to fight inflation, or simply to smooth the business cycle so that the next recession will not be as severe.

Which of the following will have the largest effect on the economy? a. a tax rebate b. a tax cut that will expire after 5 years c. a permanent tax cut

A permanent tax cut will have the largest effect since consumers are going to spend more of it instead of saving it.

Is it better to implement fiscal policy to late, rather than not at all? Explain.

No. If fiscal policy is implemented too late (after a recession is over), it can actually magnify the next business cycle rather than smoothing it out, making the next recession worse.

Are monetary and fiscal policy effective for dealing with stagflation? Explain.

Both monetary and fiscal policy will shift the AD curve. So, any policy that decreases inflation will increase unemployment and vice versa. In times of stagflation

Suppose that taxes are decreased by $100 million and output increases by $85 million. Does this number indicate whether there is crowding out or a multiplier effect?

Crowding out is having a larger effect

Compare and contrast open market operations and quantitative easing

Open market operations and quantitative easing both involve the Fed purchasing financial assets. However, open market operations applies to a narrow set of short-term US government treasury bills and quantitative easing is the purchase of a much more broad set of assets including longer-term government bonds and even private bonds and other assets.

If people do not believe that a tax cut will be permanent, how their spending of this additional money be affected?

If consumers believe a tax cut to be temporary, they are more likely to save the extra money or use it to pay down existing debts rather than spending it.

If government spending increases are funded with a tax increase, what will be the overall effect on aggregate demand? How will this be different if the spending increase is funded through a deficit?

If funded with a tax increase, the increase in government purchases is offset by a decrease in consumption and/or investment due to higher taxes. If higher government purchases are funded with a deficit, the AD can increase.

Explain what it means when we say that there is a zero lower bound on interest rates. Will buying bonds be a useful policy once an interest rate of zero is reached?

Interest rates cannot be negative. Once an interest rate of zero is reached, buying bonds will not be useful. Everyone who wants to take out a loan already has and banks won't be willing to lend at a negative rate.

What is one advantage that monetary policy has over fiscal policy?

Monetary policy has a lot of the same shortcomings as fiscal policy, but does tend to be quicker to implement since it does not involve hiring workers or congress agreeing to pass a law.

During a recession, without any changes to the law, what happens to the amount of taxes collected? What happens to government spending? If the federal government were required to balance the budget every year, what would need to be done to taxes and/or spending during a recession? Would this make the recession more or less severe?

Tax collections will fall since people make less money. Government spending will increase as more people qualify for welfare programs. If a balanced budget was required, taxes would have to be increased and/or government spending cut. This would actually be a contractionary policy and would make a recession more severe.

Give an example of a discretionary fiscal policy

The stimulus bills in response to the 2008 recession are examples of discretionary policies (TARP, ARRA)

What is the problem with keeping interest rates too low for too long?

When interest rates are kept very low, this encourages banks to make riskier and riskier loans.