Chapters 22 & 23 Monetary Policy and Fiscal Policy

Impacts of Fiscal Policy

- A change in the amount of government purchases will directly increase or decrease GDP. This is because something is purchased or produced in the transaction - An increase in government purchases or in transfer payments will increase GDP by more than that initial amount because it produces extra income across the economy. - A change in the amount of transfer payments will indirectly increase or decrease GDP. This is because nothing is purchased or produced when a change is made.

Monetary Policy Choices when Nominal Interest Rates are 0

- Forward guidance - Quantitative easing

reasons why the Fed doesn't target 0 inflation

- Inflation greases the wheels of the labor market - The Fed can lower real interest rates by more when inflation >0 - A 0% inflation target runs the risk of deflation - Measured inflation may be overstated

Tool The Fed uses to influence the Federal Funds Rate at the lower bound

- Pays interest to banks on their reserves - Borrows money overnight from financial institutions

As a result of the increase in Real Interest Rates...

- consumption, investment. government spending, and net exports (GDP) will all decrease - output will decrease - inflation will decrease - unemployment will increase

key ways in which government spending & tax expenditures differ

- government spending must be renewed or evaluated each year, whereas tax expenditures renew automatically - gov't spending explicitly subtracts from the federal budget, whereas tax expenditures reduce the tax revenue available for gov't spending

tax expenditures

- have lower political cost - encourage spending on human capital

if the Fed has conducted expansionary monetary policy to combat recession but is running up against the 0 lower bound, and the economy is. still not recovering, it should...

- lower taxes - increase government spending - increase transfer payments

corporate tax cuts

- provide the extra cash necessary to fund new projects - firms increase investments - new investments are made more profitable

If the Fed pushes rates down...

- the opportunity cost of borrowing falls - the level of output in the economy increases

payroll tax

A tax on earned income - fixed rate

expansionary fiscal policy leads to...

Higher real interest rates which reduces private spending

Tool The Fed uses to influence the Federal Funds Rate at the upper bound

Lends directly through the discount window

Quantitative easing

Purchasing large amounts of longer-term government bonds in an effort to put downward pressure on longer-term interest rates - used to help recover from recession - considered unconventional monetary policy

open market operations (monetary policy)

The Fed adjusts the federal funds rate by buying & selling short-term government bonds

How does the Federal Reserve set the lower bound of the federal funds rate?

The Fed sets other interest rates to put a lower bound on how low the federal funds rate can go

Monetary policy is defined as the:

adjustment of interest rates to influence economic conditions.

tax credit

an amount subtracted directly from taxes owed

automatic stabilizers

automatically adjust as the economy expands and contracts - boosts output during recessions - reduces output during expansion

the tax system can smooth out business cycle fluctuations by...

automatically raising taxes during expansions and lowering taxes during recessions

4th tool

buys and sells government bonds

income tax

earned income, unearned income - progressive

In order to boost output, the federal government engages in _____ fiscal policy, which _____ government spending and _____ taxes.

expansionary; raises; lowers

refundable tax credit

gives a benefit of tax expenditures to households with a zero income tax bill

A budget deficit occurs when:

government spending exceeds government revenue.

forward guidance

helps push down longer-term interest rates - strategy of providing information abt the future course of monetary policy in order to influence market expectations of future interest rates

During a recession

income taxes decrease and unemployment insurance payment increases

during an expansion...

income taxes will increase & the unemployment insurance payment will decrease

the federal government can adopt an expansionary fiscal policy by...

increasing government purchases and cutting taxes

requiring a balanced budget each year would...

limit the gov't ability to respond to an economic downturn

Quantitative easing is when the Fed buys ________ government bonds and securities in order to put ________ pressure on long‑term interest rates. It is considered unconventional monetary policy and may be used when the federal funds rate has hit _______.

long-term; downward; zero lower bound

If the output gap is negative, then relative to the neutral interest rate, the Federal Reserve will _____ the real interest rate to drive _____ consumption and investment.

lower; up

money supply

monetary policy

fiscal policy, through automatic stabilizers, can work in concert w monetary policy to...

more quickly steer the economy back to potential output bc monetary policy takes a longer time to affect the economy

With a progressive tax, those with _____ income tend to pay a _____.

more; higher share of their income in taxes

A series of short-term loans represents the _____ a long-term loan; therefore, a bank will only offer a long-term loan when the return is _____ a series of short-term loans.

opportunity cost of making; at least as great as

Forward guidance occurs when the Federal Reserve:

provides information about the future course of monetary policy in order to influence expectations about future interest rates.

when inflation is lower than the fed's inflation target, it signals the Fed that it should...

set real interest rates lower than the neutral real interest rate

cost associate w a government program doesn't disappear but...

shifts from taxpayers to employers to workers

Hidden Government Spending

tax expenditures government regulation

Government spending explicitly subtracts from from the budget whereas...

tax expenditures reduce the tax revenue available for gov't spending

an economy might be at risk of overheating when...

the Fed lowers interest rate ti create a short-term economic boom

As the economy slows...

the automatic decrease in taxes & the automatic increase in government support programs will help stabilize the economy

crowding out

the decline in private spending- particularly investment that follows from a rise in government spending

countercyclical fiscal policy means that

the gov't will spend more during a recession and spend less when the economy is expanding

fiscal policy: a countercyclical force

the government's use of spending & tax policies to attempt to stabilize the economy - tries to minimize output fluctuations & keep actual GDP close to potential output - attempts to neutralize the effects of the business cycle

Fed rule-of-thumb

the recipe that describes how the Fed often sets the interest rate.

marginal tax rate

the tax rate you pay if you earn another dollar

tax expenditures primarily benefit...

those w high incomes bc the values of tax exclusions and deductions are higher when your income tax rate is higher