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Policy Options

by: An Notetaker

Policy Options Econ101

An Notetaker

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Policy Options
Principles of Macroeconomics
Dr. Kristen Kling
Study Guide
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This 4 page Study Guide was uploaded by An Notetaker on Sunday October 9, 2016. The Study Guide belongs to Econ101 at Arizona State University taught by Dr. Kristen Kling in Fall 2016. Since its upload, it has received 3 views.


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Date Created: 10/09/16
­ Objectives of both fiscal and monetary policy are to pursue Full employment, price stability and external balance. ­ Recessionary gap : Y −Yf 0 ­ Characteristics of a recession (and rising unemployment): 1. Fall in GDP, total sales and inventory. Fall in actual profits. Fall in business and investor confidence. Fall in capacity usage i.e. fall in national produce, profit margin shrinks, business & investor activities reduced, consumption drops across all business sectors. 2. Savings increase in households. 3. Unemployment rate increases due to cyclical unemployment. 4. General prices expected to drop in bonds and financial assets. 5. Investment rate immune to rate of change in interest rate. 6. Economy in a “liquidity trap” represented by a horizontal LM curve. ­ Effects of an expansionary monetary policy: 1. Money supply increases, no effect on interest rate since LM is perfectly elastic and hence no change in interest rates. No change in investment. 2. Expectations are typically pessimistic and thus the IS curve is steep and LM curve is flat. Thus monetary policy is a weak anti recession policy as rates are already very low and if s M  will to increase further, the rates will not change and have little or no effect on output. ­ Effects of an expansionary fiscal policy i. An increase in Government Expenditure or a decrease in T increases the AE. Thus increase in Y by a multiple to Y. f ii. IS curve shift right. Both Y and i will increase. iii. Works better in recession as it increase output and reduces unemployment. S “Crowding out” occurs as government expenditure increase assuming no change in M . This leads   to   an   increase   in   the   transaction   demand   for   money   resulting   in   money   market D  S disequilibrium i.e. M > M . So interest rates increase. Increase in interest rates crowds out some private sector expenditures depending on how sensitive they are to interest rates. This can be shown using an ISLM diagram. Any change in G shifts the IS curve by 1/(1­c+ct) times the change in G. IS curve shifts right from IS  to IS . Output increases from Y  to Y  initially. 0 1 0 1  Case 1  ­ When little or partial crowding out (LM curve is elastic – LM ) e Increase Y leads to increase in M  and so iTterest rates increase to reduce M  but increase in A interest has little effect on Investment. So output falls by a little bit from Y  to 1  onlye Generally strong fiscal policy is derived from a less elastic IS curve and a more elastic LM curve, thus making it a strong anti recession policy.  Case 2  ­ When large or strong crowding out (LM curve is inelastic – LM) i Increase Y leads to increase in M  and so iTterest rates increase to reduce M  but increase in A interest has larger effect on Investment. So output falls by a large amount from Y  to Y. 1 i Generally weak fiscal policy is derived from an elastic IS curve and a inelastic LM curve a weak anti inflationary policy. Policy Option The effect of fiscal policy is strongly influenced by underlying monetary actions of the monetary authorities. Expansionary fiscal policy is accompanied by the purchase of government securities by central s bank from the public or banks, leading to an increase in the M  and so lower interest rates. So “crowding out” effect of an expansionary fiscal policy is negated by the expansionary monetary policy, leading to a full increase in output (Y  to0Y ). 1


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