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EC202 Week 9 Notes

by: Kelsey Fagan

EC202 Week 9 Notes EC 202

Marketplace > University of Oregon > Economcs > EC 202 > EC202 Week 9 Notes
Kelsey Fagan
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Here are the notes for week 9.
Intro Econ Analy Macro
Chad Fulton
Class Notes
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This 6 page Class Notes was uploaded by Kelsey Fagan on Wednesday May 25, 2016. The Class Notes belongs to EC 202 at University of Oregon taught by Chad Fulton in Spring 2016. Since its upload, it has received 7 views. For similar materials see Intro Econ Analy Macro in Economcs at University of Oregon.


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Date Created: 05/25/16
Day 17 (5/23)  ● Review Questions:  ○ A recessionary gap occurs when:  ■ Real GDP is less than potential GDP  ○ The short­run Phillips curve shifts when  ■ Potential GDP increases  ■ The natural level of unemployment rises  ■ Inflation expectations change  ○ The long­run Phillips curve shifts when  ■ Potential GDP increases  ■ The natural level of unemployment rises  ○ A demand­pull inflation event could begin with:  ■ An increase in the money supply  Fiscal Policy  ● Government spending and taxation  ● The Federal Budget  ○ The annual statement of the federal government’s outlays (spending) and tax  revenues  ○ Two purposes:  ■ To finance the activities of the federal government  ■ To achieve macroeconomic objectives  ○ Fiscal policy   ■ The use of the federal budget to achieve macroeconomic objectives:  ● Full employment  ● Sustained economic growth  ● Price level stability  *The President and Congress make fiscal policy  ○ Spending (outlays)  ■ The government spends money on:  ● Transfer payments  ○ i.e. social security  ● Expenditure on goods and services  ○ National defense  ● Debt interest  ○ Surplus or Deficit  ■ Federal government's budget balance equal ​receipts minus outlays  ● deficit=receipts­outlays  ■ If receipts exceed outlays, the government has abudget surplus  ■ If outlays exceed receipts, the government hasbudget deficit  ■ If receipts equal outlays, the government hasbalanced budget  ● Government Debt  ○ The total amount that the government has borrowed  ■ Debt is the sum of past deficits minus past surpluses  ■ Debt increase when the government has a deficit  ■ Debt decreases when the government has a surplus  ○ Debt is usually measured as a percentage of GDP  ■ debt­to­GDP = debt/GDP X 100%  ● Supply­side effects  ○ Fiscal policy has important effects on employment, potential GDP, and aggregate  supply­​upply­side effects  ○ An ​ income tax​ changes full employment and potential GDP through its effect on  the labor market  ● Labor market and taxes  ○ There are two effects of an increase in taxes  ■ It decreases the supply of labor by reducing incentives to work  ■ It creates anincome tax wedge​ : a difference between the take­home wage  of workers and the cost of labor to firms  ● Potential GDP and taxes  ○ An increased tax level will:  ■ Reduce​  the equilibrium quantity of hours worked in the labor market  ■ In turn, thisdecrease potential GDP  ● Taxes and incentives  ○ When the government implements ​ proportional taxes, taxes that are a  percentage​ of income or consumption, that changeincentives  ■ A (labor) income tax reduces the incentive to work, because  take­home­pay is lower  ■ A tax on consumption has a similar effect, because it increases prices and  so reduces real wages  ■ A tax on interest income reduces the incentive to save/loan out your  money  ● Laffer Curve  ○ In order to understand how tax revenue changes when tax rates increase, there are  two mechanisms to consider:  ■ An increased tax rate increases revenue per dollar earned  ■ An increased tax rate  can change incentives so that fewer dollars are  earned  ○ The relationship between the tax rate and the amount of tax revenue collected is  called theLaffer curve  ○ The ​ maximum tax ​ occurs at the top­most point of the curve  ○ To the left of that point, the curve upwards sloping​ , and increasing tax rates  will increase revenue  ○ To the right of that point, the curve downwards sloping​ , and decreasing tax  rates will increase revenue  ● Supply­side Debate  ○ Debate about the effect of a tax cut on government tax revenues:  ■ Because it reduces taxes per dollar earned  ■ But if it increases incentives to work a lot, then a tax cut could actually  increase government revenue  ■ Whether or not a tax cut increases revenue depends on where we are on  the Laffer curve  *​most economists believe that the U.S. is on tupwards sloping portion​  of the  Laffer curve­ this means that a tax cut will usually decrease government revenue.  ● Fiscal stimulus  ○ The use of fiscal policy to increase production and employment  ■ Automatic fiscal policy​  is a fiscal policy action triggered by the state of  the economy with no government action  ■ Discretionary fiscal policy​ is a policy action that is initiated by an act of  Congress    Day 18 (5/25)  ● Review Questions:  ○ What is the primary difference between short­ and long­run?  ■ In the short run, nominal wages are fixed  ○ What happens to prices if potential GDP increased?  ■ Decrease  ○ Why might the government decrease the money supply?  ■ To slow down the economy in an expansion   Fiscal Policy Cont.   ● Fiscal stimulus  ○ The use of fiscal policy to increase production and employment  ■ Automatic fiscal policy​  is a fiscal policy action triggered by the state of  the economy with no government action  ○ Discretionary fiscal policy​ is a policy action that is initiated by an act of  Congress  ●  Government spending and borrowing  ○ In order to spend, the government often has to borrow money. Government  borrowing is accomplished primarily by issuitreasury bonds  ■ A treasury bond is essentially a loan made by individuals, banks, or  foreign governments to the U.S. government   ● Bonds  ○ Individuals pay for a bond right now, called price of a bond  ○ In return the government promises to pay back a certain amount in the future,  called thface value of the bond  ○ The date at which the government pays back the face value is callematurity  date  ○ The time length between the purchase of the bond and its maturity date is called  the​erm length  ○ The nominal interest rate of the bond is the growth rate of the value of the bond  ■ Nominal = face value­ price/ price *100%  ○ When the government borrows money by issuing bonds, it increases real interest  rates  ■ An increase in government borrowing increase the demand for loanable  funds  ■ An increase in​demand d​rives prices up  ■ In the loanable funds market, the “price” isreal interest rate  ● Fiscal policy multiplier  ○ Recall the aggregate demand formula  ■ Y = C + I + G ­ M  ○ In order to increase aggregate demand and short­run output. The government has  two fiscal policy tools:  ■ Decrease taxes, increasing consumption (C)  ■ Increase government spending directly (G)  ○ Because an increase in aggregate demand increase output in the short­run, there is  a ​ultiplier effect.  ■ An increase in demand for any reason increase output and employment  ■ An increase in output and employment increase aggregate income  ■ An increase in aggregate income increases consumption  ■ An increase in consumption increase output and employment again  ■ Repeat 2­4  ○ Multiplier effect: an increase in government spending increases output more than  one­for­one  ● Crowding Out Effect  ○ On the other hand, an increase in government expenditure usually increases  government borrowing and raises the real interest rate  ○ With the higher cost of borrowing, investment decreases, which partly offsets the  increase in government expenditure  ○ This is called crowding out  ○ Crowding out effect: an increase in government spending increases output less  that one­for­one  ● Government spending multiplier  ○ Describes the total effect of an increase in government spending on output  ■ If the multiplier effect is bigger that the crowding out effect, the  government spending multiplier will be greater than one  ■ If the crowding out effect is bigger than the multiplier effect, the  government spending multiplier will be less than one  ● Time Lags  ○ There are three reasons why discretionary fiscal policy might not respond quickly  to economic conditions:  ■ Recognition lag: the government must realize action is required  ■ Law­making lag: the government must draft and pass a law  ■ Impact lag: laws usually take time to implement in the real world     Monetary Policy  ● Conducted by the Federal Reserve Board  ○ Congress plays no role in making monetary policy decisions, although the Fed  makes two reports a year and the Chairman testifies before Congress.   ○ The formal role of the President is limited to appointing the members and  Chairman of the Board of Governors  ● The goals of monetary policy:  ○ Maximum employment  ○ Stable prices  ○ Moderate long­term interest rates  ● In the long run, these goals are in harmony and reinforce each other, but in the short run,  they might be in conflict  ● The ​ key goal of monetary policy is price stability  ● Price stability is the source of maximum employment and moderate long­term rates  ● How does the FED operate to achieve its goals?  ○ By keeping the growth rate of the quantity of money in line with the growth rate  of potential GDP, the Fed is expected to be able to maintain full employment and  keep the price level stable.   ● Stable prices is the primary goal the Fed pays attention to the business cycle. The Fed  tries to minimize theoutput gap​ .  ○ Output gap = real GDP ­ potential GDP  ○ A positive output gap indicates an increase in inflation  ○ A negative output gap indicates unemployment above the natural rate  ● Instruments  ○ The ​ monetary policy instrument​  is a variable that the Fed can directly control or  closely control.  ■ Monetary base​ : this is one option that is easiest to understand  ■ Federal funds base​ : the interest rate at which banks borrow monetary  base overnight from other banks  ■ In practice, the US Federal Reserve use the Federal funds rate as its  instrument  ■ That means that the Fed chooses a target Federal funds rate and uses open  market operations to increase or decrease interest rates to meet that target  ■ When the Fed wants to avoid recession, it lowers the Federal funds rate  ■ When the Fed wants to check rising inflation, it raises the Federal funds  rate  ■ When the Fed wants to lower the Federal Funds rate:  ● It increases the quantity of money through open market operations  ● All short­term interest rates fall  ● The long­term real interest rate falls  ● Investment increases due to lower interest rates  ● Aggregate demand increases  ● Real GDP growth and the inflation rate increase   


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