Fiscal and Monetary Policy

Chapter 13

SECTION 1

Fiscal Policy

Two Types of Fiscal Policy

Fiscal policy deals with changes the government makes in spending or taxation to achieve particular economic goals.

• Expansionary fiscal policy is an increase in government spending or a reduction in taxes.

• Contractionary fiscal policy is a decrease in government spending or an increase in taxes.

Two Types of Fiscal Policy

Expansionary Fiscal Policy and the Problem of Unemployment

Government can use expansionary fiscal policy to decrease the unemployment rate. This is how it works:

• A high unemployment rate is the result of people not spending enough money in the economy.

• If the government increases spending or reduces taxes, or both, consumers will have more money to spend.

• An increase in government spending will mean more spending in the economy.

• As a result of the increase in total spending, business firms will sell more goods.

• When business firms sell more goods, they have to hire more workers to produce the additional goods. The unemployment rate goes down because more people are working.

The Issue of Crowding Out

Not all economists agree that it is that easy to lower the unemployment rate. They bring up the issue of crowding out.

Crowding out occurs when increases in government spending lead to reductions in private spending.

For example, if the government spends more on education, people may decide to spend less on education such as private schooling.

When increased spending by the government exactly equals reduced spending by citizens, there is complete crowding out.

Incomplete crowding out occurs when the reduction in consumer spending is less than the increase in government spending. In this case, total spending in the economy increases.

Contractionary Fiscal Policy and the Problem of Inflation

Inflation is the result of too much spending in the economy compared with the quantity of goods and services available for purchase.

The government can slow inflation by reducing the amount that it spends. As a result of the decrease in total spending, firms initially sell fewer goods. To reduce unwanted inventory, firms lower prices.

The Issue of Crowding In

Crowding in occurs when decreases in government spending lead to increases in private spending.

Crowding in can be complete or incomplete. Complete crowding in is also called zero crowding in.

Fiscal Policy and Taxes

After-tax income is the part of income that is left over after taxes are paid.

If the government lowers taxes, more money is available from earnings and total spending increases. This leads to increased sales and hiring, reducing the unemployment rate.

If the government raises taxes, the opposite occurs. After-tax income is reduced, decreasing spending and causing unemployment to increase.

People are more willing to work when taxes are lower. If taxes were 100 percent of earnings, there would be no incentive to work.

Lower tax rates do not necessarily result in lower tax revenues for the government. Lower tax rates will likely give incentive to work more, and may result in increased spending, all of which provides tax revenue for the government.

SECTION 2

Monetary Policy Two Types of Monetary Policy

Monetary policy is defined as changes the Fed makes in the money supply.

An expansionary monetary policy is an increase in the money supply.

A contractionary monetary policy is a decrease in the money supply.

Expansionary Monetary Policy and the Problem of Unemployment

Many economists believe that expansionary monetary policy lowers the unemployment rate by the following means:

• The Fed increases the money supply.

• This in turn leads to increased spending.

• Increased spending results in increased sales and increased hiring.

Crowding out is not an issue with expansionary monetary policy.

Contractionary Monetary Policy and the Problem of Inflation

Many economists believe that contractionary monetary policy works to reduce inflation in the following manner:

• The Fed decreases the money supply.

• A smaller money supply results in lower total spending.

• Firms’ inventories increase because they sell fewer products.

• Firms reduce prices to lower their inventories.

SECTION 3

Stagflation: The Two Problems Appear Together

Rising Unemployment and Inflation (at the Same Time)

For many years, economists believed that the economy would experience either high inflation or high unemployment, but not both at the same time. They believed that unemployment and inflation moved in opposite directions.

In the 1970s, inflation and unemployment began to move in the same direction. They both began to increase.

The occurrence of inflation and high unemployment at the same time is called stagflation.

What Causes Stagflation?

Stagflation may be a result of stop-and-go, on-and-off monetary policy, or an erratic monetary policy. When the Fed increases the money supply, prices rise. Inflation begins to set in, just as the Fed decides to reduce the money supply. This causes output to decrease and unemployment to increase.

Another cause of stagflation might be a market decrease in aggregate supply, such as that caused by a storm or a war.