UNIT 5 . Inflation, Unemployment, and Stabilization Policies (20–30%)
TEXTBOOK CHAPTERS
FISCAL POLICY CH 12 OR 29
MONETARY POLICY CH 14 OR 31
UMEMPLOYMENT & INFLATION CH 15 OR 32
INFLATION & DISINFLATION CH 16 OR 33
A. Fiscal and monetary policies
1. Demand-side effects
2. Supply-side effects
3. Policy mix
4. Government deficits and debt
B. Inflation and unemployment
1. Types of inflation
a. Demand-pull inflation
b. Cost-push inflation
2. The Phillips curve: short run versus long run
3. Role of expectations






WEB RESOURCES
1) INFLATION AND UNEMPLOYMENT
http://welkerswikinomics.com/downloads/Unit%203.5-3.6%20Unemployment%20and%20Inflation%20and%20Income%20Distribution.pdf

current inflation stats http://www.bls.gov/news.release/cpi.nr0.htm.

http://tw.neisd.net/webpages/dmayer/files/phillips%20curve.pps

http://tw.neisd.net/webpages/dmayer/files/2009%20econ%20rubrics.ppt

BUSH VS OBAMA UNEMPLOYMENT http://my.barackobama.com/page/content/recoveryanniversary/

http://www.orlandosentinel.com/business/os-pec-ripple-effect-flash,0,5125947.flash

2) PHILLIPS CURVE
http://www.reffonomics.com/phillipscurve12.swf
http://www.reffonomics.com/TRB/chapter29/PhillipsCurveIndexLesson3.swf
http://welkerswikinomics.com/blog/category/phillips-curve/
Self graded quizz http://www.reffonomics.com/TRB/chapter29/phillipscurvequizfinal.htm
3) Rap video on Keynes
http://www.pbs.org/newshour/bb/business/july-dec09/keynes_12-16.htmlghttp://www.youtube.com/watch?v=d0nERTFo-Sk&feature=player_embedded#at=118
4) Unemployment in USA
http://www.examiner.com/x-18425-LA-County-Nonpartisan-Examiner~y2010m1d11-85000-lose-jobs-in-Dec-US-govt-could-hire-for-infrastructure-education-but-chooses-poverty
http://online.wsj.com/public/resources/documents/JOBLESSDATA08.html
5) UNIT OUTLINE
http://welkerswikinomics.com/downloads/Unit%203.4%20Demand%20and%20Supply%20Side%20Policies.pdf
6) STAGFLATION - SUPPLY SIDE ECONOMICS
http://www.businessbookmall.com/Economics_16_Stagflation_and_the_Rise_of_Supply-Side_Economics.htm
7) FISCAL POLICY
http://www.businessbookmall.com/Economics_14_Fiscal_Policy.htm
http://www.mhhe.com/economics/mcconnell15e/student/olc/chap12origin.mhtml
8) MONETARY POLICY
http://www.businessbookmall.com/Economics_15_Monetary_Policy.htm
http://www.mhhe.com/economics/mcconnell15e/student/olc/chap15graphs.mhtml
9) BUDGETS
http://www.pagetutor.com/trillion/usdebt.html
http://www.businessbookmall.com/Economics_17_Budget_Deficits.html
10) LAFFER CURVE
http://www.youtube.com/watch?v=fIqyCpCPrvU
http://www.youtube.com/watch?v=YsB_rnzBA08&feature=channel
http://blogs.discovermagazine.com/cosmicvariance/2009/09/16/where-we-are-on-the-laffer-curve/



Real, Uglier American Unemployment
by Joel S. Hirschhorn
Can you trust national averages? As bad as the jobless data you hear are,
you have not been told the whole truth. If you think the terrible impact of
America ’s Great Recession is shown by an official unemployment rate of
about 10 percent, think again.

Economic inequality and the myth of Reagan trickle down logic are shown by
new data from the Center for Labor Market Studies at Northeastern University
in Boston . The report noted: “What has been missing from the public debate
over the labor market crisis is an honest and detailed analysis of which
American workers have been most adversely affected by the deep deterioration
in labor markets.” The researchers found a correlation between household
income and unemployment rate in the last quarter of 2009: Look carefully at
these numbers and see how unemployment rises as income drops:

$150,000 or more, 3.2 percent
$100,000 to 149,999, 8 percent
$75,000 to $99,999, 5 percent
$60,000 to $75,000, 6.4 percent
$50,000 to $59,000, 7.8 percent
$40,000 to $49,000, 9 percent
$30,000 to $39,999, 12.2 percent
$20,000 to $29,999, 19.7 percent
$12,500 to $20,000, 19.1 percent
$12,499 or less, 30.8 percent

Ten times worse unemployment in the lowest class than in the highest class!
Truly amazing and disheartening, don’t you think? And you can also infer
that in some hard hit geographical areas the poorest people and people of
color are being even more adversely impacted. And don’t think for a minute
that things have really improved in 2010

For more: http://www.nolanchart.com/article7388.html

http://www.clms.neu.edu/publication/documents/Labor_Underutilization_Problems_of_U.pdf

















HOMEWORK
1) MORTON ACTIVITIES
http://128.241.192.223/uploads/APMacroUnits56.pdf



2) Assessment Activity 30 points : In 2001, the U.S. economy slipped into recession. The GDP dropped by more than a 1 percent annual rate in the third quarter, the inflation rate dropped to below a 2 percent annual rate in the fourth quarter, and the unemployment rate rose to 5.6 percent in the fourth quarter. As an economic advisor to the Congress and the Federal Reserve, what would you suggest Congress should do with its tools of fiscal policy, and what would you propose that the Fed do with its tools of monetary policy? Write a paragraph explaining your recommendations, being sure to describe how the tools will work to help improve aggregate demand. After you have finished, visit the following two web sites to see the fiscal policy action taken by the President and Congress, and the monetary policy action taken by the Federal Reserve to resolve the 2001 recession. Did the government’s action agree with your recommendations? **www.whitehouse.gov/infocus/economy/** **www.federalreserve.gov/BoardDocs/Press/General/2001/20011002/default.htm**









3) 25 points- Go to the following website to answer the question and also go to right hand side box and click on the article “US Monetary Policy: An Introduction also there is a good tool called DR ECON

http://www.frbsf.org/education/activities/drecon/askecon.cfm
**//http://www.frbsf.org/publications/federalreserve/fedinbrief/guides//**.

a) Open Market Operations- The Fed's most flexible and often-used tool of monetary policy is its open market operations for buying or selling government securities. The Federal Open Market Committee (FOMC) sets the Fed's monetary policy, which is carried out through the trading desk of the Federal Reserve Bank of New York. How does the FED tighten and expand the money supply by using FOMO. ( 10 POINTS)

b) The Discount Rate- The discount rate is the interest rates Reserve Bank charges eligible financial institutions to borrow funds on a short-term basis. Unlike open market operations, which interact with financial market forces to influence short-term interest rates, the boards of directors of the Federal Reserve Banks set the discount rate, and it is subject to approval by the Board of Governors. Under some circumstances, changes in the discount rate can affect other open market interest rates in the economy. How would changes in the discount rate (restrictive & expansionary) causing financial markets to respond and what impact would it have on AD and AS? (10 POINTS)

Reserve Requirements By law, financial institutions, whether or not they are members of the Federal Reserve System, must set aside a percentage of their deposits as reserves to be held either as cash on hand or as reserve account balances at a Reserve Bank. The Federal Reserve sets reserve requirements for all commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks. Depository institutions use their reserve accounts at Federal Reserve Banks not only to satisfy reserve requirements, but also to process many financial transactions through the Federal Reserve, such as check and electronic payments and currency and coin services. Altering reserve requirements is rarely used as a monetary policy tool. However, reserve requirements support the implementation of monetary policy by providing a more predictable demand for bank reserves, which increases the Fed's influence over short-term interest rate changes when implementing open market operations.(explain FRACTIONAL RESERVE BANKING 5 points )








4) POWER POINT ASSIGNMENT 150 POINTS (groups of 2)
As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere. But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. One of the most important functions of our government today is to try to correct inflation and recession in our economy
1) Identify and explain the tools of fiscal and monetary policy.(30 POINTS)
2) Explain how economic stabilization tools affect the money supply, interest rates, and aggregate demand.(30PT)
3) Analyze economic data to determine how fiscal and monetary policy should be used to correct economic problems. (30 POINTS)
4) What is money-roles of money-types of money-measurements of money (30 POINTS)
5) Role of the FED- the three main policy tools it uses (30 POINTS







ACTIVITY 5 MONETARY POLICY- OPEN MARKET OPERATIONS
in class 20 points
http://www.federalreserve.gov/monetarypolicy/default.htm
1) GO TO http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html to answer
2) What is OMO
3) Explain the Discount Window
4) Purchases & Reverse Purchase Transactions- define
5) Reserve Requirements- define
6) Go to http://www.federalreserve.gov/pubs/frseries/frseri2.htm
7) Read the blue section on the right hand side The Federal Open Market Committee . What are there roles and responsibilies.
8) Go to http://www.federalreserve.gov/monetarypolicy/default.htm on the right side you will find Discount Rate, Reserve requirements & Interest on Required Reserve Balances and Excess Balances, read this and make a brief bullet summary
9) Good overview summary http://www.frbsf.org/publications/federalreserve/fedinbrief/guides.html
10) Goals and tools on monetary policy http://www.frbsf.org/publications/federalreserve/monetary/index.html








ACTIVITY 6 Supply Side Economics and the Laffer Curve:


1.) Draw and correctly label the Laffer Curve.





2.) Why is the Laffer Curve shaped the way it is?




3.) What is the Laffer Curve, and how does it relate to supply-side economics?





4.) Why is determining the economy’s position on the Laffer Curve so important for assessing tax policy?





5.) Why might one person work more, earn more, and pay more income tax when his or her tax rate is cut, while another person will work for less, earn less, and pay less income tax under the same circumstance?






IN CLASS ACTIVITY 7 Fiscal Policy debate in the U.S. House of Representatives

Problem: The United States is in danger of high inflation, your committee must recommend an appropriate fiscal policy. One thing we know about politicians is that they want to be re-elected!!!!!!!

Take on the persona of one of the following representatives:

U.S. Rep 1 – represents inner-city Chicago, Illinois
Many constituents receive welfare; those with jobs work in manufacturing

U.S. Rep 2 – represents Killeen, Temple, Fort Hood area of Texas
Constituents are mainly conservative, strong military presence in community

U.S. Rep 3 – represents St. Petersburg, Florida
Constituents are elderly retirees living off of pensions and social security

U.S. Rep 4 – represents Wyoming
Constituents are land owners and are involved in agriculture



What constraints does your group face if they decide to raise taxes?




What constraints does your group face if they decide to cut spending?





What problems does your group face in trying to trim the federal budget?









IN-CLASS-ACTIVITY 8

PHILLIPS CURVE
The inverse relationship between price level and unemployment only holds in the short-run. When you shifted AS to the right, employment in the nation increases because workers can be hired for lower wages or the productivity of labor is increasing. .

The natural rate of unemployment may decrease when AS shifts out, unless that shift was caused by an increase in the size of the labor force, in which case employment would increase without unemployment decreasing.


SRAS only shifts in the long-run, which in macroeconomics is the period of time over which wages and prices are flexible. In the long-run, therefore, there is no tradeoff between inflation and unemployment (look at the long-run phillips curve!). Explain to your student that when you shifted AS to the right, this represented the flexible wage period. The size of the labor force may have increased, or the productivity of labor increased, allowing firms to produce output, employing more workers, at a lower price level.


APE UNIT 5 IN CLASS RESEARCH ACTIVITY 30 points
USE THE ABOVE WEB RESOURCES
http://www.reffonomics.com/TRB/chapter29/PhillipsCurveIndexLesson3.swf
PHILLIPS CURVE
1) Graph and Explain the Phillips curve and give a short history
2) Explain what it means to go from one point to another point on the Phillips curve, you must also graph this
3) Graph and explain the inverse relationship between inflation and unemployment and does the curve ever shift up or down?
4) What causes the short run Phillips curve to shift?
5) Graph and explain the long run Phillips curve
6) Explain the challenges and problems of using the Phillips curve
BUDGET DEFECITE AND SURPLUS
7) What is the current situation with the US budget .You must include three graphs
8) Showing the US budget over time (at least 30 years)
9) Show the current situation of the US budget
10) Show who owns the US debt
11) Can you find a country that runs a balanced budget or a surplus budget?
**The Federal Reserve and the tradeoff between unemployment and inflation**
Federal Reserve sees slow economy, higher prices – Sep. 3, 2008
Weak aggregate demand and rising costs due to still high energy and food prices put the US economy in a tricky situation, one in which the Federal Reserve is forced to make the tough decision between tackling the unemployment problem (jobless rates have risen to 5.7%) or the inflation problem (price levels have also risen 5.7% this year, the highest inflation in 17 years).
The nation struggled with slow economic growth and still-high prices that are weighing on consumers and businesses alike…Fed Chairman Ben Bernanke and his colleagues are all but certain to leave a key interest rate alone at 2% when they meet next on Sept. 16 and probably through the rest of this year. Given the fragile state of the economy, the Fed isn’t in a hurry to boost rates to fend off creeping inflation. A growing number of analysts believe the economy is likely to hit another dangerous rough patch later this year as consumers and businesses curtail their spending even more. Heading into the fall, economic activity continued to be slow, the Fed said. Businesses described the climate as “weak” or “soft” or “subdued.” Consumers, the lifeblood of the economy, showed caution. Shoppers “concentrated on necessary items and retrenchment in discretionary spending,” the Fed observed. In the short-run, as year 2 IB students know, society faces a trade off between high inflation and high unemployment. Rising prices and rising joblessness are both harmful to the economy, but when energy and food prices drive up the price level, while week investment and consumer spending lead to falling overall demand in the economy, the conditions exist where joblessness and prices can rise simultaneously. This is America’s situation at present. The Fed must choose which problem to address. Ben Bernake, America’s central bank chief, could chose to tackle rising inflation by raising interest rates, which would discourage new investment and reduce demand for resources by firms in the economy. Investment spending by firms and consumption by households would decline, putting downward pressure on prices across the economy. In the short-run, however, the decline in investment and consumer spending that would result from higher interest rates would exacerbate the already weak level of aggregate demand in the economy, driving unemployment even high By keeping rates low, Bernanke hopes to encourage investment and consumption, which will contribute to overall demand in the economy. By encouraging new spending and investment, however, the threat that inflation will rise even more remains present.
In the trade off between unemployment and inflation, the Republican White House and the Democratic Congress made it clear that unemployment was the most important problem to address when they announced the $160 billion expansionary fiscal stimulus package earlier this year. By keeping rates at a low 2%, America’s central bank is also indicating that increasing employment is of greater importance than lowering the price level.
Answer these questions:
12) Low interest rates are clearly a demand-side policy, since they should lead to higher investment and consumption. But how might lowering interest rates result in positive supply-side effects for the economy?
13) Why do you think increasing employment is of a higher priority to policy-makers than bringing down the inflation rate? Does the fact that it’s an election year matter?
14) “Workers’ wage gains – characterized as ‘modest’ – aren’t raising inflation worries. Wary employers have cut jobs every month so far this year and aren’t inclined to be overly generous in their compensation to workers amid ‘a general pullback in hiring,’ the Fed said. If wages continue to rise even as unemployment rises, is it likely that the US economy will ever “self-correct” from in times of an economic slowdown?










APE ACTIVITY 9 30 POINTS
GO TO http://www.youtube.com/watch?v=d0nERTFo-Sk&feature=player_embedded
HOME PAGE FOR THE SONG http://www.econstories.tv/home.html
FILL THE TABLE BELOW OF THE SONG (LYRICS BELOW) WHAT ARE THEY SAYING ABOUT KEYNES AND
HAYEK-We’ve been going back and forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
Keynes No… it’s the animal spirits.John Maynard Keynes, wrote the book on modern macro
The man you need when the economy’s off track, [whoa]
Depression, recession now your question’s in session
Have a seat and I’ll school you in one simple lesson BOOM, 1929 the big crash
We didn’t bounce back—economy’s in the trash
Persistent unemployment, the result of sticky wages
Waiting for recovery? Seriously? That’s outrageous!.I had a real plan any fool can understand
The advice, real simple—boost aggregate demand!
C, I, G, all together gets to Y
Make sure the total’s growing, watch the economy fly. You see it’s all about spending, hear the register cha-ching
Circular flow, the dough is everything
So if that flow is getting low, doesn’t matter the reason
We need more government spending, now it’s stimulus season.So forget about saving, get it straight out of your head
Like I said, in the long run—we’re all dead
Savings is destruction, that’s the paradox of thrift
Don’t keep money in your pocket, or that growth will never lift…because…Business is driven by the animal spirits
The bull and the bear, and there’s reason to fear its
Effects on capital investment, income and growth
That’s why the state should fill the gap with stimulus both…The monetary and the fiscal, they’re equally correct
Public works, digging ditches, war has the same effect
Even a broken window helps the glass man have some wealth
The multiplier driving higher the economy’s healthAnd if the Central Bank’s interest rate policy tanks
A liquidity trap, that new money’s stuck in the banks!
Deficits could be the cure, you been looking for
Let the spending soar, now that you know the score.My General Theory’s made quite an impression
[a revolution] I transformed the econ profession
You know me, modesty, still I’m taking a bow
Say it loud, say it proud, we’re all Keynesians nowWe’ve been goin’ back n forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Keynes] I made my case, Freddie H
Listen up , Can you hear it?
Hayek I’ll begin in broad strokes, just like my friend Keynes
His theory conceals the mechanics of change,
That simple equation, too much aggregation
Ignores human action and motivation And yet it continues as a justification
For bailouts and payoffs by pols with machinations
You provide them with cover to sell us a free lunch
Then all that we’re left with is debt, and a bunch.If you’re living high on that cheap credit hog
Don’t look for cure from the hair of the dog
Real savings come first if you want to invest
The market coordinates time with interest.Your focus on spending is pushing on thread
In the long run, my friend, it’s your theory that’s dead
So sorry there, buddy, if that sounds like invective
Prepared to get schooled in my Austrian perspective.
Keynes No… it’s the animal spiritsThe place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key.
Malinvestments wreck the economyThe boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones
Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too fewSo the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack.
Whether it’s the late twenties or two thousand and five
Booming bad investments, seems like they’d thrive
You must save to invest, don’t use the printing press
Or a bust will surely follow, an economy depressed.Your so-called “stimulus” will make things even worse
It’s just more of the same, more incentives perversed
And that credit crunch ain’t a liquidity trap
Just a broke banking system, I’m done, that’s a wrap.We’ve been goin’ back n forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
[Keynes] No it’s the animal spirits
“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”John Maynard Keynes
The General Theory of Employment, Interest and Money.
“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” F A Hayek
The Fatal Conceit

FILL IN THE TABLE BELOW COMAPRE AND CONTRAST KEYNES WITH HAYEK
KEYNES
HAYEK

























































LECTURE NOTES 1



Unit 5 Macroeconomics

- Macroeconomics policy involves combinations of fiscal and monetary policies.
- The inside lag is the amount of time it takes policy makers to recognize the economic situation and take action. The outside or impact leg is the amount of time it takes the economy to respond to the policy and short for monetary policy. The outside lag is very short for fiscal policy and variable for monetary policy.
- Crowding out is the effect on investment and consumption spending of an increase in interest rate caused by increased borrowing by the federal government. The higher interest rates crowd out business and consumer borrowing.
- A Philips curve illustrates the trade off between inflation and unemployment. The trade off differs in the short and long run, varies at different times and is often different for increases and decreases in output.
- The short run Philips curve shows a trade off between the inflation rate in output.
- The long run Philips curve is vertical
- Both monetary and fiscal policies are primarily aggregate demand policies, but not all of the macroeconomics problems in the economy are aggregate demand problems.
- If factors other than excess aggregate demand are contributing to inflation, it is difficult for monetary policy to control inflation.
- The barro-Ricardo effect is the possibility that government deficits will lead to an increase in private savings and a decrease in consumption, thus offsetting the effects of expansionary fiscal policy
- Economic growth is concerned with increasing an economy’s total productive capacity at full employment or its natural rate of output. This output is represented by a vertical long run aggregate supply curve.
- Economic growth can be shown graphically as a rightward shift of a nation’s long run aggregate supply curve or a rightward shift of its productive possibilities curve.
- Short run economic growth is usually measured by changes in real gross domestic product or by changes in real GDP per capita.
- The rate of economic growth is affected by a variety of aggregate supply and aggregate demand factors.
- Different economics theories are only one reason why economics disagree. Other reasons are different assumptions, different values, different interpretations about economic history and different ideas about policy lags.


APE ECONOMICS AGGREGATE DEMAND/SUPPLY MONEYARY &FISCAL POLICY- As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere. But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. One of the most important functions of our government today is to try to correct inflation and recession in our economy.

Economic performance can be illustrated through the concepts of aggregate supply and aggregate demand. Aggregate supply is the total supply of goods and services produced in the nation’s economy. It is upward sloping because at higher prices firms have an incentive to produce more, and at lower prices they are likely to produce less. Aggregate demand is the total demand for goods and services in the nation’s economy. It is downward sloping because at higher prices, consumers, firms, government, and foreign customers are less willing to buy, while they will likely buy more at lower prices. Aggregate supply and demand is shown in the graph below. Shifts in the aggregate supply and aggregate demand curves can illustrate changes in the performance of our economy. If consumer confidence in the economy falls and people reduce their spending, aggregate demand can fall, reducing real output and prices and possibly dropping the country into a recession. However, if the money supply is too large, excessive consumer demand can push up the aggregate demand, raising real output and prices and possibly pushing the country into serious inflation.

Economists generally look to annual goals of GDP growth of 2.5-3 percent, an inflation rate of 3-4 percent, and an unemployment rate of approximately 5 percent for stable economic growth. However, our economy generally follows an economic cycle of recession and expansion every few years. As John Maynard Keynes argued in his 1936 book General Theory of Employment, Interest, and Money, nations need not wait for potential economic problems to correct themselves. He advocated that government take an active role in resolving economic issues through the use of two policies: fiscal policy and monetary policy.
Keynes recommends that, during periods of recession, Congress should increase government spending in order to “prime the pump” of the economy. At the same time, he recommends, Congress should decrease taxes in order to give households more disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand stimulates firms to increase production, hire workers, and increase household incomes to enable them to buy more. Keynes advocates the opposite positions during times of rapid inflation. In order to slow down the economy, Keynes calls for Congress to reduce government spending in order to reduce pressure on aggregate demand. For the same reason he calls for tax increases in inflationary times, to reduce consumers' disposable income. The reduction in aggregate demand brought about by such actions leads firms to produce fewer products, slows hiring, and reduces inflationary pressure. While both tools are effective, Keynes advocated change in government spending as the more effective fiscal policy tool, because any change in government spending has a direct effect on aggregate demand. However, if taxes are reduced, consumers most likely will not spend all of their increase in disposable income; they are likely to save some of it. In the same way, if taxes are raised, consumers are not likely to reduce their consumption of products by the same amount as the tax; they are likely to dip into savings to cover some of the change in tax rates
. Monetary policy is the use of the money supply and credit to stabilize the econom y. The demand for money consists of consumers borrowing for such items as cars and homes, firms borrowing for such items as factories and equipment, and the government borrowing to finance the national debt. The supply of money is set by the Federal Reserve Board of Governors, the central banking system for the United States. The supply and demand for money determines the interest rate that must be paid for the use of borrowed money. So if the Federal Reserve increases the money supply, interest rates will fall, making it less expensive to borrow money. In that case, those wishing to borrow money will be more likely to do so, and be more likely to spend that money on products. If the Federal Reserve reduces the money supply, interest rates will rise, so less will be borrowed and spent (because of the higher cost of borrowing). Three primary tools available to change the money supply. First, during periods of recession, Keynes recommends that the Fed buy bonds on the open market. By increasing the reserves the banks hold, the banks have more money available to loan and can reduce their interest rates. At lower interest rates, consumers and firms are more willing to borrow to make purchases, and aggregate demand can increase. Secondly, Keynes recommends that the Fed lower the discount rate. When the Fed reduces the interest rate member banks must pay to borrow from the Fed, banks become more willing to borrow, to make money available for loans at lower interest rates. In this case, again, consumers and firms are more willing to borrow and spend, increasing aggregate demand. Third, Keynes recommends that the Fed reduce the reserve requirement during a serious recession. If banks are allowed to release more of their reserved funds for loans, the lowered interest rate will again entice consumers and firms to borrow funds to make purchases, increasing the aggregate demand. Keynes advocates the opposite positions during times of rapid inflation: reducing the money supply to raise interest rates, making it less likely that consumers and firms will borrow to purchase products. Economists learned much from the experience of the Great Depression, and most economists today advocate a role for government in creating economic stabilization policy. Although economists may disagree about which particular tool is most appropriate, or the timing or strength of the tool to be used, most economists recognize the advantages of using fiscal and monetary policy for the prevention of extreme inflation or depression in our economy.







LECTURE NOTES 2
Fiscal and Monetary Policy Process
http://www.econedlink.org/lessons/index.php?lesson=EM352&page=teacher
Key Economic Concepts:
-Aggregate Demand (AD)
-Demand
-Government Expenditures
-Government Revenues
-Tools of the Federal Reserve
Description:
Students follow each step of fiscal and monetary policy processes, to see the logic of how these tools are used to correct economic instability.
- Identify the tools of fiscal and monetary policy.
-Explain how economic stabilization tools affect the money supply, interest rates, and aggregate demand.
-Analyze economic data to determine how fiscal and monetary policy should be used to correct economic problems.

Introduction:
As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere.
But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. One of the most important functions of our government today is to try to correct inflation and recession in our economy.

Resources:
"Major Schools of Economic Theory" www.frbsf.org/publications/education/greateconomists/grtschls.html#A8
This web site of the Federal Reserve Bank of San Francisco describes major economic theories and the two tools of fiscal policy.
"Federal Reserve Bank of San Francisco" www.frbsf.org/publications/federalreserve/fedinbrief/guides.html This web site of the Federal Reserve Bank of San Francisco describes the three tools of monetary policy.
"The White House; President George W. Bush" www.whitehouse.gov/infocus/economy/
This White House web site explains how the President and Congress used fiscal policy to help resolve the 2001 recession.
"Federal Reserve Release; Press Release" www.federalreserve.gov/BoardDocs/Press/General/2001/20011002/default.htm This Federal Reserve web site explains how the Federal Reserve used monetary policy to help resolve the 2001 recession.







LECTURE 3
Economic performance can be illustrated through the concepts of aggregate supply and aggregate demand. Aggregate supply is the total supply of goods and services produced in the nation’s economy. It is upward-sloping because at higher prices firms have an incentive to produce more, and at lower prices they are likely to produce less. Aggregate demand is the total demand for goods and services in the nation’s economy. It is downward-sloping because at higher prices, consumers, firms, government, and foreign customers are less willing to buy, while they will likely buy more at lower prices. Aggregate supply and demand are shown in the graph below. Shifts in the aggregate supply and aggregate demand curves can illustrate changes in the performance of our economy. If consumer confidence in the economy falls and people reduce their spending, aggregate demand can fall, reducing real output and prices and possibly dropping the country into a recession. However, if the money supply is too large, excessive consumer demand can push up the aggregate demand, raising real output and prices and possibly pushing the country into serious inflation.

Economists generally look to annual goals of GDP growth of 2.5-3 percent, an inflation rate of 3-4 percent, and an unemployment rate of approximately 5 percent for stable economic growth. However, our economy generally follows an economic cycle of recession and expansion every few years. As John Maynard Keynes argued in his 1936 book General Theory of Employment, Interest, and Money, nations need not wait for potential economic problems to correct themselves. He advocated that government take an active role in resolving economic issues through the use of two policies: fiscal policy and monetary policy.
Fiscal policy is the use of government spending and taxes to stabilize the economy. Read the brief explanation of fiscal policy under the “Keynesian School” heading at the web site: 
www.frbsf.org/publications/education/greateconomists/grtschls.html#A8.
Keynes recommends that, during periods of recession, Congress should increase government spending in order to “prime the pump” of the economy. At the same time, he recommends, Congress should decrease taxes in order to give households more disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand stimulates firms to increase production, hire workers, and increase household incomes to enable them to buy more. Keynes advocates the opposite positions during times of rapid inflation. In order to slow down the economy, Keynes calls for Congress to reduce government spending in order to reduce pressure on aggregate demand. For the same reason he calls for tax increases in inflationary times, to reduce consumers' disposable income. The reduction in aggregate demand brought about by such actions leads firms to produce fewer products, slows hiring, and reduces inflationary pressure. While both tools are effective, Keynes advocated change in government spending as the more effective fiscal policy tool, because any change in government spending has a direct effect on aggregate demand. However, if taxes are reduced, consumers most likely will not spend all of their increase in disposable income; they are likely to save some of it. In the same way, if taxes are raised, consumers are not likely to reduce their consumption of products by the same amount as the tax; they are likely to dip into savings to cover some of the change in tax rates.



According to Keynes, what should the government do to taxes and government spending during a time of recession? {Reduce taxes and increase government spending}
According to Keynes, what should the government do to taxes and government spending during a period of rapid inflation? {Increase taxes and reduce government spending}
Monetary policy is the use of the money supply and credit to stabilize the economy. Read the explanation of monetary policy at the web site: www.frbsf.org/publications/federalreserve/fedinbrief/guides.html and refer to the graph below.
The demand for money consists of consumers borrowing for such items as cars and homes, firms borrowing for such items as factories and equipment, and the government borrowing to finance the national debt. The supply of money is set by the Federal Reserve Board of Governors, the central banking system for the United States. The supply and demand for money determine the interest rate that must be paid for the use of borrowed money. So if the Federal Reserve increases the money supply, interest rates will fall, making it less expensive to borrow money. In that case, those wishing to borrow money will be more likely to do so, and be more likely to spend that money on products. If the Federal Reserve reduces the money supply, interest rates will rise, so less will be borrowed and spent (because of the higher cost of borrowing).

The Federal Reserve has three primary tools available to change the money supply. First, during periods of recession, Keynes recommends that the Fed buy bonds on the open market. By increasing the reserves the banks hold, the banks have more money available to loan and can reduce their interest rates. At lower interest rates, consumers and firms are more willing to borrow to make purchases, and aggregate demand can increase. Secondly, Keynes recommends that the Fed lower the discount rate. When the Fed reduces the interest rate member banks must pay to borrow from the Fed, banks become more willing to borrow, to make money available for loans at lower interest rates. In this case, again, consumers and firms are more willing to borrow and spend, increasing aggregate demand. Third, Keynes recommends that the Fed reduce the reserve requirement during a serious recession. If banks are allowed to release more of their reserved funds for loans, the lowered interest rate will again entice consumers and firms to borrow funds to make purchases, increasing the aggregate demand. Keynes advocates the opposite positions during times of rapid inflation: reducing the money supply to raise interest rates, making it less likely that consumers and firms will borrow to purchase products.



How can the Federal Reserve use the reserve requirement, the discount rate, and open market operations during a time of recession? {Reduce the reserve requirement, reduce the discount rate, and buy bonds}
How can the Federal Reserve use the reserve requirement, the discount rate, and open market operations during a period of rapid inflation? {Increase the reserve requirement, increase the discount rate, and sell bonds}
While these three tools work in similar ways, they differ in the power of their effects. The reserve requirement is extremely powerful and is changed only in the event of a serious economic problem. The discount rate is used more as a signal of the Fed’s intentions for monetary policy. Open market operations are by far the most widely used tool of monetary policy.
Analyze economic problems to determine how fiscal and monetary policies should be used to correct economic problems in the Self Check Activity.

The questions are written below, with the correct answer in italics.

Use the fiscal policy of taxes to solve a recession.
1) What does Congress need to do to aggregate demand?
A. Increase aggregate demand
B. Reduce aggregate demand
2) What should Congress do to taxes to change the aggregate demand?
A. Increase Taxes
B. Reduce taxes
3) How will this change in taxes affect consumers’ disposable income?
A. Disposable income increases
B. Disposable income is reduced
4) How will this change in disposable income affect consumer spending in the economy?
A. Spending increases
B. Spending is reduced
5) Use the monetary policy of open market operations to solve a recession.
6) What does the Federal Reserve need to do to aggregate demand?
A. Increase aggregate demand
B. Reduce aggregate demand
7) What does the Fed need to do to the money supply to change the aggregate demand?
A. Increase the money supply
B. Reduce the money supply
8) What should the Fed do to bonds to change the money supply?
A. Buy bonds
B. Sell bonds
9) How will this bond action affect the reserves available for loan at banks?
A. Increase reserves
B. Reduce reserves
10) How will this change in the money supply affect interest rates?
A. Increase interest rates
B. Reduce interest rates
11) How will this change in interest rates affect the amount of money borrowed?
A. Increase borrowing
B. Reduce borrowing
12) How will this change in borrowing affect consumer spending in the economy?
A. Spending increases
B. Spending is reduced

Use the fiscal policy of government spending to solve inflation.
1) What does Congress need to do to aggregate demand?
A. Increase aggregate demand

B. Reduce aggregate demand

2) What should Congress do to government spending to change the aggregate demand?
A. Increase government spending
B. Reduce government spending

3) How will this change in aggregate demand affect firms’ production and employment of workers?
A. Production and employment increase 
B. Production and employment fall
How will this change in production and employment affect consumers’ disposable income?
A. Disposable income increases
B. Disposable income is reduced
How will this change in disposable income affect consumer spending in the economy?
A. Spending increases
B. Spending is reduced
Use the monetary policy of the discount rate to solve inflation.
What does the Federal Reserve need to do to aggregate demand?
A. Increase aggregate demand
B. Reduce aggregate demand
What does the Fed need to do to the money supply to change the aggregate demand?
A. Increase the money supply 
B. Reduce the money supply
What should the Fed do to the discount rate to change the money supply?
A. Increase the discount rate 
B. Reduce the discount rate
How will this discount rate change affect the willingness of banks to borrow from the Fed and make reserves available for loan at banks?
A. Increase reserves
B. Reduce reserves
How will this change in the money supply affect interest rates?
A. Increase interest rates
B. Reduce interest rates
How will this change in interest rates affect the amount of money borrowed?
A. Increase borrowing
B. Reduce borrowing
How will this change in borrowing affect consumer spending in the economy?
A. Spending increases
B. Spending is reduced
Use the monetary policy of the reserve requirement to solve inflation.
What does the Federal Reserve need to do to aggregate demand?
A. Increase aggregate demand
B. Reduce aggregate demand
What does the Fed need to do to the money supply to change the aggregate demand?
A. Increase the money supply
B. Reduce the money supply
What should the Fed do to the reserve requirement to change the money supply?
A. Increase the reserve requirement
B. Reduce the reserve requirement
How will this reserve requirement change affect the reserves available for loan at banks?
A. Increase reserves 
B. Reduce reserves
How will this change in the money supply affect interest rates?
A. Increase interest rates
B. Reduce interest rates
How will this change in interest rates affect the amount of money borrowed?
A. Increase borrowing 
B. Reduce borrowing
How will this change in borrowing affect consumer spending in the economy?
A. Spending increases
B. Spending is reduced

Conclusion:

Economists learned much from the experience of the Great Depression, and most economists today advocate a role for government in creating economic stabilization policy. Although economists may disagree about which particular tool is most appropriate, or the timing or strength of the tool to be used, most economists recognize the advantages of using fiscal and monetary policy for the prevention of extreme inflation or depression in our economy.