Lecture Notes: Fiscal and Monetary Policy & The Phillips Curve

Key Concepts

• Fiscal and Monetary Policy Interaction

  • Fiscal Policy: Government decisions on taxation and spending.
  • Monetary Policy: Central bank actions influencing money supply and interest rates.

• Aggregate Demand (AD): Total demand for goods and services within an economy.

• Aggregate Supply (AS): Total supply of goods and services available within an economy.

Fiscal and Monetary Policy in Action

• Double Shifts: Changes in both fiscal and monetary policies can affect aggregate demand.
  • Example: Fed buys bonds (increases AD) and Congress cuts/increases taxes (affects AD).
• Current Context: Fed and Congress working together to prevent economic depression by adjusting these policies.

Economic Scenarios

• Positive Output Gap & Government Spending Increase:

  • Leads to inflation.
  • Fed can counteract by selling bonds (reduce money supply, increase interest rates).

• Negative Output Gap:

  • Fiscal: Increase spending or cut taxes.
  • Monetary: Increase money supply (buy bonds, reduce reserve requirements).

Key Questions to Consider

• Effects on money supply, interest rates, bank loans, price level, real output, unemployment, budget deficits.
• Aggregate Demand Changes: Increase in money supply lowers interest rates, increases bank loans, raises price level and real output, lowers unemployment.
• Policy Consequences: Increase in government spending and/or tax cuts may lead to budget deficits and increased national debt.

Aggregate Supply and Demand Shifts

• Double Shifters: E.g., reduction in AS and increase in AD results in definite price level increase but indeterminate output.

Phillips Curve

• Short-Run Phillips Curve (SRPC): Shows inverse relationship between inflation (y-axis) and unemployment (x-axis).
• Long-Run Phillips Curve (LRPC): Vertical at natural rate of unemployment.
• Illustrations: Changes in AD shift along SRPC; changes in AS shift the entire SRPC.

Long-Run Effects

• Economic Growth & Investment:
  • Investment increases AD in short-run and shifts LRAS outward in the long-run.
  • Promoted by pro-business policies, infrastructure spending, and investment incentives.

Supply-Side Policies

• Supply-Side Fiscal Policies: Aim to increase AS through reduced business taxes or regulations.
• Controversy: Balancing economic growth incentives with potential benefits distribution and budget impacts.

Quantity Theory of Money

• Equation: MV = PY (Money Supply x Velocity = Price Level x Output).
• Assumptions: Velocity and output are constant; changes in money supply directly affect price level.

Miscellaneous Concepts

• Crowding Out: Government borrowing increases demand for loanable funds, raises interest rates, reduces private investment, and impacts long-term economic growth.
  • Shown using Loanable Funds Graph.

Practical Application

• AP Exam Preparation: Understand connections between aggregate models and Phillips curve. Expect questions involving fiscal/monetary policies and their effects on these models.
• AP Free Response Tips: Familiarize with economic graphs and scenarios, especially dealing with changes in AD, AS, and monetary policies.

Conclusion

• Understanding the dynamics between fiscal and monetary policy, aggregate demand and supply, and the Phillips curve is crucial for analyzing economic scenarios and policy outcomes. The lecture emphasized the importance of these concepts in both theoretical and practical (AP exam) contexts.