b: Explain the importance of the timing of changes in fiscal policy and the difficulties in achieving proper timing.

There is usually a time lag between when a change in policy is needed and when policy makers recognize its need. Furthermore, there is an additional lag between when the need is recognized and when it is instituted. Finally, there is a lag between when the policy is adopted and when its impact is felt. Therefore, the use of fiscal policy to calm the business cycle is very difficult. Some economists believe that the business cycle is exacerbated by planned fiscal policy shifts, not calmed by it. This occurs when lags in fiscal policy cause it to accentuate the natural corrective action of the economy rather than correct the problem the policy was intended for.

c: Discuss the impact of expansionary and restrictive fiscal policies based on the basic Keynesian model, the crowding-out model, the new classical model, and supply-side effects.

Basic Keynesian model: An increase in government spending and/or reduction in taxes will be magnified by the multiplier process and lead to a substantial increase in aggregate demand. This will stimulate the economy leading to increases in the level of employment and output.

Crowding out model: The potency of expansionary fiscal policy will be dampened because borrowing to finance the budget deficit will push up interest rates and crowd out private spending, particularly investment.

New classical model: The potency of expansionary fiscal policy will be dampened because households will anticipate the higher future taxes implied by the debt and reduce their spending in order to pay them. Like current taxes, this future tax debt will crowd out private spending.

Supply side model: A reduction in marginal tax rates will increase the incentive to earn and improve the efficiency of resource use, leading to an increase in aggregate supply (output) in the long run.

d: Identify automatic stabilizers and explain how such stabilizers work.

Automatic Stabilizers: Automatic stabilizers are built-in fiscal devices that ensure deficits in a recession and surpluses during booms. Automatic stabilizers minimize the problem of proper timing. The three main automatic stabilizers are:

Unemployment compensation,

Corporate profit taxes,

Progressive personal income taxes.

Note that during a recession unemployment is high so the government will pay out more in unemployment compensation at the exact time that tax receipts from corporations and individuals are low. This will increase the size of the deficit and also maintain aggregate demand during recessionary periods.

e: Discuss the supply-side effects of fiscal policy

The Supply-Side Effects of Fiscal Policy

The main thrust of supply-side economics is that a reduction in marginal tax rates will give individuals and businesses the incentive to (1) invest and save, (2) work and increase their productivity in projects which provide taxable income, and (3) reduce leisure time activities and participation in tax-shelter programs. Or, in other words, a tax cut will increase the attractiveness of productive activities and reduce the attractiveness of less productive tax-avoidance schemes and leisure activities. These behavioral changes will increase aggregate supply, increase output, decrease unemployment and reduce prices.

Why do high tax rates tend to retard output?

They discourage work effort and reduce the productive efficiency of labor.

They adversely affect the rate of capital formation and the efficiency of its use.

They encourage individuals to substitute less desirable tax-deductible goods for more desirable nondeductibe goods.

f: Explain the relationship among budget deficits, inflation, and real interest rates.

Budget deficits and real interest rates: The crowding out model implies that deficits will increase the demand for loanable funds and thereby place upward pressure on the real rate of interest. The new classical model, however, implies that the higher expected future taxes will stimulate additional savings and thereby permit the government to expand its borrowing at an unchanged interest rate. The results of empirical studies on this question are mixed. If there is a relationship between budget deficits and interest rates it is very weak at best.

Budget deficits, capital inflows, and net exports: The evidence supports the theory that crowding out occurs when foreign capital flows into the US, causing exports to fall and imports to rise.

g: Explain how and why budget deficits and trade deficits tend to be linked.

Some economists may argue that higher U.S. interest rates will attract foreign investment funds, reducing the crowding out effect. This happens as foreign investors go to the foreign exchange markets to buy U.S. dollars. Their buying demand drives up the value of the dollar. The resulting increase in the value of the dollar causes U.S. exports to fall and imports into the U.S. to increase. Thus, crowding out still occurs, yet it takes a different form. Instead of government borrowing crowding out demand for capital investment goods, demand for U.S. dollars causes the dollar to appreciate causing U.S. exports to decline and imports to increase.

2.B: Money and the Banking System

a: Identify and explain the three basic functions of money.

The three basics functions of money:

Medium of exchange - money simplifies and reduces the cost of transactions

Unit of account - money serves as a unit of measure by which the value of goods can be compared.

Store of value - money enables value to be stored and transported. It is also a liquid asset, meaning that it can be easily converted into other goods.

b: Define the money supply.

M1 is the narrowest definition of money. The money supply is defined as currency in circulation (coins and paper), checkable deposits maintained in depository institutions, and travelers’ checks.

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M2 equals M1 plus savings deposits and time deposits less than $100,000 held in depository institutions plus money-market mutual fund shares.

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Credit cards versus money: Money is a financial asset that provides the holder with future purchasing power while credit is a liability acquired when one borrows funds. Credit is not purchasing power but rather a facilitator of purchasing power.

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Changes in the nature of M1 and M2: Since the 1980s, interest-earning checking accounts have grown to approximately one-fourth of the M1 money supply. Because savings and interest earning checking accounts are both part of M2, analysts now rely more on M2 when comparing the money supply across time periods.

c: Describe the fractional reserve banking system.