HOMEWORK 8

HOMEWORK 8

1. Analyze fiscal and monetary policies from the demand-side effects.

2. Analyze fiscal and monetary policies from the supply-side effects.

3. Evaluate the impact of government deficits and debt.

4. Differentiate between demand-pull and cost-push inflation.

K

·         There are two powerful tools our government and the Federal Reserve use to steer our economy in the right direction: fiscal and monetary policy. When used correctly, they can have similar results in both stimulating our economy and slowing it down when it heats up. The ongoing debate is which one is more effective in the long and short run.

·         Fiscal policy is when our government uses its spending and taxing powers to have an impact on the economy. The combination and interaction of government expenditures and revenue collection is a delicate balance that requires good timing and a little bit of luck to get it right. The direct and indirect effects of fiscal policy can influence personal spending,capital expenditure, exchange rates, deficit levels and even interest rates, which are usually associated with monetary policy. 

·         Each year, the deficit is added to the debt. The Treasury must sell Treasury bonds to raise the money to cover the deficit. This is known as the public debt, since these bonds are sold to the public.

·         In addition to the public debt, there is the money that the government loans to itself each year. This money is in the form of Government Account Securities, and it comes primarily from the Social Security Trust Fund. These loans are not counted as part of the deficit, since they are all within the government. However, as the Baby Boomers retire, they will begin to draw down more Social Security funds than are replaced with payroll taxes. These benefits will need to be paid out of the general fund. This means that either other programs must be cut, taxes must be raised or benefits must be lowered. Unfortunately, legislators have not yet agreed on an effective plan to meet Social Security obligations.

·         The difference between these two types of inflation is found in their causes.  Both have the same effects (increasing price level), but they are caused by different things.

·         Demand-pull inflation is caused by excess demand.  When the people as a whole get more money they are able to pay more for goods and services (unless more goods and services are produced).  Economists talk about more money “chasing” the same amount of goods and services.  This causes shortages and prices rise.

·         Cost-push inflation is caused by disruptions in supply.  These disruptions cause increases in the price of production.  That leads to inflation.  For example, a rise in the price of oil causes practically all production to become more expensive.

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·         How do the demand side effects affect the economy?

·         How is demand pull satisfied?

·         What is the supply side effects like?

·         What can cost push inflation be compared to?

·         What are governments deficits not like?

L

·         Inflation is the persistent rise in general price level. Demand pull inflation is one where there is an increase in price level due to the increase in the aggregate demand.

·         On the other hand the cost push inflation is one where price level increases due to the increase in the price of inputs like increase in wages and raw materials. the increase in price of inputs decreases the short run aggregate supply which increases the price level. Thus if there is a shift in the supply curve backwards we say that inflation is cost push and when there is a rightward shift in the demand curve we say that its demand pull inflation.

·         Initially, deficit spending and the resultant debt boosts economic growth. This is especially true in a recession. That's because deficit spending pumps liquidity into the economy. Whether the money goes to jet fighters, bridges or education, it ramps up production and creates jobs.

·         However, not every dollar creates the same number of jobs. In fact, military spending creates 8,555 jobs for every billion dollars spent. This is less than half the jobs created by that same billion spent on construction. For more, see Unemployment Solutions.

·         Supply-side economics, also known as trickle-down economics, is an economic theory that states that a reduction in taxes will stimulate the economy through increased consumer spending. Over time, the boost to economic growth will generate a larger tax base, which will make up for the revenue lost from the tax cut.

·         When interest rates are cut (which is our expansionary monetary policy), aggregate demand (AD) shifts up due to the rise in investment and consumption. The shift up of AD causes us to move along the aggregate supply (AS) curve, causing a rise in both real GDP and the price level. We need to determine the effects of this rise in AD, the price level, and real GDP (output) in each of our two countries.