Unit 5 Key Ideas

Unit 5: Monetary and Fiscal Combinations: Economic Policy in the Real World

* Macroeconomic policy involved combinations of fiscal and monetary policies.

* The interactions between monetary and fiscal policies can affect overall aggregate demand. For example, a tight monetary policy combined with an expansionary fiscal policy can cause “crowding out.”

* “Crowding out” is the effect of a rise in interest rates caused by increased borrowing by the federal government. The higher interest rates “crowd out” business and consumer borrowing.

* A Phillips curve illustrates the inflation unemployment tradeoff and how this tradeoff may differ in the short and long run.

* Both monetary and fiscal policies are primarily aggregate demand policies, but not all of the macroeconomic problems in the economy are aggregate demand problems.

* If factors other than excess aggregate demand are contributing to inflation, it is difficult for monetary and fiscal policies to deal with them.

* 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 is usually measured by changes in real GDP or by changes in real GDP per capita.

* 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 production possibilities curve.

* The Keynesian model is based on the belief that fiscal policy works through aggregate demand. Government fights unemployment by increasing aggregate demand and fights inflation by decreasing aggregate demand. Monetary policy works through interest rates and investment and also affects aggregate demand.
* The rate of economic growth is affected by a variety of aggregate supply and demand factors.

* The classical model represents an idealized version of a private-enterprise economy in the long run. In terms of aggregate demand and supply, the classical model is characterized by a vertical aggregate supply schedule, which is a function of tastes, technology, society’s resource base, and the distribution of economic resources, and an aggregate demand schedule that is a function of real money balances. Supply-side factors determine real output and employment. Aggregate demand and supply together determine the price level.

* The monetarist model, which is closely related to the classical model, focuses on the importance of changes in money supply on the economy. The monetarists’ basic analytical device is MV=PQ. Monetarists favor a monetary rule calling for a constant rate of change in the money supply that coincides with changes in real GDP.

* The rational expectations model, which is also closely related to the classical model, maintains that economic agents are intelligent decision makers and can be expected to take the effects of government policy changes into account in deciding their behavior. Because agents anticipate changes in policies, these policies will have no effect on read GDP.

* Supply-side economics emphasizes factors that cause the aggregate supply curve to shift. Supply-side economists argue that the inflation and stagflation are caused largely by decreases in aggregate supply-not by changes in aggregate demand. They recommend microeconomic solutions such as improved productivity and less government regulation.

* Different economic theories are only one reason why economists disagree; other reasons are disputes about time periods, different assumptions, and different values.