Business Economics

IMT G02
Session 4

Chapter 11 Fiscal Policy

Chapter 12 Monetary Theory & Policy
Chapter 13 International Trade & Finance
Chapter 14 Inflation
 Fiscal Policy

11
CHAPTER

Designed by
Amy McGuire, B-books, Ltd.
 Fiscal Policy Tools
1. Automatic stabilizers
Revenue and spending program
Stabilise DI (disposable income) leading to control
consumption & real GDP
2. Discretionary fiscal policy - Deliberate manipulation of
Government purchases (G), Transfer payment (TP), and
Taxes (T)
To achieve macroeconomic objectives of:
(a) Full Employment
(b) Price Stability
(c) Economic Growth

LO1
 A. Changes in Government
Purchases
Increase in government purchases
Stimulate the economy
Upward shift of AE line
Increase in GDP

With given price level & assuming only consumption

changes with income
1
Real GDP demanded G
1 MPC
LO1 Exhibit 1
Effect of a $0.1 Trillion Increase in Government
Purchases on Aggregate Expenditure and Real
GDP Demanded
Aggregate expenditure (trillions of dollars)

C + I + G + (X - M)
b C + I + G + (X - M)
14.5
0.1 As a result of a $0.1 trillion
increase in government
purchases, the aggregate
14.0 expenditure line shifts up by
a
$0.1 trillion, increasing the
real GDP demanded by
$0.5 trillion. This model
assumes price level
45
remains unchanged.
0 14.0 14.5 Real GDP
(trillions of dollars)
 B. Changes in Net Taxes
Decrease in net taxes
Increases DI by NT
Increases C by MPC NT (since DI = C + S) (since
consumers save some tax cut, consumption spending in
the first round increases by less than the full tax cut)
Upward shift of AE line
Increase in GDP (Amount depends on simple tax multiplier
ratio of a change in real GDP demanded to the initial
change in autonomous net taxes)
-MPC
Simple tax multiplier
1-MPC
MPC
LO1 Real GDP demanded NT
1 MPC
LO1 Exhibit 2
Effect of a $0.1 Trillion Decrease in Net Taxes on
Aggregate Expenditure and Real GDP Demanded
Aggregate expenditure (trillions of dollars)

As a result of a
C + I + G + (X - M) decrease in NT of $0.1
trillion, consumers, who
are assumed to have a
c C + I + G + (X - M) MPC of 0.8, spend $80
14.4
0.08 billion more and save
$20 billion at every
level of GDP. The
14.0 consumption function
a shifts up by $80 billion,
as does the AE line.
An $80 billion increase of AE line
eventually increases real GDP
45 demanded by $0.4 trillion. Keep
in mind that the price level is

0 14.0 14.4 Real GDP assumed to remain constant

during all this.
(trillions of dollars)
Discretionary Fiscal Policy to close a
Contractionary Gap
Output < potential
Unemployment > natural rate
Expansionary fiscal policy
Increase G
Decrease NT
Or a combination of both
Increase AD
Increase output
Increase price level
LO2 Close the contractionary gap
 Discretionary Fiscal Policy to Close a
Exhibit 3 Contractionary Gap
The aggregate demand curve AD and the
short-run aggregate supply curve SRAS130
intersect at point e. Output falls short of the
Potential output economys potential. The resulting
LRAS contractionary gap is $0.5 trillion.
Price
level

SRAS130

130 e*

e
125 e
AD*
e
AD

0 13.5 14.0 14.5 Real GDP

(trillions of dollars)
Discretionary Fiscal Policy to close an
Expansionary Gap
To close an expansionary gap
Output > potential
Unemployment < natural rate
Contractionary fiscal policy
Decrease G
Increase NT
Or a combination of both
Decrease AD
Decrease output
Decrease price level
LO2 Close the expansionary gap
LO2 Exhibit 4
Discretionary Fiscal Policy to Close an
Expansionary Gap
Potential output
LRAS The aggregate demand curve AD
Price
level

and the short-run aggregate supply

curve SRAS130 intersect at point e
SRAS130
resulting in an expansionary gap of
e $0.5 trillion.
135 e

AD
130 e*

AD*

0 14.0 14.5 Real GDP

(trillions of dollars)
Effectiveness of Discretionary Fiscal Policy

Execution of Contractionary & Expansionary Fiscal

Policy depends on whether:
Potential output is gauged accurately
Spending multiplier is predicted accurately
AD shifts by just the right amount
Government entities coordinate fiscal efforts
Shape of SRAS curve is known and remains
unaffected by the fiscal policy

LO2
The Multiplier and the Time Horizon
When Aggregate Supply changes the multiplier overstates
output or Real GDP
Real GDP in short run depends on the steepness of SRAS
curve that is affected by change in production costs increase
The steeper SRAS curve
Less impact of an AD shift on real GDP
More impact on price level
The smaller the spending multiplier

LO2
Monetary Theory and Policy
Macro

12
CHAPTER
 The Demand for Money
Quantity of money held at a point of time - Stock of money
Flow of Income amount received per period of time
More active economy - More goods and services
exchanged so more money demanded
Higher the price level the greater the demand for money
Reasons for Demand of Money
Medium of exchange
Store of value
Liquidity

LO1
LO1 Exhibit 1
Demand for Money
Interest rate

The money demand, Dm, slopes

downward. As the interest rate falls,
other things constant (price level and
real GDP), so does the opportunity
cost of holding money; the quantity of
money demanded increases.

Dm

0 Quantity of money
LO1 Exhibit 2
Effect of an Increase in the Money Supply
Because the money supply is determined by
the Central Bank, it can be represented by a
Interest

Sm Sm vertical line, denoting it is not influenced by

rate

interest rate.
At point a, the intersection of the
money supply, Sm, and the money
i a
demand, Dm, determines the
equilibrium interest rate, i.
b
i Following an increase in the
Dm money supply to Sm, the quantity
of money supplied exceeds the
quantity demanded at the original
Quantity of interest rate, i.
0 M M
money
Money and Aggregate Demand
in the Short Run
Short run: Money affects the economy through
changes in interest rate
The RBI: to stimulate output; employment
Open-market purchase of govt. securities
Money supply increase
Interest rate reduce
Investment stimulate
Aggregate demand increase
Real GDP increase
LO2 M i I AD Y
LO2 Exhibit 3
Effects of an Increase in the Money Supply on Interest Rates,
Investment, and Aggregate Demand
(a) Supply and demand (b) Demand for (c) Aggregate demand

Interest rate
Interest rate

for money investment

Price level
Sm Sm

i a i a
b
b b P
i i a
Dm AD
AD
DI

0 M M Money 0 I I 0 Y Y Real GDP

An increase in the money
supply drives the interest
rate down to i'.
Investment
With the cost of borrowing
lower, the amount invested
increases from I to I.
This sets off the spending
multiplier process, so the
aggregate output demanded
at price level P increases from
Y to Y
Money and Aggregate Demand
in the Short Run
The RBI: cool down the economy
Open-market sale of govt. securities
Money supply decrease
Interest rate increase
Investment reduce
Aggregate demand decrease
Real GDP - decrease

LO2
Adding the Short-Run Aggregate
Supply Curve
Contractionary gap
Output < potential
Price level < expected
Wages > negotiated
The RBI: expansionary
monetary policy
Stimulate AD
Increase money supply
Equilibrium
LO2
LO2 Exhibit 4
Expansionary Monetary Policy to Correct a Contractionary Gap
Potential output
LRAS
At a, the economy is producing
Price
level

SRAS130 less than its potential in the short

run, resulting in a contractionary
gap of $0.2 trillion.

130 b If the Federal Reserve increases

the money supply by just the right
a amount, the aggregate demand
125 curve shifts rightward from AD to
AD AD. A short-run and long-run
equilibrium is established at b,
with the price level at 130 and
AD
output at the potential level of
0 13.8 14.0 Real GDP $14.0 trillion
(trillions of dollars)
Contractionary gap
 Money and Aggregate
Demand in the Long Run
Equation of exchange
Buyer: exchanges money for goods
Seller: exchanges goods for money
M quantity of money in economy
V velocity of money
P average price level
Y real GDP
M V P Y
P Y
V
M
LO3
 Quantity Theory of Money
Quantity theory of money states if V is stable
(predictable), then Equation of Exchange can predict
effects of changes in money supply on nominal GDP,
P Y

In Long-run an increase in money supply, with stable

velocity increases or at least not decreasing, leads to
higher prices

LO3
LO3 Exhibit 5
In the Long Run, an Increase in the Money Supply
Results in a Higher Price Level, or Inflation
Potential output
LRAS
Price level

The quantity theory of money

predicts that if velocity is stable,
then an increase in the supply
of money in the long run results
140 b in a higher price level, or
inflation.
130 a
AD

AD

0 14.0 Real GDP

(trillions of dollars)
International Trade & Finance

Macro

13
CHAPTER

Designed by
Amy McGuire, B-books, Ltd.
 Reasons for International
Specialization
Differences in resource endowments
Create differences in opportunity cost
Countries export what they produce more cheaply
Countries import products unavailable domestically &
are cheaper elsewhere
Economies of scale -
With large scale production the long-run average cost
of the firm is lower
Differences in tastes

LO2
 Production Possibilities
without Trade

Production possibilities
With existing resources
No trade
Production possibilities = consumption possibilities
Production possibilities frontier - Assumptions
1. Two countries producing & consuming two goods
2. Labour force is fixed and efficiently employed
3. Technology is given
Autarky

LO1
 Production Possibilities Schedules for
LO1
Exhibit 2 United States and Izodia
LO1 Exhibit 3
Production Possibilities Frontiers for the United States
and Izodia Without Trade (millions of units per day)

600 U1 (a) United States 600 (b) Izodia

500 U2 500
400 U3 400

Food
Food

300 300
U4
I1
200 200 I2
U5 I3
I4
100 100
I5
U6 I6

0 100 200 300 400 Clothing 0 100 200 300 400 Clothing
 Consumption Possibilities based on
Comparative Advantage

Gains from specialization and trade

Each country should specialize in producing the good
with the lower opportunity cost
Terms of trade Rate at which one good exchanges for
another
Consumption possibilities frontier shows possible
combinations of good as result of specialization and
exchange
Depend on relative preferences

LO1
Production (and Consumption) Possibility Frontiers
with Trade (millions of units per day)
(a) United States (b) Izodia

Exhibit 4
600 600

500 500
U
400 400

Food
Food

300 300
I
200 U4 200
100 100 I3

0 100 200 300 400 Clothing 0 100 200 300 400 Clothing
 Balance of Payments
International economic transactions
Flow of transactions period of time
May not involve cash payments
Double-entry bookkeeping
Credit entry for exports
Inflow of receipts from the rest of the world
Debit entry for imports
Outflows of payments to the rest of the world

LO 1
LO3
 Balance of Payments
Balance on Current Account
Balance on goods & services
Net investment/asset income
Net unilateral transfers - Government transfers to foreign
residents, foreign aid, transfer to families abroad, personal
gifts sent abroad, charitable donations
Balance on Financial Account
International purchases of financial and real assets

Current Account Vs Capital Account

LO3
Foreign Exchange: Demand & Supply
Demand curve shows inverse
relationship between dollar
price of INR or euro and
quantity of INR or euros
demanded
Assumed constant
Income; preferences (U.S.
consumers)
Expected inflation (U.S. and
euro area)
Price of goods (euro area)
Interest rates (U.S. and
euro area)
LO2
Supply curve shows
positive relationship
between dollar price of INR
or euro and quantity of INR
or euros supplied
Assumed constant
Income, taxes (euro
area)
Expected inflation (euro
area and U.S.)
Interest rates (euro area
and U.S.)
LO2 Exhibit 4
The Foreign Exchange Market
Exchange rate (dollars per euro or INR)

The fewer the dollars needed to

S purchase 1 unit of foreign exchange
(euro or INR), the lower the price of
foreign goods, the greater the
$1.30 quantity of foreign goods demanded,
and the greater the quantity of
1.25 foreign exchange demanded. The D
curve slopes downward.
1.20

D
Foreign exchange
0 800
(millions of euros or INR)
 Effect on the Foreign Exchange Market of an
Increased Demand for Euros
(dollars per euro or INR)

The intersection of the demand

curve for foreign exchange, D,
and the supply curve for foreign
exchange, S, determines the
Exchange rate

exchange rate. At an exchange

rate of $1.25 per euro or INR,
S
the quantity demanded of euros
or INR equals the quantity
supplied.
1.27 An increase in the demand for
1.25 euros or INR from D to D
increases the exchange rate
from $1.25 to $1.27 per euro
D or INR. Thus Euro or INR
D appreciates while dollar
depreciates
Foreign exchange
0 800 820
(millions of euros or INR)
 Inflation
Macro

14
CHAPTER

Designed by
Amy McGuire, B-books, Ltd.
 Sources of Inflation
Inflation, Deflation (a decline in the prices), Disinflation (a drop
in the rate at which prices rise) , Hyperinflation, Stagflation
Sources of Inflation
A. Increase in AD
Demand-pull inflation
Increased government spending
Social programs
B. Decrease in AS
Cost-push inflation
Increase cost of production

LO2
LO2 Exhibit 6
Inflation Caused by Shifts of Aggregate Demand
and Aggregate Supply Curves
(a) Demand-pull inflation: inflation caused (b) Cost-push inflation: inflation caused
by an increase of aggregate demand by a decrease of aggregate supply

Price AS Price AS
level level AS

P P
P AD P

AD
AD

0 Aggregate output 0 Aggregate output

An outward shift of the aggregate demand A decrease of aggregate supply to AS
to AD pulls the price level up from P to P. pushes the price level up from P to P.
Anticipated vs.
Unanticipated Inflation
Anticipated inflation is the Expected
inflation
If inflation > expected
Sellers lose (Wage earners)
Buyers gain (Employer)
If inflation < expected
Sellers gain
Buyers lose

LO2