Unit+Five

=Unit Five=

__A. Monetary and Fiscal Policy__
1. Monetary and fiscal policy working together- the key to any economic growth is macroeconomy, which is combination of both fiscal and monetary policies. A. Monetary Policy- the process by which the government affects the economy through changes in the money supply. There are two types of monetary policies: expansionary and contractionary. This type of policy manily correlates to the interest rates in an economy. Until the 19th century, a gold standard was used in the United Sates. Basically, every dollar out in the public was back by one dollar's worth of gold. This created several issues and later was disbanded. Today's dollar containes no real value except what people are willing to trade for it. The problem with monetray policy is the effects of the policy usually don't come into play until after the economic problem is over. i. Expansionary Policy- Used during times of recession by the government to promote spending and to combat unemployment. The government lowers interest rates and lower reserve requirements. With more money in their pockets, people will be more likely to spend it and expand the economy. ii. Contractionary Policy- Used during times of infaltion by the government to promote saving money and cooling down an over heated economy. The government does this by increasing the interest rates as well as the resereve requirements. When the value of the dollar is low, people will be less likely to spend it. B. Fiscal Policy- this is the process by which the government directly effect the economy through changes in government spending or taxing. Crowding-out Effect- a negative effect the government can economy caused by an increase in interest rates. When the government increases its investment and consumption spending, it leave no room for private investors to enter the market.

2. The loanable funds market and relationship to the money market The key in loanable funds, such as starting a bank, is balancing your liabilities against your assets. You have to make sure that all account balance to zero. This process of loaning out money and recieving interest on money, commonly known as rent, is called the money multiplier effect. Money Multiplier Effect- banks loan out money to customers at a certain rate called the "interest rate". When people recieve this money, they go and put it into their banks. The banks then lend out this money and process continues. A $100 deposited by one person soon becomes $400 through the entire process and money is "created". However, when people withdraw money from thier banks, the reverse of the money multiplier happens and money is destroyed.

This chart shows that the key to the money multiplier effect is balancing the T-account. Liablilites must match assest and so on.

3. The interest rate effects of fiscal policy- The Fed, federal government, can directly effect the economy through fiscal policy. However, the result are high fluxuations in the interest rates. As policies contract the economy, interest rates increase and cause people to borrow less and save more. When the money velocity decreases, the economy slips into a recession and causes serious economic problems. The same is true for decreasing the interest rates. As the interest rates decrease, people feel more secure with their money and spend it. This causes an inflation in the system and people's money is now worthless (literally)!

__B. Trade-off between inflation and unemployment__
1. The Phillips Curve demonstrates the inverse relationship between inflation and unemployment. According to the Short-Run Phillips Curve, as the rate of inflation increases, the rate of unemployment decreases, and vice versa. This applies in the labor market for example. When unemployment falls, skilled labor becomes a shortage. Many people take jobs they may not be fully qualified for. This causes wages to rise, which in turn, causes prices to rise. The short run Phillip's Curve is also illustrated in the product market. A rise in GDP (output) causes suppliers to raise prices to increase profit. Rising prices is a risk when demand is exceeding the available supply of goods. This leads to excess supply which can cause a rise in unemployment. 2. The long run Phillip's Curve is also known as NAIRU or "Natural rate of unemployment" modeled as the red vertical line on the graph. According to the long run Phillip's Curve, inflation is really inevitable but at any given point on the long-run Phillip's curve, inflation is stabilized. Realistically, the long-run Phillip's curve is a lot more applicable to real-life, modern economics than the short-run Phillip's curve.

3. Effect of expectations is also referred to as the "rational expectations theory." The rational expectations theory is often used to predict inflation. Economists often predict the rise and fall in inflation and the central bank will respond to the predictions. It's like an economic fortune-teller!

(my source is wikipedia, the source to life)

__C. Economic Growth__
1. Sources of economic growth: A. Natural Resources- An abundance of natural resources can contribute to economic sucess if the economy has the skills to use them efficiently. B. Capital- The more capital a country has, the more it can produce. Countries must invest in profitable areas to increase their capital. C. Rate of Savings- Savings are what allow for investment. Economies need adequet savings in order to increase capital and ultimately economic growth. D. New Technology- technology makes it possible to create the same amount of product from fewer resources in a smaller amount of time. New technologies shift the possibility production curve to the right. Education and science play a large role in advancing technology.

2. What policies promote economic growth Fiscal and Monetary policies are extrememly important in creating economic growth because they spur demand. Reflationary policies, or policies in which the government spends more, also increase demand and boost the economy. Trial and error has shown that economic growth can also be fueled by cutting taxes or interest rates (see discussion artical). These policies don't always work, however, and sometimes a Deflationary policy such as higher interest rates or taxes must be put in place to stop inflation.

3. Showing economic growth using aggregate demand and aggregate supply analysis Here is and example of what happens when government spending increases, a policy discussed in the last section which boosts economic growth. The aggregate demand has gone up because the government is demanding more. This will increase the GDP and the price level.

[|]

4. Showing economic growth using the production possibilities curve The production possibility curve shows what a country can potentially produce using all of its resources in the most efficient way. Economic growth will increase the amount of goods and services that a country can potentially produce (virtual zambia). The graph shows how an increase in the production of goods can lead to a shift in the possibilities curve to the right. This means economic growth because the economy is working at a higher rate and producing more goods without increasing resoucres or time.

__D. **Disagreements Among Economists**__
1. __Causes of Economic Instability__: a. Classical Economic View- the prevalent view from about 1776 to the 1930s. Classical Economists believed that laissez-faire government policies were the best way to keep the economy under control. The classical view holds that aggregate demand is a downsloping curve, is stable, and determines price level. The aggregate supply curve is vertical and determines real GDP. (McConnel and Brue 338)

b. Keynesian Economic View- became prevalent in the 1930s when John Maynard Keynes theorized that laissez-faire policies are vulnerable to frequent recessions that can prompt large-scale unemployment. He claimed that the government should play a more active role in the economy (McConnel and Brue 338). The Keynesian View is based on the theory that "product prices and wages are downwardly inflexible over very long time periods" (McConnel and Brue 340). This creates a horizontal aggregate supply curve and and unstable aggregate demand curve.

c. Mainstream Economic View- the current macroeconomic view followed by the majority of economists based mostly upon the Keynesian viewpoint. Mainstream economists believe that economic instability stems from changes in investment spending (which shifts the aggregate demand curve), and from "adverse aggregate supply shocks" (which shifts the aggregate demand curve). (McConnel and Brue 340)

d. Monetarist Economic View- this is the modern equivalent of the classical view. It "focuses on the money supply, holds that markets are highly competitive, and says that a competitive market system gives the economy a high degree of economic stability" (McConnel and Brue 341). Monetarists believe that the solution to macroeconomic instability is government non-interference. They believe that minimum-wage laws and other similar types of legislation has caused downward wage inflexibility and has contributed to the business cycles. They also believe that unnecessary monetary policy is the main cause of economic instability. Monetarists follow the equation of exchange: MV=PQ, where M is money supply, V is velocity ("average number of times per year a dollar is spent on final goods and services"), P is price level, and Q is the volume of goods and services produced. Monetarists believe that velocity is relatively stable, meaning that it changes slowly and predictably (McConnel and Brue 341).

e. Real Business Cycle Economic View- this is the modern view based on the theory that macroeconomic instability is caused by factors affecting aggregate supply. Therefore, business fluctuations occur when technology and resources change (McConnel and Brue 342).

f. Coordination Failures- the modern view that macroeconomic instability is caused by coordination failures, or the failure of people to reach "a mutually beneficial equilibrium because they lack a way to coordinate their actions" (McConnel and Brue 343).

2. __Economic "Self-Correction"__ a. New Classical View of Self-Correction- a view usually held by monetarists or believers of the rational expectations theory (RET), or the theory that people's expectations can have an effect on the economy. They believe that "internal mechanisms" in the economy will automatically pull the economy back to the full employment level of output when a diversion occurs. They believe that when the economy falls below its full employment level of output, policymakers should allow automatic self-correction to take its course (McConnel and Brue 344). Monetarists believe that it could take years for these changes to take place. Followers of RET believe that when price levels are fully anticipated adjustments can occur very quickly. RET holds that when price level changes are unanticipated only temporary changes in real GDP will occur. When price level changes are fully anticipated, people change their actions so that no real GDP changes occur (McConnel and Brue 346).

b. Mainstream View of Self-Correction- a view that incorporates RET but disagrees with the view that downward wages and prices are flexible. Mainstream economists believe that the economy gets caught in recessions due to downward wage inflexibility caused by efficiency wages (wages that minimize a firm's labor costs per unit of output) and insider-outsider relationships ("outsiders, unemployed workers, may not be able to underbid existing wages because employers may view the nonwage cost of hiring them to be prohibitive") (McConnel and Brue 347).

3. __How Should Government Approach Monetary and Fiscal Policy?__ a. Monetarists and other New Classical Economists- believe the government should require the Fed to "expand the money supply each year at the same annual rate as teh typical growth of the economy's production capacity" (McConnel and Brue 348). This would greatly reduce the amount of "unnecessary monetary policy". They also believe that the government should either balance its budget annually or practice "passive" fiscal policy (not creating budget deficits or surpluses).

b. Mainstream Economists- believe that the government should practice both discretionary fiscal and monetary policy.