Economic policy

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economic policy
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comprises any means by which public agents affect the economy
directly (e.g., by government spending) or indirectly, through incentives affecting private agents’ behavior (e.g., interest rates, taxes,
if public agents like government get involved in the economy, they perform economic policy
fiscal policy
In the short run public agents use two types of tools: fiscal and monetary policy
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includes changes in government spending, taxes and transfers
monetary policy
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includes changes in money supply which affect the market interest rate
expansionary policy
Depending on its goal economic policy can be expansionary or restricitve
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when its aimed at raising ou t put and income
restrictive (contractionary)
Depending on its goal economic policy can be expansionary or restricitve
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when the aim is reducing output and income
Fiscal expansion includes
Fiscal expansionary policy
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- higher transfers and/or government expenditure -lower taxes
fiscal expansionary policy in other words
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fiscal expansion
Monetary expansion (easing)
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means increasing the money supply by the central bank through
1. buying financial assets in the open market 2. lowering the discount rate (the policy rate, 3. lowering the reserve rate
and thus lowering the market interest rate and increasing autonomous expenditure
the transmission mechanism of monetary policy
money supply is the main tool of monetary policy
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M -> i up, C, I, NX down -> Z down -> Y down
actions in the money market which translates into the goods market
Effectiveness of policy
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describes the extent to which the goal is realized
The goal of fiscal expansion is to increase output and the effectiveness will measure this goal
The crowding out effect
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is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.
G up -> Z up -> Y up -> Md up -> i up -> C, I, NX down
increasy in money demand caused by bigger government spending leads to an increase in interest rates which is followed by the decrease in consumption, investment and net exports
the stronger the crowding out effect...
how it affects the fiscal expansion
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the lower the efficiency of fiscal expansion
Income elasticity of money demand
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is an economic measure of how responsive the quantity demand for a good or service is to a change in income.
the effectiveness of fiscal policy depends on
which slope
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the LM slope
Fiscal policy is more effective when LM is
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flat - income elasticity of money demand (k) is small or interest rate elasticity of money demand (h) is high
Fiscal policy is relatively effective when
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• the interest rate does not rise much and/or • its rise does not have strong impact on autonomous spending
Fiscal expansion is relatively ineffective when
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1. interest rate elasticity of investment (d2) or of net exports (n) is high. 2. i ncome elasticity of money demand (k) is high, 3. interest rate elasticity of money demand (h) is small
The effectiveness of monetary policy depends on the
which slope
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the IS slope
Monetary policy is more effective when
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the IS is flat
•𝑡𝑛 is small or •d2, n and/or 𝑐1 is high
Monetary policy is re la tively ineffective when:
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1. interest rate elasticity of autonomous expenditure is low, 2. interest rate elasticity of money demand is high
1. (lowering the interest rate by the central bank does not boost autonomous spending) 2. (even a slight decrease in the interest rates restores equilibrium in the money market)
Liquidity trap
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at very low interest rates further increases in money supply by the central bank do not encourage more economic activity
•the only variable that rises is the money demand •the central bank essentially loses its control over the real economy
any amount of money issued by the central bank is being held by the public in liquid form instead of financial or physical assets

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