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In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply. Like the demand and supply for individual goods and services, the aggregate demand and aggregate supply for an economy can be represented by a schedule, a curve, or by an algebraic equation.
The aggregate demand curve tends to shift to the left when total consumer spending declines. Consumers might spend less because the cost of living is rising or because government taxes have increased. Consumers may decide to spend less and save more if they expect prices to rise in the future. It might be that consumer time preferences change and future consumption is valued more highly than present consumption. It is not clear whether an increase in savings necessarily shifts AD to the left. Demand might remain unchanged if those extra savings become loans to businesses and then total business spending on capital goods increases. Contractionary fiscal policy can shift aggregate demand to the left. The government might decide to raise taxes and or decrease spending to fix a budget deficit.
Monetary policy has less immediate effects. If monetary policy raises the interest rate, individuals and businesses tend to borrow less and save more. This could shift AD to the left. The last major variable, net exports exports minus imports, is less direct and more controversial. A country that runs a current account is always balanced by the capital account. The corresponding capital account surplus might raise government spending if foreign agents use their dollars to buy Treasury bonds. If they use those dollars to invest in U. S. businesses, the investment spending on capital goods might rise.
For every possible cause of a leftward shift in the AD curve, there is an opposite possible rightward shift. Increased consumer spending on domestic goods and services can shift AD to the right. It is possible that a declining marginal propensity to save can also shift AD to the right. Expansionary monetary and fiscal policy might increase aggregate demand. All of these effects are the inverse of the factors that tend to decrease aggregate demand. The defining part of the business cycle is a recession. Without a recession, the economy doesn’t really experience a business cycle, just a period of a prolonged economic expansion.
Between 1992 and 2000, the U. S. economy did not see a recession and set the record for the longest period of economic expansion without a recession. There were changes in real GDP growth during this time period, GDP even decreased in the first quarter of 2003, but no recession. The table above shows how the business cycle evolved in the 20th century. Prior to 1945, periods of recession were almost as common as days when the economy was growing. As we will discuss in Unit 9, until the Great Depression of the 1930s, economic policy makers generally did little to counteract the forces that drove the business cycle, choosing instead to allow the economy to take its own course. The result was long and frequent recessions that we usually much more severe than modern-day recessions. Modern economic thought is characterized by the use of both fiscal and monetary policies to counteract and smooth out the business cycle. economists have had success in using these policies to make the dealings of U. S. firms, as well as the life of Americans who work and save in financial markets less turbulent. To better understand the use of fiscal and monetary policies. Fiscal Policy is represented by the executive and legislative branches of government and captures changes in taxes. and government spending. In the United States, the president and Congress make these decisions.
As we can see from the equation, a decrease in T will increase disposable income, increasing and therefore increasing the growth rate of GDP. Government spending directly affects GDP growth. If the economy is in a recession, a combination of tax cuts and increases in government spending can stimulate economic activity. For example, the U. S. economy saw its first recession in a decade in 2001. Taxes were reduced in 2001, 2002 and 2003 in combination with a 13% jump in government spending over those years. In part, due to the tremendous fiscal stimulus, by late 2003, real GDP growth was in the 7%range. (macroeconomic 2001 FNU library)Monetary Policy is conducted by the central bank of a country – in the United States this is the Federal Reserve Board.
Details will be present later in the class, but the Federal Reserve can increase and decrease interest rates to change business investment (I) in the equation above. Changes in interest rates will also influence consumption, but our focus in this class will be the effect on investment. For example, in the year 2000, the federal funds interest rate was 6. 5% and by the summer of 2003, the interest rate had fallen to 1%. Since the majority of interest rates key off the federal funds rate, interest rates fell across the board along with the federal funds interest rate. A critical contributor to the rapid economic growth seen as 2003 wrapped up was due to the economic stimulus provided by the Federal Reserve. (macroeconomic 2000 FNU library)Observers have concluded that economics is a somewhat imprecise field, especially when it comes to dealing with business cycles.
Economic indicators such as GDP and the inflation rate are trailing indicators. They tell us a good deal about the economy, but importantly they tell us where the economy is at or has been, but not where it is going. For example, the latest quarterly GDP number informs us of economic growth in the past quarter. However, the statistic is not a reliable indicator of economic growth in the current calendar quarter.
Although there is often a correlation between future GDP growth and past GDP growth, the relationship is easily disrupted and conditions can change rapidly. Economists need to be able to identify changes in the growth trend and to spot these variations by using leading indicators such as changes in business inventories. To summarize, fiscal policy is a type of economical intervention where the government injects its policies into an economy in order to either expand the economy growth or to contract it. By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand, which is the total amount of goods and services in an economy.
One thing to remember concerning fiscal policy is that a recession is generally defined as a time period of at least two quarters of consecutive reduction in growth. It may take time to even recognize whether or not there is a recession. With fiscal policy, there will be certain levels of lag time in which conditions will deteriorate before being recognized. At the same time, fiscal policy takes time to implement due to legislative and administrative processes, and those same policies will take time to show results after implementation.
Consumers can also react to these policies positively or negatively. Most consumers would have a positive reaction per say to a policy that lowers taxes, while some will have an issue with a government spending more which will increase the burden of debt on nations citizens. Nevertheless, fiscal policy is a type of intervention that can help to control the direction of an economy. Deciding if and when it should be used will certainly continue to be debated.
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