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5.1 Fiscal and Monetary Policy Actions in the Short-Run

4 min readjanuary 2, 2023

J

Jeanne Stansak

Haseung Jun

Haseung Jun

J

Jeanne Stansak

Haseung Jun

Haseung Jun

Fiscal and Monetary Policies

Although the economy may seem stable to the common man, when we take a closer look at it there are several ways that we can improve the condition of the economy in the short and long term. It can be corrected through , which is carried out by and the , through , which is carried out by the , or it can self correct itself. A combination of the two can bring out dramatic effects.

If we use to correct our economy, it is done through or . If we are looking to speed up our economy because we are in a recessionary gap (negative gap output), we need to increase spending, decrease taxes, or a combination of these two things. When we increase spending or decrease taxes, then that will lead to an increase in either , , or . This will increase the aggregate demand (AD).

If we are looking to slow down our economy because we are in an inflationary gap (positive output gap), then we need to decrease spending, increase taxes, or a combination of these two things. When we decrease spending or increase taxes, then that will lead to a decrease in either , , or . This will decrease aggregate demand (AD).

If we use , we can use one of the tools of the . The most popular tools of the are the reserve ratio (requirement), , and . If we are looking to speed up an economy that is in a recessionary gap, we can decrease the reserve ratio, decrease the , or buy bonds. This will cause the to increase, which will lower . With lower , consumers and firms will be more willing to spend money, and we will see an increase in both consumer and which will increase aggregate demand (AD).

If we are looking to slow down an economy that is in an inflationary gap, we can increase the reserve ratio, increase the , or sell bonds. This will cause the to decrease, which will raise . With higher , consumers and firms will be less willing to spend money, so we will see a decrease in both consumer and which will decrease aggregate demand (AD).

Finally, if we let the economy self correct itself, we are letting wages naturally increase or decrease in the long run, which will cause the SRAS (short-run aggregate supply curve) curve to either increase or decrease.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-3gFGtMKrddTJ.png?alt=media&token=59d31704-ddbb-41f2-8358-c01add651dd3

Fiscal Policy

Recessionary Gap to Long-Run Equilibrium

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-FxOjsHC4Gm8M.png?alt=media&token=bcaeab3d-4f99-4129-8e6e-392ffd417474
  • In a recessionary gap, unemployment is above natural rate.

  • To correct this, the government can increase spending. An increase in spending government causes increases aggregate demand, which results in an increase in real GDP and income. If people have more money to spend, then the overall demand for goods will increase, meaning people will buy more.
  • Similarly, the government can decrease taxes to combat a recessionary gap. A decrease in taxes causes an increase in aggregate demand, which results in an increase in real GDP and income. If people have more money to spend (because they are paying fewer taxes), then the overall demand for goods will increase, meaning people will buy more.
  • These two methods are a part of the .

Inflationary Gap to Long-Run Equilibrium

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-5xlf8h5UPx0M.png?alt=media&token=44f3b2a9-b2aa-4133-8b5b-56f137f35a9c
  • In an inflationary gap, output is above potential and unemployment is below the natural rate.

  • To correct this, the government can decrease spending. A decrease in spending government causes a decrease in aggregate demand, which results in a decrease in real GDP and income. If people have less money to spend, then the overall demand for goods will decrease, meaning people will buy less.

  • Similarly, the government can increase taxes to combat an inflationary gap. An increase in taxes causes a decrease in aggregate demand, which results in a decrease in real GDP and income. If people have less money to spend, then the overall demand for goods will decrease, meaning people will buy less.

  • These two methods are a part of the .

Monetary Policy

Recessionary Gap Correction

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-Ingz17JgCaks.png?alt=media&token=b54d4a7b-5416-4657-938a-9603f418090b

Inflationary Gap Correction

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-gqOoWEIHoMD5.png?alt=media&token=11afb790-f8cf-4fb6-a5cc-5fed577208bf

Key Terms to Review (18)

Aggregate demand (AD)

: Aggregate demand refers to the total amount of goods and services that all sectors in an economy are willing and able to purchase at different price levels during a given time period.

Congress

: Congress is the legislative branch of the United States federal government. It consists of two houses, the House of Representatives and the Senate, and is responsible for making laws, approving budgets, and overseeing government activities.

Consumer Spending

: Consumer spending refers to the total amount of money spent by individuals on goods and services in an economy. It is a crucial component of aggregate demand and plays a significant role in driving economic growth.

Contractionary Fiscal Policy

: Contractionary fiscal policy refers to government actions aimed at reducing aggregate demand and controlling inflation during periods of high economic activity. It involves decreasing government spending, increasing taxes, or both.

Discount Rate

: The discount rate is the interest rate at which commercial banks can borrow funds directly from the Federal Reserve.

Expansionary Fiscal Policy

: Expansionary fiscal policy refers to government actions aimed at increasing aggregate demand and stimulating economic growth during periods of recession or low economic activity. It involves increasing government spending, reducing taxes, or both.

Federal Reserve

: The Federal Reserve, often referred to as the "Fed," is the central banking system of the United States. It is responsible for conducting monetary policy, supervising and regulating banks, maintaining financial stability, and providing various banking services.

Fiscal Policy

: Fiscal policy refers to the government's use of taxation and spending to influence the economy. It involves decisions on how much money the government should collect in taxes and how much it should spend on public goods and services.

Government Spending

: Government spending refers to expenditures made by federal, state, or local governments on goods, services, infrastructure projects, social programs, defense, etc., using taxpayer funds.

Interest rates

: Interest rates refer to the cost or price paid for borrowing money or using credit, usually expressed as a percentage per year. They represent how much extra you need to pay back on top of what you borrowed.

Investment Spending

: Investment spending refers to expenditures made by businesses and individuals on capital goods such as machinery, equipment, and buildings. It is one of the components of aggregate demand and contributes to economic growth.

Monetary Policy

: Monetary policy refers to actions taken by a central bank (such as adjusting interest rates or controlling money supply) to manage and stabilize an economy's money supply, credit availability, and interest rates.

Money Supply

: Money supply refers to all physical currency (coins and paper bills) circulating in an economy along with demand deposits held by individuals and businesses in commercial banks.

Open Market Operations

: Open market operations refer to the buying and selling of government securities by the central bank in order to control the money supply and interest rates.

President

: The President refers to the head of state and government in the United States. They are responsible for leading the executive branch, making important decisions, and representing the country both domestically and internationally.

Reserve Ratio (Requirement)

: The reserve ratio refers to the percentage of deposits that banks are required to hold as reserves, which cannot be lent out or invested.

Short-Run Aggregate Supply (SRAS) Curve

: The SRAS curve shows the relationship between real GDP produced and price levels in an economy in the short run when resource prices are fixed. It depicts how businesses respond to changes in demand by adjusting their production levels while keeping input costs constant.

Taxation

: Taxation refers to the process of levying and collecting taxes from individuals and businesses by the government in order to fund public expenditures and services.

5.1 Fiscal and Monetary Policy Actions in the Short-Run

4 min readjanuary 2, 2023

J

Jeanne Stansak

Haseung Jun

Haseung Jun

J

Jeanne Stansak

Haseung Jun

Haseung Jun

Fiscal and Monetary Policies

Although the economy may seem stable to the common man, when we take a closer look at it there are several ways that we can improve the condition of the economy in the short and long term. It can be corrected through , which is carried out by and the , through , which is carried out by the , or it can self correct itself. A combination of the two can bring out dramatic effects.

If we use to correct our economy, it is done through or . If we are looking to speed up our economy because we are in a recessionary gap (negative gap output), we need to increase spending, decrease taxes, or a combination of these two things. When we increase spending or decrease taxes, then that will lead to an increase in either , , or . This will increase the aggregate demand (AD).

If we are looking to slow down our economy because we are in an inflationary gap (positive output gap), then we need to decrease spending, increase taxes, or a combination of these two things. When we decrease spending or increase taxes, then that will lead to a decrease in either , , or . This will decrease aggregate demand (AD).

If we use , we can use one of the tools of the . The most popular tools of the are the reserve ratio (requirement), , and . If we are looking to speed up an economy that is in a recessionary gap, we can decrease the reserve ratio, decrease the , or buy bonds. This will cause the to increase, which will lower . With lower , consumers and firms will be more willing to spend money, and we will see an increase in both consumer and which will increase aggregate demand (AD).

If we are looking to slow down an economy that is in an inflationary gap, we can increase the reserve ratio, increase the , or sell bonds. This will cause the to decrease, which will raise . With higher , consumers and firms will be less willing to spend money, so we will see a decrease in both consumer and which will decrease aggregate demand (AD).

Finally, if we let the economy self correct itself, we are letting wages naturally increase or decrease in the long run, which will cause the SRAS (short-run aggregate supply curve) curve to either increase or decrease.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-3gFGtMKrddTJ.png?alt=media&token=59d31704-ddbb-41f2-8358-c01add651dd3

Fiscal Policy

Recessionary Gap to Long-Run Equilibrium

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-FxOjsHC4Gm8M.png?alt=media&token=bcaeab3d-4f99-4129-8e6e-392ffd417474
  • In a recessionary gap, unemployment is above natural rate.

  • To correct this, the government can increase spending. An increase in spending government causes increases aggregate demand, which results in an increase in real GDP and income. If people have more money to spend, then the overall demand for goods will increase, meaning people will buy more.
  • Similarly, the government can decrease taxes to combat a recessionary gap. A decrease in taxes causes an increase in aggregate demand, which results in an increase in real GDP and income. If people have more money to spend (because they are paying fewer taxes), then the overall demand for goods will increase, meaning people will buy more.
  • These two methods are a part of the .

Inflationary Gap to Long-Run Equilibrium

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-5xlf8h5UPx0M.png?alt=media&token=44f3b2a9-b2aa-4133-8b5b-56f137f35a9c
  • In an inflationary gap, output is above potential and unemployment is below the natural rate.

  • To correct this, the government can decrease spending. A decrease in spending government causes a decrease in aggregate demand, which results in a decrease in real GDP and income. If people have less money to spend, then the overall demand for goods will decrease, meaning people will buy less.

  • Similarly, the government can increase taxes to combat an inflationary gap. An increase in taxes causes a decrease in aggregate demand, which results in a decrease in real GDP and income. If people have less money to spend, then the overall demand for goods will decrease, meaning people will buy less.

  • These two methods are a part of the .

Monetary Policy

Recessionary Gap Correction

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-Ingz17JgCaks.png?alt=media&token=b54d4a7b-5416-4657-938a-9603f418090b

Inflationary Gap Correction

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-gqOoWEIHoMD5.png?alt=media&token=11afb790-f8cf-4fb6-a5cc-5fed577208bf

Key Terms to Review (18)

Aggregate demand (AD)

: Aggregate demand refers to the total amount of goods and services that all sectors in an economy are willing and able to purchase at different price levels during a given time period.

Congress

: Congress is the legislative branch of the United States federal government. It consists of two houses, the House of Representatives and the Senate, and is responsible for making laws, approving budgets, and overseeing government activities.

Consumer Spending

: Consumer spending refers to the total amount of money spent by individuals on goods and services in an economy. It is a crucial component of aggregate demand and plays a significant role in driving economic growth.

Contractionary Fiscal Policy

: Contractionary fiscal policy refers to government actions aimed at reducing aggregate demand and controlling inflation during periods of high economic activity. It involves decreasing government spending, increasing taxes, or both.

Discount Rate

: The discount rate is the interest rate at which commercial banks can borrow funds directly from the Federal Reserve.

Expansionary Fiscal Policy

: Expansionary fiscal policy refers to government actions aimed at increasing aggregate demand and stimulating economic growth during periods of recession or low economic activity. It involves increasing government spending, reducing taxes, or both.

Federal Reserve

: The Federal Reserve, often referred to as the "Fed," is the central banking system of the United States. It is responsible for conducting monetary policy, supervising and regulating banks, maintaining financial stability, and providing various banking services.

Fiscal Policy

: Fiscal policy refers to the government's use of taxation and spending to influence the economy. It involves decisions on how much money the government should collect in taxes and how much it should spend on public goods and services.

Government Spending

: Government spending refers to expenditures made by federal, state, or local governments on goods, services, infrastructure projects, social programs, defense, etc., using taxpayer funds.

Interest rates

: Interest rates refer to the cost or price paid for borrowing money or using credit, usually expressed as a percentage per year. They represent how much extra you need to pay back on top of what you borrowed.

Investment Spending

: Investment spending refers to expenditures made by businesses and individuals on capital goods such as machinery, equipment, and buildings. It is one of the components of aggregate demand and contributes to economic growth.

Monetary Policy

: Monetary policy refers to actions taken by a central bank (such as adjusting interest rates or controlling money supply) to manage and stabilize an economy's money supply, credit availability, and interest rates.

Money Supply

: Money supply refers to all physical currency (coins and paper bills) circulating in an economy along with demand deposits held by individuals and businesses in commercial banks.

Open Market Operations

: Open market operations refer to the buying and selling of government securities by the central bank in order to control the money supply and interest rates.

President

: The President refers to the head of state and government in the United States. They are responsible for leading the executive branch, making important decisions, and representing the country both domestically and internationally.

Reserve Ratio (Requirement)

: The reserve ratio refers to the percentage of deposits that banks are required to hold as reserves, which cannot be lent out or invested.

Short-Run Aggregate Supply (SRAS) Curve

: The SRAS curve shows the relationship between real GDP produced and price levels in an economy in the short run when resource prices are fixed. It depicts how businesses respond to changes in demand by adjusting their production levels while keeping input costs constant.

Taxation

: Taxation refers to the process of levying and collecting taxes from individuals and businesses by the government in order to fund public expenditures and services.


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AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.


© 2024 Fiveable Inc. All rights reserved.

AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.