Memory tricks for fiscal and monetary policy

Expansionary fiscal policy: increase G or cut T, increases aggregate demand. Contractionary: decrease G or raise T. Keynesian: use fiscal policy actively in recessions. Classical: markets self-correct, policy counterproductive.

Multiplier = 1/(1-MPC). If MPC = 0.8, multiplier = 5: $1B government spending increases GDP by $5B. Mechanism: government spends, workers earn, spend 80%, recipients earn, spend 80%, etc. Tax multiplier is smaller: -(MPC/MPS).

Budget deficit: spending exceeds revenue annually. National debt: accumulated deficits. Debt-to-GDP ratio better than raw debt. US exceeded 120% after COVID. Keynesian: deficits appropriate in recessions.

Open Market Operations (OMO): buy bonds (inject money, lower rates) or sell bonds (withdraw money, raise rates). Discount Rate: interest rate Fed charges banks. Reserve Requirement: fraction banks must hold. OMO used most frequently.

Fractional reserve: banks hold fraction of deposits as reserves, lend rest. $1,000 deposit at 10% reserve: bank lends $900, deposited, bank lends $810... Total money = $1,000 x (1/10%) = $10,000.

Fed dual mandate: maximum employment and 2% inflation. Goals sometimes conflict. Raise rates: less spending, lower inflation but higher unemployment. Lower rates: more spending, lower unemployment but inflation risk.

Fiscal: directly in GDP through spending. Slower (legislation). More effective at zero lower bound. Monetary: through interest rates and credit. Faster (Fed meets 8x/year). More politically independent.

Supply-side economics: cutting taxes on high earners increases incentives to work, save, invest, shifts LRAS right. Laffer Curve: too-high rates reduce revenue. Reagan cut top rate from 70% to 28%. Results contested.

Exchange rates affect trade and capital flows. Appreciation: exports expensive (fall), imports cheaper (rise), trade balance worsens. Higher US rates attract capital, appreciate dollar. BOP: current account deficit = capital account surplus.

Reserve ratio (rr): fraction of deposits kept as reserves. Money multiplier = 1/rr. With 10 percent reserve requirement: 1000 dollars times (1/0.10) = 10000 dollars total new money. Simple multiplier assumes all money gets re-deposited and banks lend all excess reserves. Real multiplier is smaller because people hold cash and banks hold excess reserves. Quantitative Easing: Fed buys securities, banks gain reserves, can multiply into more loans.

Mechanism: deficit spending, Treasury borrows, increases demand for loanable funds, raises interest rates, private investment declines. Complete crowding out: interest rate rise exactly offsets fiscal stimulus — Classical view. Partial crowding out: dampens but does not eliminate. Keynesian near-zero rates: no crowding out possible. This is why fiscal policy is most effective in deep recessions with very low interest rates.

Progressive income tax: revenue automatically falls in recession, rises in boom. Unemployment insurance: payments automatically rise in recession, fall in recovery. Welfare and SNAP: enrollment rises automatically in downturns. These reduce the amplitude of business cycles without any legislative action. Structural deficit: deficit even at full employment. Cyclical deficit: caused by recession and automatic stabilizers.

MV = PQ: M = money supply, V = velocity of money, P = price level, Q = real output. If V is constant and Q grows at natural rate, M growth drives P growth. Quantity Theory prediction: double the money supply and you double the price level in the long run. Monetarist prescription: stable predictable money growth rule rather than discretionary policy. During 2008 crisis, velocity fell sharply — large QE did not cause high inflation as some feared.

Inside lag: time between problem arising and policy being enacted. Fiscal: long — Congress must pass legislation, months to years. Monetary: short — FOMC meets 8 times per year. Outside lag: time between policy enacted and its effect on the economy. Fiscal: short — spending enters economy immediately. Monetary: long — 6 to 18 months for rate changes to fully affect investment and consumption. Risk: policy arrives too late and destabilizes the next phase of the cycle.

Taylor Rule (1993): nominal rate = 2 percent + inflation + 0.5 times (inflation minus 2 percent) + 0.5 times output gap. Inflation target: 2 percent (Fed mandate). Output gap: actual GDP minus potential GDP as percent. If inflation at 4 percent and economy at potential: rate = 2 + 4 + 0.5(2) + 0 = 7 percent. Zero lower bound: rule can prescribe negative rates — impossible with cash. Solved by QE and forward guidance instead.