ECON 101 Lecture Notes - Lecture 7: Liquidity Trap, Loanable Funds, Tax Cut
Economics 101
Lori Leachman
Part 7 • Lecture
• Loanable funds market
o Changes Supply
▪ Open market operations (OMO)
• OMO purchase increases S
▪ Capital inflow/outflow
• Capital inflow increases S
o Changes Demand
▪ Business investment
• Increase in investment increases D
▪ Fiscal deficits
• Increase in deficit increases D
• r* is set by Supply and Demand of loanable funds market, which then sets i* through fisher equation (i = r
+ p) and determines quantity invested I, which determines TS and AD because TS = C + I + G + (Xn = 0)...
AD?
• Monetary policy doesn’t always work due to things out of Fed’s control & the liquidity trap
o Keynesian argument against monetary policy - people may hold money - reasons people invest
and borrow are different - can lead to liquidity trap
• Fiscal Policy changes MEI with corp tax cuts
• Keynesian Model:
o Aggregate Supply (AS) is 45 degrees thru origin
▪ Dollar of spent is dollar of income to someone - income approach to GDP
▪ Supply will always accommodate demand infinitely - only AD matters
• Keynesian is demand oriented
• Written during g. depression
o TS = C + I + G + (Xn = 0)
o C = a + b (Y - t)
o a = autonomous consumption
▪ Money one spends when income = 0, affected by social safety net, wealth, savings of
economy, pension system, educational system
o b = marginal propensity to consume = MPC
▪ Sets the SLOPE of the y = mx + b equation above...
▪ Fraction of each extra dollar earned that is spent
▪ 0 <= b <= 1
▪ MPC + MPS = 1
▪ MPS = marginal propensity to save
▪ MPC can be above 1 (like kids spending parents money... autonomous consumption)
o Y is income - t is taxes (lump sum tax assumed)
▪ So Y - t is disposable income
o Multiplier effects (fiscal policy)
▪ Simple Multiplier (Ms) = 1 / (1 - b)
• Impacts of changes in G and I (expectations or corp tax)
• Takes much bigger change in I, because I is smaller portion spending
▪ Tax Multiplier (Mt) = - MPC / MPS
• Impacts of changes in income tax
▪ Tax multiplier is always negative and one less than the simple multiplier
• Mt = - (Ms - 1)
o Yt = Target income; income consistent w/ full employment & price stability (classical range of
AS and on PPC)
▪ If Y* = Yt all is perfect
▪ If Yt > Y, actual is lower than should
• In a trough/recession
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Part 7 lecture: loanable funds market, changes supply, open market operations (omo, omo purchase increases s, capital inflow/outflow, capital inflow increases s, changes demand, business investment. Increase in investment increases d: fiscal deficits. Increase in deficit increases d r* is set by supply and demand of loanable funds market, which then sets i* through fisher equation (i = r. + p) and determines quantity invested i, which determines ts and ad because ts = c + i + g + (xn = 0) Impacts of changes in g and i (expectations or corp tax: takes much bigger change in i, because i is smaller portion spending, tax multiplier (mt) = - mpc / mps. If yt > y, actual is lower than should. If yt < y, actual is higher than should. Implications for most to least expansionary policies - order rank. Increased gov spending alone: tax cut alone.