Topic 10: Stabilization Policy and Introduction to Open Economy - Knowledge Summary and Exam Analysis

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Economics for Management Studies
Iris Au

Knowledge Summary: Topic 10: Part A – Stabilization Policy Does Monetary Policy Always Work? • Monetary policy could be used: o To increase output when the central bank runs expansionary monetary policy o To decrease output when the central bank runs contractionary monetary policy • Monetary policy only works when a change in MS will affect interest rate, thus affecting investment and output • A liquidity trap might occur when the interest rate is extremely low (close to zero) such that monetary policy is no longer effective (i.e. could not be used to affect output) Comparison between Monetary Policy and Fiscal Policy – How Fiscal and Monetary Policies Affect AD • Fiscal policy – the government’s choice regarding levels of spending, taxes, and transfers • Monetary policy – the central bank’s choice regarding money supply • Both fiscal and monetary are, sometimes, referred as stabilization policy – public policy aimed at reducing the fluctuations in output in the short run (i.e. to keep Y to Y ) FE o Expansionary Fiscal Policy  Includes increases in G or TR, or decreases in T  End result: AE and AD increases => Y increases o Expansionary Monetary Policy – Open Market Purchase  Central bank buys bonds => MS increases  End result: r deceases => I increases => AE and AD increases => Y increases Note regarding monetary policy: • How much MS would increases depends on the loan creation process of commercial banks. When RR is high, then 1/RR will be low, thus the change in MS will be low • In addition, the effect on Y also depends how firms and households respond to the change in r. If firms and households are not responsive to the change in r, then investment will not change a lot, hence, output will not change a lot. Stabilization Policy and Business Cycles • Two policy options to adjust output when SR level of output is not the same as full employment level of output (i.e. Y* FEY ) o Option 1: Maintain status quo (i.e. do nothing) o Option 2: Use fiscal or monetary policy (i.e. adjust G, T, TR or MS) • Case 1 – Deflationary or Recessionary Gap (Y* < Y )FE o Option 1: Maintain status quo  Since Y* < Y , in the LR, there will be pressure for wages to drop => production cost FE decreases  AS curve shifts to the right untiFE=> P decreases, Y increases to Y FE o Option 2: Use Expansionary Fiscal or Monetary Policy  MS, G, TR increases, or T decreases  AD curve shifts to the right untiFE=> P increases, Y increases to Y FE • Case 2 – Inflationary or Expansionary Gap (Y* > Y FE o Option 1: Maintain status quo  Since Y* > Y FEin the LR, there will be pressure for wages to increase => production cost increases  AS curve shifts to the left untiFE=> P increases, Y decreases to Y FE o Option 2: Use Contractionary Fiscal or Monetary Policy  T increases or MS, G, TR decreases  AD curve shifts to the left untiFE=> P decreases, Y decreases to Y FE Note: • Wage-price spiral might occur during an inflationary gap where people demand higher wages when observing higher prices. This could lead to a spiral as prices may continue to increase, in which we experience higher inflation • Crowding-out effect occurs when the government runs expansionary fiscal or monetary policy that increases output, but the increase in output will cause demand for money to increase, thus driving interest rate (cost of borrowing) up. This leads to a decrease in investment from the private sector and will partially offset the initial increase in output • Budget deficits may adversely affect the economy because 1) they slow down the accumulation of capital stock by the private sector, which lowers future economic growth because we have fewer productive inputs and a decrease in future productivity; and 2) they will increase the level of national debt that needs to be serviced by the government, which means they have to pay larger interest payment and will use up more the tax revenue need to run public programs Topic 10: Part B – Introduction of Open Economy • The BOP account is a summary record of a country’s international transactions, including the buying and selling of goods, services, and assets • BOP = CA + KA Current Account (CA) • CA = NX of goods & services + Net unilateral transfers • NX of goods & services includes the net exports of
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