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A Note on Demand-Side Policies:
Demand-side policies try to counteract the effects of short term fluctuations of GDP and bring aggregate
demand to the full employment level of real GDP
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Contractionary fiscal policy is used
when there is an inflationary gap and aims to shift the AD curve to the left leading to equilibrium at the
full employment level of real GDP
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Types of Government Expenditure
 Current Expenditures: day-to-day spending on recurring items and consumable items
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School
supplies, medical supplies, and health care); and interest payments on loans
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 Transfer Payments: payments by the government to vulnerable groups (ex
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The Budget Outcome
 Government Budget: a type of plan of a country’s tax revenues and expenditures over a period
of time
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o if (government expenditures < tax revenue) {there is a budget surplus}
 Public Debt (Government Debt): government’s accumulation of deficits minus surpluses
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 The components of AD (Aggregate Demand) are consumption (C), investment (I), government
spending (G), and net exports (X-M)
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Investment Spending can be influenced if the government changes taxes on business profits
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Expansionary Fiscal Policy
 Expansionary Fiscal Policy: fiscal policy undertaken to eliminate a recessionary gap
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Increasing government spending
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3
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 Deflationary (recessionary) gaps are caused by insufficient AD
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o May consist of:
1
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It shifts to the left
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Increasing personal income taxes
 As personal income taxes increase, after-tax income falls, causing
consumption spending and AD to fall
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Increasing business taxes
 After-tax profits fall leading businesses to spend less on investment
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The Keynesian Model with The Ratchet Effect
 Feature of the Keynesian model: PL (price level) can easily increase with strong AD, but does
not easily fall as AD decreases
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The Role of Automatic Stabilizers
Automatic Stabilizers
 Automatic Stabilizers are factors that automatically, without government action, work toward
stabilizing the economy by reducing the short-term fluctuations of the business cycle
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In a recession, real GDP and income taxes fall, government tax revenues decline, and
after-tax income is higher than normal
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Unemployment Benefits
 In a recession, unemployment benefits rise as they are offered to more unemployed workers
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Discretionary Fiscal Policy
 The effects of fiscal policy depend on the value of the multiplier
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o The larger the MPC (Marginal Propensity to Consume), the larger the size of the
multiplier and the greater is the expansionary impact of the government’s increase in
spending
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o REMEMBER: MPC + MPS + MPT + MPM = 1
 An increase in government spending has a larger impact on aggregate demand than an
equivalent decrease in taxes
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 Can deal with rapid and escalating inflation
 Ability to target sectors of the economy
o Examples: education, health care, infrastructure, public goods
 Direct impact of government spending on AD
 Ability to affect potential output
Weaknesses of Fiscal Policy
 There is a lag until the problem is recognized by the government, appropriate policy is decided
upon, and the policy takes effect in the economy
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Evaluating Fiscal Policy

Responsibilities of the Central Bank
 Banker to the government
o The central bank acts as a banker to the government
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 Banker to commercial banks
o Holds deposits for commercial banks and makes loans to them in times of need
 Regulator of commercial banks
o Supervises commercial banks to make sure they operate with appropriate levels of cash
and according to rules that ensure the safety of the financial system
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 The money market is a market where the demand for money and the supply of money
determine the equilibrium rate of interest
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It DOES NOT
depend on the rate of interest
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How the Central Bank Changes the Money Supply
 Open Market Operations are the buying and selling of government securities in the open
market in order to expand or contract the amount of money in the banking system
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o The more excess reserves commercial banks have, the more loans they can make and
the more money is created
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Monetary Policy

Some Definitions:
 Monetary Policy is carried out by the central bank of each country
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 Central Bank is a government financial institution with many responsibilities
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It will shift AD to the left
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Expansionary Monetary Policy
 A decrease in interest rates causes a lower cost of borrowing; therefore, consumers and firms
are likely to borrow and spend more
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 Easy Monetary Policy an increase in the money supply by the central bank
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C & I will decrease and AD will
fall
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Advantages of Inflation Targeting
 A lower rate of inflation
 A more stable rate of inflation
 Improved predictions of future levels of inflation due to public knowledge
 Greater coordination between monetary and fiscal policy
 Greater central bank transparency and accountability
Disadvantages of Inflation Targeting
 Reduced ability of the central bank to pursue other macroeconomics objectives
 Reduced ability of the central bank to respond to supply-side shocks
 Reduced ability to deal with sudden events
 Finding an appropriate inflation target
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It’s faster than fiscal policy because it does not have to go through a
political process

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