ECO 201-1W0V SU 12

Margarita Arnold

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1. How do you use fiscal policy to fight a recession? What is this policy

called? Expansionary fiscal policy is used when a recession occurs. The government increases its spending, tax reductions occur, designed to increase aggregate demand and raise real GDP. The Congress and the President sign off on the budget for every year, so if we are in the middle of a recession, the budget would increase. Tax cuts would make the households, businesses, and well as governments spend more because they have more money to spend on goods and services rather than taxes. 2 .How do you use fiscal policy to fight inflation? What is this policy called? Contractionary fiscal policy is used when inflation occurs. The government reduces spending, and taxes increase. The Congress and the President again approve the fiscal budget for the year. The congress also establishes tax rates which vary directly with the level of GDP the economy achieves. These tax rates are not established with the fiscal budget, but change with the fluctuations of the business cycle. 3. What are the three time lags? Explain why timing might be a problem for implementing fiscal policy. What might happen if expansionary policy is implemented after an economy has recovered? A) Recognition Lag: Recognizing inflation/recession has proven to be difficult that it is actually happening at the time. B) Administrative Lag: The Congress may have to vote when implementing fiscal policy, which may take a while. C) Operational Lag: Planning and putting policy into action would take a while. Tax changes contradict and help make the necessary changes rather than the policy itself. If expansionary policy has been implemented after an economy has recovered, inflation might occur.

4. When government borrowing leads to higher real interest rates, what will likely happen to gross investment? What do we call this effect? The crowding out effect is when deficit spending increases the interest rate and reduces investment spending. In #1 and #2 make sure you explain what Congress and the President do to government spending and taxes.
1. What should the Federal Reserve do to fight a recession?

In a recession, open market operations: selling and buying government bonds to commercial banks and the public. The Fed buys bonds from commercial banks, so they can have more money to lend. The required reserve is lowered so banks can lend more money for the households/businesses to spend. The discount rate is also lowered, so commercial banks can acquire more reserves and lend more credit for spending. 2. What should the Federal Reserve do to fight inflation? To fight inflation, open market operation: the Fed sells bonds to commercial banks and the public which in turn reduces reserves in commercial banks. This makes loans and credit harder to acquire. The required reserve is raised, requiring banks to have more money that they cannot loan out. The discount rate is also raised, making it harder for commercial banks to borrow money from the Fed, thus keeping the reserves low. 3. What can make these policies less effective (pitfalls)? For Fiscal Policy: The 3 time lags mentioned above, political business cycles: swings in the economic activity which is resulted from election motivated policy, crowding out effect. For Monetary Policy: Time lags, cyclical asymmetry, liquidity trap. In #1 and #2 detail what the Fed does with each of the following tools: open market operations, required reserve, and discount rate.