GOVERNMENT MANIPULATION

OF THE

ECONOMY

When the economy is doing badly, should we do something to try to fix it,

or should we leave it alone?

CENTRAL QUESTION:

Classical economics refers to work done by a group of economists in the eighteenth

and nineteenth centuries. It stressed economic freedom and promoted ideas such as laissez-faire and free competition.

Classical economists like Adam Smith believed that the economy is self-regulating: supply and demand naturally move back to

equilibrium when there are imbalances.

CLASSICAL ECONOMIC THEORY:

CLASSICAL ECONOMIC THEORY:

In the long-run, the economy works itself out. Recessions

eventually turn back into growth, and disequilibrium becomes

equilibrium again.

But, “in the long run, we are all dead.”

1883-1946

JOHN MAYNARD KEYNES:

Famous British economist

who changed the way we look at

macroeconomics by promoting the idea that governments

should try to stimulate the economy.

When the Great Depression happened, I

decided that there must be some way we can prevent this

disaster from reoccurring!

IDEAS…JOHN MAYNARD KEYNES:

• Optimal economic performance can be achieved (and economic recessions prevented) by increasing aggregate demand through economic intervention policies by the government.

!• The market is imperfect, and not self-sustaining. !• Consumer income stimulates demand, which causes

economic growth. !• Thus, when economic growth is lacking, the

government should find ways to stimulate consumer demand.

Monetary policy is one of the ways that governments attempt to control the economy.

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!

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The monetary authority of a country (usually a central bank) controls the supply of money, often targeting a certain interest rate for the purpose of promoting economic growth and

stability.

MONETARY POLICY:

Types of monetary policies:MONETARY POLICY:

Expansionary Monetary

Policy

Contractionary Monetary

Policy

Helps speed up the economy, or increase

economic growth

Helps slow down the economy,

or slow economic growth

MONETARY POLICY: Expansionary monetary policy is used to increase

economic growth. The target growth rate is somewhere around 2%, because we want growth without causing

too much inflation. !

BAD: -5% growth

BAD: 10% growth

GOOD: 2% growth

Remember: inflation is a side-effect of economic growth.

MONETARY POLICY: How do we increase economic growth?

One way to increase growth is to lower the interest rates that people pay on loans and mortgages. If

people save money by paying low rates for the money they must borrow, they will have more money to spend: this money will circulate back into the economy, helping

businesses grow and prosper.

Consumer spending stimulates economic growth

MONETARY POLICY: Contractionary monetary policy is used to slow

economic growth. The goal is not to cause recession, but to temporarily slow growth to lower inflation.

!Why lower inflation?

High inflation causes the purchasing power of consumer money to decrease, which means people will be forced

to buy less. Ultimately, high inflation can lower nationwide demand, and cause economic recession.

BAD: -2% inflation

BAD: 6% inflation

GOOD: 2% inflation

MONETARY POLICY: How do we lower inflation?

Raising interest rates on loans and mortgages helps slow economic growth, because people will be forced to pay more when they

borrow money from banks. People have less money to spend in the

economy, the lack of money flowing into the economy causes recession,

and recession lowers inflation.

FISCAL POLICY: Fiscal policy is another way that governments

attempt to control the economy. !

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Governments adjust tax rates and government spending for the purpose of promoting

economic growth and stability.

FISCAL POLICY: How does lowering taxes

create growth? If people are paying less in

taxes, they have more money to spend or invest. Increased

consumer spending or investment could improve

economic growth. Governments don’t want to see too great of a spending

increase though, as this could increase inflation.

FISCAL POLICY: How does gov. spending create growth?

The government might decide to increase its own spending – say, by building more highways.

The idea is that the additional government spending creates jobs and lowers the

unemployment rate.

FISCAL POLICY: Expansionary fiscal policy is used to

increase economic growth. This is when governments cut taxes or increase

spending.

Contractionary fiscal policy is used to decrease economic growth. This is when governments increase taxes or decrease

spending.

The terms “expansionary” and “contractionary” are used the same way in relation to fiscal policy as to monetary policy.

FISCAL POLICY:

Expansionary Fiscal Policy

Contractionary Fiscal Policy

Helps speed up the economy, or increase

economic growth

Helps slow down the economy,

or slow economic growth

Remember that, in theory, increasing consumer spending (or demand) stimulates the economy.

FISCAL POLICY:

Expansionary Policy

Contractionary Policy

Increases aggregate

demand (or nationwide

consumption)

Decreases aggregate

demand (or nationwide

consumption)

COMPARE: TOOLS USED TO INFLUENCE AGGREGATE DEMAND

Government Role in the Economy

Monetary Policy Fiscal Policy

Bonds

Interest Rates

Reserves Taxing Spending