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Unit 3: Macroeconomic
Models
A.
Read the following selection from the Margin Notes by clicking on the
link.
B.
Watch these presentations. When you click on one of the links below,
a new screen will pop up. Use the scrollbar on the side of the new screen to
navigate.
You need Adobe Reader to view PDF files.
C.
(Optional) Read the following chapters from the textbook.
Chapters 08 - 10
D. The following Optional
Links will help you do better in your course but they are not
required.
E.
Activity #2: The Fiscal and Monetary Policy Process (10 points)
As the American economy slid into recession in 1929, economists
relied on the Classical Theory of economics, which promised that the
economy would self-correct as long as government didn’t interfere.
But as the recession deepened into the Great Depression and no self-correction
occurred, economists realized that a revision in theory would be necessary.
John Maynard Keynes developed Keynesian Theory, which called for government
intervention to correct economic instability. One of the most important functions
of our government today is to try to correct inflation and recession in our
economy.
In this activity, you will learn about the tools the Congress and the Federal
Reserve can use to correct economic problems, and how the use of those tools
affects the money supply, interest rates and aggregate demand. Then you will
analyze economic data to determine how fiscal and monetary policy should be
used to correct economic problems.
Theory
|
Main Idea
|
Classical
|
The economy
will self-correct if government doesn’t interfere.
|
Keynesian
|
Government
intervention is necessary to correct economic instability.
|
We can illustrate economic performance through the concepts of aggregate supply
and aggregate demand. Aggregate supply is the total supply of goods and
services produced in the nation’s economy. It is upward-sloping because at higher
prices firms have an incentive to produce more and at lower prices they are
likely to produce less. Aggregate demand is the total demand for goods
and services in the nation’s economy. It is downward-sloping because at higher
prices, consumers, firms, government and foreign customers are less willing
to buy, while they will likely buy more at lower prices. The graph below shows
aggregate supply and aggregate demand.

Shifts in the aggregate supply and aggregate demand curves can illustrate changes
in the performance of our economy. If consumer confidence in the economy falls
and people reduce their spending, aggregate demand can fall, reducing real output
and prices and possibly dropping the country into a recession. However, if the
money supply is too large, excessive consumer demand can push up the aggregate
demand, raising real output and prices and possibly pushing the country into
serious inflation.
aggregate supply
|
total supply of
goods and services produced in the nation’s economy
|
upward-sloping
(If prices are up,
supply is up.)
|
aggregate demand
|
total demand for
goods and services in the nation’s economy
|
downward-sloping
(If prices are up,
demand is down.)
|
For stable economic growth, economists generally look to annual goals of a 2.5-3%
GDP growth, a 3-4% inflation rate and an approximately 5% unemployment rate.
However, our economy generally follows an economic cycle of recession and expansion
every few years. As John Maynard Keynes argued in his 1936 book General Theory
of Employment, Interest and Money, nations need not wait for potential economic
problems to correct themselves. He advocated that government take an active
role in resolving economic issues through the use of two policies – fiscal policy
and monetary policy.
Stable Economic Growth Annual Goals
|
GDP growth
|
Inflation rate
|
Unemployment rate
|
2.5-3%
|
3-4%
|
5%
|
Fiscal policy is the use of government spending and taxes to stabilize
the economy. Read Amos Web’s explanation of
Fiscal Policy.
During periods of recession, Keynes recommended that Congress increase government
spending in order to “prime the pump” of the economy. At the same time, he recommended
that Congress decrease taxes in order to give households more disposable income
with which they can buy more products. Through both methods of fiscal policy,
the increase in aggregate demand stimulates firms to increase production, hire
workers and increase household incomes to enable them to buy more.
Keynes advocated the opposite positions during times of rapid inflation. In
order to slow down the economy, Keynes called for Congress to reduce government
spending in order to reduce pressure on aggregate demand. For the same reason
he called for tax increases in inflationary times to reduce consumers' disposable
income The reduction in aggregate demand brought about by such actions leads
firms to produce fewer products, slows hiring and reduces inflationary pressure.
While both tools are effective, Keynes advocated change in government spending
as the more effective fiscal policy tool because any change in government spending
has a direct effect on aggregate demand. However, if taxes are reduced, consumers
most likely will not spend all of the increase in disposable income. They are
likely to save some of it. In the same way, if taxes are raised, consumers are
not likely to reduce their consumption by the same amount as the tax. They are
likely to dip into savings to cover some of the change in tax rates.
Think about the following questions.
-
According to Keynes, what should
the government do regarding taxes and government spending during a period
of recession?
-
According to Keynes, what should
the government do regarding taxes and government spending during a period
of rapid inflation?
Monetary policy is the use of the money supply and credit to stabilize
the economy. Read Amos Web’s explanation of
Monetary Policy and refer to the graph below.

The demand for money consists of consumers borrowing for items such as cars
and homes, firms borrowing for items such as factories and equipment, and the
government borrowing to finance the national debt. The supply of money is set
by the Federal Reserve Board of Governors, the central banking system for the
US. The supply and demand for money determine the interest rate paid for the
use of borrowed money. If the Federal Reserve increases the money supply, interest
rates will fall, making it less expensive to borrow money. In that case, those
wishing to borrow money will be more likely to do so -- and be more likely to
spend that money on products. If the Federal Reserve reduces the money supply,
interest rates will rise, so less will be borrowed and spent (because of the
higher cost of borrowing). Think of money as a product and interest rates as
the price of money. As a product, money is affected by supply and demand the
same as any other product.
The Federal Reserve has three primary tools available to change the money supply.
(1) During periods of recession, Keynes recommended that the Fed buy bonds
on the open market. By increasing the reserves the banks hold, the banks
have more money available to loan and can reduce their interest rates. At lower
interest rates, consumers and firms are more willing to borrow to make purchases,
and aggregate demand can increase. (2) Keynes recommended that the Fed lower
the discount rate. When the Fed reduces the discount rate (the interest
rate member banks must pay to borrow from the Fed), banks become more willing
to borrow in order to make money available for loans at lower interest rates.
In this case, again, consumers and firms are more willing to borrow and spend,
increasing aggregate demand. (3) Keynes recommended that the Fed reduce the
reserve requirement during a serious recession. If banks can release more of
their reserved funds for loans, the lowered interest rate will again entice
consumers and firms to borrow funds to make purchases, increasing the aggregate
demand.
Keynes advocated the opposite positions during times of rapid inflation: reducing
the money supply to raise interest rates, making it less likely consumers and
firms will borrow to purchase products.
While these three tools work in similar ways, they differ in the power of their
effects. The reserve requirement is extremely powerful and changed only in the
event of a serious economic situation. The discount rate is more of a signal
of the Fed’s intentions for monetary policy. Open market operations are by far
the most widely used tool of monetary policy.
Think about the following questions.
-
How can the Federal Reserve use
the reserve requirement, the discount rate and open market operations
during a period of recession?
-
How can the Federal Reserve use
the reserve requirement, the discount rate and open market operations
during a period of rapid inflation?
Policy
|
Definition
|
Goals
|
Actors
|
Tools
(*most effective)
|
Recession
|
Inflation
|
Fiscal
|
the use of
government spending and taxes to stabilize the economy
|
fund programs
manage growth
administration
|
Congress
President
|
government spending*
taxation
[transfer payments,
borrowing]
|
increase
decrease
|
decrease
increase
|
Monetary
|
managing the
money supply to influence interest rates and the availability of credit
|
price stability
full employment
growth
|
Federal Reserve
|
open market ops*
discount
rate
reserve requirements
|
buy
reduce
reduce
|
sell
raise
raise
|
It’s time to analyze a few economic situations and determine how we should use
fiscal and monetary policies to correct economic problems. The
Fiscal and Monetary Policy Tools Self Test covers 5 economic
situations, each of which is followed by several questions. For each question
choose the policy action you think is most likely to correct that economic situation.
You'll get immediate feedback. If you choose the wrong action, you’ll get an
“Oops” and should stop and think about why your choice was wrong. If you choose
the correct action, keep going to the next question but think carefully about
the rationale for your choice and use what you learn when considering the other
situations.
It's important that you take the self test and get this experience. With
no one watching, you can take as long as you want and start over as often as
you want. Before you leave the self test make certain you understand which policy
tools are used in which situations and why.
In 2001, the US economy slipped into recession. The GDP dropped by more than
a 1% annual rate in the third quarter, the inflation rate dropped to below a
2% annual rate in the fourth quarter and the unemployment rate rose to 5.6%
in the fourth quarter.
Apply the skills you honed in the self test to a real world situation. Take
on the role of an economic advisor to the Congress and to the Federal Reserve.
It’s 2001. What do you recommend the US Congress do with its fiscal policy
tools? What do you recommend the Fed do with its monetary policy tools? How
will the tools work to help improve aggregate demand?
After you have decided on your recommendations, visit the following websites
to see the actual 2001 fiscal policy actions taken by the President and the
Congress, and the actual 2001 monetary policy actions taken by the Federal Reserve.
Federal Reserve Bank of Boston Speeches: Asset Bubbles and Systemic Risk
Federal Reserve Release; Press Release
Did the 2001 fiscal policy actions or the 2001 monetary policy actions agree
with your recommendations? If they differed, why do you think that is?
Economists learned much from the experience of the Great Depression, and most
economists today advocate a role for government in creating economic stabilization
policy. Although economists may disagree about which particular tool is most
appropriate, or about the timing or strength of the tool used, most economists
recognize the advantages of using fiscal and monetary policy for the prevention
of extreme inflation or depression in our economy.
[This activity is based on work from – but no longer
maintained by – EconEdLink.]
When you've finished the online work, I will expect you to send me a summary
of your work that includes the 4 points below. Your answers should be thorough,
specific, include relevant concepts from the course material and be free of
spelling and grammar errors. [NOTE: As I've done below, I almost always list
the things you need to include in your assignment so you won't miss anything.
However, you should never write an assignment as a list unless the instructions
specifically tell you to do so (as in your first assignment). Lists encourage
short, quick responses, and they don't usually require much thought or much
attention to spelling and grammar. They also won't earn you many points! Instead,
write your assignment in complete sentences and paragraphs, using the list only
to be certain you cover everything. Do your best to make your writing thorough,
thoughtful and organized. Don't try to be concise ,,, Try to be complete.]
-
What should the government do
with (a) taxes and (b) government spending during (a) a period of recession
and during (b) a period of rapid inflation, according to Keynes?
Write a brief essay that answers those questions. Do not copy-and-paste.
Explain to me what you learned in your own words.
-
How can the Federal
Reserve use (a) the reserve requirement, (b) the discount rate and
(c) open market operations during (a) a period of recession and during
(b) a period of rapid inflation. Write a brief essay that answers those
questions. Do not copy-and-paste. Explain to me what you learned in
your own words.
-
I asked you above to answer three
questions: (a) In response to the 2001 economic situation the assignment
described, what do you propose Congress do with its fiscal
policy tools? (b) In response to the 2001 economic situation the assignment
described, what do you propose the Fed do with its monetary
policy tools? (c) How do the government’s and Fed’s actual policies
compare to your recommendations in (a) and (b). Write a brief
essay that explains your recommendations and how they compare to the
government's and/or the Fed's actions.
-
Make specific and detailed connections
to the course material you have been studying. Always include course
concepts in your work. If you're reading your margin notes and watching
the presentations, you'll have plenty of material from which to choose
on every activity. (When it comes to making specific and detailed connections
to the course material, I always show some leniency in the first assignment.
With this second assignment, you need to begin to approach this item
in a more scholarly fashion. This is the part of each assignment in
which you should show off how much you know. You should have already
completed margin notes and presentations that deal with relevant theoretical
concepts so it should be easy to make those connections. If you don't,
then you miss the purpose of the assignment and cannot expect to earn
full points for it.)
I am not asking you to write separate essays. I'm asking you to send me one
thoughtful in-depth piece covering the topics given. It ought to all fit together.
If you have trouble with spelling and grammar, find someone to help you edit
your work before you send it. Don't hide great ideas with poor writing habits.
Activity Submission Instructions
By the deadline shown in the Course Schedule
on the main page of your syllabus:
-
Send your summary containing the 4 items requested
in the body of a new email to
dramyglenn@gmail.com.
-
Put only your name and Activity #2 at the beginning
of your email.
-
Be careful to use the correct subject line.
-
Late responses lose one point per day late,
including weekends and holidays.
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