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ECON FINAL STUDY SET

Terms in this set (594)

If individuals have different preferences, exchanging goods that they value less for goods that they value more increases the well-being of all parties to such exchanges. As long as individuals freely trade, exchange is guided by an invisible hand--both parties to the exchange will be better off. Thus, exchagne is a way of coordinating competing interests.

Exchange allow individuals to specialize. Specialization depends upon relative production costs: the cost to one person of producing something relative to the cost of producing the same thing to someone with whom the person might trade. That is, specialization depends on comparative advanatage. An individual has a comparative advantage in the production of a good if his or her relative costs of producing that good are lower than those of someone with whom the individual might trade.

Specialization consistent with comparative advantage will increase the amount of goods and services available to an economy without using additional resources. Hence, specialization coordinates competing interests in a useful and productive way. Moreover, the gains to an individual from specialization do not depend upon being absolutely better at some activity than other individuals. All that matters is that an individual be relatively better or have a comparative advantage. So long as individuals are different from one another, each will have a comparative advantage.

Exchange and specialization lead to a kind of spontaneous order, in which competing interests are cooridanted in ways that have the potential to beefit all participants.
Not everyone who is out of work is unemployed. In order to be counted as unemployed you have to be out of work, looking for work, and able to accept a job if one is offered to you. If you are out of work and not looking, then you are considered "not in the labor force" rather than unemployed.

We tend to think of unemployment as an undesirable thing, but a certain amount of unemployment is actually part of a healthy economy. Structural unemployment occurs when new industries are created and old industries become obsolete. For example, when we moved from using horses and buggies to using cars to get around, this put a lot of buggy makers in the structurally unemployed category
.
Frictional unemployment might not seem very fun, but consider what it means to have zero unemployment—nobody ever looks for a job, they just remain in whatever job they are given! In fact, a number of dystopian novels have been written in which everyone in a society is automatically assigned a fixed career (such as the Divergent series). Those societies have zero frictional unemployment, but they are also quite unpleasant if you are unhappy with that career!

A decrease in the unemployment rate isn't necessarily a sign of an improving economy. When people stop looking for jobs and drop out of the labor force as discouraged workers, the unemployment rate will decrease even though the true employment situation hasn't gotten any better. This is why it is important to look at both changes in the unemployment rate and changes in the labor force participation rate. Looking at both changes let's you get a more complete idea about changes in the employment situation.
Why would producers see inflation and think, "let's all make more stuff"? After all, during inflation, shouldn't producers be scared to produce more?
Let's start with the first reason producers might continue despite deflation: sticky input prices. Economists used to believe that all prices were flexible. That means that if conditions change, like a recession happens, prices will quickly adapt to that change. For example, if there is a recession, high unemployment will quickly drive down wages. Lower wages make firms more willing to hire more workers. More workers mean more output, so flexible prices (like wages) mean that recessions should mostly fix themselves. Or so the thinking was at the time!
The Great Depression made us question the idea that all prices are flexible. After all, if prices adjust so well, why wasn't the depression going away? Economists had to rethink what they thought they knew about how well prices adjust. Price adjustment might work well in the long run, but the short run is a different story altogether. This developed into an idea called "short-run nominal price rigidity," which is just an economist's way of saying "prices don't adjust quickly."
Today, most economists believe that prices are sticky (at least in the short run). After all, wages are usually set for long time periods because of labor contracts. Businesses might lock themselves into long-term purchase agreements for other resources too. If there is unanticipated inflation, firms benefit from those long-term contracts because they are paying wages (and other resource prices) using dollars that aren't worth as much, so the real wages they are paying decrease.
The LRAS represents a point on a country's PPC, translated into the AD-AS model. Every point on the PPC represents the maximum sustainable capacity for production in an economy. This value of real GDP represents the economy's maximum sustainable capacity given its current stock of resource

The LRAS is vertical because, in the long-run, the potential output an economy can produce isn't related to the price level. There are only two things that matter for potential output: 1) the quantity and the quality of a country's resources, and 2) how it can combine those resources to produce aggregate output. When an economy is producing exactly its full employment output, the rate of unemployment is equal to the natural rate of unemployment.

The LRAS curve is also vertical at the full-employment level of output because this is the amount that would be produced once prices are fully able to adjust. In the short-run, some prices are sticky. This means that producers might respond to changes in the price level by changing their output. However, in the long-run, those prices get "unstuck," and once they have fully adjusted the economy will produce the efficient, full employment output.

Economists tended to assume that prices were fully flexible before the Great Depression. In times of high unemployment, they believed, wages will go down and restore full employment. There was just a slight problem: that didn't happen during the Great Depression! High unemployment and output persisted for a long time. The logical conclusion is that wages (and other prices) are temporarily rigid.
An economy is in short-run equilibrium when the aggregate amount of output demanded is equal to the aggregate amount of output supplied. In the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. The equilibrium consists of the equilibrium price level and the equilibrium output. A good practice is to think of the short-run equilibrium as "how much real GDP is this economy creating right now, and what is the CPI an economy has right now?"

In our analysis of markets, an economy in disequilibrium results in price adjusting until the market finds an equilibrium. The same general idea applies to a short-run macroeconomic equilibrium as well, but with a minor modification. If the amount of output demanded is greater than the amount of output produced, people chase after the limited goods available and drive up the price level. In response to the increase in the price level, producers create more goods and services. This continues until the amount of aggregate production equals the amount of aggregate demand.
Suppose the aggregate output demanded and the aggregate output supplied at different price levels are as shown in the table below:

Real output demanded price level real output supplied
\$400$400dollar sign, 400 125125125 \$500$500dollar sign, 500
\$430$430dollar sign, 430 120120120 \$480$480dollar sign, 480
\$460$460dollar sign, 460 115115115 \$460$460dollar sign, 460
\$490$490dollar sign, 490 110110110 \$440$440dollar sign, 440

If the price level in this economy is only 110, for example, aggregate demand will exceed aggregate supply, leading to shortages. Buyers will compete with each other to get output, driving the price level up. Higher price levels will induce producers to increase their output. This price level adjustment will keep occurring until there is no incentive to change. After all, the definition of an equilibrium is "no tendency to change"!

The opposite happens when the amount of output demanded is less than the amount produced. The amount of output supplied will be greater than aggregate demand. Prices will begin to fall to eliminate the surplus output. As prices fall, the amount of aggregate demand increases and the economy returns to equilibrium.
Shocks are unanticipated changes in economic conditions. Demand shocks are unanticipated changes that impact the Aggregate Demand (AD) curve. The basic idea of the self-correction mechanism is that shocks only really matter in the short run. If AD changes, then output and unemployment will change in the short run, but not in the long run. Output gaps due to a change in AD exist in the short run only because prices haven't had a chance to fully adjust to that change yet. Once those prices have fully adjusted in the long run, the output gap will close.

Let's walk through how a shock to AD in the short run can be corrected in the long run.

First, the shock:
Everyone in Hamsterville woke up one morning filled with optimism and confidence that incomes were going to increase, and that this increase will be permanent. ¡Viva Hamsterville! This optimism triggers an increase in consumer spending, causing a positive shock to AD. An increase in consumer spending will cause the AD curve to increase. As a result, output increases and unemployment decreases. Unfortunately, this positive AD shock also means that inflation increases. An increase in AD leads to an increase in real GDP and the price level.

How is shock corrected in the long run?

Inflation has made everyone's real wages decrease. Boo! As a result, workers demand higher wages. This drives up the cost of labor. Rising labor costs causes SRAS to decrease. This happens because expectations of further inflation and higher resource costs lead firms to produce less and charge higher prices. Output decreases and the price level increases. Output keeps falling and price level keeps rising until real GDP returns to full employment output. As long as output is higher than full employment output, an unemployment rate that is higher than the natural rate will put upward pressure on wages and prices. The long-run outcome is that real GDP returns to the full employment level of output and the unemployment rate is equal to the natural rate. The price level, however, is now permanently higher.
Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation.
Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done?
Yes! Both governments can use fiscal policy as a tool to bring their countries back to "normal." For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation.
Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level.
Marthlandia's inflation is caused by producing more than is sustainable, so reducing output would fix its problem. Instead, they can draw on contractionary fiscal policy tools, such as increasing taxes or decreasing government spending or government transfers.
Doing any of these things will decrease Marthlandia's aggregate demand, which leads to lower output, lower employment, and a lower price level. Usually, governments engage in expansionary fiscal policy during recessions, and contractionary fiscal policy when they are concerned about inflation.
Altogether, this lesson is about how government spending and taxes have different impacts on aggregate demand (AD). Government spending impacts AD directly, while taxes impact AD indirectly. Because government spending immediately impacts AD, but some fraction of a change in taxes will be saved rather than spent, there is a difference in impact.
If we want to know the amount of taxes that will close an output gap, we need to use the tax multiplier to figure that out. If we want to use government spending to close an output gap, we need to use the spending multiplier to figure that out.
Imagine a government wants to fix a recession or dial back an expansion. Its concrete goals would be to return the economy to full employment, or to control inflation, respectively. Fiscal policy can help them achieve their goals.
The tools of fiscal policy are government spending and taxes (or transfers, which are like "negative taxes"). You want to expand an economy that is producing too little, so expansionary fiscal policy is used to close negative output gaps (recessions). Expansionary fiscal policy includes either increasing government spending or decreasing taxes.
An economy that is producing too much needs to be contracted. In that case, contractionary fiscal policy (either decreasing government spending or increasing taxes) is the correct choice.
For example, if Burginville is experiencing a recession, the government might give everyone a tax refund (an example of expansionary fiscal policy). Here's what will play out: the tax refund leads to an increase in disposable income An increase in disposable income causes an increase in consumption, the increase in consumption increases aggregate demand An increase in aggregate demand leads to an increase in output and a decrease in unemployment As a side effect of the decrease in unemployment and the increase in output, inflation will increase.
Marthlandia is experiencing a boom and inflation. They cut government spending. Here's what will play out in Marthlandia: First, the cut in government spending leads to a decrease in aggregate, because government spending is a component of AD. The decrease in AD leads to a decrease in output, because the decrease in AD will lead to a new short-run equilibrium with a lower output, higher unemployment rate, and lower price level.
When a gap is negative, you want output to get bigger, and so expansionary fiscal policy the right choice. When a gap is positive, you want output to get smaller, and so contractionary fiscal policy is the right choice. Once you decide on the type of policy (expansionary or contractionary), you can then decide on which tool to use (taxes or spending).
Policymakers also have to be careful to "mind the gap." If they want to close an output gap, they need to know how much stimulus is necessary. Too little stimulus and you won't close the gap. Too much stimulus and you may cause a different kind of gap.
For example, suppose that the economy of Burginville has an output gap of \$20$20dollar sign, 20 billion. They need to take a policy action that causes exactly the amount of change. The good news is that they don't actually have to spend \$20$20dollar sign, 20 billion to close that gap. Why? Because they can count on multipliers.
Recall that the spending multiplier gave us the final impact on AD of an increase in any category of spending. If the spending multiplier is 4, then an increase in government spending of \$20$20dollar sign, 20 billion would increase real GDP by 4x\$20=\$804x$20=$804, x, dollar sign, 20, equals, dollar sign, 80 billion.
The tax multiplier is always one less than the spending multiplier (and is negative). If the spending multiplier is 444, the tax multiplier must be -3−3minus, 3. That means that if the government cuts taxes by \$20$20dollar sign, 20 billion, the final impact will be -3x-\$20=\$60−3x−$20=$60minus, 3, x, minus, dollar sign, 20, equals, dollar sign, 60 billion. In either of these cases, increasing output by too much will cause output to be higher than full employment output.
A government has a balanced budget when its expenditures are equal to its revenues. In other words, if a government wants to spend \$20$20dollar sign, 20, but it also wants to maintain a balanced budget, then it needs to take in \$20$20dollar sign, 20 in taxes. Governments run deficits when spending is higher than tax revenue, and they run surpluses when spending is lower than tax revenue. Over time, those deficits accumulate into national debt.
What if a government wants to use expansionary fiscal policy, but it also wants to maintain a balanced budget? If Burginvlle is in a recession and has a \$100$100dollar sign, 100 million negative output gap, it needs to use expansionary fiscal policy to close that gap. Because it has a spending multiplier of 101010, it decides to increase government spending by \$10$10dollar sign, 10 million to close that gap:
10 \times \$10 \text{million}=\$100 \text{million}10×$10million=$100million10, times, dollar sign, 10, m, i, l, l, i, o, n, equals, dollar sign, 100, m, i, l, l, i, o, n.
However, to maintain a balanced budget, it also raises taxes by \$10$10dollar sign, 10 million. But wait . . . that will have its own multiplier effect! Remember that the tax multiplier is always one less than the spending multiplier, and negative.Therefore, if the spending multiplier is 101010, the tax multiplier is -9−9minus, 9. The impact of the tax increase will be:
-9 \times \$10 \text{million} = \$-90\text{ million}−9×$10million=$−90 millionminus, 9, times, dollar sign, 10, m, i, l, l, i, o, n, equals, dollar sign, minus, 90, space, m, i, l, l, i, o, n.
To find the final impact of these actions, we add them together:
\$100 \text{million} + -\$90 \text{million} = \$10 \text{million}$100million+−$90million=$10milliondollar sign, 100, m, i, l, l, i, o, n, plus, minus, dollar sign, 90, m, i, l, l, i, o, n, equals, dollar sign, 10, m, i, l, l, i, o, n.
Notice that the final impact is exactly equal to the increase in government spending. The balanced budget multiplier will always be equal to one. Why? Because if you increase spending by \$10$10dollar sign, 10 million, but then increase taxes by \$10$10dollar sign, 10 million to pay for that spending, the final impact on real GDP is only \$10$10dollar sign, 10 million.
In reality, four things can slow down a fiscal policy's implementation and e effectiveness:
Data lag
This is the time to collect information about the economic conditions in a country. Suppose there is some shock to an economy, such as a decline in consumer confidence. A policymaker might not notice this until data on real GDP and unemployment rate are collected.
Recognition lag
This is the time it takes to realize there might be a problem. The policy-maker gets handed a report from their intern that says unemployment is up and real GDP is down. But is this a temporary thing? Or is the start of a long-run trend? If it is temporary, there isn't any need to take any action. If it is a long-run trend, that trend has already started by the time it is recognized.
Decision lag
Our policymaker reviews all of the evidence and decides that action is definitely needed. Ok, now what? Should the government take a wait-and-see approach and let the self-correction mechanism kick in? Even if they decide that the self-correction mechanism might take too long or, even deciding to actually do something will take time. Should we lower taxes? Increase spending? Now the legislature needs to get together to decide the actual policy action to take. That will take awhile.
Implementation lag
Now that the legislature passed a spending bill, it will take time to put it into place. A new agency might need to be set up to coordinate the spending. Burginville decides to implement a new infrastructure development program, building bridges and roads. Which river needs a bridge? Where should we build the road? Deciding on this will take time too.
[I'm still stuck on the notion of lags.
When first learning about stabilization policies, some people think that the objective of stabilization policies is to eliminate the business cycle. But that is not the case. The objective of stabilization policy is not to "fine-tune" the economy. The goal of stabilization isn't to make the business cycle go away completely, but to make the ups and downs less dramatic. In other words, we don't want to make the budget cycle a flat line, just less "bumpy".
Some people mistakenly assume that fiscal policy (or any kind of discretionary policy) is as easy as some simple calculations. Unfortunately, that isn't very realistic. Lags make active stabilization policy tricky. For one, the self-correction mechanism may be working in the background, so by the time a policy is finally implemented, it might not be the correct action anymore. Another problem is they make it longer before a corrective action kicks in. One potential solution is to have some form of passive, or automatic, stabilizers that will kick in automatically when a problem arises. We learn more about those in the next lesson.
Some learners confuse two important types of stabilization policy: fiscal policy and monetary policy. Fiscal policy is the domain of governments. Monetary policy is the domain of central banks (which are usually independent of government budgetary actions).
Another common misperception is that if government spending increases by the same amount as a tax increase, they completely cancel each other out. A \$100$100dollar sign, 100 million increase in government spending that is paid for by increasing taxes by \$100$100dollar sign, 100 million won't completely cancel each other out. The balanced budget multiplier is equal to one, not zero. When there is a balanced budget, the final impact on real GDP is a \$100$100dollar sign, 100 million increase as a result of the balanced budget multiplier.
When first learning about discretionary stabilization policies, it can be tricky to remember what specific actions are expansionary and what are contractionary. The table below can be your guide:
Imagine two countries that have the same tax revenues and government spending.
Salvania starts out in long-run equilibrium and a balanced budget, with \$500$500dollar sign, 500 million in government outlays paid for with \$500$500dollar sign, 500 million in tax revenues collected every year. Suddenly, the stock market crashes in Salvania causing widespread panic and decreased consumption. Luckily, the automatic stabilizers kick-in. Tax revenues decrease to \$300$300dollar sign, 300 million, while the government is now paying for \$700$700dollar sign, 700 million in government spending and transfer payments. Salvania is now facing a budget deficit of \$400$400dollar sign, 400 million.
On the other hand, Nadyaland's long-run equilibrium is interrupted by a boom. When the automatic stabilizers kick in, tax revenues increase to \$600$600dollar sign, 600 million and spending falls to \$400$400dollar sign, 400 million. As a result of the stabilizers, Nadyaland has a budget surplus of \$200$200dollar sign, 200 million.
In the real world, there are a lot of other reasons that a country might run a budget deficit or a budget surplus. But, automatic stabilizers contribute to those deficits and surpluses too. For example, the United States was in a recession during 1982. That year it ran a deficit of around \$182$182dollar sign, 182 billion. But if you remove the effect of automatic stabilizers that had kicked in, the deficit was actually only \$72$72dollar sign, 72 billion. Similarly, during the expansion in 1999, the United States had a budget surplus of around \$126$126dollar sign, 126 billion, but if you remove the effect of automatic stabilizers, the surplus was actually around \$39$39dollar sign, 39 billion. [Source: CBO]
How does a bank decide what interest rate to charge? It needs to consider two important things: How much interest is enough to make it worthwhile for the bank to loan the money (the real interest rate they earn)? How much of the interest's purchasing power might be lost to inflation?
For example, suppose a bank wants to earn 10\%10%10, percent interest, but it thinks there will be 3\%3%3, percent inflation. If they don't factor that inflation into what they change in interest, they will effectively earn only 7\%7%7, percent (because they will lose 3\%3%3, percent of the purchasing power of an interest rate of 10\%10%10, percent). Instead, banks factor inflation into their interest rates. To account for inflation, this bank would charge 13\%13%13, percent interest.
Remember from a previous lesson that inflation results in winners and losers? Suppose the bank thought inflation would be 3\%3%3, percent, but inflation turned out to be 4\%4%4, percent. We can figure out the real inflation that the bank actually earned in retrospect:
\begin{aligned}\text{real interest rate}&=\text{nominal interest rate}-\text{inflation}\\\\ &=13\%-9\%\\\\ &=9\%\end{aligned}
real interest rate

=nominal interest rate−inflation
=13%−9%
=9%

The bank was hurt by the unexpected inflation because they only got a return of 9\%9%9, percent, not the 10\%10%10, percent they hoped for. On the other hand, the borrower ended up only paying 9\%9%9, percent real interest. The borrower got the better deal!
This is an important takeaway: it was the unanticipated aspect of the inflation that hurt the bank and helped the borrower. If the bank had anticipated the higher rate of inflation, they would have simply charged a higher nominal interest rate to ensure they got the real interest rate.
This is the basic idea behind something called the Fisher Effect. When expected inflation changes, the nominal interest rate will increase. However, inflation will not effect the real interest rate.
Monetary aggregates might be easy to confuse with each other. An easy way to remember them is that the higher the number on the aggregate is, the less liquid that kind of money is. M2 is less liquid than M1.
It might be confusing that checking accounts are considered narrow money, but savings accounts are considered near money. The reason for this is that savings accounts tend to have some limitations on them that checking accounts usually do not. Most checking accounts are demand deposit. Savings accounts frequently will have limitations such as being only able to make five withdrawals per month or having to wait ten days after you deposit money to get them.
You might see a reference to an even broader monetary aggregate in your textbook or class and be confused why it isn't here. The monetary aggregate M3 is tracked in some countries, but not others (the U.S. stopped tracking this category in 2006). If you see M3 elsewhere, the most important thing to remember about it is that M3 is less liquid than M2. In fact, you might even see a broader category called L, which is even less liquid than M3. -Are cryptocurrencies money? There is actually some debate about whether cryptocurrencies (such as bitcoin) are money or just a financial asset. In fact, central banks around the world are grappling with this question right now, and there isn't any consensus on this issue. A main sticking point to argue that cryptocurrencies aren't money is that they generally cannot be used as legal tender (in other words, to buy stuff). Not a lot of stores are equipped to take cryptocurrencies to buy goods and services, at least not yet. As of right now, cryptocurrencies aren't included in either the narrow or broad definition of the money supply.
To understand how banks create money, let's take a step back. What if that poetry competition money was the only money that existed in the economy. Before you deposit the money in the bank, let's calculate the money supply:
\begin{aligned} M1&=\text{currency in circulation} + \text{deposits}\\\\ &=\$100 + \$0\end{aligned}
M1

=currency in circulation+deposits
=$100+$0

Once you deposit your money in the bank, M1 doesn't change; only the composition of the money supply changes:
M1=\$0 + \$100M1=$0+$100M, 1, equals, dollar sign, 0, plus, dollar sign, 100
How does the First Bank of Pulitzer bank create more money out of this \$100$100dollar sign, 100? Our bank now has \$80$80dollar sign, 80 just sitting around. This is the bank's excess reserves - the extra money beyond what they must keep in required reserves. The bank can do one of two things with that money:
Keep it in the bank (just in case you want to withdraw more than \$20$20dollar sign, 20)
Loan it out
In the real world, your deposit wouldn't be the only deposit in the bank. Usually, only a small number of people want to withdraw their money on a given day. So, the bank might want to loan out that money to earn a profit.
Now, suppose Sylvia shows up at the bank and wants to borrow \$50$50dollar sign, 50. Let's see how the bank's loan to Sylvia impacts their T-account and the money supply:
Assets Liabilities
Required reserves \$20$20dollar sign, 20 \$100$100dollar sign, 100 Your Deposit
Loan to Sylvia \$50$50dollar sign, 50
Excess reserves \$30$30dollar sign, 30
M1 has changed as well. Remember, your \$100$100dollar sign, 100 deposit is still your money. If you check your account balance, it still says you have \$100$100dollar sign, 100. But Sylvia now has \$50$50dollar sign, 50 in cash in her pocket, too:
\begin{aligned} M1 &= \text{cash in circulation} + \text{deposits}\\\\ &=\$50 + \$100\\\\ &=\$150\end{aligned}
M1

=cash in circulation+deposits
=$50+$100
=$150

By loaning out from excess reserves, the bank has added to the money supply.
Recall that the relationship between nominal and real interest rates is:
\text{Nominal interest rate} = \text{real interest rate} + \text{expected inflation}Nominal interest rate=real interest rate+expected inflationN, o, m, i, n, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, equals, r, e, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, plus, e, x, p, e, c, t, e, d, space, i, n, f, l, a, t, i, o, n
For example, suppose that initially the real interest rate is 4% and the expected rate of inflation is 2%, resulting in a nominal interest rate of 6%:
\begin{aligned}\text{Nominal interest rate} &= \text{real interest rate} + \text{expected inflation} \\\\ &= 4\%+2\%\\\\ &=6\%\end{aligned}
Nominal interest rate

=real interest rate+expected inflation
=4%+2%
=6%

Now, suppose that a government increased its spending. This expansionary fiscal policy would increase aggregate demand, which leads to more output, a lower rate of unemployment, and higher inflation. If people adjust their expectations, and expected inflation increases from 2% to 5%, then the nominal interest rate becomes:
\begin{aligned} \text{nominal interest rate} &=\text{real interest rate} + \text{expected inflation}\\\\ &= 4\%+5\%\\\\ &=9\%\end{aligned}
nominal interest rate

=real interest rate+expected inflation
=4%+5%
=9%

Uh-oh! An increase in interest rates might undo some of the intended effects of the expansionary fiscal policy-so the central bank might simultaneously engage in expansionary monetary policy to lower the nominal interest rate back to its initial level.
Key equations
The government budget
\begin{aligned} \text{Budget Balance} &= T-G, \text{where}\\\\ T&=\text{ tax revenue}\\\\ G&= \text {government spending}\end{aligned}
Budget Balance
T
G

=T−G,where
= tax revenue
=government spending

For example, if a country collects \$100$100dollar sign, 100 million in taxes and spends \$100$100dollar sign, 100 million, the budget balance is zero. Sometimes you will also see this referred to being "in balance" rather than "the budget balance is zero." In either case, this is the formula:
\$100 \text{ million} - \$100 \text{ million} = 0$100 million−$100 million=0dollar sign, 100, space, m, i, l, l, i, o, n, minus, dollar sign, 100, space, m, i, l, l, i, o, n, equals, 0
But, if a government spends more than it takes in, it has a deficit. So if tax revenue is \$100$100dollar sign, 100 million, but government spending is \$120$120dollar sign, 120 million:
\$100 \text{ million} - \$120 \text{ million} = -\$20 \text{ million}$100 million−$120 million=−$20 milliondollar sign, 100, space, m, i, l, l, i, o, n, minus, dollar sign, 120, space, m, i, l, l, i, o, n, equals, minus, dollar sign, 20, space, m, i, l, l, i, o, n
The budget is short \$20$20dollar sign, 20 million, so the government will need to borrow that money. If the government runs the same deficit every year for three years, it will accrue a debt of \$60$60dollar sign, 60 million:
\begin{aligned}\text{Debt} &= Deficit_{yr1} + Deficit_{yr2} +Deficit_{yr3}\\\\ &= \$20 \text{ million} + \$20 \text{ million} + \$20 \text{ million}\\\\ &=\$60 \text{ million}\end{aligned}
Debt

=Deficit
yr1
​ +Deficit
yr2
​ +Deficit
yr3

=$20 million+$20 million+$20 million
=$60 million
If you want to spend \$50$50dollar sign, 50 on pizzas, but you only have \$10$10dollar sign, 10, you can't afford it unless you take out a loan. Governments have an advantage you do not, though, in that they can print money. However, this is a tactic that governments rarely take because it leads to inflation or even hyperinflation. Instead, just like you, governments borrow money.
What if you want to borrow \$40$40dollar sign, 40 and the government wants to borrow \$50$50dollar sign, 50, but there is only \$60$60dollar sign, 60 available to borrow? Now you and the government are competing to buy something that is scarce, which will drive prices up. As the real interest rate goes up, you decide you don't really need a pizza that much. As a result of the government competing with you, and with any other private borrower, the interest rate goes up, and there is less private spending.
Your pizza dilemma illustrates the crowding out effect: when governments borrow it crowds out private sector borrowing. Less of that borrowing means less investment spending and interest-sensitive consumption in the short run.
Ultimately, the extent of crowding out depends on whether the economy can accommodate additional borrowing. If an economy is in a recession, there is less private investment spending to compete with, and crowding out is less of a concern. On the other hand, if an economy is near full employment output, there is likely to be more private investment; as a result, there is more potential for crowding out.