Just as research finds that the discount rate is the most important driver of stock prices, Cochrane finds that the discount rate has played an important role in US inflation as well. Historically, unexpected inflation has largely corresponded with rises in real interest rates that lower the value of debt, and vice versa—not to changes in expected surpluses. Turning specifically to the effects of monetary and fiscal policy, Cochrane finds that a monetary-policy shock—in the form of an interest-rate increase unaccompanied by changes in the fiscal surplus or growth—led to an immediate and persistent increase in inflation.
Meanwhile, a negative fiscal-policy shock, or a decline in surpluses, also resulted in persistent inflation, about half of which was offset by changes in the discount rate. It suggests that the models the Fed uses to describe how its actions affect inflation are wrong, and that the Fed by itself cannot stop inflation or deflation. Monetary and fiscal policy need to act together to keep the price level stable.
The findings point to the danger of running consistent annual deficits, together with the short-term nature of US debt, Cochrane argues. The government rolls over about half the debt every two years. Increasing diversity among members of the Federal Open Market Committee could have significant benefits for both the policy makers and the public. Researchers have been puzzling over an apparent blockage in the European financial system that is preventing monetary policy from having its full effect.
How fiscal policy drives inflation. Sections Economics Collections Monetary Policy. Works cited John H. Lucking, Brian, and Dan Wilson. Fiscal Policy: Headwind or Tailwind? Greenstone, Michael, and Adam Looney. Skip to content Government Budgets and Fiscal Policy.
Learning Objectives By the end of this section, you will be able to: Explain how expansionary fiscal policy can shift aggregate demand and influence the economy Explain how contractionary fiscal policy can shift aggregate demand and influence the economy.
A Healthy, Growing Economy. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E 0 to E 1 to E 2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level.
However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop. Expansionary Fiscal Policy Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates.
Expansionary Fiscal Policy. The original equilibrium E 0 represents a recession, occurring at a quantity of output Y 0 below potential GDP. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P 0 to P 1 that results should be relatively small. Contractionary Fiscal Policy Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. A Contractionary Fiscal Policy.
The economy starts at the equilibrium quantity of output Y 0 , which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. Key Concepts and Summary Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes.
Self-Check Questions What is the main reason for employing contractionary fiscal policy in a time of strong economic growth? To keep prices from rising too much or too rapidly. Review Questions What is the difference between expansionary fiscal policy and contractionary fiscal policy? Critical Thinking Questions How will cuts in state budget spending affect federal expansionary policy? Problems Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: A recession.
A stock market collapse that hurts consumer and business confidence. Extremely rapid growth of exports. Rising inflation. A rise in the natural rate of unemployment. A rise in oil prices. References Alesina, Alberto, and Francesco Giavazzi. Glossary contractionary fiscal policy fiscal policy that decreases the level of aggregate demand, either through cuts in government spending or increases in taxes expansionary fiscal policy fiscal policy that increases the level of aggregate demand, either through increases in government spending or cuts in taxes.
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Share: Facebook Twitter Email Print page. These are ways of controlling inflation in the medium term i. A reduction in company taxes to encourage greater investment ii.
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