Homework

1. Explain the concepts of fiscal and monetary policy. Who conducts them and how do they work their way through the economy.
Monetary Policy is headed by the Federal Reserve and involves influencing the supply and demand for money through interest rates. It is usually conducted by the central bank and its main target is to achieve low inflation (to promote economic growth) by changing interest rates.
Fiscal Policy relates to the impact of government spending and tax. Expansionary fiscal policy is an attempt to increase collective demand and therefore involves higher government spending and lower taxes leading to a larger budget deficit. Contractionary fiscal policy attempts to reduce collective demand and involves lower government spending and higher taxes helping reduce budget deficit.
While the policies differ, they both aim at creating a more stable economy distinguished by low inflation and positive economic growth.
2. Describe the mechanism that leads from a change in fiscal policy to changes in interest rates, the exchange rate, and the trade balance. Do the same for monetary policy.
Fiscal policy is the use of government spending and taxation to influence the economy. It is an important tool for managing the economy because of its ability to affect the total amount of gross domestic product.
Expansionary fiscal policy pushes interest rates up, while contractionary fiscal policy pulls interest rates down. The rationale behind this relationship is fairly basic because when output increases, the price level tends to increase. According to the theory of money demand, as the price level rises, people demand more money to purchase goods and services. Given that there is no change in the money supply, this increased demand for money leads to an increase in the interest rate. The opposite is the case with contractionary fiscal policy. When output decreases, the price level tends to fall. According to the theory of money demand for this situation, as the price level falls, people demand less money to purchase goods and services. Given that there is no change in the money supply, this decreased demand for money leads to a decrease in the interest rate therefore affecting the interest rate.
Fiscal policy can also affect the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In the attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation. This appreciation makes imported goods cheaper for us in the U.S. and exports more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell more to the U.S. than they buy from it and, in return, acquire ownership of U.S. assets. In the long run, this accumulation of