Course: ECO 2013, Principles of Macroeconomics | Textbook: Macroeconomics by Michael Parkin
Difficulty: Intermediate to Advanced | Prerequisites: Module 2, especially the AS-AD model, the expenditure multiplier, and the loanable funds market. If you are not comfortable shifting AD and SAS curves and calculating the multiplier, go back and revise before starting here.
Module 3 is where the course comes together. You now know how the macroeconomy is measured (GDP, unemployment, inflation) and modelled (AS-AD). This module asks: what can governments and central banks do about it? Fiscal policy works through taxes and government spending. Monetary policy works through the money supply and interest rates. The module closes by connecting the domestic economy to the rest of the world through exchange rates and the balance of payments. This is the most policy-heavy and most exam-relevant part of the course.
Fiscal policy uses government spending and taxation to shift aggregate demand and influence output, employment, and prices. Monetary policy uses the central bank's control of the money supply and interest rates to do the same. Both have limitations and lags. Exchange rates are determined by supply and demand in the foreign exchange market, and they link domestic monetary and fiscal decisions to the global economy.
Fiscal policy
The use of the government budget (government spending and tax policy) to influence macroeconomic conditions. Expansionary fiscal policy increases G or decreases T; contractionary fiscal policy does the opposite. Think of it as: the government deciding to spend more or tax less to boost the economy, or spend less or tax more to cool it down.
Government budget deficit
When government spending exceeds tax revenue. The government borrows to cover the difference.
Government budget surplus
When tax revenue exceeds government spending.
National debt (public debt)
The accumulated total of past government budget deficits minus past surpluses. It is a stock variable (a total at a point in time), not a flow.
Automatic stabilisers
Features of the tax and transfer system that automatically reduce the severity of business-cycle fluctuations without any deliberate policy action. Progressive income taxes and unemployment benefits are the main examples. In simple terms: when the economy slows, tax revenue falls and transfer payments rise automatically, partially cushioning the downturn. No legislation required.
Discretionary fiscal policy
Deliberate changes in government spending or taxes that require new legislation. Stimulus packages and targeted tax cuts are examples.
Crowding-out effect
When government borrowing to finance a deficit raises the real interest rate, which reduces (crowds out) private investment. This limits the effectiveness of expansionary fiscal policy.
Supply-side fiscal policy
Tax policies designed to increase aggregate supply rather than aggregate demand. Cutting taxes on capital income or providing investment tax credits are intended to increase incentives to save, invest, and work, shifting the LAS curve rightward over time.
Money
Anything that is generally accepted as a means of payment. Money serves three functions: medium of exchange, unit of account, and store of value.
M1
Currency held by the public plus chequable deposits at commercial banks. This is the narrowest commonly cited measure of money.
M2
M1 plus savings deposits, small time deposits, and money market mutual funds. A broader measure that includes assets that are highly liquid but not immediately spendable.
Fractional reserve banking
A system in which banks hold only a fraction of their deposits as reserves and lend out the rest. This process creates money: a single deposit leads to multiple rounds of lending and redepositing.
Required reserve ratio
The minimum fraction of deposits that banks are required to hold as reserves. If the ratio is 10%, a bank with $1,000 in deposits must hold at least $100 in reserves.
Money multiplier
The maximum amount of money the banking system can create from each dollar of reserves. Money multiplier = 1 / Required reserve ratio. In simple terms: if the reserve ratio is 10%, one new dollar of reserves can support up to $10 of deposits in the banking system.
Federal Reserve (the Fed)
The central bank of the United States. It conducts monetary policy, regulates banks, and serves as lender of last resort.
Open market operations
The purchase and sale of government securities (bonds) by the Fed. Buying bonds injects reserves into the banking system (increasing the money supply); selling bonds withdraws reserves (decreasing it). This is the Fed's primary tool for conducting monetary policy.
Federal funds rate
The interest rate at which banks lend reserves to each other overnight. The Fed targets this rate through open market operations. Changes in the fed funds rate ripple through to other interest rates in the economy.
Discount rate
The interest rate at which the Fed lends reserves directly to banks. Typically set above the federal funds rate.
Quantity theory of money
MV = PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is real GDP. If V and Y are roughly constant, an increase in M leads to a proportional increase in P. This theory underpins the claim that inflation is "always and everywhere a monetary phenomenon."
Velocity of money
The average number of times a dollar is used to purchase final goods and services in a year. V = PY / M.
Monetary policy transmission mechanism
The chain of events through which a change in monetary policy affects the economy. Simplified: the Fed changes the money supply, which changes the interest rate, which changes investment (and other interest-sensitive spending), which shifts AD, which changes real GDP and the price level.
Expansionary monetary policy
The Fed increases the money supply (buys bonds), which lowers interest rates, increases investment, shifts AD rightward, and raises real GDP and the price level.
Contractionary monetary policy
The Fed decreases the money supply (sells bonds), which raises interest rates, decreases investment, shifts AD leftward, and lowers real GDP and the price level.
Liquidity trap
A situation in which interest rates are at or near zero, and increasing the money supply has no further effect on interest rates. Monetary policy becomes ineffective because it cannot push rates lower. This was a concern during and after the 2008 financial crisis.
Exchange rate
The price of one currency in terms of another. For example, 1 USD = 0.85 EUR.
Foreign exchange market (forex market)
The market in which currencies are traded. The exchange rate is determined by the demand for and supply of a currency in this market.
Appreciation
An increase in the value of a currency relative to another currency. If the dollar appreciates, each dollar buys more foreign currency.
Depreciation
A decrease in the value of a currency relative to another currency. If the dollar depreciates, each dollar buys less foreign currency.
Balance of payments
A record of all transactions between a country's residents and the rest of the world. It consists of the current account and the capital and financial account.
Current account
Records trade in goods and services, investment income, and transfers. A current account deficit means the country is importing more than it is exporting (broadly defined).
Capital and financial account
Records capital flows: purchases and sales of assets (stocks, bonds, real estate, direct investment) between domestic and foreign residents. A capital account surplus means more foreign money is flowing into the country than domestic money is flowing out.
Current account + Capital and financial account = 0
By accounting identity, a current account deficit is exactly offset by a capital and financial account surplus, and vice versa. A country that imports more than it exports must, by definition, be borrowing from abroad (or selling assets to foreigners).
Fixed exchange rate
A system in which the government or central bank pegs the domestic currency to a foreign currency at a specific rate and intervenes in the forex market to maintain it.
Flexible (floating) exchange rate
A system in which the exchange rate is determined purely by market supply and demand, with no government intervention.
Managed float (dirty float)
A system in which the exchange rate mostly floats, but the central bank occasionally intervenes to smooth fluctuations or prevent excessive movements.
Purchasing power parity (PPP)
The theory that exchange rates adjust so that identical goods cost the same in all countries when expressed in a common currency. In practice, PPP holds roughly in the long run but not the short run.
Interest rate parity
The condition that the expected return on domestic assets equals the expected return on equivalent foreign assets, once exchange rate changes are accounted for. It links interest rate differentials between countries to expected changes in the exchange rate.
Expansionary fiscal policy (increase G or cut T) shifts AD rightward. In the short run, real GDP rises and the price level rises. If the economy starts with a recessionary gap, this can move output closer to potential.
Contractionary fiscal policy (decrease G or raise T) shifts AD leftward. Used to close an inflationary gap: real GDP falls and the price level falls (or rises less than it otherwise would).
The expenditure multiplier from Module 2 applies here. A $100 billion increase in G does not raise GDP by exactly $100 billion; the multiplied effect is larger. But the crowding-out effect works in the opposite direction: increased government borrowing raises interest rates, which reduces private investment, partially offsetting the stimulus.
Automatic stabilisers smooth the cycle without legislation. In a recession, tax revenue falls (because incomes fall) and transfer payments rise (more people qualify for unemployment benefits), which automatically cushions the drop in disposable income and spending. In a boom, the reverse happens, automatically dampening the expansion.
Time lags are a serious practical limitation. There is a recognition lag (noticing the economy has changed), a legislative lag (passing new spending or tax bills), and an implementation lag (actually getting the money spent or collected). By the time discretionary fiscal policy takes effect, the economy may have already moved on.
Supply-side effects: tax cuts aimed at saving and investment can shift aggregate supply rightward over time. The debate is over how large these effects are relative to the demand-side effects.
Money is defined by its functions, not by what it is physically made of. Any asset that serves as a medium of exchange, unit of account, and store of value qualifies.
Banks create money through fractional reserve lending. A new deposit of $1,000 with a 10% reserve ratio can eventually support $10,000 in total deposits across the banking system (money multiplier = 1 / 0.10 = 10).
The quantity theory of money (MV = PY) is a long-run theory of the price level. If velocity (V) and real output (Y) are stable, then growth in the money supply (M) translates directly into growth in the price level (P), i.e. inflation.
In the short run, changes in M also affect real GDP because prices and wages are sticky. In the long run, money is neutral: changes in M affect only the price level, not real output. This is the classical dichotomy.
The Fed's primary tool is open market operations. Buying government bonds from banks increases bank reserves, increases the money supply, and puts downward pressure on the federal funds rate.
Transmission mechanism (step by step):
Fed buys bonds on the open market.
Bank reserves increase.
Banks lend more, money supply increases.
Interest rates fall.
Investment spending rises (businesses find it cheaper to borrow).
AD shifts rightward.
Real GDP rises and the price level rises (short run).
Contractionary monetary policy reverses each step: sell bonds, decrease reserves, decrease money supply, raise interest rates, reduce investment, AD shifts left.
Taylor rule (conceptual, not a formula you must memorise for this course): a guideline for how the Fed should set the federal funds rate based on the current inflation rate and the output gap (how far real GDP is from potential). When inflation is above target or real GDP is above potential, the rule calls for a higher rate.
Limitations: monetary policy cannot push interest rates below zero (the zero lower bound). In a liquidity trap, expansionary monetary policy may be ineffective. There are also time lags between a policy action and its full effect on the economy.
The exchange rate is a price, and it is determined by supply and demand in the foreign exchange market.
Demand for a currency comes from foreigners who want to buy the country's exports, invest in the country, or speculate on currency appreciation.
Supply of a currency comes from domestic residents who want to buy imports, invest abroad, or speculate on currency depreciation.
An increase in demand for a currency (or a decrease in its supply) causes it to appreciate. A decrease in demand (or increase in supply) causes it to depreciate.
Interest rate differentials are a major driver of short-run exchange rate movements. If the domestic interest rate rises relative to foreign rates, foreign investors move money in to earn the higher return, increasing demand for the domestic currency and causing it to appreciate.
A current account deficit means the country imports more (goods, services, and investment income) than it exports. This is exactly offset by a capital and financial account surplus (net foreign borrowing or asset sales). Neither a deficit nor a surplus is inherently good or bad; it depends on the context.
Fixed exchange rate: the central bank must buy or sell its own currency to maintain the peg. This means it gives up independent monetary policy, because it must set interest rates to whatever level keeps the exchange rate stable. If the currency is under downward pressure, the central bank must sell foreign reserves and raise rates, even if the domestic economy needs lower rates.
Flexible exchange rate: the exchange rate adjusts freely, and the central bank retains the ability to set monetary policy independently. The trade-off is exchange rate volatility, which can disrupt trade and investment.
Most large economies today operate under a managed float: the exchange rate mostly floats, but the central bank reserves the right to intervene if movements become disorderly.
Government budget balance:
Budget balance = Tax revenue - Government spending
Positive = surplus. Negative = deficit.
Money multiplier:
Money multiplier = 1 / Required reserve ratio
Quantity theory of money:
MV = PY
Where M = money supply, V = velocity, P = price level, Y = real GDP.
Rearranged for inflation: %ΔP ≈ %ΔM + %ΔV - %ΔY
If V is constant (%ΔV = 0), then: Inflation rate ≈ Money supply growth rate - Real GDP growth rate
Velocity of money:
V = (P x Y) / M = Nominal GDP / M
Exchange rate determination:
An increase in domestic interest rates (relative to foreign) increases demand for the domestic currency and causes appreciation.
An increase in domestic inflation (relative to foreign) decreases demand for the domestic currency and causes depreciation.
The 2020 COVID-19 pandemic prompted both massive fiscal stimulus (direct payments, enhanced unemployment benefits) and aggressive monetary policy (near-zero interest rates, large-scale bond purchases). These are textbook examples of simultaneous expansionary fiscal and monetary policy.
The Federal Reserve's interest rate decisions are among the most closely watched events in financial markets. A surprise rate hike can strengthen the dollar, reduce stock prices, and slow borrowing within hours.
The US has run a persistent current account deficit for decades, offset by a capital and financial account surplus. Foreign investors, particularly in Asia and Europe, hold large quantities of US Treasury bonds. This pattern reflects the role of the US dollar as the world's primary reserve currency.
Students often assume that a government deficit is always bad. Deficits during recessions can be part of a deliberate (and textbook-recommended) counter-cyclical policy. What matters is the trajectory of the debt relative to GDP, not whether there is a deficit in any single year.
A common error is thinking the Fed prints money and hands it out. The Fed creates reserves by buying bonds from banks. The new reserves enter the banking system, and banks then lend them out. The process is indirect and depends on banks' willingness to lend and borrowers' willingness to borrow.
Students frequently confuse appreciation and depreciation with "good" and "bad." An appreciating currency makes imports cheaper (good for consumers) but makes exports more expensive (bad for exporters). The net effect depends on the circumstances.
Many students think a current account deficit means the country is "losing money." In fact, it means the country is attracting foreign investment. A current account deficit is simultaneously a capital account surplus, by accounting identity.
⚠️ You must be able to trace the full monetary policy transmission mechanism: open market operation, reserves, money supply, interest rate, investment, AD shift, effect on real GDP and price level.
⚠️ Know how to show fiscal and monetary policy on an AS-AD diagram. Expansionary policies shift AD right; contractionary policies shift AD left. Be clear on the short-run and long-run effects.
⚠️ Crowding out: be able to explain why expansionary fiscal policy may be partially offset by rising interest rates and falling private investment.
⚠️ The money multiplier formula and a basic calculation (given new reserves and the reserve ratio, how much can total deposits increase?) is a likely exam question.
⚠️ Exchange rate questions may ask: if country X raises its interest rate, what happens to its exchange rate and why? Answer through the lens of supply and demand in the forex market.
⚠️ Understand the balance of payments identity: current account + capital and financial account = 0. If you are told the current account deficit, you know the capital account surplus, and vice versa.
⚠️ The exam is multiple choice, closed-book, with a 3x5 handwritten notecard. Prioritise the quantity theory formula (MV = PY), the money multiplier, the transmission mechanism steps, and the balance of payments identity.
True or False: Expansionary fiscal policy shifts the aggregate supply curve to the right.
Fill in the blank: The money multiplier equals 1 divided by the _______.
True or False: If the Fed sells government bonds, the money supply increases.
Fill in the blank: A country with a current account deficit must have a capital and financial account _______.
True or False: Under a fixed exchange rate, the central bank can freely set monetary policy to stabilise the domestic economy.
Answers:
False. Expansionary fiscal policy (increased G or decreased T) shifts aggregate demand to the right, not aggregate supply.
Required reserve ratio.
False. Selling bonds withdraws reserves from the banking system and decreases the money supply.
Surplus.
False. Under a fixed rate, the central bank must use monetary policy to defend the exchange rate peg, so it loses monetary policy independence.
Q: The economy is in a recessionary gap. Describe how expansionary fiscal policy can close the gap, and identify one limitation of this approach.
A: The government increases spending or cuts taxes, which raises aggregate expenditure and shifts AD to the right. Through the multiplier, the increase in GDP is larger than the initial policy change. The recessionary gap narrows or closes as real GDP moves toward potential. One limitation: increased government borrowing raises the interest rate, crowding out private investment and partially offsetting the stimulus.
Q: Banks have a required reserve ratio of 20%. The Fed buys $500 million of government bonds. By how much can the money supply potentially increase?
A: Money multiplier = 1 / 0.20 = 5. Maximum increase in the money supply = 5 x $500 million = $2,500 million ($2.5 billion).
Q: Using the quantity theory of money, if the money supply grows at 6% per year, velocity is constant, and real GDP grows at 2% per year, what is the approximate inflation rate?
A: Inflation rate ≈ Money supply growth - Real GDP growth = 6% - 2% = 4%.
Q: The US interest rate rises relative to the European interest rate. What happens to the USD/EUR exchange rate and why?
A: The higher US interest rate attracts European investors seeking a better return. They need to buy dollars to invest in US assets, increasing the demand for dollars in the forex market. The dollar appreciates relative to the euro (the exchange rate, expressed as euros per dollar, rises).
Q: Explain why a country with a fixed exchange rate cannot independently set its monetary policy.
A: To maintain the fixed rate, the central bank must match its interest rate to what the market requires for the peg. If the domestic currency is under downward pressure, the bank must raise rates and sell foreign reserves to defend the rate, even if the domestic economy would benefit from lower rates. The peg ties the central bank's hands.
Fiscal policy connects back to Module 1's coverage of government intervention. Taxes, which you analysed at the micro level in Module 1, now have macroeconomic effects through AD and the multiplier.
Monetary policy and the money supply tie into Module 2's loanable funds market. The interest rate that balances saving and investment is influenced by the central bank's control of the money supply.
Exchange rates connect every topic together. A country's fiscal deficit can affect its interest rates, which affect its exchange rate, which affects its trade balance, which feeds back into GDP. This is the interconnectedness the course is building toward.
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