Source: Case/Fair, Principles of Macroeconomics 8e, Chapter 5
Tags: fiscal policy, monetary policy, supply-side policy, Federal Reserve, government spending, taxes, budget surplus, budget deficit, circular flow diagram, transfer payments, saving, dissaving, money market, goods and services market, labour market, Treasury bonds, corporate bonds, dividends, capital gains, shares of stock
Difficulty: Introductory Prerequisites: Part 1 of these study notes (Sections 5.1–5.2), covering Classical vs. Keynesian economics and basic business cycle terminology.
Sections 5.3 and 5.4 answer two questions: what can government do about the economy, and how does the economy actually fit together? Section 5.3 introduces the three main policy levers (fiscal, monetary, supply-side). Section 5.4 introduces the circular flow diagram, the foundational model showing how money moves between households, firms, the government, and the rest of the world. These sections give you the vocabulary and mental map you need before the course digs into GDP measurement and policy analysis in later chapters.
Governments influence the macroeconomy through fiscal policy (taxes and spending), monetary policy (the money supply, managed by the Federal Reserve), and supply-side policy (measures aimed at increasing production and productivity). The circular flow diagram shows that every pound spent in the economy is someone else's income, and it identifies the three key markets: goods and services, labour, and money (financial).
Fiscal policy
Government policy regarding taxes and expenditures. The government implements fiscal policy when it changes taxes and/or spending. Think of it as the government's chequebook: how much it takes in and how much it pays out.
Contractionary fiscal policy
Fiscal policy that aims to slow the economy, typically by increasing taxes and/or decreasing government spending. Used during inflationary periods.
Expansionary fiscal policy
Fiscal policy that aims to stimulate the economy, typically by decreasing taxes and/or increasing government spending. Used during recessions.
Monetary policy
Policy that involves changing the money supply and interest rates, conducted by the Federal Reserve (the central bank). Think of it as controlling how much money is sloshing around in the economy.
Federal Reserve (the Fed)
The central bank of the United States. It is the institution that can change the quantity of money in the economy.
Supply-side policy
Government policies that focus on increasing production, productivity, and the supply of goods and services, rather than stimulating aggregate demand. Examples include cutting business taxes to encourage investment, reducing regulations that hinder productivity, and measures designed to increase the supply of labour and capital.
Budget surplus
Exists when federal tax revenues exceed federal expenditures in a year (the difference is positive).
Budget deficit
Exists when federal expenditures exceed federal tax revenues in a year (the difference is negative).
Circular flow diagram
A diagram showing the income received and payments made by each sector of the economy. Its central lesson: total income in the economy must always equal total spending.
Transfer payment
A cash payment made by the government to people who do not supply goods, services, or labour in exchange for the payment. Social Security retirement benefits are a classic example.
Saving
When a household spends less than it receives in income during a given period.
Dissaving
When a household spends more than it receives in income during a given period.
Treasury bonds
Promissory notes issued by the federal government when it borrows money.
Corporate bond
A promissory note issued by a corporation when it borrows money. Corporate bonds pay a fixed payment each year.
Shares of stock (equity)
Financial instruments that give the holder partial ownership of a firm and the right to share in its profits.
Dividend
The portion of a corporation's profits that the firm pays out each period to its shareholders. Think of it as your cut of the company's earnings, paid regularly.
Capital gain
An increase in the value of an asset over the price initially paid for it. If you buy a share for $100 and sell it for $110, the $10 difference is a capital gain. If you hold the asset rather than sell, the gain is "unrealised."
Involves changes to taxes and/or government spending.
Congress increasing government spending = fiscal policy.
Cutting income taxes to encourage consumer spending = fiscal policy.
Keynes's recession remedy: decrease taxes and/or increase government spending (expansionary).
Keynes's inflation remedy: increase taxes and/or decrease government spending (contractionary).
Note: contractionary fiscal policy does not include reducing taxes. Reducing taxes is expansionary.
Involves changes to the money supply, conducted by the Federal Reserve.
If the central bank decreases the money supply, that is monetary policy.
Monetary policy does not include changing the level of government spending. That is fiscal policy.
Focuses on increasing production rather than stimulating demand.
Cutting business taxes to encourage investment = supply-side policy. (This is a common exam distinction: a tax cut aimed at boosting consumer spending is fiscal; a tax cut aimed at boosting investment and productivity is supply-side.)
Eliminating regulations that reduce business productivity = supply-side policy.
Reagan's proposed tax-rate cuts to promote investment and increase productivity were supply-side.
Proponents argue the best way to increase the supply of goods and services is to stimulate the supply of labour and capital and increase investment.
Supply-side policies are those intended to increase economic growth.
Surplus: tax revenues > expenditures (the difference is positive).
Deficit: tax revenues < expenditures (the difference is negative).
Firms demand labour from households. Households demand goods and services from firms.
In the goods-and-services market, households are demanders (buyers). Firms are suppliers.
The demanders in the goods-and-services market include households, the government, business firms, and the rest of the world.
Firms pay households wages, profits, interest, dividends, and rent.
Goods-and-services market: firms supply, households (plus government, firms, and the rest of the world) demand.
Labour market: households supply labour, firms demand labour.
Money (financial) market: funds are demanded and supplied. This is where saving and borrowing happen.
Total income in the economy must always equal total spending.
Everyone's expenditure is someone else's receipt.
A bond is a promise to repay (a promissory note).
Treasury bonds: issued by the federal government.
Corporate bonds: issued by corporations. Pay a fixed payment each year.
Companies issue both shares and bonds. The government issues bonds but not shares.
Shares of stock represent partial ownership of a firm.
Shareholders earn dividends; bondholders do not earn dividends.
Bondholders earn fixed interest payments; shareholders do not receive fixed payments.
A dividend is a government payment to a person or firm: this is false. Dividends come from corporations, not the government. (Government payments without exchange of goods/services are transfer payments.)
Capital gain = selling price – purchase price (when positive).
Buying a share for $100, selling for $110 → capital gain of $10.
Buying a share for $50, selling for $125 → capital gain of $75.
Buying baseball cards for $200, selling for $1,000 → capital gain of $800.
If the asset increases in value but you do not sell, the gain is an unrealised capital gain.
Budget position
Budget surplus or deficit = Federal tax revenues – Federal expenditures
Positive result = surplus. Negative result = deficit.
Capital gain
Capital gain = Selling price – Purchase price
Unemployment rate (repeated for reference)
Unemployment rate = Unemployed ÷ Labour force
Fiscal policy is what governments deploy in response to recessions: the 2009 stimulus package in the United States is a textbook example of expansionary fiscal policy. Monetary policy is what the Federal Reserve uses when it raises or lowers interest rates. Supply-side policy was the centrepiece of Reaganomics in the 1980s, built on the idea that cutting taxes on businesses would boost investment and growth. The circular flow model, while simplified, is the framework behind national income accounting, which you will use to understand GDP data.
Students often classify a tax cut on businesses as fiscal policy. If the purpose is to encourage investment and increase productivity, it is supply-side policy. If the purpose is to boost consumer spending (income tax cuts), it is fiscal policy. The intent and mechanism matter.
Students often think the Federal Reserve controls government spending. The Fed controls the money supply. Government spending is set by Congress (fiscal policy).
A dividend is sometimes confused with a transfer payment. Dividends are paid by corporations to shareholders. Transfer payments are paid by the government to individuals who do not provide goods or services in return.
Students sometimes think a capital gain requires selling the asset. An unrealised capital gain exists when the asset has increased in value but has not yet been sold.
⚠️ Distinguishing fiscal, monetary, and supply-side policy is one of the most commonly tested skills in this chapter. Know the defining feature of each.
⚠️ "Congress increases spending" = fiscal. "The Fed changes the money supply" = monetary. "Tax cut to boost investment/productivity" = supply-side. Memorise these patterns.
⚠️ The circular flow diagram's key lesson (total income = total spending) is a frequent true/false question.
⚠️ Capital gain calculation questions appear regularly. Be comfortable with the arithmetic and know the difference between realised and unrealised gains.
⚠️ Know that shareholders earn dividends and bondholders earn fixed interest. This distinction is tested in several question variants.
True or false: Monetary policy includes changing the level of government spending. (False – that is fiscal policy)
Fill in the blank: The ________ can change the quantity of money in the economy. (Federal Reserve)
True or false: A budget deficit exists when tax revenues exceed expenditures. (False – that is a surplus)
Fill in the blank: In the circular flow diagram, total income always equals ________. (total spending)
True or false: A capital gain is the increase in value of an asset above its initial cost. (True)
Q: If Congress increases government spending, what type of policy is it using?
A: Fiscal policy.
Q: What type of policy was President Reagan proposing when he suggested tax-rate cuts to promote investment and increase productivity?
A: Supply-side policy.
Q: What is a transfer payment? Give an example.
A: A cash payment made by the government to people who do not supply goods, services, or labour in exchange. A Social Security retirement benefit is an example.
Q: Aaron purchases a share of stock for $50 and later sells it for $125. What is his capital gain?
A: $75 ($125 – $50).
Q: You purchase 100 shares of stock for $40,000. A year later the stock is valued at $42,000 but you do not sell. What is the $2,000 increase called?
A: An unrealised capital gain.
Q: To get the economy out of a slump, what did Keynes believe the government should do?
A: Decrease taxes and/or increase government spending (expansionary fiscal policy).
Q: What is the difference between a Treasury bond and a corporate bond?
A: A Treasury bond is a promissory note issued by the federal government. A corporate bond is a promissory note issued by a corporation. Both promise repayment, but the issuer differs.
Fiscal policy connects directly to the multiplier effect you will study in later chapters, where a change in government spending has a magnified impact on total output. Monetary policy links to the chapters on money, banking, and the Federal Reserve. The circular flow diagram is the simplified version of the national income accounts framework used to measure GDP (Chapter 6). Capital gains, dividends, and bonds reappear when you study financial markets and investment.
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