Economic Policy & the Aggregate Demand-Aggregate Supply Model

Objectives:

Macroeconomic PolicyIn the long run, the economy is self-

sufficient – it will eventually trend back to potential output

Process of self-correction typically takes a decade or moreEspecially if aggregate output is below

potential outputEconomy can suffer an extended period of

depressed aggregate output and high unemployment before it returns to normal

Macroeconomic PolicyJohn Maynard Keyes's said, “in the long run we are all dead.”

Keynes is recommending that governments not wait for the economy to correct itself, instead, government should use fiscal policy to get the economy back to potential output

Stabilization PolicyStabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions

Does it work?

1996 U.S. returned to potential output after a 5 year recessionary gap due to active stabilization policy

Policy & Demand Shocks

Monetary & fiscal policy shift the aggregate demand curve

If policy makers react quickly to a fall in the

aggregate demand, they can use monetary or fiscal policy

to shift the aggregate demand curve back to the

right

If policy was able to perfectly anticipate the

shifts of the AD curve and counteract them, it could

short-circuit the whole process

Policy & Demand ShocksTwo reasons a policy to short-circuit &

maintain the economy is desirable:

1.The temporary fall in aggregate output that would happen without policy intervention is a bag thing, because such a decline is associated with high unemployment

2.Price stability is generally regarded as a desirable goal, so preventing deflation (a fall in the aggregate price level) is good

Policy & Demand ShocksOverall, economists all believe that using macroeconomics policy to offset major negative shocks to the AD curve

What about positive shifts to the AD curve?

Yes!

Policy & Supply Shocks

Policy & Supply ShocksThere are no easy remedies for a supply shock

No government policies that can easily counteract the changes in production costs that shift the short-run aggregate supply curve

Fiscal Policy: The BasicsObvious:

Modern governments spend a great deal of money and collect a lot in taxes

Taxes, Gov’t Purchases of Goods and Services, Transfers, & Borrowing

Circular FlowFunds flow into the government in the form of taxes and government borrowing

Funds flow out of government purchases of goods and services and government transfers to households

Taxes, Gov’t Purchases of Goods and Services, Transfers, & BorrowingTaxes are required payments to the

government

Taxes are collected at the: national level by the federal government

Income taxes on personal & corporate taxes as well as social insurance taxes

State level by each state governmentLocal levels by counties, cities, and towns

State & local rely on a mix of sales taxes, property taxes, income taxes and fee of all kinds

Social insurance programs are government

programs intended to protect families against economic

hardship.

Social Insurance Programs:Social Security

Medicare

Medicaid

Unemployment Insurance

Food Stamps

Government Budget & Total Spending

Left side = GDP

Right side = aggregate spending (total spending on final goods and services produced in the economy)

Government directly controls G but also with changes in taxes and transfers, influences C and sometimes I

Budget effect consumers spending because of the effect on disposable income

Government Budget & Total Spending

Important point:Government taxes profits, and changes in the rules that determine how much a business owners can increase or reduce the incentive to spend on goods

Expansionary & Contractionary Fiscal PolicyWhy would the government want to shift the aggregate demand curve?

Wants to close a recessionary gap, created when aggregate output falls below potential output

Or wants to close an inflationary gap when aggregate output exceeds potential output

Government wants to increase

aggregate demand,

shifting the aggregate

demand curve rightward to AD1. Would

increase aggregate

output, making it equal to potential output

Recessionary Gap

Expansionary Fiscal PolicyIncreases aggregate demand

Three forms:

1.An increase in government purchases of goods and services

2.A cut in taxes

3.An increase in government transfers

Fiscal policy has to reduce AD and shift the AD curve leftward to AD1. This reduces

aggregate output and

makes it equal to potential output

Inflationary Gap

Contractionary Fiscal PolicyReduces aggregate demand

Implemented by:

1.A reduction in government purchases of goods and services

2.An increase in taxes

3.A reduction in government transfers

Lags in Fiscal PolicyIn the case of fiscal policy, there is an important reason for caution: there are significant lags in its use.Realize the recessionary/inflationary

gap by collecting and analyzing economic data takes time

Government develops a spending plan takes time

Implementation of the action plan (spending the money takes time