Long-Run Macroeconomic Equilibrium And Government Policy

SRAS to LRAS Economy is always at

a point (PL & real GDP) on the SRAS curve.

If that point is not also on the LRAS curve, the SRAS curve will shift until it is.

Let’s consider three scenarios…

Long-Run Macro Equilibrium (#1)

Economy on both SRAS and LRAS curves

YE = YP

Inflationary Gap (#2) Aggregate output above potential output Results from positive AD shiftSelf-Correcting in the Long Run… Low unemployment will lead to nominal

wages rising, along with other “sticky” costs

Producers decrease output, bringing the economy back into equilibrium (at a higher price level)

Recessionary Gap (#3) Aggregate output below potential output Results from negative AD or negative SRAS

shiftSelf-Correcting in the Long Run… High unemployment will cause nominal

wages to fall, along with other “sticky” costs Producers increase output, bringing the

economy back into equilibrium (at a lower price level)

Analysis of Gaps Output gap – The difference between actual

aggregate output and potential output

Output gap = Actual aggregate output – Potential output X 100

Potential output

The Purpose of Macroeconomic Policy Most economists believe that it takes the

economy a decade or longer to self-correct Economists like Keynes believe in active

stabilization, use of government policy to reduce the severity and length of recessions or to rein in excessive expansions

Response to Demand Shocks Fall in demand is easiest to correct through

policy Unfortunately, policy measures to increase

AD can increase deficits & may hinder long-run growth

Government tries to offset positive shocks too, as inflationary gaps have significant costs in the long-run

Response to Supply Shocks No easy remedy for these, as they result

from changes in production costs A negative supply shock leads to rising

prices and decreasing output (& employment)

Policy to fix one of these problems makes the other worse

Governmental Circular Flow Inflows – Taxes and borrowing Outflows – Government purchases and

transfers

GDP = C + I + G + X - IM Government directly controls G, but also

indirectly influences C and I through fiscal policy

C is based on disposable income, which is directly related to transfers and taxes

I is influenced by business regulation

Expansionary Fiscal Policy To address a recessionary gap, the

government attempts to increase AD: Increase government purchases AND/OR Cut taxes AND/OR Increase transfers

Contractionary Fiscal Policy To address an inflationary gap, the

government attempts to decrease AD: Reduce government purchases AND/OR Raise taxes AND/OR Reduce transfers

Lags in Fiscal Policy Many economists argue against

extremely active stabilization policies One caution for fiscal policy is time lag

1. Government must acknowledge gap2. Government has to develop a plan3. Plan implementation

Multiplier Effect of Increasing Government Purchases Government spending is an autonomous

increase in aggregate spending Money is spent again and again, so it is

subject to the multiplier Also the same multiplier for reduction

Multiplier Effect of Changes in Government Transfers & Taxes Smaller effect than government

purchases Instead, change in GDP results from

household spending – so its initial infusion is subject to the multiplier

Taxes and the Multiplier Taxes capture part of the increase in

real GDP As a result of tax structure, government

revenue increases when real GDP does

Types of Government Stabilizers The overall result of tax policies is to reduce

the multiplier, creating greater stability – so these are known as automatic stabilizers

Some government transfers are also automatic stabilizers, but active policies are discretionary fiscal policies