Post on 28-Jan-2016
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