Section 4. What You Will Learn in this Module Explain the difference between short-run and long-run...

Section 4Module 19

What You Will Learn in

this Module

• Explain the difference between short-run and long-run macroeconomic equilibrium

• Describe the causes and effects of demand shocks and supply shocks

• Determine if an economy is experiencing a recessionary or an inflationary gap and explain how to calculate the size of an output gap

Section 4 | Module 19

The AS–AD Model

• The AS-AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations.


Short-Run Macroeconomic Equilibrium

• The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded.

• The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium.

• Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.


The AS–AD Model

YE

PE ESR

SRAS

AD

Real GDP

Short-run macroecon

omic equilibrium

Aggregate price level


Demand Shocks

Y2

2P2

AD2

A negative demand shock...

Y1

E1

E

SRAS

AD1

Y1

2

E1

SRAS

AD1

P1

P1

Real GDP


Real GDP


...leads to a higher

aggregate price

level and higher

aggregate output.

(a) A Negative Demand Shock (b) A Positive Demand Shock

EP2

Y2

AD2

A positive demand shock...

...leads to a lower

aggregate price level and lower

aggregate output.


Supply Shocks

P1

AD

Y1

E1

Real GDP


(a) A Negative Supply Shock

SRAS

1

SRAS

Y2

2E

P2

2

Y1

1

AD

E 2

E

SRAS

P1

Real GDP


(b) A Positive Supply Shock

P2

Y2

SRAS

2

1

A negative supply shock...

…leads to a lower

aggregate output and a

higher aggregate price

level.

...leads to a higher

aggregate output and

lower aggregate price level.

A positive supply shock...


Negative Supply Shocks

Stagflation is the combination of inflation and stagnating (or falling) aggregate output.

“Stagnation plus inflation”


Long-Run Macroeconomic Equilibrium

• The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.



YP

PE

SRAS

LRAS

AD

ELR

Real GDP


Long-run Macroeconomic

equilibrium

Potential output Section 4 | Module 19

Short-Run Versus Long-Run Effects of a Negative Demand Shock

Y1

P E1

2

SRAS1LRAS

AD1

Real GDP

Aggregateprice level

Potential

output

E3P3

SRAS2

3. …until an eventual

fall in nominal wages

in the long run increasesshort-run

aggregate supply and moves the

economy back to potential output.

2

2. …reduces the aggregate

price level and aggregate

output and leads to higher

unemployment in the short run…

AD2

Recessionary gap

Y2

E

1. An initialnegativedemand shock…

1

P

11 of 17 Section 4 | Module 19

Short-Run Versus Long-Run Effects of a Positive Demand Shock



• There is a recessionary gap when aggregate output is below potential output.• There is an inflationary gap when aggregate output is

above potential output.• The output gap is the percentage difference between

actual aggregate output and potential output.



• The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run.


F Y

ISupply Shocks versus Demand Shocks in Practice

• Recessions are mainly caused by demand shocks. But when a negative supply shock does happen, the resulting recession tends to be particularly severe.

• There’s a reason the aftermath of a supply shock tends to be particularly severe for the economy: macroeconomic policy has a much harder time dealing with supply shocks than with demand shocks.


Summary

1. In the AD–AS model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output.

2. A demand shock causes the aggregate price level and aggregate output to move in the same direction as the economy moves a long the short-run aggregate supply curve.

3. A supply shock causes them to move in opposite directions as the economy moves along the aggregate demand curve.

4. Stagflation is inflation and falling aggregate output and is caused by a negative supply shock.


Summary

5. Demand shocks have only short-run effects on aggregate output because the economy is self-correcting in the long run.

6. In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, where aggregate output is equal to potential output.

7. In an inflationary gap, an eventual rise in nominal wages moves the economy to long-run macroeconomic equilibrium.

8. The output gap is the percentage difference between actual aggregate output and potential output


Section 4Module 20


this Module

• Discuss how the AS–AD model is used to formulate macroeconomic policy

• Explain the rationale for stabilization policy

• Describe the importance of fiscal policy as a tool for managing economic fluctuations

• Identify the policies that constitute expansionary fiscal policy and those that constitute contractionary fiscal policy


Macroeconomic Policy

• Economy is self-correcting in the long run.

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



• Policy in the Face of Demand Shocks– If policy were able to perfectly anticipate shifts of

the aggregate demand curve and counteract them, the period of low aggregate output and falling prices could be avoided.

– Price stability is generally regarded as a desirable goal.



Responding to supply shocks:

– There are no easy policies to shift the short-run aggregate supply curve.

– Policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.


F Y

IIs Stabilization Policy Stabilizing?

• Has the economy actually become more stable since the government began trying to stabilize it?

• Yes. Data from the pre–World War II era are less reliable than more modern data, but there still seems to be a clear reduction in the size of economic fluctuations.

• It’s possible that the greater stability of the economy reflects good luck rather than policy.

• But on the face of it, the evidence suggests that stabilization policy is indeed stabilizing.


Government Spending and Tax Revenue for Some

High-Income Countries in 2012


Taxes, Government Purchases of Goods and Services, Transfers,

and Borrowing

• Funds flow into the government in the form of taxes and government borrowing

• Funds flow out of the government in the form of government purchases of goods and services and government transfers to households


Sources of Tax Revenue in the U.S., 2013


Government Spending in the U.S., 2013


• Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.

The Government Budget and Total Spending


Expansionary and Contractionary Fiscal Policy

• Expansionary fiscal policy increases aggregate demand and can take one of three forms:– an increase in government purchases of goods and

services– a cut in taxes– an increase in government transfers

• Contractionary fiscal policy reduces aggregate demand and can take one of three forms:– a reduction in government purchases of

goods and services– an increase in taxes– a reduction in government transfers



Expansionary Fiscal Policy Can Close a Recessionary Gap



Contractionary Fiscal Policy Can Eliminate an Inflationary Gap

31 of 17Section 4 | Module 20

A Cautionary Note: Lags in Fiscal Policy

• In 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)


Will the stimulus come in time to be worthwhile? President Barack Obama listens to a question during a news conference in the East Room of the White House in Washington, D.C.

Summary1. Many economists advocate active stabilization policy: using fiscal or

monetary policy to offset demand shocks. 2. Negative supply shocks pose a policy dilemma:

a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

3. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.

4. Expansionary fiscal policy shifts the aggregate demand curve rightward.5. Contractionary fiscal policy shifts the aggregate demand curve leftward.


Section 4Module 21


this Module

• Explain why fiscal policy has a multiplier effect

• Describe how automatic stabilizers influence the multiplier effect


Using the Multiplier to Estimate the Influence of Government Policy

• Fiscal policy has a multiplier effect on the economy.

• Fiscal policy can take the form of changes in taxes, transfers, and government spending.

• Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in aggregate spending caused by the policy.

• Conversely, contractionary fiscal policy leads to a fall in real GDP larger than the initial reduction in aggregate spending caused by the policy.


Using the Multiplier to Estimate the Influence of Government Policy

The multiplier on changes in government purchases is 1/(1 − MPC).


Multiplier Effects of Changes in Taxes and Government Transfers

• Example: The government hands out $50 billion in the form of tax cuts.

• There is no direct effect on aggregate demand by government purchases of goods and services; GDP goes up only because households spend some of that $50 billion.

• How much will they spend? – MPC × $50 billion. For example, if MPC = 0.6, the first-

round increase in consumer spending will be $30 billion (0.6 × $50 billion = $30 billion).

– This initial rise in consumer spending will lead to a series of subsequent rounds in which real GDP, disposable income, and consumer spending rise further.


Multiplier Effects of Changes in Government Transfers and Taxes


Multiplier Effects of Changes in Government Transfers and Taxes

• The multiplier on changes in taxes or transfers, MPC/(1 − MPC), because part of any change in taxes or transfers is absorbed by savings.

• The results from changes in taxes are complicated by the fact that governments rarely impose lump sum taxes.

• Changes in government purchases have a more powerful effect on the economy than equal-sized changes in taxes or transfers.


How Taxes Affect the Multiplier

• Rules governing taxes and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle.

• In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.


F Y

IAbout That Stimulus Package . . .

• The U.S. economy needed a fiscal stimulus. There was, however, sharp partisan disagreement about what form that stimulus should take.

• Republicans favored tax cuts on general political principles. Democrats preferred transfer payments, especially increased unemployment benefits and expanded food stamp aid.

• The eventual compromise gave most taxpayers a flat $600 rebate, $1,200 for married couples.

• Many economists believed that only a fraction of the rebate checks would actually be spent, so that the eventual multiplier would be fairly low.


Summary1. Fiscal policy has a multiplier effect on the economy, the

size of which depends upon the fiscal policy.2. Except in the case of lump-sum taxes, taxes reduce the

size of the multiplier. Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a reduction in real GDP.

3. Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers.


Summary

4. Rules governing taxes—with the exception of lump-sum taxes—and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle.

5. Discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.


Section 4. What You Will Learn in this Module Explain the difference between short-run and long-run...

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