Transcript Economic Policy & the Aggregate Demand

Economic Policy & the
Aggregate DemandAggregate Supply Model
Objectives:
Macroeconomic Policy
 In 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 more
 Especially if aggregate output is below potential
output
 Economy can suffer an extended period of depressed
aggregate output and high unemployment before it
returns to normal
Macroeconomic Policy
John 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 Policy
Stabilization 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 Shocks
 Two 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 Shocks
Overall, 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 Shocks
There 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 Basics
 Obvious:
 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 Flow
Funds 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, & Borrowing
 Taxes 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 government
 Local 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 Policy
Why 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
Recessionary Gap
Government
wants to
increase
aggregate
demand, shifting
the aggregate
demand curve
rightward to AD1.
Would increase
aggregate
output, making it
equal to
potential output
Expansionary Fiscal Policy
Increases 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
Inflationary Gap
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
Contractionary Fiscal Policy
Reduces 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 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