UNIT 5 NOTES Stabilization Policies

The Phillips Curve

Short Run Phillips Curve  There is an inverse relationship between inflation and the unemployment rate which has come to be known as the Phillips curve which is down sloping in the short run. Inflation Rate Unemployment Rate PC

Shifts to SRPC  When SRAS shifts left, we get stagflation, where unemployment and inflation both increase. This causes a rightward shift of the SRPC. (PC2)  When SRAS shifts right, we get a leftward shift of SRPC as unemployment and inflation both decrease. (PC 3 ) Inflation Rate Unemployment Rate PC1 PC2 PC3

Long-Run Phillips Curve  The long-run Phillips curve is vertical at the natural rate of unemployment, where cyclical unemployment is equal to zero. Inflation Rate Unemployment Rate LRPC SRPC 4%

Expectations  The differences between SRPC and LRPC when there is a gap, is the actual rate of inflation and the expected rate of inflation.  Inflationary expectations play a role in the derivation of the LRPC

1. Expected inflation is 2% at the natural unemployment rate (4%) (point a). 2. If AD unexpectedly rises, this drives up the rate of inflation to 5% and as a result firms earn higher profits. Inflation Rate Unemployment Rate LRPC PC1 4% PC2 2% 5% 2% a b c

3. Firms respond by hiring more people and the unemployment rate drops to 2% (point b). This is a movement along the SRPC. 4. Workers will realize their real wages are falling and demand a raise, causing inputs to become more expensive and SRAS will decrease, bringing the SRPC back to LRPC. Inflation Rate Unemployment Rate LRPC PC1 4% PC2 2% 5% 2% a b c

Fiscal Policy

The Employment Act of 1946  “The Congress hereby declares that it is the continuing policy of the Federal Government to use all practicable means…to promote maximum employment, production, and purchasing power.”

Fiscal Policy  Changes in federal spending or tax levels that influence levels of output, employment and prices.

Expansionary Fiscal Policy Price Level Real GDP SRAS LRAS AD 1 AD 2 Recessionary Gap When recession occurs, govt. decreases taxes and increases spending. G increases, as well as I and C because less taxes means more money to spend. Expansionary policy leads to budget deficits and greater debt.

Contractionary Fiscal Policy  When demand-pull inflation occurs, govt. increases taxes and decreases spending.  G decreases, as well as I and C because more taxes means less money to spend.  Contractionary policy leads to budget surpluses. Price Level Real GDP SRAS LRAS AD 1 Inflationary Gap AD 2

Homework: “Problems, Criticisms, and Complications”  Read pages and answer questions 6 and 8 on page 225

Crowding Out

 If govt. must borrow funds to pay for expansionary policy, it will affect the loanable funds market.  Govt. deficit or negative public savings is a reduction in savings and ↓ the Supply of loanable funds available to private borrowers.  i % will ↑ and fewer will be willing to borrow. D Loanable Funds ($) Interest Rate $F i % S Market for Loanable Funds S1S1 i %

 When i % ↑ households and firms are “crowded out” of the market for loanable funds. This ↓ of C and I will lower the effect of expansionary fiscal policy.  When fighting inflation and using contractionary policy, the govt. surplus will increase the S of loanable funds dropping i % and increasing AD.

Net export Effect  If the govt. is borrowing, to conduct fiscal policy, the increase in i % will have a similar effect on net exports through foreign interest rates.  If you are German and you see i % rising in the US, you will want to invest there. You will need $ to purchase bonds and this will ↑ the D for $.

 This drives up the “price” of the $, which is measured in euros for you.  The increased price of the $ makes US goods more expensive for foreigners and drives net exports ↓. € price of a $ Quantity of $ Demand $ Supply $ €0€0 €1€1 Market for Dollars

Monetary and Fiscal Policy Combined The Problem:Fiscal Policy Solution Budget Impact Potential Consequence Monetary Policy Complement Keep an Eye On… Deep recession with high unemployment ↓ Taxes and ↑ G to rapidly ↑ AD Large Deficit ↑ interest rates, crowding out, lower net exports and ↓ AD Expand MS to keep interest rates from rising Higher inflation Mild recession with moderate unemployment ↓ Taxes or ↑ G to gradually ↑ AD Moderate Deficit Rising prices. Mild crowding out and lower net exports Contract MS to keep inflation from rising. ↓ AD offsetting fiscal policy Rising Interest Rates Inflation ↑ Taxes and/or ↓ G to rapidly ↓ AD SurplusLower interest rates crowding in private investment causing an ↑ in AD Contract MS to keep interest rates from falling. Decrease AD Higher Unemploy- ment

Graphs: 1. Production Possibilities Curve 2. Supply and Demand 3. Aggregate Supply and Aggregate Demand 4. Money Market 5. Market for Loanable Funds 6. Foreign Currency Market 7. The Phillips Curve

Economic Growth and Productivity

 This PPC shows a nation that can build some # of either cars or computers.  This PPC can expand over time if:  The quantity of resources ↑  The quality of resources ↑  The nation’s technology ↑  Each of these represents an ↑ in productivity Cars Computers

Determinants of Productivity  Natural Resources – More raw materials = more productivity  Technology – A nation’s knowledge of how to produce goods in the best possible way.  Supply of Capital Goods – Workers are more productive when they have tools/machinery at their disposal.  Human Capital – The amount of knowledge and skills that a person uses at labor. (Training)

 All of these determinants require an investment, and funds for investment come from saving.  Firms invest in physical capital and individuals invest in human capital. Nations invest in conservation of natural resources, and entrepreneurs invest in technology.  Many economists believe that policies that encourage saving and investment have the ability to contribute to economic growth.

Supply-Side Policies  Some economists believe that fiscal policy should not focus on AD, but AS instead.  Supply-side fiscal policy consists of tax reductions targeted to AS so that an increase in AS and RGDP does not lead to inflation.  Supply-side proponents suggest policies that lower or remove taxes on income earned from savings.

 Removing taxes would encourage savings and ↑ the supply of loanable funds, driving down interest rates.  Lower taxes would offer more disposable income and increase both saving and consumption, and increase in both AS and AD.  The effectiveness of these policies is open for debate.