MODULE 20 Economic Policy and the Aggregate Demand—Aggregate Supply Model Krugman/Wells

How the AS–AD model is used to formulate macroeconomic policy The rationale for stabilization policy Why fiscal policy is an important tool for managing economic fluctuations Which policies constitute expansionary fiscal policy and which 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. Notes to the Instructor: There can be drawbacks, however, because such deficit and erroneous predictions can increase economic policies that may contribute to a long-term rise in the budget instability.

Macroeconomic Policy 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.

Macroeconomic Policy 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.

Is 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 2006 Figure Caption: Figure 20.1: Government Spending and Tax Revenue for Some High-Income Countries in 2008 Government spending and tax revenue are represented as a percentage of GDP. Sweden has a particularly large government sector, representing nearly 60% of its GDP. The U.S. government sector, although sizable, is smaller than those of Canada and most European countries. Source: OECD.

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 or government purchases of goods and services and government transfers to households

Sources of Tax Revenue in the U.S., 2008 Figure Caption: Figure 20.2: Sources of Tax Revenue in the United States, 2008 Personal income taxes, taxes on corporate profits, and social insurance taxes account for most government tax revenue. The rest is a mix of property taxes, sales taxes, and other sources of revenue. Source: Bureau of Economic Analysis.

Government Spending in the U.S., 2008 Figure Caption: Figure 20.3: Government Spending in the United States, 2008 The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and the Medicare and Medicaid health care programs. (Numbers do not add to 100% due to rounding.) Source: Bureau of Economic Analysis. Social insurance programs are government programs intended to protect families against economic hardship.

The Government Budget and Total Spending Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. Notes to the Instructor: The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and health care programs.

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 and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap Expansionary fiscal policy increases aggregate demand. Figure Caption: Figure 20.4: Expansionary Fiscal Policy Can Close a Recessionary Gap At E1 the economy is in short-run equilibrium where the aggregate demand curve AD1 intersects the SRAS curve. At E1, there is a recessionary gap of YE − Y1. An expansionary fiscal policy—an increase in government purchases, a reduction in taxes, or an increase in government transfers—shifts the aggregate demand curve rightward. It can close the recessionary gap by shifting AD1 to AD2, moving the economy to a new short-run equilibrium, E2, which is also a long-run equilibrium. Recessionary gap 14 of 17

Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap Contractionary fiscal policy reduces aggregate demand. Figure Caption: Figure 20.5: Contractionary Fiscal Policy Can Eliminate an Inflationary Gap At E1 the economy is in short-run equilibrium where the aggregate demand curve AD1 intersects the SRAS curve. At E1, there is an inflationary gap of Y1 − YE . A contractionary fiscal policy—reduced government purchases, an increase in taxes, or a reduction in government transfers—shifts the aggregate demand curve leftward. It can close the inflationary gap by shifting AD1 to AD2, moving the economy to a new short-run equilibrium, E2, which is also a long-run equilibrium. Inflationary gap 15 of 17

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)

Many economists advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. 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. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. Expansionary fiscal policy shifts the aggregate demand curve rightward. Contractionary fiscal policy shifts the aggregate demand curve leftward.