20 Module Economic Policy and the Aggregate Demand-Aggregate Supply Model odel KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How the AD-AS 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 Self-correction? Stabilization Policy The long-run adjustment back to Yp may take a long time so most economists believe that the government can help expedite the return to full employment and stable prices.   stabilization policy: the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

Policy in the Face of Demand Shocks Negative Demand Shocks & Positive Demand Shocks Why are they bad? Should policymakers counteract? Negative demand shock causes a recessionary gap. The price level falls, but so does real GDP. Unemployment becomes a problem. Government policy (both fiscal and monetary) is designed to reverse this decline in AD. This shortens the duration of a recession.   Positive demand shocks cause an inflationary gap. The price level rises and so does real GDP. Unemployment falls, but inflation is the real problem. Again, government policy would be geared toward reversing the increase in AD. This shortens the duration of an inflationary period.

Responding to Supply Shocks There is very little policymakers can do to reverse a supply shock. It is much easier to affect spending (through AD) than it is to affect production (through AS).   What if we tackled a negative supply shock by trying to influence AD? Negative Supply Shock: Note: show the students what happens when SRAS shifts to the left. Inflation and unemployment. Suppose policymakers wanted to shift AD to the right to fight unemployment. This would worsen the inflation. Or suppose policymakers wanted to shift AD to the left to fight the inflation. That would only worsen the unemployment. There are no good options here. Supply shock Policy dilemma

Fiscal Policy: The Basics A key to understanding fiscal policy is to understand its origins. Fiscal policy is all about taxation and government spending. The President proposes a budget to Congress that includes plans for spending and tax collection. Eventually Congress will amend and approve a budget and it becomes law.   We will see that this fundamentally differs from monetary policy which is created by the Federal Reserve, the central bank of the U.S.

Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing Tax Collection Like households, the government must collect money in order to pay for this spending. The government collects taxes. Note: ask the students to start a list of all of the taxes they, or their parents, pay. Sales tax, income tax, property tax, vehicle registration tax, gas (or liquor or tobacco) excise taxes, tax on corporate profits…   And like households, the government can borrow to make up for a shortfall in tax revenue that does not pay for all of the spending. Government borrowing will be covered future sections of the course.

Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing The government plays a sizeable role in the circular flow diagram.   Government Spending Like households, the government spends money on goods and services. Note: can the students provide some examples of goods and services purchased by the government? Remind the students that government includes all levels of government (local, state, federal). Local: police cars in your city. State: a system of State Parks. Federal: the military Transfer Payments The government also provides transfer payments to some households. Note: can the students provide some examples of transfer payments sent from the government to households? Social Security, Medicare, Medicaid, VA benefits, food stamps, etc.

The Government Budget and Total Spending GDP = C + I + G + X - M The effect of taxes and transfers Effects on Investment How does the government affect AD? Remind the students that if we add up all of the spending in the economy we get GDP.   GDP = C + I + G + X - IM G: government purchases of goods and services. This directly affects GDP and thus AD. Indirectly, the government can influence consumption spending (C) through taxes and transfers. To see this, look at what goes into consumption spending. A person receives income Y from his/her job. Taxes are paid to the government and sometimes transfer payments are received by the government. What is left over is disposable income Yd. Disposable income can now either be consumed or saved. Yd = Y – taxes + transfers = C + S or C = Yd – S As we saw in a previous module, when Yd increases, so does C. So the government can indirectly increase C if it can increase Yd. How can it increase Yd? By cutting taxes or by increasing transfers. The government can also affect investment spending (I) through tax policy.

Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy increase G decrease T increase transfers Note: the instructor should have the students consider two short-run states of the economy: a recessionary gap and an inflationary gap.   Begin by drawing a short-run equilibrium with a recessionary gap. Recessionary gap: fiscal policy should try to shift AD to the right. expansionary fiscal policy, normally takes one of three forms: An increase in government purchases of goods and services A cut in taxes An increase in government transfers Show how any of these policies would shift the AD curve to the right and GDP closer to Yp.

Expansionary and Contractionary Fiscal Policy decrease G increase T decrease transfers Begin by drawing a short-run equilibrium with an inflationary gap.   Inflationary gap: fiscal policy should try to shift AD to the left. contractionary fiscal policy, normally takes one of three forms: A decrease in government purchases of goods and services An increase in taxes A decrease in government transfers Show how any of these policies would shift the AD curve to the left and GDP closer to Yp.

A Cautionary Note: Lags in Fiscal Policy Time lags Recognition lag Decision lag Implementation lag Lags make decision making more difficult Fiscal policy looks easy on the chalkboard. In reality it is more difficult because there are important time lags in its use.   Recognition lag: The government has to realize that the recessionary gap exists because economic data take time to collect and analyze, and recessions are often recognized only months after they have begun. Decision lag: the government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation. Implementation lag: It takes time to spend money. For example, a road construction project begins with activities such as surveying that don’t involve spending large sums. It may be quite some time before the big spending begins. By this time, the economy might have already begun self-correcting back to Yp.