Unit 5 Inflation, Unemployment, and Stabilization Policies

Fiscal Policy Government use of Government Spending (G) and Taxes (T) to shift AD (AS) in order to stabilize the economy Two components of stabilization?

Fiscal Policy Need Expansionary Need Contractionary

Fiscal Policy- Basic Terms Surplus Balanced Budget Deficit Debt

Fiscal Policy- Basic Terms Discretionary v. Mandatory Spending

Fiscal Policy Basics Discretionary Fiscal Policy Examples: Stimulus Spending Tax Cuts Automatic Stabilizers (generally “Mandatory” programs) Population qualifying for Food Stamp Applicable tax bracket within progressive tax system

Types of Deficits

Types of Deficits/Surpluses Total (Headline) Deficit/Surplus Structural- result from underlying imbalance in government budget Cyclical- deficit or surplus attributed to ups and downs of the business cycle

Types of Deficits

Debt to GDP Ratio Debt/GDP X 100

Debt to GDP Ratio

Components of National Debt National Debt- value of outstanding treasury securities (government bonds) Debt held by Public- $13.7 trillion Securities held by Individuals Corporations Governments (state, local, and foreign (6 trillion) Intragovernmental (Interdepartmental) Debt- $5.3 trillion Securities held by government itself Social Security Trust Fund

Fiscal Policy Expansionary Contractionary Decrease Taxes Increase Spending and Transfers Contractionary Increase Taxes Decrease Spending and Transfers

Policy Lags Inside Outside Recognition Decision Implementation Impact (operational)

Policy Lags- Fiscal Decision and Implementation are generally considerable

Inside Lags- Fiscal Fiscal- 535 members of Congress and the President Bill becomes law process (decision) Federal Bureaucracy (implementation)

Outside Lags- Fiscal Impact Lag Spending Multiplier

Fiscal Policy Complications Lags Ricardo-Barro Effect Deficit spending leads public and businesses to save more for fear of future tax increases Negates expansionary effect of gov’t spending May cancel crowding out Controlled by Politicians Lag length Policy reversals Certain policies will NEVER be popular Current structural deficit problem

Fiscal Policy Complications… Uncoordinated State and Local Policies Crowding Out

Three Tools of MP Reserve Requirement Discount rate Open market operations Main tool of MP Buying/selling government securities on the open market

OMO and Interest Rates Fed target – the federal funds rate This “drives” all other interest rates

Evaluation of MP 2 advantages over FP A. speed and flexibility B. isolation from political pressure

Policy Lags- Monetary Policy Inside Recognition Decision Implementation Outside Impact

Policy Lags- Monetary Policy Decision and Implementation Lags are relatively short Meet every six weeks or SOONER

Inside Lags Monetary- 12 member open market committee Quick decisions Immediate implementation

Outside Lags and Complications Monetary Deposit multiplier Banks holding excess reserves Cyclical Asymmetry Monetary policy may be better at controlling inflation than stimulating growth Liquidity Trap Increases in Money Supply leads to cash hoarding, not spending Increases in money supply fail to decrease interest rates

Stabilization Policy may be Destabilizing if poorly timed

2009- $100,000 to $250,000

Quantitative Easing

Quantitative Easing v. OMO Size of purchases Types of Purchases Long term securities Mortgage-backed securities

Phillips Curve SR- inverse relationship between inflation and unemployment

Rightward Shift (think leftward SRAS) Negative Supply Shock (increase in input prices) Increased inflation expectations

Leftward Shift (think rightward SRAS) Positive Supply Shock (decrease input prices) Decreased inflation expectations

Stagflation and the Phillips Curve 70s seemed to discredit the Phillips Curve Economist today see Phillips curve as a short run relationship

SRAS Shifts and Returns to LRE following expansionary policy

SRPC Shifts and Returns to LRE following expansionary policy

Phillips Curve Expectation of Future Inflation is the most important determinant of future inflation Rational Expectations Theory Individuals use all available information in forming expectations about future inflation Workers’ expecting increasing inflation demand higher wages thus causing greater inflation

Expectation of Inflation Expect higher, shift SRPC right Expect lower, shift SRPC left

Adam Smith- Classical View “An Inquiry into the Nature and Causes of the Wealth of Nations” aka “The Wealth of Nations” “Invisible Hand” Laissez-Faire Government Stimulus only leads to inflation

Demand-side Economics John Maynard Keynes Gov’t should target AD during recession Unemployment creates slack in markets allowing increases in AD without inflation Gov’t can smooth the business cycle

WPA

WPA

Supply-side Economics Aka “trickle-down” Reaganomics

Supply-Side Economics “trickle down” Fiscal Policies that target SRAS and LRAS Key Methods Decrease business regulation Decrease business marginal tax rates Investment Incentives/Tax Credits

Rahn Curve (not in curriculum)