Economic Policy & the Aggregate Demand- Aggregate 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

 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

Government wants to increase aggregate demand, shifting the aggregate demand curve rightward to AD1. Would increase aggregate output, making it equal to potential output Recessionary Gap

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

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 Inflationary Gap

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