Government Policies to Address… Macro – Unit 5 – part 2 and

______ _____ policies – seek to improve the economy by shifting the _____ curve towards ______________ -- monetary & fiscal policy Types of Policies If an economy is not at full employment equilibrium or does not show growth there are 2 types of policies a government may pursue: AD ______ _____ policies – seek to improve the economy by shifting the _______ curve out – (1) tax subsidies for investment, (2) encourage R&D, (3) encourage trade equilibrium LRAS Demand side Supply side

A. Demand Side Policies ______________ Fiscal PolicyMonetary Policy  Taxes  Gov’t Spending  discount rate  required reserves open market operations 3 of 27

A. Demand Side Policies May cause problems deficit To fund _______ spending, governments must borrow  increasing _______ rates  _________ out private Investment. interest So if M  ___ crowding M V = P Q P Thus expansionary policies may cause inflation.

A. Demand Side Policies May cause problems 3. Short Run Trade-Off Between Unemployment & Inflation PL SRAS AD 2005 LRAS AD 1 PL YY1Y1 PL 1 Q=realGDP=Y Is this economy at full employment? What happens if the Gov’t seeks to improve employment?

3. Short Run Trade-Off Between Unemployment & Inflation Inflation Rate (Percent / year) Phillips Curve 3% 4%7% 6% Unemployment Rate (percent) In 1958 British Economist A.W. Phillips published an article on the relationship between unemployment and inflation. Phillips Curve When inflation lowered from 6% to 3%, what happened to unemployment? 6 of 27

Phillips based his curve on unemployment & inflation data he collected in Great Britain from : Colander, p. 696

Inflation Rate (Percent / year) Phillips Curve 3% 4%7% 6% Unemployment Rate (percent) What’s a good trick to remember which axis is labeled which? Phillips Curve Inflation is same as PL Employment = GDP = Y is always on this axis. 8 of 27

But after the paper was published and the Phillips Curve was widely accepted, look what happened to the data.

In the Long Run Inflation Rate (Percent / year) L-R Phillips Curve 3% 4% 6% Unemployment Rate (percent) Economists Milton Friedman and Edmund Phelps later published papers in 1968 denying the existence of a short-run Phillips Curve. L-R Phillips Curve Having more $ printed can’t make more people work. Monetary growth may cause inflation, but that is just an increase in the price level; having more money printed does not affect “real” variables such as output and employment. 10 of 27

Rational Expectations – people optimally use all the information they have, including information about government policies when forecasting the future When economic policies change, people adjust their expectations of inflation accordingly. The expected price level affects nominal wages. A. Demand Side Policies May not be effective b/c of …

rational expectationfully anticipated 54. According to the theory of rational expectation, a fully anticipated expansionary monetary policy expansionary monetary policy will a. increase potential output b. increase unemployment c. have no impact on real output d. promote the production of consumer goods over capital goods e. result in deflation Consumers would anticipate higher inflation & at contract time ask for higher wages than in the past. Firms would not experience increasing profits so the economy would not expand. From 2005 exam 52% got it correct

B. Supply Side Policies ______ _____ policies – seek to improve the economy by shifting the _______ curve LRAS Supply side PL LRAS AD SRAS 1 PL Q PL 2 Q2Q2 AD 2 computers LRAS 1 housing Shifting out the LRAS is the same as shifting out what other curve? 13 of 27

Long-Run Economic Growth Significance of growth: higher GDP indicates a higher standard of living Why such large differences in living standards around the world? Primary Reason: Productivity Country Real GDP / person in 1900 Growth Rate / year Real GDP / person in 2003 Japan$1,280$28, % Mexico$ 987$ 8, % USA$3,412$37, % Pakistan$ 628$ 2, %

Long-Run Economic Growth Productivity – the quantity of goods & services produced from each unit of labor. Determinants of Productivity Physical Capital / Worker – stock of equipment & structures that are used to produce G & S Human Capital / Worker – knowledge & skills acquired thru education, training & experience Natural Resources / Worker – land, rivers, mineral deposits Technological Knowledge

Long-Run Economic Growth Public Policy to Promote Growth Saving & Investment – capital is a produced factor of production, so a society can invest its resources into producing more capital. To invest more a society must s ________ more and c _________less. Investment from Abroad Education Health & Nutrition Property Rights Political Stability Free Trade R________ & D_________ Population Growth ave onsume esearch evelopment

Important aspects: dollar amount multiply 1. The multiplier model allows a prediction of a ____________ of the output of the economy. 2. If you’re told the multiplier is 4, the multiplier model proves that just a $100 change in G will _________ and increase the economy by _______. $ The Keynesian/multiplier model assumes ____________ is constant. price level 17 of 27 some questions for review

What are the 3 curves drawn in the AS / AD model? PL Q=realGDP=Y LRAS Y AD SRAS Why is LRAS vertical...what does it represent?

some questions for review In this particular drawing is the economy in a recession, inflationary period or at equilibrium? PL Q=realGDP=Y LRAS YFYF AD SRAS What is LRAS frequently labeled? Explain why. 19 of 27

Keynesian Range Intermediate Range Classical Range Single Aggregate Supply curve consists of 3 parts... alternative format to draw AS/AD model.... label? PL label? AD Y = Real GDP =Q Which range is which? Keynesian Range Intermediate Range Classical Range

Keynesian Range Intermediate Range Classical Range What is represented if the economy is at this point? alternative format to draw AS/AD model.... PL AD Y = Real GDP =Q YFYF Full employment income..which is ____% unemployment. 5

Where would you draw AD curve to show an inflationary gap? PL AD Y = Real GDP =Q YFYF Y1Y1

Long-Run Economic Growth In the USA real GDP/capita has grown by about ___% / year. This is known as the _________ growth trend. PL Q=realGDP=Y LRAS YFYF AD SRAS How would you illustrate long term growth on this graph? LRAS 1 Y1Y1 2 secular

So what if you’re told there’s a decrease in G? What does it affect? G is a part of.... PL LRAS YFYF AD SRAS PL Q PL 2 Q2Q2 AD 2 GDP=Y=Q 24 of 27

PL LRAS YFYF AD SRAS PL Q PL 2 Q2Q2 AD 2 GDP=Y=Q Now that you know what shifted, it might ask... what happened to output? where do you look? what happened to inflation? what happened to employment? what happened to income? what happened to the overall level of prices?

So what if you’re told there’s an increase in the discount rate? The discount rate is the interest rate the Fed charges banks to borrow money. ____   ____   ____  & ____   ____  PL LRAS YFYF AD SRAS PL Q PL 2 Q2Q2 AD 2 iMSIC AD

Crowding out The government should spend the money it earns through ______. If the government it spending more than it’s taxing, it is conducting ______ spending. To spend what it doesn’t have, the gov’t needs to ________ money. The government borrowing money increases the demand for __________ funds which drives the ____ up. With the interest rate up, private investment is _______ ___. defici t taxes I borrow loanable i crowded out 27 of 27