1 of 62 chapter: 28 >> Krugman/Wells ©2009  Worth Publishers Aggregate Demand and Aggregate Supply

2 of 62 WHAT YOU WILL LEARN IN THIS CHAPTER  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 stabilization  Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy

3 of 62 Macroeconomic Policy  Economy is self-correcting in the long run.  Most economists think it takes a decade or longer!!!  John Maynard Keynes: “In the long run we are all dead.”  Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

4 of 62 FOR INQUIRING MINDS Keynes and the Long Run  The British economist Sir John Maynard Keynes (1883– 1946), probably more than any other single economist, created the modern field of macroeconomics.  In 1923 Keynes published A Tract on Monetary Reform, a small book on the economic problems of Europe after World War I.  In it he decried the tendency of many of his colleagues to focus on how things work out in the long run: “This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the sea is flat again.”

5 of 62 Macroeconomic Policy  The high cost — in terms of unemployment — of a recessionary gap and the future adverse consequences of an inflationary gap  Active stabilization policy, using fiscal or monetary policy to offset shocks.

6 of 62 Macroeconomic Policy  Policy in the face of demand shocks:  If policy were to perfectly anticipate shifts in AD and counteract them, it could short-circuit adjustment process.  Policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, especially if they increase budget deficits could have long-run costs of lower economic growth. Without perfect information the policy could do more harm than good.

7 of 62 Macroeconomic Policy  Policy in the face of 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.

8 of 62 ►ECONOMICS IN ACTION 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.

9 of 62  Why a large public debt may be a cause for concern  Why implicit liabilities of the government are also a cause for concern

10 of 62 Government Spending and Tax Revenue for Some High-Income Countries in 2006

11 of 62 Sources of Tax Revenue in the U.S., 2007

12 of 62 Government Spending in the U.S., 2007 Social insurance programs are government programs intended to protect families against economic hardship.

13 of 62 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.

14 of 62 Investment Tax Credits  An investment tax credit is a tax break given to firms based on their investment spending. This increases the incentive for investment spending.  Investment tax credits are often temporary, applying only to investment spending within a specific period.  Like department store sales that encourage shoppers to spend a lot while the sale is on, temporary investment tax credits tend to generate a lot of investment spending when they’re in effect. Even if a firm doesn’t think it will need a new computer server or lathe for another year or so, it may make sense to buy it while the tax credit is available, rather than wait.

15 of 62 Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap Expansionary fiscal policy increases aggregate demand. Recessionary gap

16 of 62 Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap Contractionary fiscal policy reduces aggregate demand. Inflationary gap

17 of 62 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

18 of 62 SUMMARY 1. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. There can be drawbacks, however, because such policies may contribute to a long-term rise in the budget deficit and crowding out of private investment, leading to lower long-run growth. Also, poorly timed policies can increase economic instability. 2. 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.

19 of 62 The End of Module 20 coming attraction: Module 21: Fiscal Policy & Multiplier