1. Unit 6: Inflation, Unemployment, & Stabilization Policies
Modules 30-36
20-30% of the AP Exam

2. Module 30 Key Terms & Review Long-Run Implications of Fiscal Policy: Deficits and the Public Debt
Business cycle
Government debt
Fiscal year
Public debt
Implicit liabilities 1. 2. 3. 4. 5.

3. Budget Balance Government savings =
Can we use the budget balance to determine if fiscal policy is occurring?
Changes in G have a greater affect on the economy than changes in taxes and transfer payments
An equal change in G and taxes will result in no change in the budget balance but have an expansionary effect on the economy

4. Business Cycle & the Budget
Strong correlation: deficits during recessions / surpluses (or smaller deficits) during expansions
Driven by automatic stabilizers (Module 21) and discretionary fiscal policy
How do we know which has the bigger impact?
Cyclically adjusted budget balance
Estimate of what the balance would be if RGDP always equaled full employment output
Takes into account what tax revenues/transfers would be if not for the recessionary/inflationary gap
Lets economists know if a government’s policies are sustainable in the long-run

6. Do deficits matter?
Requiring a balanced budget every year would eliminate the government’s ability to use fiscal policy to smooth out the business cycle

7. Long-run implications of Fiscal Policy
Debt – accumulation of deficits & surpluses over time
Fiscal year: October 1 – September 30
Public debt – debt held by people outside of the government
Impact on the economy
Crowding out effect (Can you draw it?)
Pressure on future budgets
Read Deficits and Debt in Practice, pgs

12. Module 31 Key Terms & Review Monetary Policy & the Interest Rate
Federal funds rate
Taylor rule
Inflation targeting
Review Modules 28 & 29 1. 2. 3. 4. 5.

13. Review Money Market & Loanable Funds graphs!
“In the short run, the interest rate is determined in the money market and the loanable funds market adjusts in response to changes in the money market.” (pg. 304)

14. Federal Funds Rate The FOMC uses open market operations to set
Reserve requirement / discount window are rarely used
Discount window was opened to non-banks after the 2008 financial crisis
Read FYI “The Fed Reverses Course” pg. 306

15. Monetary Policy & AD
AP Exam Tip: It is never enough to say “expansionary” or “contractionary” policy will solve a problem. Name a specific tool and how you would apply it.

16. Monetary Policy in Practice
Fed must balance GDP growth & inflation
1990s: Fed did not raise interest rates despite positive GDP gap because inflation remained low
Taylor rule
Fed funds rate = 1 + (1.5 x inflation rate) + (0.5 x output gap)

17. Inflation targeting
2012 – Ben Bernanke announces Fed will try to maintain 2% inflation rate
Pros:
Con:

18. Module 32 Key Terms & Review Money, Output, and Prices in the Long Run
Monetary neutrality 1. 2. 3. 4. 5.

19. Long run impact of monetary policy
What if the Fed gets it wrong?

20. Expansionary monetary policy

21. Contractionary monetary policy

22. Monetary neutrality

23. Long run determination of interest rates
Remember monetary neutrality!

24. Module 33 Key Terms & Review Types of Inflation, Disinflation, and Deflation
Inflation tax
Cost-push inflation
Demand-pull inflation 1. 2. 3. 4. 5.

25. The Classical Model

26. Who is to blame for inflation?
The Treasury issues bonds to finance debt
The Federal Reserve monetizes the debt by creating money to buy bonds from the public & banks
Creates an artificial demand for bonds via open market operations
Government pays interest on debt owned by the Fed, but they turn most of it back over to the Treasury
Seignorage – revenue generated by the government’s right to print money
Inflation tax –

27. Types of inflation

28. And now let’s randomly talk about unemployment…
Unemployment rate =
Varies indirectly with the output gap
Positive (inflationary) gap 
Negative (recessionary) gap 

30. Module 34 Key Terms & Review Inflation & Unemployment: The Phillips Curve
Nonaccelerating inflation rate of unemployment
Disinflation
Deflation 1. 2. 3. 4. 5.

31. Short-Run Phillips Curve 1955-1968

32. SRPC & Demand Shocks
Okun’s law –

33. On this graph, up is bad & down is good.
SRPC & Supply Shocks
Note:
On this graph, up is bad & down is good.

34. Short-Run Phillips Curve cont.
Future expectations about inflation directly affect the current inflation rate

35. Long-Run Phillips Curve
Expansionary fiscal / monetary policy: E0  A
People begin to expect 2% inflation & SRAS decreases
SRPC shifts up, E2 is the new normal
If we still want lower unemployment, policies will continue to increase inflation, E2  B
SRPC shifts up, E4 is the new normal

36. NAIRU
Nonaccelerating inflation rate of unemployment

37. Disinflation & Deflation
Disinflation – process of bringing down the rate of inflation
Deflation – falling aggregate price level
Debt deflation – reduction in AD because borrowers’ debts are a greater burden

38. The Fisher Effect (Module 29)
Nominal interest rate = real interest rate + inflation premium

39. The Liquidity Trap
Expected deflation affects the nominal interest rate just like expected inflation does

40. Module 35 Key Terms & Review History & Alternative Views of Macroeconomics
Keynesian economics
Monetarism
Velocity of money
Political business cycle
Rational expectations
Real business cycle theory 1. 2. 3. 4. 5.

41. Classical Macroeconomics

42. The Great Depression “In the long run we are all dead.”
Keynesian Revolution!

43. Challenges to Keynesian Economics
1960s saw the rise of Monetarism, led by Milton Freedman
Emphasized the importance of monetary policy
Take power away from politicians (fiscal policy) and give it to the Federal Reserve
GDP will grow steadily if the MS grows steadily
Still emphasized the short-run, but said that due to lags, discretionary fiscal policy just led to booms after recessions
If government attempts to boost the economy but the Fed holds the MS constant, the crowding out effect will lessen the effects of the fiscal policy

44. So what should monetary policy look like?
Friedman suggested putting monetary policy on “autopilot”

45. Limits of policy activism
Natural rate hypothesis
Economists realized in the late1960s / early 1970s that there was a natural rate of unemployment
Attempts to push AD beyond that only results in inflation
Once inflation expectations are embedded in prices and wages, inflation will continue even in economy downturns (stagflation of the 1970s)
Fiscal policy can be misused for political purposes, causing a political business cycle

46. NEW Classical Macroeconomics
Return to the belief that shifts in AD do not affect output, only the price level
Rational expectations
If people think there will be inflation in the future, they immediately build it into their prices / wage negotiations
NEW Keynesian economics – prices/wage are sticky
Real business cycle theory
Changes in the growth of technology / productivity cause the business cycle
Vertical aggregate supply curve shifts left and right with these changes

47. Module 36 Key Terms & Review Consensus and Conflict in Modern Macroeconomics
YOYO!
Laffer Curve- pg. 356 1. 2. 3. 4. 5.

48. Laffer Curve
Supply-side economics

49. Unit 6 Review – pgs 1. 2. 3. 4. 5. 6. 7. 8. 9.
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