1. Section 4

2. What You Will Learn in this Module Explain the difference between short-run and long-run macroeconomic equilibrium Describe the causes and effects of demand shocks and supply shocks Determine if an economy is experiencing a recessionary or an inflationary gap and explain how to calculate the size of an output gap Section 4 | Module 19

3. The AS–AD Model The AS-AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations. Section 4 | Module 19

4. Short-Run Macroeconomic Equilibrium The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium. Section 4 | Module 19

5. The AS–AD Model Y E P E E SR SRAS AD Real GDP Short-run macroecon omic equilibrium Aggregate price level Section 4 | Module 19

6. Demand Shocks Y 2 2 P 2 AD 2 A negative demand shock... Y 1 E 1 E SRAS AD 1 Y 1 2 E 1 SRAS AD 1 P 1 P 1 Real GDP Aggregate price level Real GDP Aggregate price level...leads to a higher aggregate price level and higher aggregate output. (a) A Negative Demand Shock(b) A Positive Demand Shock E P 2 Y 2 AD 2 A positive demand shock......leads to a lower aggregate price level and lower aggregate output. Section 4 | Module 19

7. Supply Shocks P 1 AD Y 1 E 1 Real GDP Aggregate price level (a) A Negative Supply Shock SRA S 1 Y 2 2 E P 2 2 Y 1 1 AD E 2 E SRAS P 1 Real GDP Aggregate price level (b) A Positive Supply Shock P 2 Y 2 SRA S 2 1 A negative supply shock... …leads to a lower aggregate output and a higher aggregate price level....leads to a higher aggregate output and lower aggregate price level. A positive supply shock... Section 4 | Module 19

8. Negative Supply Shocks Stagflation is the combination of inflation and stagnating (or falling) aggregate output. “Stagnation plus inflation” Section 4 | Module 19

9. Long-Run Macroeconomic Equilibrium The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve. Section 4 | Module 19

10. Long-Run Macroeconomic Equilibrium Y P P E SRAS LR AD E LR Real GDP Aggregat e price level Long-run Macroeconomic equilibrium Potential output Section 4 | Module 19

11. Short-Run Versus Long-Run Effects of a Negative Demand Shock Y 1 P E 1 2 SRAS 1 LR AD 1 Real GDP Aggregat e price level Poten tial outpu t E 3 P 3 SRAS 2 3. …until an eventual fall in nominal wages in the long run increases short-run aggregate supply and moves the economy back to potential output. 2 2. …reduces the aggregate price level and aggregate output and leads to higher unemployment in the short run… AD 2 Recessionary gap Y 2 E 1. An initial negative demand shock… 1 P 11 of 17 Section 4 | Module 19

12. Short-Run Versus Long-Run Effects of a Positive Demand Shock Section 4 | Module 19

13. Long-Run Macroeconomic Equilibrium There is a recessionary gap when aggregate output is below potential output. There is an inflationary gap when aggregate output is above potential output. The output gap is the percentage difference between actual aggregate output and potential output. Section 4 | Module 19

14. Long-Run Macroeconomic Equilibrium The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run. Section 4 | Module 19

15. F YIF YIF YIF YI F YIF YIF YIF YI Supply Shocks versus Demand Shocks in Practice Recessions are mainly caused by demand shocks. But when a negative supply shock does happen, the resulting recession tends to be particularly severe. There’s a reason the aftermath of a supply shock tends to be particularly severe for the economy: macroeconomic policy has a much harder time dealing with supply shocks than with demand shocks. Section 4 | Module 19

16. Summary 1.In the AD–AS model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output. 2.A demand shock causes the aggregate price level and aggregate output to move in the same direction as the economy moves a long the short-run aggregate supply curve. 3.A supply shock causes them to move in opposite directions as the economy moves along the aggregate demand curve. 4.Stagflation is inflation and falling aggregate output and is caused by a negative supply shock. Section 4 | Module 19

17. Summary 5.Demand shocks have only short-run effects on aggregate output because the economy is self-correcting in the long run. 6.In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, where aggregate output is equal to potential output. 7.In an inflationary gap, an eventual rise in nominal wages moves the economy to long-run macroeconomic equilibrium. 8.The output gap is the percentage difference between actual aggregate output and potential output Section 4 | Module 19

18. Section 4

19. What You Will Learn in this Module Discuss how the AS–AD model is used to formulate macroeconomic policy Explain the rationale for stabilization policy Describe the importance of fiscal policy as a tool for managing economic fluctuations Identify the policies that constitute expansionary fiscal policy and those that constitute contractionary fiscal policy Section 4 | Module 20

20. Macroeconomic Policy Economy is self-correcting in the long run. Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions. Section 4 | Module 20

21. Macroeconomic Policy Policy in the Face of Demand Shocks – If policy were able to perfectly anticipate shifts of the aggregate demand curve and counteract them, the period of low aggregate output and falling prices could be avoided. – Price stability is generally regarded as a desirable goal. Section 4 | Module 20

22. Macroeconomic Policy Responding to 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. Section 4 | Module 20

23. F YIF YIF YIF YI F YIF YIF YIF YI 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. Section 4 | Module 20

24. Government Spending and Tax Revenue for Some High-Income Countries in 2012 Section 4 | Module 20

25. Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing Funds flow into the government in the form of taxes and government borrowing Funds flow out of the government in the form of government purchases of goods and services and government transfers to households Section 4 | Module 20

26. Sources of Tax Revenue in the U.S., 2013 Section 4 | Module 20

27. Government Spending in the U.S., 2013 Section 4 | Module 20

28. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. The Government Budget and Total Spending Section 4 | Module 20

29. Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy increases aggregate demand and can take one of three forms: – an increase in government purchases of goods and services – a cut in taxes – an increase in government transfers Contractionary fiscal policy reduces aggregate demand and can take one of three forms: – a reduction in government purchases of goods and services – an increase in taxes – a reduction in government transfers Section 4 | Module 20

30. Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap Section 4 | Module 20

31. Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap 31 of 17 Section 4 | Module 20

32. 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) Section 4 | Module 20 Will the stimulus come in time to be worthwhile? President Barack Obama listens to a question during a news conference in the East Room of the White House in Washington, D.C.

33. Summary 1.Many economists advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. 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. 3.Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. 4.Expansionary fiscal policy shifts the aggregate demand curve rightward. 5.Contractionary fiscal policy shifts the aggregate demand curve leftward. Section 4 | Module 20

34. Section 4

35. What You Will Learn in this Module Explain why fiscal policy has a multiplier effect Describe how automatic stabilizers influence the multiplier effect Section 4 | Module 21

36. Using the Multiplier to Estimate the Influence of Government Policy Fiscal policy has a multiplier effect on the economy. Fiscal policy can take the form of changes in taxes, transfers, and government spending. Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in aggregate spending caused by the policy. Conversely, contractionary fiscal policy leads to a fall in real GDP larger than the initial reduction in aggregate spending caused by the policy. Section 4 | Module 21

37. Using the Multiplier to Estimate the Influence of Government Policy The multiplier on changes in government purchases is 1/(1 − MPC). Section 4 | Module 21

38. Multiplier Effects of Changes in Taxes and Government Transfers Example: The government hands out $50 billion in the form of tax cuts. There is no direct effect on aggregate demand by government purchases of goods and services; GDP goes up only because households spend some of that $50 billion. How much will they spend? – MPC × $50 billion. For example, if MPC = 0.6, the first- round increase in consumer spending will be $30 billion (0.6 × $50 billion = $30 billion). – This initial rise in consumer spending will lead to a series of subsequent rounds in which real GDP, disposable income, and consumer spending rise further. Section 4 | Module 21

39. Multiplier Effects of Changes in Government Transfers and Taxes Section 4 | Module 21

40. Multiplier Effects of Changes in Government Transfers and Taxes The multiplier on changes in taxes or transfers, MPC/(1 − MPC), because part of any change in taxes or transfers is absorbed by savings. The results from changes in taxes are complicated by the fact that governments rarely impose lump sum taxes. Changes in government purchases have a more powerful effect on the economy than equal-sized changes in taxes or transfers. Section 4 | Module 21

41. How Taxes Affect the Multiplier Rules governing taxes and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle. Section 4 | Module 21

42. F YIF YIF YIF YI F YIF YIF YIF YI About That Stimulus Package... The U.S. economy needed a fiscal stimulus. There was, however, sharp partisan disagreement about what form that stimulus should take. Republicans favored tax cuts on general political principles. Democrats preferred transfer payments, especially increased unemployment benefits and expanded food stamp aid. The eventual compromise gave most taxpayers a flat $600 rebate, $1,200 for married couples. Many economists believed that only a fraction of the rebate checks would actually be spent, so that the eventual multiplier would be fairly low. Section 4 | Module 21

43. Summary 1.Fiscal policy has a multiplier effect on the economy, the size of which depends upon the fiscal policy. 2.Except in the case of lump-sum taxes, taxes reduce the size of the multiplier. Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a reduction in real GDP. 3.Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers. Section 4 | Module 21

44. Summary 4.Rules governing taxes—with the exception of lump-sum taxes—and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. 5.Discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle. Section 4 | Module 21