U5: Stabilization Policies

Unit 5: Long-Run Consequences of Stabilization Policies

Fiscal Policies

Expansionary Fiscal Policy increases AD curve in short-run (fixes recessionary gap & creates a budget deficit).

Contractionary Fiscal Policy decreases AD curve in short-run (fixes expansionary gap & creates a budget surplus).

Expansionary Monetary Policy increases AD (helps fix recessionary gaps).

Contractionary Monetary Policy decreases AD (helps fixes expansionary gap).

Combination of fiscal & monetary policies can influence AD, real output, PL, and interest rates.

● Thus, in the short run, government deficits can cause an inflationary gap and raise interest rates which can delay economic growth.

○ Government deficits means government spending is a lot. (This causes the AD curve to shift to the right resulting in an inflationary gap.)

● In the long run, government deficits can add to rising government debt.

Short-Run Phillips Curve (SRPC)

● Shows short-run trade-off b/w the unemployment rate & inflation rate

● Negative supply shock would shift the SRPC up and a positive supply shock would shift the SRPC down.

● SRPC also shifts up the same amount that the expected inflation rate increases.

● Demand shocks move the economy along the SRPC (ex. Positive demand shock → economy move up the SRPC)

● Supply shocks shift SRPC

Long-Run Phillips Curve (LRPC)

● Is the natural rate of employment

● The point where the economy would not have accelerating inflation.

○ Accelerating inflation - The cycle of the inflation rate constantly increasing from the government trying to make the unemployment rate below the natural rate.

(This causes expected inflation to rise, and then actual inflation, and then expected…)

● Shifters of the natural rate of unemployment also shift the LRPC.

● Long-run equilibrium is the intersection of SRPC & LRPC.

● Economy is in an inflationary gap if left to the equilibrium.

● Economy is in an recessionary gap if right to the equilibrium

Rapid uses of expansionary monetary policy can cause inflation:

○ When the economy is at full-employment, changing the money supply would have no effect on real output in the long-run.

Quantity Theory of Money

● The money supply and price level are in direct proportion (ex. Increase in the money supply → inflation) in the long-run.

Budget Balance

● Budget Balance = Tax revenue - government spending + transfer payments

Budget surplus - tax revenue > government spending

Budget deficit - tax revenue < government spending

● Government has to pay interest on accumulated debt which increases national debt.

Crowding-Out

● Government usually starts borrowing a budget deficit. (This increases money demand and therefore, the interest rate which then decreases private investment.)

● May cause a lower rate of physical capital accumulation & less economic growth in the long-run

Economic Growth

● Growth rate of GDP/capita over time

● Rule of 70 tells us how long GDP/capita takes to double

= 70 / (Annual growth rate of variable)

● Sources

○ Labor productivity (more workers and more productive ones increase GDP)

○ Determined by the amount of technology, physical, and human capital

○ More/better technological, physical, & human capita → more productivity

○ PPC curve is analogous to the LRAS curve. (ex. LRAS shifting right causes the PPC curve to shift to the left)

○ Public policies affecting productivity & # of employed workers. (ex. Unemployment benefits) affect RGDP/capita & economic growth

Supply-Side Fiscal Policies

● When producers focus on employing contractionary fiscal policies to foster increased production

● Affects AD, SRAS, & potential output in the short-run