Economic Policy and the Aggregate Demand/Supply Model

Economic Policy and the Aggregate Demand/Supply Model

Macroeconomic Policy

• A. Policy in the Face of Demand Shocks• B. Responding to Supply Shocks

Fiscal Policy – The Basics

• A. Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing

• B. The Government Budget and Total Spending• C. Expansionary and Contractionary Fiscal

Policy• A Cautionary Note: Lags in Fiscal Policy


• The Long-Run adjustment back to Yp may take a long time so most economists believe that the government can help expedite the return to full employment and stable prices.

• Stabilization Policy: The use of government policy to reduce the severity of recessions and rein in excessively strong expansions.


• A. Policy in the Face of Demand Shocks– Negative demand shock causes a recessionary

gap.– The price level falls, but so does real GDP.– Unemployment becomes a problem– Government policy (both Fiscal and monetary) is

designed to reverse this decline in AD.– This shortens the duration of a recession.


– Positive demand shocks cause an inflationary gap.– The price level rises and so does real GDP.– Unemployment falls, but I inflation is the real

problem– Again, government policy would be geared toward

reversing the increase in AD– This shortens the duration of an inflationary

period.


• Responding to Supply Shocks– There is very little policy makers can do to reverse

a supply shock– It is much easier to affect spending (through AD)

than it is to affect production (through AS)

– What if we tackled a negative supply shock by trying to influence AD?


• Negative Supply Shocks– Suppose policy makers wanted to shift aD to the

right to fight unemployment.– This would worsen the inflation.– Or suppose policy makers wanted to shift AD to

the left to fight the inflation.– That would only worsen the unemployment– There are no good options here.


• A Key understanding to fiscal policy is to understand its origins.

• Fiscal policy is all about taxation and government spending.

• The President proposes a budget to Congress that includes plans for spending and tax collection.

• Eventually Congress will amend and approve a budget and it becomes law.– This fundamentally differs from monetary policy which is

created by the Federal Reserve, the central bank of the U.S.


• Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing– The government plays a sizeable role in the circular

flow diagram• Government Spending – Like households, the

government spends money on goods and services.

• What are examples of goods and services purchased by the government?


• Local: police cars in your city• State: A system of State Parks• Federal: The Military


• Transfer Payments– The government also provides transfer payments

to some households.– Examples of transfer payments:• Social Security• Medicare• Medicaid• VA benefits,• Food Stamps• Etc.


• Tax Collection– Like households, the government must collect

money in order to pay for this spending.– The Government Collects Taxes– What are some taxes that you or your parents

pay?


• Tax Collection (cont.)• Sales tax• Income tax• Property tax• Vehicle registration tax• Gas• Excise taxes (on liquor or tobacco)• Tax on corporate profits (dividends)


• Like households, the government can borrow to make up for a shortfall in tax revenue that does not pay for all of the spending.

• Government borrowing will be covered in future sections of the course.

Government Budget and Total Spending

• How does the government affect AD?• Remember, if we add up all of the spending in

an economy we get:– C+I+G+(X-M)– G: government purchases of goods and services• This directly affects GDP and thus AD


• Indirectly, the government can influence consumption spending ( C) through taxes and transfers.

• Look at what goes into consumption spending:– A person receives income Y from his/her job– Taxes are paid to the government and sometimes transfer

payments are received by the government.– What is left over is disposable income Yd– Disposable income can now either be consumed or saved– Yd = Y – taxes = C + S or– C = Yd – S

• Remember, when Yd increases, so does C


• So the government can indirectly increase C if it can increase Yd

• How can it increase Yd?– By cutting taxes or by increasing transfer payments– The government can affect investment spending

(I) through tax policy

Expansionary and ContractionaryFiscal Policy

• (Two short-run states of an economy – recessionary gap and an inflationary gap

• Recessionary GAP - fiscal policy should try to shift AD to the right– Expansionary Fiscal Policy normally takes one of

three forms:• An increase in government purchases of goods and

services• A cut in taxes• An increase in government transfers

Expansionary and ContractionaryFiscal Policy

• Inflationary Gap – Fiscal policy should try to shift AD to the left.

• Contractionary fiscal policy, normally takes one of three forms:– A decrease in government purchases of goods and

services– An increase in taxes– A decrease in government transfers

A Cautionary Note: Lags in Fiscal Policy

• Fiscal policy looks easy but in reality it is more difficult because there are important time lags in its use.

• Recognition Lag: The government has to realize that the recessionary gap exists because economic date takes time to collect and analyze, and

• Recessions are often recognized only months after they have begun.

A Cautionary Note: Lags in Fiscal Policy

• Decision Lag: The government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation.

• Implementation Lag: It takes time to spend money.• For example, a road construction project begins with

activities such as surveying that don’t involve spending large sums.

• It may be quite some time before the big spending begins.• By this time, the economy might have already begun self-

correcting back to Yp.

In-Class Activities• Practice Questions:

1. The economy is currently experiencing a recessionary gap.

– List two fiscal policy options that would move the economy closer to potential real GDP

– Describe how your policy would achieve the desired result

2. The economy is currently at a level of output that exceeds potential GDP (Yp).

– List two fiscal policy options that would move the economy closer to potential real GDP.

– Describe how your policy would achieve the desired result.

Documents

Economic Policy and the Aggregate Demand/Supply Model