Module 20 economic policy and the aggregate demand aggregate supply model
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This document discusses the rationale for active stabilization policy using fiscal policy to reduce the severity of recessions and control excessively strong expansions. It describes how governments can use expansionary or contractionary fiscal policy through taxes, government spending, and transfers to shift the aggregate demand curve and close recessionary or inflationary gaps. However, it notes there are lags in the implementation and impact of fiscal policy that make its effects hard to predict and could potentially worsen economic situations if not applied carefully.
Module 20 economic policy and the aggregate demand aggregate supply model
- 1. ECONOMIC POLICY AND THE AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL MODULE 20
- 2. MACROECONOMIC POLICY Although the economy is self-correcting in the long- run, this process can take up to a decade or more. Particularly, if output is below potential output, the economy can suffer an extended period of depressed aggregate output an high unemployment during this period of self-correction. John Maynard Keynes: “In the long run we are all dead.” He recommended that governments not wait for the economy to correct itself, but use fiscal policy to get the economy back to potential output more quickly.
- 3. MACROECONOMIC POLICY This is the rationale for active stabilization policy, which is the use of government policy to reduce the severity of recessions and control excessively strong expansions. However, the ability to improve the economy’s performance is not always guaranteed; it depends on the kinds of shocks the economy faces.
- 4. MACROECONOMIC POLICY This is the rationale for active stabilization policy, which is the use of government policy to reduce the severity of recessions and control excessively strong expansions. However, the ability to improve the economy’s performance is not always guaranteed; it depends on the kinds of shocks the economy faces.
- 5. POLICY IN THE FACE OF DEMAND SHOCKS If policy makers react quickly to a negative demand shock, they can use monetary or fiscal policy to shift the aggregate demand curve back to the right. If it was possible to anticipate shifts of the AD curve and counteract them, it could short-circuit the whole process of going through a period of low aggregate output and falling prices. This is desirable because: 1. The temporary fall in aggregate output is associated with high unemployment. 2. Price stability is regarded as a desirable goal (avoiding deflation-a fall in the aggregate price level.
- 6. POLICY IN THE FACE OF DEMAND SHOCKS However, some policy measures to increase aggregate demand may have long-term costs in terms of lower long-run growth. It also could be that the policy-makers are not perfectly informed, and the effects of their policies are not perfectly predictable. This could cause the attempts to create more stability to end up creating more instability. Despite this, many economists believe in the use of macroeconomic policy to offset major negative shocks to the AD curve.
- 7. RESPONDING TO SUPPLY SHOCKS The effect of a negative supply shock is to lower aggregate output but increase to a higher aggregate price level. Two bad things happen simultaneously: a fall in aggregate output leads to a rise in unemployment, and a rise in the aggregate price level decreases the purchasing power of incomes. In contrast to the case of a demand shock, there are no easy remedies for a supply shock. This means that there are no government policies that can easily counteract the changes in production costs that shift the SRAS curve.
- 8. RESPONDING TO SUPPLY SHOCKS Using monetary or fiscal policy to shift the AD curve would do one of two things: a) A policy to increase AD to limit the rise in unemployment would reduce the decline in output but cause even more inflation. b) A policy to decrease AD, it curbs inflation but causes a further rise in unemployment. This is then a trade-off with no right answer; it requires facing harder choices than usual. In the end, economic policy eventually chooses to stabilize prices at the cost of higher unemployment.
- 9. FISCAL POLICY: THE BASICS Modern governments spend a great deal of money and collect a lot in taxes. Changes in the federal budget (in government spending or in taxation) can have large effects on the economy by affecting the economy’s flow of income. Funds flow into the government in the form of taxes and government borrowing, and funds flow out of the government in the form of government purchases of goods and services and government transfers to households.
- 10. TAXES, GOVERNMENT PURCHASES OF GOODS AND SERVICES, TRANSFERS, AND BORROWING Taxes are required payments to the government: a) At the federal level, the main taxes are income taxes on both personal income and corporate profits, as well as social insurance taxes. b) At the state and local levels, governments rely on a mix of sales taxes, property taxes, income taxes, and fees of various kinds.
- 11. TAXES, GOVERNMENT PURCHASES OF GOODS AND SERVICES, TRANSFERS, AND BORROWING Government spending takes two forms: a) Purchases of goods and services. b) Government transfers, which are payments by the government to households for which no good or service is provided in return. Most US government spending on transfer payments is accounted by three big programs: 1. Social Security 2. Medicare 3. Medicaid Social Insurance are government programs that are intended to protect families against economic hardship (Social Security, Medicare, Medicaid, unemployment insurance, and food stamps.
- 12. THE GOVERNMENT BUDGET AND TOTAL SPENDING Remember that GDP = C + I + G + X – IM The right-hand side is aggregate spending, the total spending on final goods and services produced in the economy. The government directly controls on of the variables in the aggregate spending: government purchases of goods and services (G). But that is not the only effect fiscal policy has on aggregate spending: through changes in taxes and transfers, it influences consumer spending (C) and in some cases, investment spending (I).
- 13. THE GOVERNMENT BUDGET AND TOTAL SPENDING Disposable income (total income households have available to spend) is equal to the total income they receive from wages, dividends, interest, and rent, minus taxes, plus government transfers. Either an increase in taxes or a decrease in government transfers reduces disposable income, which leads to a fall in consumer spending. Either a decrease in taxes or an increase in government transfers increases disposable income, which leads to a rise in consumer spending. The government´s ability to affect investment spending comes from taxing profits, which can increase or reduce the incentive to spend on investment goods.
- 14. EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY Therefore, the government can use changes in taxes or government spending to shift the AD curve. Expansionary fiscal policy: Government would want to shift the AD curve to the right to close a recessionary gap, when aggregate output falls below potential output. This would increase aggregate output, making it equal to potential output. Contractinary fiscal policy: Government would want to shift the AD curve to the left to close an inflationary gap, when aggrgate output exceeds potential output. This would decrease aggregate output, bringing it back to potential output.
- 15. EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY Expansionary fiscal policy may be implemented by: 1. An increase in government purchases of goods and services 2. A cut in taxes 3. An increase in government transfers Contractionary fiscal policy may be implemented by: 1. A reduction in government purchases of goods and services 2. An increase in taxes 3. A reduction in government transfers
- 16. LAGS IN FISCAL POLICY Many economists caution against an extremely active stabilization policy, arguing that overly agressive fiscal or monetary policy to stabilize the economy may end up making the economy less stable. In the case of fiscal policy, there are important time lags (problems with timing): 1. The recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence. 2. The administrative lag is the difficulty in changing policy once the problem has been recognized and policy is implemented 3. The operational lag is the time elapsed between change in policy and its impact on the economy.
- 17. LAGS IN FISCAL POLICY Because of these lags, an attempt to increase spending to fight a recessionary gap may take so long that the economy is already recovering by the time policy begins to act, which may turn the recessionary gap into an inflationary gap , which will make things worse off instead of better. An attempt to decrease spending to close an inflationary gap may take so much time that the economy is already recovering on its own, and this policy may push an economy into a recession, which again would worsen the situation, instead of making it better. Therefore, fiscal policy must be used carefully, as both fiscal and monetary policy are harder to implement than appears with the simple explanation given.