AP Macro Unit 5 - Long-Run Consequences of Stabilization Policies

Recessionary Gap Fiscal Policy Actions and Outcome

Recessionary Gap Fiscal Policy Actions and Outcome

• ACTIONS: Government spending increases AND/OR taxes decrease

• OUTCOME: Aggregate Demand (AD) increases

Inflationary Gap Fiscal Policy Actions and Outcome

• ACTIONS: Government spending decreases AND/OR taxes increase

• OUTCOME: Aggregate Demand (AD) decreases

Recessionary Gap Monetary Policy Actions and Outcome

• ACTIONS: Reserve Ratio decreases, Discount Rate decreases, AND/OR the Federal Reserve buys bonds

• OUTCOME: Money supply increases, which lowers interest rates, which increases Aggregate Demand (AD)

Inflationary Gap Monetary Policy Actions and Outcome

• ACTIONS: Reserve Ratio increases, Discount Rate increases, AND/OR the Federal Reserve sells bonds

• OUTCOME: Money supply decreases, which raises interest rates, which decreases Aggregate Demand (AD)

Recessionary Gap No Policy (Self Correcting) Actions and Outcome

• ACTIONS: Wages will drop

• OUTCOME: Short-run Aggregate Supply (SRAS) will shift outwards/decrease

Inflationary Gap No Policy (Self Correcting) Actions and Outcome

• ACTIONS: Wages will increase

• OUTCOME: Short-run Aggregate Supply (SRAS) will shift inwards/increase

Phillips Curve

• A graph that shows how inflation rates and unemployment rates are related to each other in the short-run and long-run

Stagflation

• When inflation AND unemployment are high

• The economy is on the verge of collapsing at this point

Why is inflation low when unemployment is high?

• Fewer people are working, so there’s less demand for goods and services. Therefore, prices don’t rise as fast

Why is inflation high when unemployment is low?

• Many more people have jobs and have the money to spend on things, so there is a higher demand for goods and services, which increases prices

ADAS Graph and Philips Curve relationship

• When AD decreases, that signals that unemployment is increasing AND inflation is decreasing, so the short-run Philips Curve point shifts to the right (BUT NOT THE CURVE ITSELF)

• When AD increases, that signals that unemployment is decreasing AND inflation is increasing, so the short-run Philips Curve point shifts to the left (BUT NOT THE CURVE ITSELF)

• When the SRAS shifts in one direction, the SRPC will shift in the opposite direction

Long-Run Philips Curve (LRPC)

• Shows that in the long-run, there is no trade-off between inflation and unemployment - it exists at an economy’s natural rate of unemployment and with correspond with the LRAS

Demand Pull Inflation

• Caused by an increase in consumer demand

• Happens when Aggregate Demand shifts to the right with consumers spending more, causing the Price Level AND RGDP to increase

• Thought to be caused by too much government deficit spending, because government spending usually drives up Aggregate Demand

Cost Push Inflation

• Happens when production is decreased (or input costs increased, causing a decrease in the amount of production)

  • Can be caused by labor or natural resource shortages or natural disasters - anything that disturbs production and decreases supply

• Causes the Price Level to increase but RGDP to decrease

• A bit harder to fix

Wage-Price Spiral

• Worst case scenario - a self-perpetuating spiral where demand rises and supply goes down

  • Demand-pull and cost-push work together

• This causes everything to rise in price, meaning that individuals would want higher wages to afford the high costs, which pushes prices up further because it’s more expensive to produce with higher wages, and it becomes a circle

• Double-shifting graph - both AD and SRAS

Inflation due to Changes in the Money Supply

• Can also happen due to changes in the money supply

  • Every time the money supply increases or decreases, price level can be indirectly affected

• When the money supply increases, interest rate decreases and quantity of money increases, leading to an increase in price, increasing inflation

• When money supply decreases, interest rate increases and quantity of money decreases, leading to a decrease in price, decreasing inflation

Theory of Monetary Neutrality

• Increase in money supply increases price level almost proportionately, including the price of labor, which will increase the cost of production, but also increase revenue because selling prices are higher

  • Same with households - their income has increased, but the price of their groceries have increased as well

• A change in the money supply actually has no effect in the economy and only dollar values are changed

Quantity Theory of Money Equation

M x V = P x Y

• M = money supply (usually M1)

• V = velocity of money

• P = price

• Y = real output (sometimes T), or RGDP

Quantity Theory of Money

• Money supply times the velocity of money is equal to the price level times the real output

• At a constant velocity and GDP, and increase in the money supply will lead to a proportional increase in prices

  • Inflation is proportional to the growth rate of the money supply

Velocity of Money

• The average times a dollar is spent and re-spent in a specific period of time

• If the tendency to save is high (and consume is low), the velocity is lower

• If the tendency to save is low (and consume is high), the velocity is higher

Federal Budget

• The recorded projection of all government expenditures and revenues over the course of a 12 month period

• The fiscal year begins October 1st

Fiscal Stimulus

• The use of expansionary fiscal policy

  • Increase in government spending

  • Decrease in personal taxes

  • Increase in income transfers

Fiscal Restraint

• The use of contractionary fiscal policy

  • Decrease in government spending

  • Increase in personal taxes

  • Decrease in income transfers

Government Revenue

• The total income gained by the government at all levels through tax policies, including income taxes, excise taxes, and regulatory taxes

Government Expenditures

• The total spending payments made by the government at all levels, including discretionary and non-discretionary purchases

Budget Surplus

• When the government has more revenue gained than expenditures spent

• The government spent less than what was received

What happens to excess tax revenue when the government has a budget surplus?

• It is used to help pay off any national debt the nation holds

Budget Deficit

• When the government has spent more expenditures than gained in revenue

• The government spent more than what was received

• When the government is in deficit, it will borrow even more money, increasing the national debt

National Debt

• The accumulation of deficits over multiple years

  • If there is a large amount of national debt, it will impact government spending in the future, causing it to fall

Mandatory Spending

• Certain areas where the government is required to spend a certain amount of money each year

  • The US government is required to use spending for social security, Medicare, and interest on national debt

Discretionary Spending

• Government spending that is non-essential that lawmakers have decided to use money for

Why is it not ideal to ALWAYS balance the federal government budget?

• Because it would cause a cycle of inflation and recession, and sometimes it is better to go into deficit or surplus to stabilize the economy

Does the Federal Government have to balance their budget? Do state and local governments have to balance their budget?

The Federal Government does NOT have to balance their budget.

MANY state and local governments DO have to balance their budget. This can mean that some state actions might outdo work done by the federal government to stabilize the economy, which the state must do by law.

Crowding Out Effect

• The economic theory that public sector spending can lessen or eliminate private sector spending

• The cancelling out of EXPANSIONARY policy

• When the government increases its demand for loanable funds, it reduces the amount of loanable funds available for private investors because the increased demand raises interest rates, decreasing demand in the private sector, so national economic growth is not occurring and reduces AD

Long Run Impact of the Crowding Out Effect

• Economic growth

  • Economic growth can be severely reduced if crowding out goes on for a long time, widening a recessionary gap because more people are spending rather than saving/investing, decreasing AD

  • The government can increase government spending, but that will require loans, and it cancels out

• Infrastructure

  • Private investments decrease from crowding out, so more private firms will be discouraged from participating in infrastructure building due to low investment or its unprofitable nature - leads to a decrease/inefficiency in building this like roads, hospitals, etc. and decrease infrastructure quality

Real GDP per capita over time

• How growth is measured

• If it’s grown, then the economy has grown as well

Real GDP per capita over time Equation

(Real GDP) / (population)

What Economic growth can look on graphs

• LRAS - shifts to the right

• PPC Curve - shifts to the right

• Aggregate Production Function - shifts upwards

Aggregate Production Function

• A function that shows the relationship between production and capital

• Another way to show long-run economic growth

• Shows aggregate employment and aggregate output are directly related

  • More workers produce more if all other factors are constant

• Calculates what inputs efficiently produce outputs

• When it shifts upwards, there is an increase in productivity and economic growth

Productivity

• Determined by the amount of technology and physical and human capital per worker

• Measurement of how much stuff can be produced by one worker in a given amount of time

Factors of Productivity

• TAAN

  • All of these require money - saving and investing are important to fund these things for productivity

• Technology

  • Advancement could increase productivity

• Amount of physical capital

  • The man-made objects a company buys to help produce products - increase in physical capital would increase productivity

• Amount of human capital

  • The resources people provide (education, experience, etc.) - if the workers are more educated or skilled, productivity would increase

• Natural Resources

  • A lack of resources would create a struggling economy

Public Policies that can promote economic growth

• Increase in education spending

• Increase in infrastructure spending

• Policies that spur innovation

• Increasing employment

Increase in education spending - public policy

• Increasing investment in the education of workers make more effective workers that can produce more and increase in labor quality - leads to economic growth

Increase in infrastructure spending - public policy

• Increasing investment in improving/creating infrastructure can help improve the speed and ability to transport goods and resources

• This raises government spending and contributes to economic growth in the long-run

Policies that spur innovation - public policy

• Policies that promote innovation, such as protecting patents, private companies have greater incentive to create and sell, increasing economic growth

Increasing employment - public policy

• Increasing employment means more workers, which increases productivity, leading to economic growth

Supply-side Fiscal Policy

• Laws that are designed to increase output by shifting SRAS and LRAS by lowering taxes and reducing regulations for businesses and firms to increase production and therefore increase supply

• Supply increases, RGDP increases, and PL decreases

• States that by shifting supply to the right, AD and AS and output are all affected (increase) in the short run

• Increases GDP without high inflation

Investment tax credit

• Reduces a firm’s taxes if it invests - encourages investment