Unit 5: Long-Run Consequences of Stabilization Policies

Stabilization policy

Use of fiscal policy and/or monetary policy to reduce the severity of recessions and inflationary booms by influencing aggregate demand in the short run.

Fiscal policy

Government changes in spending and taxes intended to affect aggregate demand, real output, and unemployment (especially in the short run).

Monetary policy

Central bank actions that affect interest rates and the money supply, influencing aggregate demand in the short run and inflation in the long run.

Aggregate demand (AD)

Total spending on domestic output at different price levels; shifts in AD change real GDP and the price level in the short run.

Potential output

The level of real GDP produced when unemployment is at the natural rate; the long-run level the economy tends to return to.

Full-employment output

Another name for potential output; real GDP when the economy is at the natural rate of unemployment.

Natural rate of unemployment

Unemployment that persists at potential output; equals frictional plus structural unemployment (not cyclical).

Frictional unemployment

Short-term unemployment from workers transitioning between jobs or entering the labor force.

Structural unemployment

Unemployment caused by mismatches between workers’ skills/locations and job requirements.

Cyclical unemployment

Unemployment caused by downturns in the business cycle; occurs when real GDP is below potential output.

Recessionary gap

Situation where real GDP is below potential output (often after AD shifts left), with higher unemployment and a lower price level in the short run.

Inflationary gap

Situation where real GDP is above potential output (often after AD shifts right), with lower unemployment and a higher price level in the short run.

Short-run aggregate supply (SRAS)

The relationship between the aggregate price level and real output in the short run; shifts when wages and input prices change.

Self-correction

The long-run tendency for the economy to return to potential output as wages and input prices adjust, shifting SRAS.

Factor prices

Costs of inputs used in production (especially wages and resource prices) that influence firms’ costs and SRAS.

Sticky wages/prices

Short-run condition where wages and prices adjust slowly, allowing AD changes to affect real GDP and unemployment.

Flexible wages/prices

Long-run condition where wages and input prices adjust more fully, moving the economy back to potential output.

Aggregate price level

Average level of prices in the economy (e.g., GDP deflator); changes represent one-time shifts in the overall level of prices.

Inflation rate

The rate at which the aggregate price level rises over time (ongoing percentage increase, not a one-time level change).

Demand-pull inflation

Inflation caused by increases in aggregate demand that push the price level upward, especially as the economy nears or exceeds full employment.

Cost-push inflation

Inflation caused by decreases in aggregate supply (SRAS shifts left), raising the price level while lowering real GDP.

Stagflation

Combination of rising inflation and rising unemployment, typically linked to an adverse supply shock (SRAS shifting left).

Supply-side boom

A rightward shift of SRAS (with AD constant) that lowers the price level and raises real GDP, reducing unemployment.

Phillips curve

Model showing the relationship between inflation and unemployment; short-run trade-off can exist, but long-run curve is vertical at the natural rate.

Short-run Phillips curve (SRPC)

Downward-sloping relationship between inflation and unemployment when expected inflation is fixed; AD shifts move the economy along it.

Long-run Phillips curve (LRPC)

Vertical curve at the natural rate of unemployment, implying no permanent inflation-unemployment trade-off in the long run.

Expected inflation

Inflation rate households and firms anticipate; changes in expected inflation shift the SRPC up (higher expectations) or down (lower expectations).

Deflation

Sustained fall in the aggregate price level (negative inflation), often associated with severely weakened aggregate demand.

Disinflation

A reduction in the inflation rate (inflation still positive but falling), often requiring contractionary policy and higher unemployment in the short run.

Sacrifice problem (disinflation cost)

The short-run increase in unemployment/output loss that may occur when reducing inflation, as contractionary policy lowers AD before expectations adjust.

Equation of exchange (MV = PY)

Identity linking money supply (M) and velocity (V) to nominal GDP (P×Y); used in quantity theory to relate money growth to inflation long run.

Velocity of money

Average number of times a dollar is spent per year; computed as V = (P×Y)/M.

Monetary neutrality

Idea that changes in the money supply do not affect real variables (real GDP, unemployment) in the long run, mainly affecting nominal variables (price level, inflation).

Interest-sensitive spending

Spending that responds strongly to interest rates (especially investment), forming a key channel through which monetary policy affects AD.

Private investment

Firm spending on capital goods (factories, equipment); influenced by real interest rates and important for long-run capital accumulation and growth.

Wage-price spiral

Self-reinforcing cycle where higher prices raise wage demands, higher wages raise firms’ costs, and firms raise prices again (often AD right + SRAS left).

Fisher equation

Relationship between nominal interest rate (i), real interest rate (r), and expected inflation (π^e): i = r + π^e.

Fisher effect

Long-run tendency for nominal interest rates to rise when expected inflation rises, as lenders demand compensation for lost purchasing power.

Nominal interest rate

Market interest rate not adjusted for expected inflation; equals real interest rate plus expected inflation (i = r + π^e).

Real interest rate

Inflation-adjusted interest rate; approximately the nominal rate minus expected inflation (r = i − π^e).

Loanable funds market

Model of saving and borrowing where the “price” is the real interest rate and quantity is funds lent/borrowed; used to analyze deficits and investment.

Crowding out effect

When deficit-financed government borrowing raises real interest rates and reduces private investment, potentially lowering long-run growth.

Budget deficit

When government expenditures exceed government revenues in a year (a flow).

Budget surplus

When government revenues exceed government expenditures in a year (a flow).

National debt

Accumulated past budget deficits minus past surpluses; a stock measured at a point in time.

Cyclical deficit

Deficit that occurs because the economy is in a recession (revenues fall and some spending rises automatically); tends to shrink as the economy recovers.

Structural deficit

Deficit that exists even at potential output, reflecting policy choices about spending and taxes; tends to persist unless policies change.

Automatic stabilizers

Budget features that automatically increase deficits in recessions and decrease them in expansions (e.g., progressive taxes, unemployment insurance).

Central bank credibility

How strongly the public believes the central bank will follow through on its policy goals (especially low inflation), affecting inflation expectations and disinflation costs.

Investment tax credit

Tax reduction for firms that invest in new capital; intended to increase investment, capital accumulation, and long-run productive capacity.