AP Macroeconomics Unit 5 – Long-Run Consequences of Stabilization Policies: Ultimate Study Notes

Classical vs. Keynesian View

Classical Economics

• Assumption: Economy is self-correcting in the long run

• Prices, wages, and interest rates are flexible

• No long-term government intervention needed

AP Tip

• Focus on LRAS: economy will naturally return to full employment

Memory Trick

• Classical = Clean self-correction

Keynesian Economics

• Assumption: Economy may stay below full employment for long periods

• Prices and wages are sticky in the short run

• Government intervention (fiscal policy) can help stabilize

AP Tip

• Keynesians focus on short-run gaps and AD management

Memory Trick

• Keynes = Keep economy moving (via policy)

Long-Run Aggregate Supply (LRAS)

Definition

• Vertical at full employment GDP

• Determined by resources, technology, and institutions

• Not affected by price level in the long run

Shifters

• Increase in resources (labor, capital)

• Technological improvements

• Better productivity or institutions

AP Tip

• LRAS shifts → long-term growth

• FRQs may ask to compare short-run vs long-run effects of policies

Long-Run Effects of Fiscal Policy

Expansionary Fiscal Policy

• ↑ Government spending or ↓ Taxes

• Short run: AD ↑ → GDP ↑, price level ↑

• Long run: Economy returns to full employment → mostly inflation, minimal output effect

Contractionary Fiscal Policy

• ↓ Government spending or ↑ Taxes

• Short run: AD ↓ → GDP ↓, price level ↓

• Long run: Economy returns to full employment → mostly price effects

AP Tip

• Remember crowding out: government borrowing ↑ → interest rates ↑ → private investment ↓

Memory Trick

• Expansion → Short-run boost, long-run mostly price

• Contraction → Short-run slowdown, long-run mostly price

Long-Run Effects of Monetary Policy

Expansionary Monetary Policy

• ↑ Money supply → ↓ Interest rates → AD ↑

• Short run: GDP ↑, price level ↑

• Long run: Economy returns to full employment → price level higher, real GDP unchanged

Contractionary Monetary Policy

• ↓ Money supply → ↑ Interest rates → AD ↓

• Short run: GDP ↓, price level ↓

• Long run: Economy returns to full employment → mostly price effects

AP Tip

• Long-run: Monetary policy affects prices, not real GDP

Memory Trick

• Money = Medium for AD in short run, Price changes in long run

Inflation and Expectations

Adaptive Expectations

• People base inflation expectations on past inflation

• Can lead to stagflation if policy mistakes occur

Rational Expectations

• People anticipate effects of policies immediately

• Government policies may be less effective if expected

AP Tip

• FRQs may ask: “Why might a policy fail in the long run?” → think expectations

Memory Trick

• Adaptive = After the fact, Rational = Right away

Long-Run Phillips Curve (LRPC)

Definition

• Shows natural rate of unemployment vs inflation

• Vertical in the long run → no trade-off between unemployment and inflation

Short-Run vs Long-Run

• SRPC: Downward sloping → lower unemployment → higher inflation

• LRPC: Vertical → unemployment returns to natural rate

AP Tip

• Use LRAS diagram to show shift in AD → short-run gap → long-run adjustment

Memory Trick

• SRPC = Short-term trade-off, LRPC = Long-term steady

Key Terms to Remember

• Classical vs Keynesian

• LRAS and shifters

• Fiscal policy: expansionary vs contractionary

• Monetary policy: expansionary vs contractionary

• Crowding out

• Adaptive vs Rational Expectations

• Short-Run vs Long-Run Phillips Curve

Memory Trick

• C-K-L-F-M-C-E-P → Classical, Keynesian, LRAS, Fiscal, Monetary, Crowding out, Expectations, Phillips