Solving Recessionary Gaps: Fiscal and Monetary Policy

Recessionary and Expansionary Gaps

Potential vs. Actual Output

• The economy's resources include capital and labor.
• $k^*$: Efficient use of capital.
• 5% unemployment rate: Labor is used to its potential.
• Potential output: Output when resources are used efficiently.
• Analogy: A runner's potential vs. actual speed.
  • Potential: Running 100 meters in 10 seconds.
  • Actual: May vary (sometimes faster, sometimes slower).
• Economy's actual output can vary relative to its potential.

School Example

• A school building designed for 5,000 students.
• Past: Used to be a community college with 5,000 students.
• Present: Fewer than 5,000 students, some classrooms are empty.
• Not using all capital resources efficiently.
• Y < Y^*: Current output is less than potential output.

Recessionary Gap Defined

• $Y - Y^* = \text{negative number}$
• Recessionary gap: Actual output is less than potential output.

Expansionary Gap Defined

• Temporary situation (e.g., summer influx of new students).
• Y > Y^*: Actual output exceeds potential output.
• The outcome is positive.
• Expansionary gap: Temporary.

Natural Rate of Unemployment

• Unemployment rate of 5% or less.
• The economy is performing at full capacity.
• Two types of unemployment present:
  • Frictional
  • Structural
• Cyclical unemployment is not present at the natural rate.
• Analogy: 5% unemployment is like getting an A+ (95% grade).

Policy Options

Fiscal Policy

• Used to solve recessionary gaps.
• Involves government spending and/or tax cuts.
• Examples:
  • The New Deal during the Great Depression: Government spending on projects.

Government Spending

• One approach within fiscal policy.
• Creating jobs by building infrastructure (highways, schools).

Tax Cuts

• Alternative approach within fiscal policy.
• Returning money to people and businesses.
• Idea: People will spend the money and stimulate the economy.
• Stimulus checks during COVID-19 pandemic: Example of tax cuts.

Fiscal Policy: Two Options

• Government spending.
• Tax cuts (sending checks to people).
• The goal is to stimulate the economy.

Monetary Policy

• Implemented by the Federal Reserve.
• Doesn't require Congressional approval.
• Involves Federal Open Market Operations.

Federal Open Market Operations

• Purchase bonds: Increase the money supply.
• Sell bonds: Decrease the money supply.

Keynesian Economics

Keynesian Model

• Developed by John Maynard Keynes.
• $Y = C + I + G + NX$
  • Where:
    • $Y$ is the total output.
    • $C$ is consumption.
    • $I$ is investment.
    • $G$ is government expenditure.
    • $NX$ is net exports.
• Before Keynes, economic problems were considered money or trade issues.
• Keynes argued that an economic problem is caused by one of these components not performing well.
• Keynes advocated for bigger government spending to solve economic problems.

Consumption Function

• $C = C_0 + \alpha(Y - T)$
  • Where:
    • $C$ is total consumption.
    • $C_0$ is autonomous consumption.
    • $\alpha$ is the marginal propensity to consume.
    • $Y$ is income.
    • $T$ is taxes.
• Consumption is a function of disposable income ($Y - T$).

Disposable Income

• Income minus taxes.
• The amount of money you receive after taxes.

Alpha (Marginal Propensity to Consume - MPC)

• The portion of your disposable income that you consume (spend).
• Example: If you earn $100 and spend $90, your $\alpha$ is 90% (0.9).
• $1 - \alpha$: The portion of income you save.

Autonomous Consumption

• Consumption that is not related to income.
• Symbolized as $C_0$.
• If you have no income ($Y = 0$), you still need to consume.
• Examples: Food, rent paid by someone else.

Stimulus Checks and the Consumption unction

• Stimulus checks are based on the consumption function.
• Government assumes you will spend some of the check.
• Research indicates that Americans spend approximately $80 out of every $100 received as a check.
• Marginal Propensity to Consume (MPC): How much of each dollar is spent.