Unit 5 Long–Run Consequences of Stabilization Policies 🪙

Topic 5.1 Fiscal and Monetary Policy Actions in the Short Run

• Why are policies implemented?

  • A policy is implemented to close output gaps.

  • If we have. a recessionary gap, lower unemployment

  • If we have an inflationary gap, lower inflation.

• How are policies implemented?

  • A fiscal policy manipulates aggregate demand by changing spending and taxes.

  • A monetary policy manipulates aggregate demand by changing interest rates.

• A combination of expansionary or contractionary fiscal and monetary policies may be used to restore full employment when the economy is in an inflationary or recessionary output gap.

• In a recessionary gap, increase spending, lower taxes, increase aggregate demand, and decrease unemployment.

• In an inflationary gap, decrease spending, increase taxes, decrease aggregate demand, and decrease price level.

• A combination of fiscal and monetary policies can influence aggregate demand, real output, price level, and interest rates.

Topic 5.2 The Phillips Curve

• The short-run phillips curve shows the inverse relationship between inflation and unemployment.

  • As inflation decreases, unemployment increases.

  • When inflation is high, it means that the value of dollars decreases.

  • Erosion in purchasing power causes wages to go down in value. as well as the cost of materials

  • When inflation increases, companies can hire new workers, they can expand production

  • So, the interest or the inflationary rate goes down in value, unemployment increases.

• The rate of inflation and unemployment (a point on the curve) moves up or down as GDP or AD changes.

• The long run phillips curve shows the natural rate of unemployment.

  • It is also called full employment.

• There is an equilibrium hen the SRPC and the LRPC intersect.

• An inflationary gap is on the left of the SRPC.

• A recessionary gap is on the left of the SRPC.

Topic 5.3 Money Growth and Inflation

• An inflation or deflation is an increase or decrease in price level.

• Inflations or deflations result from increasing or decreasing the money supply at a very rapid rate for a sustained period of time.

• A demand pull inflation occurs when aggregate demand increases faster than the economy’s capacity to produce.

  • More government spending.

  • Increased consumer confidence.

  • Lower taxes.

  • Lower interest rates.

• A cost push inflation occurs when the cost of production increases. Also known as stagflation because inflations occurs with production issues.

  • Rising wages

  • Oil/commodity price shocks.

  • Supply chain shortages.

  • Natural disasters.

• Theory of money neutrality explains why printing more money doesn’t actually help economic growth in the long run.

  • Doubling the money supply doubles all prices, but nothing “real” changes — no rise in output or employment.

  • Households’ purchasing power stays the same because wages and prices rise together.

  • Firms face higher costs but also get more revenue — so production doesn’t change.

• This theory supports the idea that inflation is a monetary phenomenon.

• When the economy is in long run equilibrium/full employment, changes in the money supply have no effect on real output in the long run.

• In the long run, the growth rate of the money supply determines the growth rate of the price level (inflation rate) according to the quantity theory of money.

• Equation of Exchange: MV=PY

  • M = money supply.

  • V = velocity of money.

  • P = price level.

  • Y = real output.

• In the long run, changes in the price level are directly proportional to changes in the money supply.

• In the long run, change in the money supply have enough effect on real variables.

• In the short run:

  • Expansionary monetary policy can increase output and lower unemployment.

  • This helps fix recessionary gaps temporarily.

• In the long run:

  • The economy returns to full employment.

  • Real GDP returns to the natural rate (Y stays the same).

  • All that’s left is a higher price level.

  • Consistent with the quantity theory and monetary neutrality.

• U.S. 2008-2020: Large monetary stimulus, but low inflation due to low velocity and underutilized resources.

• COVID stimulus: Boosted demand faster than supply increased, which led to inflation concerns.

Topic 5.4 Government Deficits & National Debt

• The total amount owed or an accumulation of deficits and surpluses is debt.

• When spending is greater than income, we have a deficit.

• When income is greater than spending, we have a surplus.

• A statement or plan of a government’s receipts and expenses required to function is budget.

• The difference between tax revenue and government spending is the government budget balance.

  • Government receipts, revenue, and income is earned through taxes.

  • Government expenses or outlays are government spending and transfers.

• The state of the government budget balance can be in 3 states.

  • Balanced budget: income=expenses.

  • Budget surplus: income, revenue, taxes> expenses, outlays, and transfers.

  • Budget deficit: expenses, outlays, and transfers> income, revenue.

• A government adds to the national debt when it runs a budget deficit.

• An expansionary fiscal policy leads to a budget deficit. I

• A contractionary fiscal policy leads to a budget surplus.

• Over time, continuous deficit spending is what creates the national debt.

Topic 5.5 Crowding Out

• When government borrowing raises real interest rates and reduces private investment, the government is crowding out.

• It happens most often during expansionary fiscal policy when the government increases spending or runs a deficit to stimulate the economy.

• The higher interest rates make it harder for households and businesses to borrow, which pulls down investment spending—especially on interest-sensitive things like capital purchases, construction, or consumer durables.

• Government borrowing can be seen in the loanable funds market.