MODULE 20 Economic Policy and the Aggregate Demand—Aggregate Supply Model

2. MODULE 20Economic Policy and the Aggregate Demand—Aggregate Supply Model

3. How the AS–AD model is used to formulate macroeconomic policy • The rationale for stabilization policy • Why fiscal policy is an important tool for managing economic fluctuations • Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy

4. Macroeconomic Policy • Economy is self-correcting in the long run. • Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

5. Macroeconomic Policy • Policy in the Face of Demand Shocks • If policy were able to perfectly anticipate shifts of the aggregate demand curve and counteract them, the period of low aggregate output and falling prices could be avoided. • Price stability is generally regarded as a desirable goal.

6. Macroeconomic Policy • Responding to supply shocks: • There are no easy policies to shift the short-run aggregate supply curve. • Policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

7. Government Spending and Tax Revenue for Some High-Income Countries in 2006

8. Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing • Funds flow into the government in the form of taxes and government borrowing • Funds flow out of the government in the form of government purchases of goods and services and government transfers to households

9. Sources of Tax Revenue in the U.S., 2008

10. Government Spending in the U.S., 2008 Social insurance programs are government programs intended to protect families against economic hardship.

11. The Government Budget and Total Spending • Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.

12. Expansionary and Contractionary Fiscal Policy • Expansionary fiscal policy increases aggregate demand and can take one of three forms: • an increase in government purchases of goods and services • a cut in taxes • an increase in government transfers • Contractionary fiscal policy reduces aggregate demand and can take one of three forms: • a reduction in government purchases of goods and services • an increase in taxes • a reduction in government transfers

13. Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap Expansionary fiscal policy increases aggregate demand. Recessionary gap 13 of 17

14. Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap Contractionary fiscal policy reduces aggregate demand. Inflationary gap 14 of 17

15. A Cautionary Note: Lags in Fiscal Policy • In the case of fiscal policy, there is an important reason for caution: there are significant lagsin its use. • Realize the recessionary/inflationary gap by collecting and analyzing economic data  takes time • Government develops a spending plan takes time • Implementation of the action plan (spending the money  takes time)

16. Many economists advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. • Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump. • Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. • Expansionary fiscal policy shifts the aggregate demand curve rightward. • Contractionary fiscal policy shifts the aggregate demand curve leftward.