Unit 5: Long-Run Consequences of Stabilization Policies

5.1: Fiscal and Monetary Policy Actions in the Short-Run

Although the economy may seem stable to the common man, when we take a closer look at it there are several ways that we can improve the condition of the economy in the short and long term. It can be corrected through fiscal policy, which is carried out by Congress and the President, through monetary policy, which is carried out by the Federal Reserve, or it can self correct itself.

If we use fiscal policy to correct our economy, it is done through government spending or taxation. If we are looking to speed up our economy because we are in a recessionary gap (negative gap output), we need to increase spending, decrease taxes, or a combination of these two things. When we increase spending or decrease taxes, then that will lead to an increase in either consumer spending, investment spending, or government spending. This will increase the aggregate demand (AD). 

If we are looking to slow down our economy because we are in an inflationary gap (positive output gap), then we need to decrease spending, increase taxes, or a combination of these two things. When we decrease spending or increase taxes, then that will lead to a decrease in either consumer spending, investment spending, or government spending. This will decrease aggregate demand (AD).

If we use monetary policy, we can use one of the tools of the Federal Reserve. The most popular tools of the Federal Reserve are the reserve ratio (requirement), discount rate, and open market operations. If we are looking to speed up an economy that is in a recessionary gap, we can decrease the reserve ratio, decrease the discount rate, or buy bonds. This will cause the money supply to increase, which will lower interest rates. With lower interest rates, consumers and firms will be more willing to spend money, and we will see an increase in both consumer and investment spending which will increase aggregate demand (AD). 

If we are looking to slow down an economy that is in an inflationary gap, we can increase the reserve ratio, decrease the discount rate, or sell bonds. This will cause the money supply to decrease, which will raise interest rates. With higher interest rates, consumers and firms will be less willing to spend money, so we will see a decrease in both consumer and investment spending which will decrease aggregate demand (AD).

Finally, if we let the economy self correct itself, we are letting wages naturally increase or decrease in the long run, which will cause the SRAS (short-run aggregate supply curve) curve to either increase or decrease.

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Fiscal and Monetary Policy Actions in the Short-Run

 is a graph that shows how inflation rates and unemployment rates are related to each other, both in the short-run and long-run. It is actually just a reflection of the AD/AS graph. In the short-run, there is a trade-off between inflation and unemployment.

Inflation is low when unemployment is high because fewer people are working, and there is less demand for goods and services. As a result, prices don't rise as fast. When unemployment gets lower, inflation gets higher because so many more people have jobs and the money to spend on things. This means that there is a higher demand for goods and services, which increases prices.

The AS/AD graph and the Phillips curve have a lot in common. In the AS/AD graph, a decrease in AD causes a change in equilibrium from point A to point B. The same change in AD that causes the price level (PL) to fall and the real GDP to fall causes inflation to fall but unemployment to rise. This is mirrored on the short-run Phillips curve with a movement from point A to point B. See graph below.

In the AS/AD graph, an increase in AD causes a change in equilibrium from point A to point B. The same change in AD that causes the price level (PL) to increase and the real GDP to increases causes inflation to rise but unemployment to fall. This is mirrored on the short-run Phillips curve with a movement from point A to point B.

Whenever something makes the SRAS curve shift right or left, the short-run Phillips Curve (SRPC) shifts in the opposite direction. If the SRAS curve shifts right, the SRPC will shift left. If the SRAS curve shifts left, the SRPC will shift right. 

An increase in the SRAS curve, a shift to the right of this curve, will result in a leftward shift of the SRPC curve. 

A decrease in the SRAS curve, a shift to the left of this curve, will result in a rightward shift of the SRPC curve.

The long-run Phillips curve (LRPC) shows that, in the long-run, there is no trade-off between inflation and unemployment. The LRPC exists at an economy's natural rate of unemployment, which just so happens to correspond to full employment and the LRAS. The graph below shows an LRPC at the economy's natural rate of unemployment of 5%. When an economy's natural rate of unemployment changes, so does LRPC. The LRPC tells us that policies to change the level of employment in the economy will ultimately result in only changes in the inflation rate.

The Phillips Curve

The equation for the quantity theory of money is M x V = P x Y.  M stands for the money supply (usually M1). V stands for the velocity of money. P stands for price, and Y stands for real output. So, the quantity theory of money is the money supply times the velocity of money equals the price level times the real output. So at a constant velocity and GDP, an increase in the money supply will lead to a proportional increase in prices.
Velocity of money is the average times a dollar is spent and re-spent in a specific period of time.

So let's assume the money supply is $40, and it's used to purchase 10 products with a price of $20 each.  Calculate the velocity of money.

Money Growth and Inflation

The Federal budget is the recorded projection of all government expenditures and revenues over the course of a 12 month period. The fiscal year begins on October 1st.

When there is an existence of a large national debt, it will affect government spending in the future.  Future spending will fall. Since a government must pay interest on its accumulated debt, this means that the government will not have those funds for alternative uses.

Deficits and the National Debt

The crowding-out effect is the economic theory that public sector spending can lessen or eliminate private sector spending. For example, the government just borrowed a good portion of the bank’s loanable funds. You go to the bank for a car loan, however, the interest rate increased because the government owns a large portion of the funds. You decide not to buy the car because the monthly payments and interest rates are too high. Other people make the same decision as you. This causes the demand for cars to drop and auto workers are laid off.

The graph on the left shows an economy in a recessionary gap. The graph in the middle shows the rightward shift of aggregate demand (AD) that can correct a recessionary gap when the government increases its spending in order to get the economy moving again. The graph on the right shows what can happen when crowding out occurs. Instead of government spending correcting the economy, they choose to spend money on a good or service that will decrease or eliminate private spending, causing the economy to move only from AD to AD2. When crowding out occurs, the economy does not quite get back to long-run equilibrium.

Crowding Out

Economic growth is seen by a rightward shift of the LRAS (Long-run aggregate supply)* curve. This corresponds to a rightward shift of the Production Possibilities Frontier.

Economic Growth

There are three types of public policy that can promote economic growth: 

Supply-side fiscal policies are laws designed to increase output by shifting SRAS and LRAS by lowering taxes for businesses.

Public Policy and Economic Growth

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