15
Tip
Students may wonder why we have recessions and inflations if fiscal policy can be used against them. The answer is that fiscal policy has drawbacks and is not completely effective. One drawback of fiscal policy is that the same policies that fight recessions promote inflation. And if the economy is suffering from stagflation, recession, and inflation simultaneously, fiscal policy can address only one of these problems while making the other worse.
marginal propensity to consume
The - (MPC) is how much is spent out of an extra dollar of income. Young people are well known to have an MPC = 1. Give them an extra dollar, and it is spent. But middle-aged people thinking about their retirement or their children's education may save 15 cents out of any extra dollars they may earn, giving them an MPC = 0.85.
marginal propensity to save
The -(MPS) is simply 1 − MPC. If the MPC is 0.85, then the MPS = 0.15. That is, given an extra dollar of income, 15 cents will be saved.
long runq
The Phillips curve portrays the tradeoff between inflation and unemployment in the short run. In the -, it is doubtful that such a relationship exists. Consider (as in Figure 15.7) an increase in aggregate demand with a long-run aggregate supply curve:
To close an inflationary gap with fiscal policy...
The aggregate demand curve should be shifted to the left
To close a recessionary gap with fiscal policy...
The aggregate demand curve should be shifted to the right
Surplus
The appropriate fiscal policy to close an inflationary gap is to decrease government spending and/or increase taxes. These policies would result in a - where government tax collections exceed government spending. This would slow the economy by curtailing the amount of spending that occurs. The aggregate demand curve shifts to the left when the gov- ernment decreases its level of spending or raises taxes. This is shown in Figure 15.4.
Automatic stabilizers
government policies already in place that promote deficit spending during recessions and surplus budgets during expansions
Deficit
situation that exists when government spending exceeds tax revenues
Surplus
spending by the government that is less than tax revenues
Stagflation.
term used to describe the situation when the economy experiences inflation and a recession simultaneously
Marginal propensity to consume (MPC)
the amount of an extra dollar of income that is spent
Multiplier
the degree of magnification that an initial change in spending will have on the economy
balanced budget multiplier
the factor by which a change in both spending and taxes changes real GDP
Rational expectation
the idea that households and businesses will use all the informa- tion available to them when making economic decisions
Crowding out
the increase in interest rates and subsequent decline in spending that occur when the government borrows money to finance a deficit
Phillips tradeoff
the inverse relationship between inflation and unemployment
rational expectations
the theory that people optimally use all the information they have, including information about government policies, when forecasting the future
Inflationary gap
what occurs when the equilibrium quantity of output is above potential output
Recessionary gap
what occurs when the equilibrium quantity of output is below potential output
inflationary gap
when aggregate output is above potential output
Tip
you can take the shortcut: the balanced-budget multiplier is equal to 1. This means an increase in government spending of x dollars that is matched by an increase in tax revenues of x dollars results in an increase in real GDP of x dollars. Based on the same reasoning, a decrease in government spending of x dollars that is matched by a decrease in tax revenues of x dollars results in a decrease in real GDP of x dollars.
Tip
Recent AP exams have tested students' understanding of crowding out by asking questions concerning the market for loan- able funds.
Unemloyment is up
"Output is lower"
Supply-side economics
- is an attempt to shift the aggregate supply curve to the right to cure stagflation. Supply-side economists recommend special tax policies and less government regulation to accomplish the task. So far, however, these policies have not been fully tested.
Stagflation
- shifts the phelps curve to the right
Tip
. The higher rates of interest induce consumers and businesses to borrow and spend less than before
Tip
After the aggregate demand curve shifts to the left, the new equilibrium is where all three curves cross. The new level of output is Qf and there is no longer an inflationary gap; in fact,the price level is lower at the new equilibrium. This fall in prices is the inflation being cured.
Tip
After the aggregate demand curve shifts to the right, the new equilibrium occurs where all three curves cross
Tip
Automatic stabilizers work to prevent business cycles from becoming too extreme in either direction. Many economists credit automatic stabilizers, not fiscal policy, for the decreased amplitude of business cycles since World War II.
Tip
Be careful not to say that an increase in government spending increases the money supply. It does not. An increase in government spending increases aggregate demand which, in turn, increases real GDP, income, and prices in the short run. But the money supply is unchanged.
The appropriate fiscal policy to remedy a recession
Calls for the federal government to run a deficit
Initial change in spending *multiplier
Change in real GDP=
Tip
Crowding out and rational expectations can make fiscal policy completely or partially ineffective. Crowding out refers to the rise in borrowing costs to firms and households after the government borrows to deficit spend. Higher borrowing costs can result in lower spending by households and firms that would offset the expansionary fiscal policy. Rational expectations assume that people and firms will know that an expan- sionary fiscal policy will result in higher prices. Because prices are expected to be higher in the future, people work less and firms supply less right now. They would prefer to work and supply more later when wages and prices are higher. The reduction in supply offsets the expansionary fiscal policy.
Tip
Crowding out can render fiscal policy ineffective. Crowding out is the increase in interest rates and subsequent decline in spending that occur when the government borrows money to finance a deficit.
Tip
Do not confuse the supply and demand for loanable funds with the supply and demand for money. The supply of money is vertical because the Federal Reserve controls it. The supply of loanable funds is upward sloping because loans can come from many sources.
Tip
Economists are now able to explain why the Phillips relationship holds in some periods and not in others. Notice that when the aggregate demand curve shifts to the left, it results in the price level falling (lower inflation) and the quantity of output falling (higher unemployment). When the aggregate demand shifts to the right, just the opposite occurs— inflation rises and unemployment falls. All of this is in line with what Phillips discovered. This indicates that the aggregate demand curve must have been shifting about in the United States in the 1960s, while the aggregate supply curve remained stable.
tip
Recent AP exams have tested students' understanding of crowding out by asking questions concerning the market for loan- able funds.
Q1>Qf
Recessionary gap
Tip
Stagflation occurs whenever the aggregate supply curve shifts to the left. Since both infla- tion and unemployment are rising, this defies the Phillips relationship, which concludes that unemployment and inflation move in opposite directions.
Tip
Expecting higher prices for their labor and products, people and firms reduce their sup- ply of labor and products right now. This causes the aggregate supply curve to shift to the left. The shift to the left of the aggregate supply curve occurs simultaneously with the shift to the right of the aggregate demand curve. The result is we move from E1 directly to E3. The quantity of output never increases; it remains unchanged. Only prices rise because of the fiscal policy. The validity of the theory of rational expectations is still very much in question despite Professor Lucas having won the Nobel Prize for his development of it. However, the more people and firms in the economy who use the information available to them, the less effective fiscal policy will be. Along with the Phillips curve and crowding out, rational expectations are one more reason to suspect that fiscal policy will not work to cure all recessions or inflations.
Vertical
Fig. 15.7 The Phillips Curve Is - in the Long Run since Changes in Aggregate Demand Affect Only Prices
close
Fiscal policy could be used to - the recessionary gap.
government run a deficit by spending more and/or lower tax collections.
Fiscal policy is just one of several options policymakers can use to address economic concerns such as unemployment or inflation. The appropriate fiscal policy to combat unemployment and recessions is to have the -To fight inflation, the government should run a surplus by cutting government spending and raising tax rates. These policies shift the aggregate demand curve to a more suitable position.
Close
Fiscal policy to - an inflationary gap
Unemployment, and inflation
Fiscal policy, however, has its drawbacks. We have already seen that a fiscal policy designed to remedy a recession will result in inflation. Similarly, a fiscal policy designed to combat inflation will result in declines in output and possibly a recession. It seems that fiscal policy cannot remedy both - and - at the same time.
shifts right.
If either aggregate supply curve shifts left, the Phillips curve -
shifts left.
If either aggregate supply curve shifts right, the Phillips curve -
Tip
If fiscal policy is used to combat the recession during stagflation, then inflation will be taken to even higher levels. This is a major drawback of fiscal policy. It cannot cope with stagflation because it can remedy only one problem at the expense of another.
slides down the Phillips curve.
If the aggregate demand curve shifts left, the economy -
economy slides up
If the aggregate demand curve shifts right, th- the Phillips curve.
automatic stabilizers.
Income taxes and antipoverty programs such as Temporary Aid to Needy Families (TANF) are examples of -
Qf>Q1
Inflationary gap
Tip
Keynes concluded that the Great Depression was caused by a deficiency of spending, or aggregate demand, in our terms
Tip
No government was willing to try Keynes's radical new idea to remedy the Great Depression and the economic bad times persisted. It wasn't until the early 1940s that World War II forced many governments to spend more money than they had and borrow to make up the difference. That was how the Great Depression was finally put behind us.
Tip
No matter what kind of trouble the economy finds itself in, recession or inflation, fiscal policy is a potential remedy
Tip
Notice that stagflation poses a special problem for fiscal policy. If both inflation and unemployment are high, should fiscal policy be used to fight the high unemployment or the high inflation? It cannot remedy both at the same time.
Formulas on pg 283
OK
Know formulas for this unit
Ok
Income
Output is below potential and if output is low, so is -
Fadie just to clarify...
Q1 first then Qf is a recessionary gap Qf then Q1 is a inflationary gap Dont **** with the greater than or equal signs lowkey
Full employment
QD is
Tip
The fact that a $20 billion dollar change in government spending has a slightly more powerful impact on real GDP than a $20 billion change in taxes has an interesting implica- tion. What would happen if the government were to increase spending by $20 billion while simultaneously increasing taxes by $20 billion? The increase in government spending of $20 billion would cause a $100 billion increase in real GDP, while the $20 billion increase in taxes would reduce real GDP by $80 billion. The net effect is a $20 billion increase in real GDP.
The appropriate fiscal policy to remedy inflation calls for
The federal government to run a surplus
Tip
The higher interest rate discourages borrowing and spending, especially for investment. The decrease in investment spending by businesses can offset the government's expansionary fiscal policy. Diagrammatically, crowding out is reflected in an aggregate demand curve that shifts back to the left after a fiscal policy has just shifted it to the right.
Recessionary gap
The horizontal distance between the quantity of output the economy is producing, Q , 1 and its potential, Qf, is called the -
Phillips tradeoff.
The idea that inflation and unemployment move in opposite directions was first noticed by a British economist, A. W. Phillips. Looking back over 100 years of British economic history he discovered that when inflation was high, unemployment was low. When inflation was low, unemployment tended to be high. The inverse relationship between inflation and unemploy- ment became known as the -
Tip
The inflation has been cured but the recession has been made worse.
Tip
The multiplier is equal to 1/(1 − MPC) = 5.0 (= 1/(1 − 0.8) = 1/0.2). This means any change in government spending will be magnified 5 times.
no change in unemployment
The result is an increase in the price level from P1 to P2, but output does not change from Qf. Therefore, unemployment will not change. We have an increase in the price level but -. In other words, the Phillips relationship is a vertical line in the long run.
Fiscal
The situation is not good when the economy is producing more than its potential. Inflation is typical during these times. Resources are being strained and the economy may be overheating. Prices are usually driven higher in these situations. That is why the distance between Qf and Q1 in Figure 15.3 is called the inflationary gap. - policy can be applied to resolve the problem.
stagflation
This goes against the Phillips relationship. Indeed, it is the worst of all situations, with both inflation and unemployment rising. Economists call thisq.
Tip
This is how crowding out can nullify the beneficial effects of fiscal polic
Tip
To remedy recessions the government should increase its level of spending and/or reduce taxes. In other words, the government should run a deficit.
Expansionary
To sum up, fiscal policy can be used to reposition the aggregate demand curve. - fiscal policy (tax cuts and/or increases in government spending) shifts the aggregate demand curve to the right. Contractionary fiscal policy shifts aggregate demand to the left.
Tip
Whenever the government changes spending and taxes so that the effects on the budget are neutral, this is known as a "balanced-budget" move. So an increase in government spend- ing of $5 million and an increase in taxes of $5 million is a balanced-budget move. Similarly, a decrease in government spending of $4 billion and a decrease in taxes of $4 billion is a balanced-budget move. In each of these cases, the change in government spending has a stronger impact than the change in taxes. Real GDP will be affected by the amount of the spending and tax change. For instance, when government increases spending by $5 million and taxes by the same amount, real GDP will increase by $5 million.
Phelps curve holds true in some cases and some not: t or f
Yes
Tip
Yet another problem with fiscal policy is the fact that Congress and the President have to first realize the economy is in trouble, then design a fiscal policy to combat the recessionary or inflationary gap. All of this takes time. Fortunately, there are laws and programs already on the books that will work to fight recessions or inflations. These laws and programs are called automatic stabilizers. Tax laws and antipoverty programs are examples of built-in stabilizers. Automatic stabilizers cannot prevent recessions or inflations, but they can prevent recessions from becoming depressions and inflations from becoming hyperinflations.
Tip
You may well ask how an economy can produce above its potential. One response is overtime. Resources are being worked more than full time. Another response is that unemployment is below 5 percent. Remember that full employment does not mean zero unemployment. We are at full employment when the unemployment rate reaches 5 percent or so. If the unemployment rate falls lower still, we can wind up producing more than our full employment potential.
automatic stabilizers
changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action
Fiscal policy
changes in government spending and taxes to fight recessions or inflations
Fiscal policy
changes in government spending and taxes to fight recessions or inflations.