1. ECONOMIC POLICY
AND THE AGGREGATE
DEMAND-AGGREGATE
SUPPLY MODEL
MODULE 20

2. MACROECONOMIC POLICY
 Although the economy is self-correcting in the long-
run, this process can take up to a decade or more.
 Particularly, if output is below potential output, the
economy can suffer an extended period of depressed
aggregate output an high unemployment during this
period of self-correction.
 John Maynard Keynes: “In the long run we are all
dead.” He recommended that governments not wait
for the economy to correct itself, but use fiscal policy
to get the economy back to potential output more
quickly.

3. MACROECONOMIC POLICY
 This is the rationale for active stabilization policy,
which is the use of government policy to reduce the
severity of recessions and control excessively strong
expansions.
 However, the ability to improve the economy’s
performance is not always guaranteed; it depends
on the kinds of shocks the economy faces.

4. MACROECONOMIC POLICY
 This is the rationale for active stabilization policy,
which is the use of government policy to reduce the
severity of recessions and control excessively strong
expansions.
 However, the ability to improve the economy’s
performance is not always guaranteed; it depends
on the kinds of shocks the economy faces.

5. POLICY IN THE FACE OF DEMAND
SHOCKS
 If policy makers react quickly to a negative demand
shock, they can use monetary or fiscal policy to shift
the aggregate demand curve back to the right.
 If it was possible to anticipate shifts of the AD curve
and counteract them, it could short-circuit the whole
process of going through a period of low aggregate
output and falling prices.
 This is desirable because:
1. The temporary fall in aggregate output is associated
with high unemployment.
2. Price stability is regarded as a desirable goal (avoiding
deflation-a fall in the aggregate price level.

6. POLICY IN THE FACE OF DEMAND
SHOCKS
 However, some policy measures to increase
aggregate demand may have long-term costs in
terms of lower long-run growth.
 It also could be that the policy-makers are not
perfectly informed, and the effects of their policies
are not perfectly predictable. This could cause the
attempts to create more stability to end up creating
more instability.
 Despite this, many economists believe in the use of
macroeconomic policy to offset major negative
shocks to the AD curve.

7. RESPONDING TO SUPPLY SHOCKS
 The effect of a negative supply shock is to lower
aggregate output but increase to a higher aggregate
price level.
 Two bad things happen simultaneously: a fall in
aggregate output leads to a rise in unemployment,
and a rise in the aggregate price level decreases the
purchasing power of incomes.
 In contrast to the case of a demand shock, there are
no easy remedies for a supply shock. This means
that there are no government policies that can easily
counteract the changes in production costs that shift
the SRAS curve.

8. RESPONDING TO SUPPLY SHOCKS
 Using monetary or fiscal policy to shift the AD curve
would do one of two things:
a) A policy to increase AD to limit the rise in
unemployment would reduce the decline in output
but cause even more inflation.
b) A policy to decrease AD, it curbs inflation but
causes a further rise in unemployment.
 This is then a trade-off with no right answer; it
requires facing harder choices than usual.
 In the end, economic policy eventually chooses to
stabilize prices at the cost of higher unemployment.

9. FISCAL POLICY: THE BASICS
 Modern governments spend a great deal of money
and collect a lot in taxes.
 Changes in the federal budget (in government
spending or in taxation) can have large effects on
the economy by affecting the economy’s flow of
income.
 Funds flow into the government in the form of taxes
and government borrowing, and funds flow out of the
government in the form of government purchases of
goods and services and government transfers to
households.

10. TAXES, GOVERNMENT PURCHASES OF GOODS
AND SERVICES, TRANSFERS, AND
BORROWING
 Taxes are required payments to the government:
a) At the federal level, the main taxes are income
taxes on both personal income and corporate
profits, as well as social insurance taxes.
b) At the state and local levels, governments rely on a
mix of sales taxes, property taxes, income taxes,
and fees of various kinds.

11. TAXES, GOVERNMENT PURCHASES OF GOODS
AND SERVICES, TRANSFERS, AND
BORROWING
 Government spending takes two forms:
a) Purchases of goods and services.
b) Government transfers, which are payments by the
government to households for which no good or service
is provided in return. Most US government spending on
transfer payments is accounted by three big programs:
1. Social Security
2. Medicare
3. Medicaid
 Social Insurance are government programs that are
intended to protect families against economic
hardship (Social Security, Medicare, Medicaid,
unemployment insurance, and food stamps.

12. THE GOVERNMENT BUDGET
AND TOTAL SPENDING
 Remember that GDP = C + I + G + X – IM
 The right-hand side is aggregate spending, the total
spending on final goods and services produced in the
economy.
 The government directly controls on of the variables
in the aggregate spending: government purchases of
goods and services (G).
 But that is not the only effect fiscal policy has on
aggregate spending: through changes in taxes and
transfers, it influences consumer spending (C) and in
some cases, investment spending (I).

13. THE GOVERNMENT BUDGET
AND TOTAL SPENDING
 Disposable income (total income households have
available to spend) is equal to the total income they
receive from wages, dividends, interest, and rent, minus
taxes, plus government transfers.
 Either an increase in taxes or a decrease in government
transfers reduces disposable income, which leads to a
fall in consumer spending.
 Either a decrease in taxes or an increase in government
transfers increases disposable income, which leads to a
rise in consumer spending.
 The government´s ability to affect investment spending
comes from taxing profits, which can increase or reduce
the incentive to spend on investment goods.

14. EXPANSIONARY AND CONTRACTIONARY
FISCAL POLICY
 Therefore, the government can use changes in taxes or
government spending to shift the AD curve.
 Expansionary fiscal policy: Government would want to
shift the AD curve to the right to close a recessionary
gap, when aggregate output falls below potential output.
This would increase aggregate output, making it equal to
potential output.
 Contractinary fiscal policy: Government would want to
shift the AD curve to the left to close an inflationary gap,
when aggrgate output exceeds potential output. This
would decrease aggregate output, bringing it back to
potential output.

15. EXPANSIONARY AND CONTRACTIONARY
FISCAL POLICY
 Expansionary fiscal policy may be implemented by:
1. An increase in government purchases of goods and
services
2. A cut in taxes
3. An increase in government transfers
 Contractionary fiscal policy may be implemented by:
1. A reduction in government purchases of goods and
services
2. An increase in taxes
3. A reduction in government transfers

16. LAGS IN FISCAL POLICY
 Many economists caution against an extremely active
stabilization policy, arguing that overly agressive fiscal or
monetary policy to stabilize the economy may end up
making the economy less stable.
 In the case of fiscal policy, there are important time lags
(problems with timing):
1. The recognition lag is the elapsed time between the
beginning of recession or inflation and awareness of this
occurrence.
2. The administrative lag is the difficulty in changing policy
once the problem has been recognized and policy is
implemented
3. The operational lag is the time elapsed between change in
policy and its impact on the economy.

17. LAGS IN FISCAL POLICY
 Because of these lags, an attempt to increase spending
to fight a recessionary gap may take so long that the
economy is already recovering by the time policy begins
to act, which may turn the recessionary gap into an
inflationary gap , which will make things worse off
instead of better.
 An attempt to decrease spending to close an inflationary
gap may take so much time that the economy is already
recovering on its own, and this policy may push an
economy into a recession, which again would worsen the
situation, instead of making it better.
 Therefore, fiscal policy must be used carefully, as both
fiscal and monetary policy are harder to implement than
appears with the simple explanation given.