Chapter 33 & 34Chapter 33 & 34Crowding In, Crowding Out,

Phillips Curve, Rational Expectations

Why do recessions add to Why do recessions add to national debt?national debt?

When in a recession, we use expansionary fiscal policy – which means that G spending increases, taxes decrease, and transfers increase, thus adding to the national debt

G

TTr

Crowding In & Crowding OutCrowding In & Crowding Out

Crowding OutG spending increases AD, RGDP and PL, so

D for Money increases, due to PL This increases i rates & MSThe increase in i rates causes a decrease

in I spending which lowers ADCrowding InStimulation in G causes businesses to gain

confidence and produce more to take advantage of the growing economy

Monetizing the DebtMonetizing the Debt

Because AD shifts right, the SCM shifts the AS curve to the left due to a rise in costs of production, which lowers profitability and AS

The Fed can control i rates using Expansionary Monetary Policy to bring i rates down

This will shift AD curve even farther out, increasing the national deficit

The Fed is buying bonds that the gov’t is selling to fund their deficit◦Fed creates money from government’s debt

Monetizing the debt is more inflationary than non-monetized debt

Phillips CurvePhillips CurveIn

flati

on

Unemployment Rate

Long run

Short Run

Contractionary

Policy

Expansionary Policy

Natural Rate of Unemployment

SCM

SCM

Structural DeficitStructural Deficit

How the deficit would look if we were at full employment and the gov’t receives as much tax revenue as expected and spends only as much as expected

Costs of Closing Costs of Closing Recessionary/Inflationary GapRecessionary/Inflationary Gap

Use Expansionary Fiscal Policy during a recession◦Creates deficit – Increases G spending,

decreases taxes, increases transfersUse Contractionary Fiscal Policy during an

inflation◦Decreases G spending, increases taxes,

decreases transfers, which DECREASES THE DEFICIT and BALANCES THE BUDGET

Rational ExpectationsRational Expectations

Forecasts that are the best that can be made given the available data, not necessarily correct

If correct, short run PC is vertical ◦Inflation can be produced without the need for high

unemploymentWhy Keynesians and Liberals want to fight

unemployment:◦Believe AD and SR PC curve is flat◦Unemployment is more costly than inflation◦Expectations react sluggishly, SCM is unreliable and

slow

Rational ExpectationsRational Expectations

Why Rational Expectation Adherent and Conservatives are more eager to fight inflation:

- Because AD and SR PC is steep- Inflation more costly than UE- Depends on region of AS- Expectations react quickly- SCM works smoothly and rapidly