Macroeconomic policy & the Aggregate Demand & Supply Model

Richard AranaAndres GomezRodrigo CamachoDaniel Batista

Part I

Macroeconomic Policy

Stabilization Policy: is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

“In the long run we are all dead.” Quote by Keynes that is usually interpreted as having recommended that governments not wait for the economy to correct itself.

Policy in the Face of Demand Shocks

Reasons to maintain the economy at its original equilibrium.

Reason 1: The temporary fall in aggregate output that would happen without policy intervention is a bad thing, particularly because such a decline is associated with high unemployment.

Reason 2: Price stability is generally regarded as a desirable goal. So preventing deflation – a fall in the aggregate price level – is a good thing.

Policy in the Face of Demand Shocks (cont.)

Some policy measures to increase aggregate demand may have long-term costs in terms of lower long-run growth.

Because real world policy makers aren’t perfect, there is a danger that stabilization policy will do more harm than good.

Most economists believe that any short-run gains from an inflationary gap must be paid back later.

Responding to Supply Shocks In a negative supply shock, there are no

easy remedies. There are no government policies that

can easily counteract the changes in production cost that shift the short-run aggregate supply curve.

Using monetary or fiscal policy to shift the aggregate demand curve in response to a supply shock causes two bad things to happen.

Responding to Supply Shock (cont.)

Bad thing 1: A fall in aggressive output which leads to a rise in unemployment.

Bad thing 2: A fall in aggregate price level. Any policy that shifts the aggregate

demand curve helps one problem only by making the other problem worse.

Increasing aggregate demand reduces the decline in output but causes more inflation. Reducing aggregate demand curbs inflation but causes higher rise in unemployment.

Fiscal Policy: The Basics

The U.S.’s government plays less of a role than other countries, such as Canada and European countries, but still plays enough of a role to be noticed.

Ex. Changes in federal budget can have large effects on the American economy.

Taxes, Government Purchases of Goods and Services, Transfers and Borrowing

Funds flow into the government in the form of government borrowing, and the fund flow out in the form of government purchases of goods and services and transfers into households.

Overall, taxes on personal income and corporations accounted for 44% of total government revenue in 2008; social insurance taxes accounted for 27%; and a variety of other taxes, collected mainly at the state levels, accounted for the rest.

Cont.

(After the funds go in and the funds go out bullet point) The federal government relies on both personal income taxes, corporate profits, and social insurance taxes.

At the state and local levels, governments rely on a mix of sales taxes, property taxes, income taxes, etc.

Government Spending The other form of government spending is government transfers, or

payments by the government to households for which no good or

service is provided in return.

Government Transfers

-Social Security: 15%

-Medicare and Medicaid: 20%

-Other Government transfers-9%

Government Purchases-

-National defense: 13%

-Education: 16%

-Other goods and services- 27%

Part II

Social Insurance

Governmental programs that are

designed to help families in times of

economic hardship

Ex. Medicare, Medicaid, Social

Security, Food Stamps,

Unemployment insurance, etc.

Paid for by the insurance taxes.

Government Budget and Total Spending

Government can affect government purchases of

goods and services, consumer spending by an

change in taxes and/or in government transfers,

and investment spending by changing the rules

that increase or reduce the incentive to spend of

investment goods.

Because of this, the government can shift the

aggregate demand curve.

Expansionary and Contractionary Fiscal Policy

The government does this to either close a recessionary

gap, when aggregate output falls below potential output, or

an inflationary gap, when aggregate output exceeds

potential output.

Expansionary Fiscal Policy increases aggregate demand by

increasing government purchases of goods and services,

cut in taxes, or an increase in government transfers.

Contractionary Fiscal policy decreases aggregate demand

by deceasing government purchases of goods and

services, raising taxes, or reducing government transfers.

Lags in Fiscal Policy

Economists argue that if the government were to try

too hard to stabilize the economy through fiscal

policies, it can cause the economy to become less

stable.

One reason is the time lags associated with the fiscal

policies.

These policies can take a long time to implement,

months to years at each step of the process, such as

collecting data and introducing a spending plan for the

government.

Lags in Fiscal Policy Cont.

For example, by the time the

government tries to fix a

recessionary gap, the gap may have

become an inflationary gap, causing

colossal amounts of damage to the

economy.