Slide 1Questions of the DayI. How The economy can ‘self-correct’LONG-RUN SELF-STABILIZATIONSlide 5Slide 6Slide 7AD, AS and Explaining SR Economic FluctuationsPercentage Change in U.S. Real GDPU.S. Historical Inflation RateHistorical U.S. Unemployment RateAD, AS and explaining economic fluctuationsAD, AS and explaining economic fluctuationsBIG IDEA IN ECONOMICS!!John Maynard Keynesii. Fiscal aggregate demand policyFISCAL POLICY‘Smoothing’ Business CyclesSlide 19Demand-Side AD Fiscal PolicyChanges in Government Spending (G)Multiplier EffectMultiplier Effect (cont.)Multiplier Effect (cont.)Slide 25Multiplier Effect: CalculationSlide 27Example: Expansionary AD Fiscal PolicyExample: Expansionary AD Fiscal PolicyExpansionary Demand Fiscal PolicyContractionary Demand Fiscal PolicyContractionary Demand Fiscal PolicyAD Fiscal Policy ExamplesExpansionary AS Fiscal PolicyPotential Problem with Active PoliciesKEY TERMS AND CONCEPTSFiscal and Monetary PolicyTOPIC XVIII:SMOOTHING GROWTH - FISCAL POLICYWhat can the Govt. do for you?“Bush signs stimulus package into law: Rebates of $300 to $1,200 go out beginning in May”;Associated Press, Feb 13, 2008Questions of the Day•As the economy grows over time, it is very uneven•Recall business cycles that economy repeats again and again•Can the Federal Government help ‘smooth’ these cycles?•Can the Federal Government improve macroeconomic conditions?•Lower inflation? Boost output? Lower unemployment?•If so, how does this work?•How can the government influence output, unemployment and prices?•Should the government attempt this?I. HOW THE ECONOMY CAN ‘SELF-CORRECT’LONG-RUN SELF-STABILIZATIONMacroeconomic stabilization is very controversial•Should the government become actively involved in the economy?•The involvement of public policy into the workings of the economy is one of the most hotly debated topics among economists, policy makers, and the general publicMost agree that in the long-run, the economy is actually self-stabilizing•If actual real GDP ≠ potential real GDP, then economic forces will push the economy towards potential GDP•How does this work?ASADPotential GDPŶPPOutputPerfect World – AD, AS and Ŷ all grow at the same speedASADPotential GDPŶPOutputActual World – AD, AS and Ŷ all grow at the different speedsNext, suppose there is a dramatic fall in housing values and the domestic stock market, along with a freezing of the credit market, decreasing C & IHow does this affect our economy (P, U and Y) in the short-run?ASADŶPPOutputStart in long-run macroeconomic equilibriumLong-run self stabilization (cont)How does this affect our economy (P, U and Y) in the long-run?ASADŶPPOutputAD, AS and Explaining SR Economic Fluctuations•The fall in consumer confidence and wealth along with fall in business activity means less aggregate demand •This puts downward pressure on prices, from P to P’•Firms will reduce output (since price of their product has fallen but input prices have stayed the same)•represented as a move down along SRAS•The fall in output (from Ŷ to Y’) means we need less workers, which leads to an increase in unemployment8 Short-Run Result? in P, in Y, Up in UPercentage Change in U.S. Real GDP2002q12002q32003q12003q32004q12004q32005q12005q32006q12006q32007q12007q32008q12008q32009q12009q32010q12010q32011q12011q32012q12012q32013q12013q32014q1-10.0-8.0-6.0-4.0-2.00.02.04.06.08.0Source: Bureau of Economic Analysis; www.bea.govU.S. Historical Inflation RateJan-03 Jan-05 Jan-0 7 Jan-09 Jan-11 Jan-13-3-2-10123456Percentage10Source: Bureau of Labor Statistics; www.bls.govHistorical U.S. Unemployment RateJul-98 Apr-01 Jan-04 Oct-06 Jul-09 Apr-12 Dec-140.02.04.06.08.010.012.011Source: Bureau of Labor Statistics; www.bls.govASADŶPPOutputAD, AS and explaining economic fluctuationsBut that is not the end of the story•Firms initially reduced output because output prices had fallen while input prices (wages) remained the same•Eventually, firms will downwardly renegotiate wages with their workers•After lowering their input prices (wages), producing will become more profitable and firms will increase output•This is an outward shift in the SRAS 12AD’P’YASADPotential GDPŶPPOutputAD, AS and explaining economic fluctuations1. The economy begins in long-run macroeconomic equilibrium•Unemployment = the natural rate•Output = the potential rate2. Fall in C and I leads to a decrease in AD for U.S. goods•Unemployment rises, output falls, prices fall3. Firms eventually increase output after lowering wages•Unemployment = the natural rate•Output = the potential rate13AD’P’Y12Long-Run result? In P, no change in U or YBIG IDEA IN ECONOMICS!!Long-Run result:•Any shift in AD will cause short-run fluctuations in the economy •(P, U, Y)•Shifts in AD will have no long-run effect on the economy (except P)Obvious question:•How long does this self-correction (move from 2 to 3) take???•We do not want to remain at 2 any longer than necessary•Output/sales/profits are down; unemployment is upEmployment Act of 1946•Obligates the Govt. & F to keep output high, and unemployment low•Implies an active role in macroeconomics policy!John Maynard Keynes •The general theory of employment, interest and money •Argued recessions and depressions can result from inadequate demand; policymakers should shift AD•Famous critique of classical theory:•The long run is a misleading guide to current affairs…II. FISCAL AGGREGATE DEMAND POLICYFISCAL POLICYFiscal Policy: manipulation by the Government (Congress and/or White House) of the AD or AS in order to achieve some macroeconomic goalKinds of Fiscal Policy:1. Automatic fiscal policy (automatic stabilizers): fiscal policy that acts on its own (tax system (people with low income pay smaller taxes and people with a larger income pay higher taxes) and social welfare payments)•Automatically these things kick in, “they are already in the books”2. Discretionary fiscal policy: policy explicitly enacted by Congress or White House to manipulate the AD•This is where Congress or the White House literally has to do something What is the ultimate goal?•Make the highs not so high and the lows not so low‘Smoothing’ Business CyclesGeneral price levelReal GDP (Y)Long – run growth trendActual real GDP no smoothingFiscal PolicyDiscretionary (active)Demand SideGovernment spending (G)Personal tax rates (t)Supply