Inflation, Unemployment, & Stabilization Policies

20-30% of AP ExamSection 6

A . Fiscal and monetary policies◦ 1 . Demand-side effects◦ 2 . Supply-side effects◦ 3 . Policy mix◦ 4 . Government deficits

and debt B . The Phillips curve

◦ 1 . Short-run and long-run Phillips curves

◦ 2 . Demand-pull versus cost-push inflation

◦ 3 . Role of expectations

Unit Outline

Fiscal Policy, Deficit, & Public Debt

Module 30

Government decisions about tax rates and spending levels.

Two types:◦ Expansionary – Grows the economy/increases deficit

Decrease Taxes Increase Spending Increase transfers

◦ Contractionary – Slows the economy/reduces deficit Increase Taxes Decrease Spending Decrease Transfers

Reminder: Fiscal Policy

The budget balance is the difference between the government’s tax revenue and its spending, both on goods and services and on government transfers, in a given year. ◦ A budget surplus is a positive budget balance and a budget deficit

is a negative budget balance.

the budget balance (or savings by the government) is defined by: ◦ SGovernment = T - G – TR

T is the value of tax revenues G is government purchases of goods and services TR is the value of government transfers.

The Budget Balance

Expansionary Policies reduce the budget balance for the year

Contractionary Policies increase the budget balance for the year

Fiscal Policy and the Budget Balance:

Expansionary fiscal policy is in order.

3 options:◦ Cut taxes.◦ Increase transfers.◦ Increase government spending.

  These three policies should

increase AD and reverse the recession, but will cause the budget balance to decrease. This means either a smaller surplus or a bigger deficit.

Example 1: Recessionary Gap

Contractionary fiscal policy is in order. 3 options:◦ Increase taxes.◦ Decrease transfers.◦ Decrease government

spending.

These three policies should decrease AD and reverse the inflation, but will cause the budget balance to increase. This means either a bigger surplus or a smaller deficit.

Example 2: Inflationary Gap

Changes in the budget balance don’t always perfectly reflect changes to fiscal policy. ◦ Just because the balance is decreasing does not mean an

expansionary policy is being implemented Two important reasons why it is more complicated.

1. Two different changes in fiscal policy that have equal-size effects on the budget balance may have quite unequal effects on the economy. Example: If government spending increases by $1000, it will have a larger impact on real

GDP than a tax decrease of $1000. The budget balance would change by $1000 in each case, but the impacts would be different.

2. Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.

Keep in mind:

1. Problems of Timing• Recognition Lag- Congress must

react to economic indicators before it’s too late

• Administrative Lag- Congress takes time to pass legislation

• Operational Lag- Spending/planning takes time to organize and execute (changing taxing is quicker)

Other Problems with Fiscal Policy

2. Politically Motivated Policies• Politicians may use economically

inappropriate policies to get reelected.

• Ex: A senator promises more public works programs when there is already an inflationary gap.

Other Problems with Fiscal Policy

3. Crowding-Out Effect• If the government spends more money, and needs to

increase borrowing, it will lead to increased interest rates• This may “crowd out” business and individuals and

decrease investment spending which will in turn reduce economic growth

Other Problems with Fiscal Policy

Monetary Policy and Interest Rates

Module 31

Actions taken by the Federal Reserve (or a central bank) to control the supply of money

Two types:◦ Expansionary – Lowers interest rates/grows the economy/increases

inflation OMO: Buy bonds Lower Reserve Requirement Lower Discount Rate

◦ Contractionary – Increases interest rates/slows the economy/reduces inflation OMO: Sell Bonds Increase Reserve Requirement Increase Discount Rate

Reminder: Monetary Policy

Main tool of stabilization policy in practice◦ Like Fiscal Policy, there are lags BUT Central

Banks are able to act more quickly then the government in implementing changes.

Monetary Policy

Fed Funds Rate – Interest rate banks charge other banks for loans (based on Discount Rate)

Every 6 weeks, when the FOMC meets, a Target FFR is set.◦ This target rate is reached through Open Market

Operations carried out at the New York branch. This alters the supply of money and allows the FED

to drive rates up or down.

Target Federal Funds Rate

Expansionary Policy◦ Lower interest rates = higher investment

spending◦ Higher investment spending = higher GDP◦ Higher GDP = more consumer spending

Monetary Policy and Aggregate Demand

Contractionary Policy◦ Higher interest rates = lower investment

spending◦ Lower investment spending = lower GDP◦ ….

Monetary Policy and Aggregate Demand

Central Banks tend to engage in expansionary policies when real GDP is below potential output (recessionary gap) and contractionary policies when real GDP exceeds potential (inflationary gap)

Monetary Policy in Practice

Rule proposed in 1993 by Stanford economist John Taylor◦ Federal Funds Rate = 1 + (1.5x inflation) + (0.5 X

output gap)◦ This rule is the best way of predicting the Federal

Reserve’s behavior when it comes to setting the discount rate

Taylor Rule

Used by some central banks outside the US Central Banks set a target for inflation, and

implement a monetary policy to hit that target. Two Advantages

◦ The public knows the objective of the bank for the year

◦ The central bank’s effectiveness can be judged by how close they are to hitting their target yearly

Disadvantage◦ Some argue this is too restrictive and reduces

flexibility to act in a crisis.

Inflation Targeting

Money, Output, and Prices in the Long

RunModule 32

In the short-run an increase in the money supply will reduce interest rates, increases investment spending, and increases consumer spending◦ Output and prices increase as AD shifts

right As a result of the expansionary

monetary policy, output is now ABOVE potential◦ This will cause nominal wages to rise, and

the SRAS curve to shift to the left

THE LONG RUN EFFECT OF AN INCREASE IN THE MONEY SUPPLY IS JUST AN INCREASE IN PRICE LEVELS

Monetary Policy in the Long Run

monetary neutrality: changes in the money supply have no real effects on the economy.

In the long run, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage.◦ If MS grows by 50%, prices will grow by 50%◦ If MS decreases by 25%, prices will drop 25%

Economists argue that money is neutral in the long run.

Monetary Nutrality

A change in the money supply lowers interest rates in the short run

However, as price levels rise, the demand for money increases◦ This shifts the MD curve

to the right, bring interest rates back to where they began

Monetary Policy and Interest Rates (long run)

InflationModule 33

Hyperinflation◦ Extremely high inflation. Usually caused by a

government printing out too much fiat money

Cost-push inflation◦ Inflation caused by a negative supply shock◦ AKA Stagflation

Demand-Pull inflation◦ Inflation caused by increased demand in the

economy

Inflation: Reminders

Remember: ◦ YP = Potential Output (Assumes economy is at full

employment)◦ Short Run eq left of YP = Recessionary Gap

Unemployment is high, inflation is low◦ Short Run eq right of YP = Inflationary gap

Unemployment is low, inflation high

Output Gap and Unemployment

The Phillips CurveModule 34

In the short run there is a negative relationship between unemployment and inflation.◦ First theorized by economist Alban Phillips

The Phillips Curve

Reminder: Supply Shocks◦ Sudden changes in SRAS

Supply Shocks can cause the SRPC to shift◦ Positive, shifts down◦ Negative, shifts up

Supply Shocks and the Phillips Curve

Increase in expected inflation shifts the SRPC up

Expected inflation and the Phillips Curve

In the long run, employment is not impacted by inflation.◦ Therefore the Long-run Phillips Curve is vertical at

the Natural Rate of Unemployment

Long Run Phillips Curve