Module 6: The Business Cycle and Government Policy
Mankiw Chapter 15 (Aggregate Supply and Demand) and
Mankiw Chapter 16 (Fiscal and Monetary Policy)
Introduction
Market economies have always been subject to the boom and bust of the BUSINESS CYCLE.
Modern macroeconomics was born in the greatest economic downturn of the last 100 years, the
Great Depression of the 1930s. More recently, the Great Recession of 2007-2009 stirred new
controversy and revived old debates within the economics profession as to whether and how the
government should respond to such crises.
The Classical model of inflation and output that we studied in the last three modules does a
good job of explaining the long run behavior of the macroeconomy, but it does not explain the
business cycle well. In the Classical model, real GDP is determined by the number of workers
and their productivity. Nominal variables such as the money supply and the price level (M and
P) have no effect on real GDP or real economic well-being in the Classical model. In this
module we’ll introduce an alternative model in which nominal variables such as P and M do
affect real variables such as unemployment (U) and real GDP (Y) in the short run. In the long
run, we’ll see, the AS/AD model is consistent with the Classical model.
In the first half of this module we will describe the business cycle and its characteristics, and
then sketch out the theory of Aggregate Supply (AS) and Aggregate Demand (AD). We’ll also
show how this short-run “Keynesian” AS/AD model of the business cycle is consistent with the
long-run Classical model. In the second half of this module we will use the AS/AD model to
explain how government fiscal policy (spending and taxation) and monetary policy might be
used to “stabilize” (reduce the severity) of the business cycle. Finally, we will explore the pros
and cons and difficulties of implementing stabilization policies.
Three Facts About the Business Cycle
The Business Cycle is the short-term fluctuation of real GDP, unemployment, and other
economic variables around their long term trend. It is the cycle of boom and bust that
characterizes economic activity in a market economy.
The National Bureau of Economic Research recognizes 32 full cycles of the U.S. economy
since 1857, averaging about five years in length (see
http://www.nber.org/cycles/cyclesmain.html for the full list).
There are three basic facts that I want you to know about the business cycle.
1) The Business Cycle is irregular and hard to predict.
Usually when we think about cycles we think of regular cycles, such as the phases of the moon
or the passing of the seasons. The Business Cycle is not like that. Instead, it’s irregular and very
difficult to predict. Figure 6.1 shows the quarterly percentage changes in U.S. nominal GDP
since World War II. The gray bars indicate recessions. As you can see, the times between the
gray bars are variable, and the rate of change in GDP varies abruptly. Over the past 100 years,
business cycles have ranged from less than two to more than ten years in length.
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Figure 6.1: Growth Rates of U.S. GDP, 1947 – 2010
Source: St. Louis Federal Reserve Economic Data (FRED2)
2) Unemployment rises when GDP falls.
The negative relationship between GDP and unemployment makes a lot of sense, if you think
about it. GDP is a measure of the production of goods and services. Businesses produce goods
and services using labor. When output falls, fewer workers are needed, and more people
become unemployed. It’s a very strong relationship, as you can see in figure 6.2 below, which
shows the annual percentage change in GDP (blue) plotted along with the unemployment rate
(red). When one rises, the other falls, pretty much.
Figure 6.2: GDP growth rates and Unemployment Rates, 1947-2010.
Source: St. Louis Federal Reserve Economic Data (FRED2)
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3) Many economic variables move together.
Here’s a picture of annual percentage changes in GDP (blue) since 1929, along with changes in
two other economic variables: private Investment (green) and federal government tax receipts
(red). You can see that the three variables move together, and that investment and tax receipts
are very sensitive to GDP changes. Most other economic variables move with the business
cycle, including retail sales, car miles driven, loans, stock market prices, and inflation rates.
Figure 6.3: Government Tax Receipts (red), GDP (blue), and Investment (green), 19292010 Source: St. Louis Federal Reserve Economic Data (FRED2)
That’s why the business cycle is so important. It affects nearly everything.
Explaining the Business Cycle’s Short-Run Fluctuations
Aggregate Supply and Demand. We can summarize the short run relationship between the
aggregate price level (P) and real GDP (Y) using a model of Aggregate Supply (AS) and
Aggregate Demand (AD), as shown in figure 6.4 below. “Aggregate” means “formed by a
combination or collection of many separate units.” The aggregate price P on the vertical axis is
a price index P such as the CPI or the GDP Deflator. The aggregate quantity Y on the horizontal
axis is aggregate output, or real GDP.
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Figure 6.4: Aggregate Supply and Aggregate Demand
The Aggregate Demand Curve shows the relationship between the price level and the
quantity of goods and services that households, firms, government, and foreigners wish to
buy. There are four components of Aggregate Demand: Y = C + I + G + NX.
The Aggregate Supply Curve shows the relationship between the price level and the
quantity of goods and services that firms choose to produce and sell.
The macroeconomy is in equilibrium when desired spending equals desired production.
We will manipulate the Aggregate Supply and Aggregate Demand model the same way that we
manipulate an ordinary microeconomic supply and demand model for a single good such as
peanut butter: Given an event, we’ll ask
1) Which curve shifts?
2) Which way does it shifts?, and
3) What happens to price and real GDP (and, therefore, unemployment)?
But before we can manipulate the AS/ AD model, we need to understand why the AS and AD
curves slope the way they do, and what makes them shift.
The Aggregate Demand Curve: YD = C + I + G + NX
Why does the AD Curve Have a Negative Slope? A negative slope to AD means that if the
price level rises desired spending falls. Since desired spending is composed of desired
consumption (C), investment (I), government spending (G), and net exports (NX), desired
spending will fall if C, I, G, or NX falls. Government spending G is driven by politics, and is not
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affected much by prices. That gives us at least three possible reasons why the Demand
Curve might have a negative slope:
1)
P  C (The Wealth Effect): Some of consumers’ wealth is in the form of money, which
becomes less valuable as P rises, making consumers poorer. Poorer people consume less.
In symbols, we write: P  Wealth  C  (GDP demanded), so AD has a negative
slope.
2)
P  I (The Interest-Rate Effect): When price levels rise, people need to hold more
cash for transactions purposes, since prices are higher. To get more cash they will borrow
more and lend less, which will drive up interest rates (r). When interest rates rise, desired
investment falls. P  r  I  (GDP demanded), so AD has a negative slope.
3)
P  NX: The Exchange-Rate Effect. When price levels rise, people need to hold more
cash for transactions purposes, since prices are higher. To get more cash they will borrow
more and lend less, which will drive up domestic interest rates (r). When domestic interest
rates rise, everyone will seek to buy domestic bonds and sell foreign bonds, driving
exchange rates up, and Net Capital Outflow (NCO) will fall. Since NCO=NX, and domestic
currency appreciation discourages exports and encourages imports, NX falls too.
P  r  NCO  e  NX  (GDP demanded), so AD has a negative slope.
In the U.S. economy, the interest rate effect is probably the most important of these three
effects. In a smaller economy that relies more on trade, Belgium for example, the exchange-rate
effect is stronger.
What will shift the AD curve? Again, anything (other than a change in P) that affects C, I, G,
or NX will shift the AD curve. Consequently, we have four categories of reasons for AD shifts:
1.
AD Shifts Due to Consumption (C) Shifts. Examples include:
 If consumers decide to save less, C will rise and AD will shift rightward.
 If the government reduces taxes, C will rise and AD will shift rightward.
 If wealth increases due to a stock market rally or an increase in house prices, C will rise
and AD will shift rightward.
2.
AD Shifts Due to Investment (I) Shifts. Examples include:
 Improved technology makes investment more attractive; I will rise and so will AD.
 If business owners become more optimistic, I will rise and so will AD.
 If the government gives tax breaks for investment spending, I will rise and so will AD.
 The Fed increases the Money Supply to make interest rates fall, I will rise and so AD.
3.
AD Shifts Due to Government Spending (G) Changes. Examples include
 Wars increase G and therefore AD.
 Capital projects (roads, canals, buildings, etc) increase G and therefore AD.
4.
AD Shifts Due to Changes in Net Exports
 If foreign countries’ econonomies expand, foreigners will have more income to buy more
of our exports, increasing NX and therefore AD will shift to the right.
 Changes in exchange rates due to central bank actions
Remember, if the quantity of desired spending changes because of a change in the price level
P, the AD curve does not shift. Instead, you move along a stationary AD curve.
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Try This: What happens to the AD curve in each of the following scenarios?
A.
A ten-year-old investment tax credit expires.
B.
The U.S. exchange rate falls.
C. A fall in prices increases the real value of everyone’s savings account.
D. State governments replace their sales taxes with new taxes on interest, dividends, and
capital gains.
Answers:
A: AD shifts left, because investment (I) falls.
B: AD shifts right, because imports get more expensive and exports get cheaper, so NX
increases.
C: AD does not move; consumption increases, but it’s a movement to the right along a
stationary AD curve because the increase in C is caused by a fall in P
D: AD shifts to the right. C increases as savings falls, because there’s less tax on consumption,
and more tax on the returns from savings.
The Aggregate Supply Curve
Aggregate Supply (AS) is the relationship between the aggregate price level P and the quantity
that producers actually produce. The aggregate supply relationship is different in the long run
than it is in the short run. The short-run AS curve has a positive slope, but the long-run
Aggregate Supply (LRAS) curve is vertical.
Why is the LRAS curve vertical? In the long run, the amount of production in the economy is
determined by the physical ability to produce. The economy’s ability to produce depends on the
full employment of its workers (L), their skills and education (human capital), social capital,
physical capital (K), natural resources, and technology. None of these physical factors is
affected by the aggregate price level, so the amount of output that the economy produces (at full
employment) is the same, regardless of the price level. In other words, the Long Run
Aggregate Supply (LRAS) Curve is Vertical, as illustrated in figure 6.5 below.
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Figure 6.5: Long Run Aggregate Supply
Notice that if the LRAS is vertical, a movement of the AD curve will change the equilibrium level
of price, but not of real GDP, YFE. A vertical LRAS curve therefore indicates that the nominal
variable (P) changes independently of the real variable (Y), so it is consistent with the Classical
model, in which the classical dichotomy holds and money is neutral.
Also, notice that the equilibrium level of real GDP in figure 6.5 is labeled YFE. The “FE” stands
for “full employment.” YFE is the amount of real GDP that the economy will produce if all the
inputs, including labor, are fully employed. Full employment does not mean that the
unemployment rate is zero. Rather, it means that the economy is at the its Natural Rate of
Unemployment. Recall from Module 2 that the Natural Rate of Unemployment consists of
frictional plus structural unemployment, and it’s the rate of unemployment (about 5.5 to 6
percent in the U.S.) that the economy experiences when it is neither in recession, nor
overheated. So, YFE is the amount of GDP produced when unemployment is at its Natural Rate.
What Shifts the LRAS Curve? Since the position of the LRAS curve is completely determined
by the level of Full Employment GDP (YFE), the LRAS curve will shift to the right whenever
something happens that makes the economy more productive, and it will shift to the left
whenever something happens that makes the economy less productive.
Recall from Module 3 that the productive capacity of the economy, YFE, is determined by the
availability of labor, capital, human capital, social capital, natural resources, and technology.
Therefore, shifts of the LRAS curve will occur when one of these factors changes. Here is a list
of possible shifters; in many cases it is indicated what changes will shift the LRAS curve
outward (+), and which inward (-).
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1) LRAS shifts when LABOR’s availability changes. This may occur when the number of workers
changes due to immigration (+), emigration (-), plagues (-), or war (-). It may also occur when
the natural rate of unemployment changes due to changes in minimum wage, unionization,
unemployment insurance, or changes in the health care system.
2) LRAS shifts when the availability of PHYSICAL CAPITAL changes. This occurs when investment
increases (+) or decreases (-) for a long period, or when some of the capital stock is destroyed
by war or natural disaster (-).
3) LRAS shifts when the availability of HUMAN CAPITAL changes. This occurs when the
educational system improves (+) or gets worse (-), or when the work force learns to use new
tools such as computer hardware and software (+).
4) LRAS shifts when the availability of SOCIAL CAPITAL changes. This occurs when civil war
starts (-) or ends (+), when corruption in government and the judicial system increases (-) or
decreases (+), when the rule of law is established (+) or deteriorates (-), or in general when
people in society get better or worse at getting along and working together.
5) LRAS shifts when the availability of NATURAL RESOURCES changes. This occurs when new
sources of energy and other useful natural commodities such as iron ore or rare earths are
discovered (+) or old sources are depleted (-); when prices of useful natural resources such as
oil or natural gas rise (-) or fall (+) relative to other prices; when farmland is reclaimed (+) or
depleted (-); or when clean air and water are polluted (-).
6) LRAS shifts when technology of production improves (+) or is forgotten (-). For example,
during the 1990’s firms found new and productive uses for computers and the internet (+).
Similarly, the use of hydraulic fracturing and horizontal drilling techniques have vastly increased
the availability of natural gas and oil to the U.S. economy since 2006 (+).
Figure 6.6 illustrates the effect of a rightward shift in the LRAS curve: the price level drops from
P1 to P2, while the economy’s output increases.
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Figure 6.6: Macroeconomic Effects of An Increase in Long Run Aggregate Supply
Ever since the Industrial Revolution, developed countries have seen steady increases in LRAS
because of steady technological improvements, high levels of investment, and increases in the
size and quality of the workforce. Clearly, output has risen in the long run, as predicted by the
AS/AD model in figure 6.6, but why haven’t prices fallen? Instead, for the past 80 years or so
we’ve seen fairly steady increases in both output and prices, year after year. How can the
AS/AD model explain this pervasive pattern of economic growth with moderate inflation?
The answer is that the increase in population and in living standards, along with increases in the
money supply, have driven the AD curve rightward too. These long run dynamics of the
economy are illustrated in figure 6.7, which shows long-run economic growth with price inflation.
If the AD curve shifts to the right more quickly than the LRAS curve, there will be inflation; if
LRAS shifts faster, there will be deflation.
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Figure 6.7: Long Run Growth with Inflation in the AS/AD Model
The Short Run Aggregate Supply (AS) Curve
The Aggregate Supply curve slopes upward in the short run. That is, if the aggregate price
level increases, desired production will also increase, in the short run. When you consider
that an increase in aggregate prices implies an increase in input prices (wages, rents, prices of
materials and machinery) as well as output prices, it is unclear why an increase in aggregate
prices would provide producers with an incentive to increase production. In other words, why
does a purely nominal increase in prices affect real output?
Why Does the Short-Run AS Curve Have a Positive Slope? There are several possible
answers to this question, and economists disagree about the details of the answer. They
generally agree, though, that any upward slope of the short run AS curve can be explained by
misperceptions of prices, or poorly formed expectations about prices, which cause some prices
to be “sticky.” That is, not all prices rise at the same rate.
The “Sticky-Wage” theory provides one explanation of why the AS curve has a positive slope.
The argument is as follows. For most goods, it is easy to raise or lower the price. Take gasoline,
for instance. If the wholesale cost of gasoline goes up, Sheetz can raise its pump price very
easily. If the wholesale cost of gasoline goes down the following week, Sheetz can easily lower
the price at the pump.
The price of labor, also known as the nominal wage rate W, is very different from the price of
almost anything else. It is extraordinarily difficult to lower wages of current workers because
lowering wages makes workers angry, and angry workers are less productive. Because it is so
hard to lower nominal wages, employers are very reluctant to raise wages, even if the price
of their product has risen. Nominal wages W are “sticky.”
Suppose you run a pizzeria, and you notice that the other pizza places in town have quit offering
special deals and discounts, so effectively the price of pizza gone up. You’re not sure if that is a
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permanent price increase, or if it’s temporary. A higher pizza price would allow you to pay your
workers more, but you’ll lose money if you raise their wages just before the price of pizza falls
again.
Holding your employees’ wages constant, when the price of pizzas rises your profits will
increase, and that increased profit will make you try harder to produce more pizzas. In effect,
the real wage that you are paying your workers (the price of an hour of labor divided by the
price of a pizza) has fallen, even though the nominal wage W has stayed the same. You may
even hire an extra worker or two at the current wage rate, since labor has become relatively
cheap.
Let’s suppose that the increase in pizza prices is in fact the result of a general inflation; that is,
the price of pizzas is simply rising with the aggregate price level P. Because wages are sticky,
when P rises, W/P falls, so your profits rise, and you produce more. Higher P, higher
output: that means your supply curve slopes upward. If the same process is occurring
throughout the economy, then aggregate output (real GDP) will rise when P rises.
In symbols, we can summarize the sticky wage theory like this: P  W/P  Profits  Y.
One more detail of the theory is important: Current Nominal wages (W) are linked to expected
prices at the time the wages are negotiated. When nominal wages are negotiated, both workers
and employers take into account the level of prices that they expect. If the employer expects the
price of the firm’s output to rise in the current year, it will be willing to pay a higher wage. If
workers expect the prices of groceries and gasoline to rise in the current year, they will demand
higher wages. Thus, nominal wages (W) rise and fall with the expected price level (EP).
We can summarize this model of the short-run AS curve with the following equation:
Y S = YFE + a(P EP)
where a is a positive number related to the slope of the AS curve, Y S is real GDP produced in
the economy, YFE is full-employment GDP, P is the current price level, and EP is the price level
that was expected when wages were set.
The AS curve described by this equation has these essential properties.

The higher the current price level relative to expectations, the more real GDP supplied.

If the price level is as expected (P EP) = 0, then the economy is at full employment
(Y S = YFE + 0).

If the current price level is higher than expected, then output exceeds full employment
(Y S > YFE), and we’re in an unsustainable boom.

If the current price level is lower than expected, then output is less than full employment
(Y S < YFE), and we’re in a recession.
Figure 6.8 is a picture of the relationship between AS and LRAS as described in our model of
aggregate supply. Notice that the AS curve intersects the LRAS curve where P = EP. Notice
also that if the aggregate price level is above EP (at P1, for example) real GDP supplied output
on the AS curve (Y1) exceeds YFE. Similarly, if price is P2 < EP, then output is Y2 > YFE.
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Figure 6.8: Relationship Between Long Run and Short Run AS.
What will Shift the Short Run Aggregate Supply Curve?
There are two things that will shift the short-run Aggregate Supply Curve:
1)
Anything that shifts the LRAS curve also shifts the short-run AS curve. Anything that
changes YFE, negative or positive, shifts both LRAS and AS. Figure 6.9, for example, shows
what would happen to both AS and LRAS if there were a big increase in the price of oil, or if
a disease or war killed a large percentage of the workforce, or if a natural disaster
destroyed factories. Such an event is often referred to as a “negative supply shock.”
Positive supply shocks are possible too, of course, for example when new supplies of
natural gas are discovered, or immigration increases the size of the workforce.
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Figure 6.9: A Negative Supply Shock Shifts both LRAS and AS
2) Changes in price expectations shift the short run AS but not LRAS. If sellers expect
higher prices, EP will increase and the AS curve will shift to the left (upward), as shown in figure
6.10. Expectations of the price level don’t affect the economy’s productive capacity, though, so
the LRAS curve does not shift when AS shifts due to a change in expected prices.
Figure 6.10: An Increase in Price Expectations Shifts AS but not LRAS
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AS/AD Model of the Business Cycle
With an understanding of the AS/AD model, we can proceed to describe how the cycle of
recession and recovery occurs within that model. Our analysis will ask four questions about the
effects of an event on the macro economy:
1) Which curve will shift? (AS or AD)
2) Which way will it shift? (left, or right)
3) What happens to short-run equilibrium P, Y, and Unemployemnt U? ( or )
4) How does the economy adjust in the long run? (Does it move back to YFE?)
The first three questions are just like the questions we always ask when manipulating supply
and demand models. The only change is that we also ask about unemployment effects;
remember, U always goes in the opposite direction as Y: The more GDP, the less
unemployment. Question 4 is unique to AS/AD models, and it expresses the ability of the
economy to recover on its own in the long run.
Long Run Equilibrium
Figure 6.11 shows the macroeconomy in long-run equilibrium, which is where LRAS, AS, and
AD cross. Notice that in long-run equilibrium the price level P0 is equal to EP, which is the price
level that people expected. Also, Real GDP is at its full employment level, YFE.
Figure 6.11: Long Run Equilibrium of Aggregate Supply and Aggregate Demand
How does the economy reach equilibrium? If the price is higher than P0, then domestic firms
produce more output than consumers, investors, government, and foreigners want to buy.
Inventories pile up, and prices fall toward equilibrium. If the actual price is lower than P0 then
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desired spending will exceed production, inventories will fall, and prices will rise toward
equilibrium and the economy will move toward full employment YFE.
A recession begins when something bad happens to the economy that shifts either AS or AD to
the left. These events are sometimes called negative “shocks.” Many economists believe that
demand shocks are more common. Both the Great Depression of 1929-1932 and the Great
Recession of 2007-09 started with financial panics during which Investment spending fell, and
the effects of both shocks lingered for many years after.
1) Demand-Driven Recession
Any of the AD curve shifters could set off a recession, but usually AD-driven recessions begin
with a drop in investment. The economy started out in long run equilibrium at point A, with price
level P1 and full employment output YFE. Then, as in 2008, financial panic strikes, firms become
pessimistic about future sales, and so their Investment spending for new facilities dries up.
Figure 6.12: A Negative Aggregate Demand Shock Causes Recession
Which curve shifts? (AD, since AD = C + I + G + NX and I was affected by the panic.)
Which way does it shift? (To the left: AD from AD1 to AD2, since I fell).
What happens to P, Y, and U? (Since short-run equilibrium moves from point A to point B,
P falls from P1 to P2. Output falls from YFE to Y2, so Unemployment increases above the Natural
Rate of Unemployment. P, Y, U.)
Since output is below YFE and unemployment is above its natural rate, we have a recession.
Long Run Adjustment and Recovery to Full Employment
In the long run, most economists believe that the economy will recover and return to full
employment on its own. How does this happen? Workers experience high unemployment and
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lower prices, so they lower price expectations and are willing to accept lower nominal wages.
Nominal wages can not fall until expected future prices EP fall. People form price expectations
based on their experience, so it will take some time (the “long run”) for expected prices to fall.
Figure 6.13: The Economy Recovers from Recession
Profitability of firms improves as nominal wages fall, so the short-run AS curve shifts to the right,
as shown in green in figure 6.13. Output increases and unemployment falls when the AS curve
shifts. Prices continue to fall, price expectations (EP) continue to adjust downward and the AS
curve continues to shift to the right, until the economy returns to full employment at point C in
figure 6.13. Point C is a new point of long run equilibrium, where prices equal expected prices.
In symbols, we say in the long run: P  EP  W  W/P  Profits  AS  Y, U
Expressing the same long-run adjustment in terms of our three supply-and-demand questions:
When, in the long run, price expectations (EP) fall:
Which curve shifts? AS, since a drop in EP allows W to fall.
Which way? To the right. AS, so the equilibrium point moves from B to C.
What happens to aggregate price, real GDP, and unemployment? P, Y, U.
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Summary of the AS/AD Model of a Demand-Driven Recession and Recovery:
Short Run (A to B in fig 6.12): Demand Shock (usually Investment)  AD  P, Y, U.
Long Run (B to C in fig 6.13): P  EP  AS  P, Y, U

In the Short Run, a decrease in the price level due to a shift in AD reduces output (because
short run AS slopes upward)

In the Long Run, a decrease in AD will affect only the price level, not output (because longrun AS is vertical).
Once real GDP returns to YFE, P = EP = P3, and the recovery process stops.
In a sense, the entire course has been leading up to this description of the business cycle, it’s
VERY IMPORTANT that you fully understand it. Take a little while to study it, and sketch out your
own versions of figures 6.12 and 6.13 on paper without looking. Master this, and convince
yourself that you understand the reasons for each curve shift (long run and short run) before
you move on.
Once you’ve mastered the model of recession and recovery,
TEST YOURSELF by answering this question:
Suppose that the economy has recovered and returned to point C. At this point, business
people get so excited about the recovery that they become overly optimistic and start on an
investment spending binge, building new factories and housing and buying new machinery that
are unlikely to pay for themselves in the long run.
Using the AS/AD model, show the effects of this investment binge on aggregate price P, real
GDP (Y), and unemployment U, in the short run and the long run. Explain the role of price
expectations in the process.
Answer: (See figure 6.14)
Short Run: I  AD  (P, Y, U). The economy moves to point D in figure 6.14. Inflation
occurs, unemployment falls below its natural rate, and GDP moves to Y1, which exceeds YFE.
This increase in Y can only occur because expected prices (and therefore nominal wages)
remain constant, so the AS curve stays at AS2.
Long Run: P  EP  AS  P, Y, U. As prices rise, so do price expectations and
nominal wages, and the AS curve shifts to the left. Price will continue to rise, and output Y will
continue to fall, until the economy reaches Long Run Equilibrium at point A, where P = EP = P5,
unemployment is at its natural rate, and Y = YFE.
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Figure 6.14: Bubbly Boom and Bust
In the AS/AD model, the business “cycle” consists of the movement around the circle from full
employment (point A) to recession (point B) through recovery to full employment (C), often
followed by a boom (D), and a correction back to full employment (A). YFE changes over time as
the population grows and technology improves, but the business cycle causes output,
unemployment, and prices to fluctuate around YFE.
In an AD-driven recession both the price level and GDP decline together as the recession hits,
moving the economy from point A to point B. Specifically, in the Great Depression real GDP fell
by about 33% during four years following the financial panic of 1929, and the price level fell by
about 22%, while the unemployment rate rose from 3% to about 25%. In most AD-driven
recessions since that time prices have not actually fallen, and real GDP often has not fallen.
Still, the rate of inflation and the rate of GDP growth have both slowed during all AD-driven
recessions.
2) Aggregate-Supply-Driven Recessions
In an Aggregate-Supply-driven recession, in contrast, inflation rises as real GDP growth falls,
which makes a combination of inflation and economic stagnation called “stagflation.”
Stagflation in the AS/AD model is shown in figure 6.15.
An Aggregate Supply shock initiates an episode of stagflation. This may be a big increase in the
price of crude oil, as occurred in 1973 during the Yom Kippur War and again in 1979 as a result
of the Iranian Revolution. Other possibilities include a decline in population or destruction of
factories and farms due to war or disease or natural disaster, such as occurred in the
Confederacy in 1864-65, or in late Medieval Europe during the Black Plague.
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Figure 6.15: Aggregate Supply Shock and Stagflation
Whatever the nature of the supply shock, it will reduce the productive capacity of the economy,
driving both long-run and short-run aggregate supply to the left (from LRAS1 to LRAS2 and from
AS1 to AS2), as shown in figure 6.15. In the short run, prices rise (from P1 to P2), and output falls
(from Y1 to Y2) as the economy moves from point A to point B. Full-employment output falls
even farther, from Y1 to Y3.
In the long run, there will be further inflation and further reductions in output, as price
expectations increase, driving the short run AS curve to AS3, and bringing the economy back to
long-run equilibrium at point C.
Clearly, an aggregate supply shock is a very bad thing for an economy, as President Jimmy
Carter learned when he ran for re-election in 1980 with CPI inflation at about 13% and
unemployment at nearly 8%.
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Figure 6.16: Real GDP Growth (blue) and Inflation (GDP Deflator, green)
The gray bars in figure 6.16 indicate the seven recesssions of the U.S. economy since 1965.
The blue line shows real GDP growth, while the green line shows inflation as measured with the
GDP deflator. In the graph you can identify demand-shock recessions as those in which inflation
and GDP growth both declined (1982-83, 2001, 2007-2009, and, less obviously 1969-70 and
1990-91). You can identify the supply-shock regressions (stagflations) as those in which
inflation rose and real GDP declined (the oil-price shock recessions of 1973-75 and 1980).
Monetary Policy, Fiscal Policy, and Aggregate Demand
(Mankiw Chapter 16)
Recessions cause high unemployment with its attendant suffering and loss of production. This
course concludes with a review of how and why most economists believe that certain
government and central bank policies could, in theory at least, reduce the length and severity of
recessions. We will also sketch out the arguments as to whether or not government policy can
in fact effectively reduce the severity of the business cycle, and whether or not it should attempt
to do so.
Two types of policies: Monetary and Fiscal. When the Federal Reserve increases or
decreases the rate of growth of the money supply M it is conducting MONETARY POLICY. When
Congress increases or decreases government spending G or taxes T it is conducting FISCAL
POLICY. Both types of policies affect the business cycle by shifting the Aggregate Demand
curve.
Recall that Aggregate Demand is the relationship between the aggregate price level P and
desired spending Y = C + I + G + NX. Monetary policy affects interest rates, which affect I.
Fiscal policy affects G directly, and it affects C indirectly by changing disposable income.
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Monetary Policy
Monetary policy affects AD by influencing interest rates: M  r  I  AD.
How does the money supply affect interest rates? The Theory of Liquidity Preference, by
John Maynard Keynes, provides an explanation.
The Theory of Liquidity Preference is really just a supply-and-demand analysis of money, but
with the interest rate r, rather than the value of money, on the vertical axis, as shown in figure
6.20:
Figure 6.20: Theory of Liquidity Preference
The money supply curve is vertical at MA, reflecting the assumption that the money supply is set
by the Federal Reserve.
Keynes’s Theory of Liquidity Preference is expressed in the money demand curve. Why does
MD have a negative slope? Think of money as an asset that you can own, a place you can store
your wealth as an alternative to interest-bearing assets such as bonds. If you have $100,000,
you can hold part of it, all of it, or none of it in the form of money. Suppose you decide to hold all
$100,000 in cash. You’re giving up the interest on $100,000. On the other hand, if you used the
cash to buy $100,000 in bonds, you might have trouble selling those bonds if you wanted to buy
something, or if you needed the cash quickly for an emergency. Also, if the riskiness of your
bonds increases, the value of your bonds will decrease.
So, there’s great convenience (and some safety) in holding your wealth in liquid (money) form,
but you sacrifice interest payments when you do so. The higher the interest rate r, the greater
your sacrifice, and the less money and more bonds you are likely to hold.
In figure 6.20, suppose the current interest rate is rB, so the quantity of money demanded is MB,
but the money supply is at MA. There is more money in the economy than people want to hold,
so they go looking for ways to lend it out (and obtain bonds). There are not enough people
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willing to borrow at rate rB, and some of the people holding cash will be willing to lend at a lower
interest rate, so market interest rates will fall until interest rates reach equilibrium at rA.
Money Demand increases (the MD curve shifts to the right), when people choose to hold more
cash regardless of the interest rate. This frequently occurs when people lose faith in the value of
bonds during financial panics. It also can occur in wartime, or in other times of uncertainty when
people value the flexibility of money balances. For example, there was a brief but substantial
surge in the demand for money following the events of September 11, 2001. By the same token,
Money Demand will shift to the left when people become more confident about the future, and
also when technological changes such increased credit card usage reduce the need to carry
cash.
Note that when MD shifts to the right, interest rates increase, and when MD shifts to the left
interest rates decrease. (Try drawing the liquidity preference diagram 6.20 on paper from
memory, shift MD to the right and see what happens.) When MD increases during a financial
panic, the Fed typically will increase the money supply to satisfy the increased demand without
an increase in interest rates.
Figure 6.21: Effect of Monetary Policy on Interest Rates
Now, suppose the Fed decides to increase the money supply from MA to MC, as in figure 6.21.
Again, when the interest rate is at rA there’s a money surplus, and people seeking to get rid of
their cash and buy bonds will drive interest rates down to rC.
By shifting the money supply curve to the left, it’s easy to see that the Fed can raise interest
rates by reducing the money supply. As an exercise, try drawing the liquidity preference
diagram like figure 6.20 from memory, shift MS to the left, and show the effect of a reduction of
the money supply on interest rates.
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Interest Rates Affect Investment Spending (I)
Investment spending (I) usually involves borrowing. Businesses borrow in order to build new
stores, restaurants, and factories, and to buy new machinery for their workers to operate.
Individuals take out mortgages in order to invest in new housing.
The cost of borrowing money is the interest rate. When interest rates rise, investment spending
falls, and when interest rates fall investment spending rises.
Investment spending is part of Aggregate Demand (AD): Y = C + I + G + NX. Falling interest
rates cause investment spending (I) to rise, which increases Aggregate Demand.
Expansionary Monetary Policy: An expansion of the money supply by the Fed causes interest
rates to fall, which stimulates investment spending, which causes the AD curve to shift to the
right, and causes higher prices and higher real GDP in the short run, as shown in figure 6.22.
To summarize in symbols, M  r  I  AD  (P, Y, Unemployment.)
Figure 6.22: Effect of Expansionary Policy on AD/AS
As we have seen in a previous module, the Fed most commonly implements expansionary
monetary policy (expands the money supply) when the FOMC buys bonds. Other examples of
expansionary monetary policy occur when the Fed lowers interest on reserves (IOR), lowers the
required reserve ratio, or offers to lend reserves to banks at a lower interest rate. The Fed
implemented several additional, rather creative, expansionary policies during the financial panic
of 2008-2009.
Contractionary Monetary Policy: A contraction of the money supply by the Fed causes
interest rates to rise, which reduces investment spending, which causes the AD curve to shift to
the left, and causes lower prices and lower real GDP in the short run.
To summarize in symbols, M  r  I  AD  (P, Y, Unemployment.).
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The Fed most commonly implements contractionary monetary policy (contracts the money
supply) when the FOMC to sells bonds. Other examples of expansionary monetary policy
occur when the Fed raises interest on reserves (IOR), raises the required reserve ratio, or
deters banks from borrowing reserves by raising its interest rate.
The most dramatic and effective application of contractionary monetary policy occurred during
1980-83, when Fed Chairman Paul Volcker (with support from Presidents Carter and Reagan)
caused a severe recession, driving unemployment up to nearly 11% in 1982.
The contractionary monetary policy also put an end to the double-digit inflation rates of the
1970s. The recession soon ended, but the decline in the inflation rate was permanent. It fell
from nearly 15% in mid-1980 to less than 4% by the end of 1982, and it stayed low. Inflation
averaged less than 3% for the following 30 years.
Fiscal Policy: Changes in G and Taxes (T)
Fiscal policy affects Aggregate Demand directly, by changing government spending G:
G  AD (since AD is C + I + G + NX),
and indirectly by changing consumers’ disposable income through taxation (T):
T  Disposable Income  C  AD.
Disposable Income is simply the income that people have left over after they pay their taxes,
DI = (Y – T).
Government spending (G) and taxation (T) in the United States are determined by Congress,
under the leadership (and potential veto) of the President.
Expansionary Fiscal Policy: An increase in government spending (G) or a tax cut (T) are
both considered expansionary. Again, the increase in G affects AD directly:
G  (C+I+G) AD  (P, Y, Unemployment.)
while the tax cut affects AD because lower taxes leave consumers more disposable income:
T  DI  C  (C+I+G) AD  (P, Y, Unemployment).
World War II involved a massive increase in government spending, an expansionary policy that
is widely (though not universally) credited with bringing the United States out of the Great
Depression. (Hitler’s military buildup provided a similar stimulus to the German economy in the
1930s.)
Notice that expansionary policy, by increasing government spending G and decreasing
government income T, increases the government’s budget deficit (G – T), forcing the
government to borrow and reducing national saving. If the government was running a fiscal
surplus (T – G > 0) prior to implementing expansionary policy, expansionary policy reduces the
surplus and national saving.
Contractionary Fiscal Policy: A decrease in government spending (G) or a tax increase (T)
are both considered contractionary.
G  (C+I+G) AD  (P, Y, Unemployment.)
while the tax increase affects AD by leaving consumers with less disposable income:
T  DI  C  (C+I+G) AD  (P, Y, Unemployment).
Because of large government budget deficits in 2008-2011 many countries in the world,
including the United States, implemented “austerity” measures designed to reduce those
deficits, primarily by reducing government spending. Though these austerity measures have
found considerable support among economists worried about the negative effects of
government debt on economic growth, many others argue that these spending cuts were
contractionary and therefore prolonged the Great Recession.
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Figure 6.22 above shows the effect of expansionary fiscal policy on the AS/AD model of the
economy. It looks identical to the effect of expansionary monetary policy, though it arises from a
very different source.
The Fiscal Multiplier Effect
There is considerable controversy among economists as to exactly how much an additional
dollar of government spending or tax cuts will increase AD.
Let’s consider tax cuts first. Suppose Congress enacts a tax cut of $1000 per person. The
average person getting an additional $1000 in income will spend some of it (C) and will save
some of it. Overall spending (AD) will increase only to the extent that the person spends that tax
cut on additional consumption spending. Suppose that the average person spends $900 of his
or her $1000 tax cut. In that case, the AD curve will initially shift to the right by $900. (The actual
increase in short-run GDP will be somewhat less than $900, since the AS curve slopes upward,
as shown in figure 6.22.)
John Maynard Keynes, shown in the photo to the right, based much of his theory
on this human tendency to increase spending by less than a dollar when income
rises by a dollar. He stated it thus:
"The fundamental psychological law upon which we are entitled to depend
with great confidence, both a priori from our knowledge of human nature and
from the detailed facts of experience, is that men are disposed, as a rule and
on average, to increase their consumption as their income increases, but not
by as much as the increase in their income." J.M. Keynes, General Theory of
Employment, Interest, and Money, 1936
He gave a name to this concept: the Marginal Propensity to Consume.
Definition: The amount of additional consumption spending induced by an additional dollar of
disposable income is called the Marginal Propensity to Consume, or MPC.
The MPC can be calculated as follows:
MPC =
Change in Consumption
Change in Income
In the $1000 tax cut example described above, MPC = (900/1000) = 0.9. Another way of
thinking of it is that a tax cut in the amount T will induce an immediate increase in consumption
spending, and therefore an immediate rightward shift of the AD curve, equal to MPC x T, so a
$1000 tax cut will increase Aggregate Demand by MPC x $1000 = $900 almost immediately.
The effects of the tax cut can expand and multiply. The $900 of additional consumption
spending (say, on a new TV) will be an additional $900 in income to the people who produce
and sell the TV. Of that additional $900 income, those TV sellers will consume an additional
MPC x $900 = $810, which will be income to someone else, who will spend MPCx$810 = $729,
and so on and so on. This is called the “Keynesian Multiplier” process.
Here’s what you need to know about the Keynesian Multiplier:
1) It is a model of how an additional dollar of G or decrease in T affects the AD curve, and
2) The multiplier is larger when MPC is larger.
You should also see that a $1 billion increase in G has a larger multiplier effect on AD than a $1
billion tax cut T, since the full $1 billion of G is spent on goods and services, whereas only
MPC xT is spent in the initial round of spending from a tax cut.
Finally, notice that the multiplier process works in reverse, too. If G falls by a dollar (or T rises by
a dollar) AD may decrease (shift to the left) by much more than a dollar, since a decrease in
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spending results in a decrease in income, which causes consumption spending to decrease,
which decreases income further, and so on.
Limitations on the Multiplier Effect of Expansionary Fiscal Policy
There are at least two major reasons to believe that the multiplier effect is limited, and hence to
doubt the ability of expansionary fiscal policy to fix a recession. In both cases, the expansionary
policy has a side effect that causes some category of spending (I or C) to decrease.
1. Crowding Out: Expansionary fiscal policy consists of increases in G and decreases in T,
either one of which will increase the government’s budget deficit, G – T. When the budget deficit
increases, national saving decreases, which our Loanable Funds model tells us will drive up
interest rates and decrease investment spending, shifting AD back to the left.
To summarize “Crowding Out”:
Expansionary policy (G, T )  S r  I  AD.
2. “Ricardian Equivalence.” Other things constant, when the government increases spending
and cuts taxes it creates debt that must be repaid someday, which will require higher taxes in
the future. People will reduce their consumption spending (C) today so as to have money
available later on to pay those higher taxes.
To summarize “Ricardian Equivalence”:
Expansionary policy (G, T ) Expected future taxes)  S C  AD.
Most economists believe that the crowding out effect is greater when the economy is at full
employment, so the multiplier is higher when the economy is in recession. (Crowding out does
not occur without an increase in interest rates.) As to Ricardian Equivalence, some economists
dismiss it almost entirely, since (1) people may not really plan that far ahead; (2) even forwardplanning people may believe that higher future taxes will be paid by someone else; and (3) not
everyone is able to save even if they want to, particularly during a recession.
To summarize, the exact size of the Keynesian multiplier is controversial among economists,
most believe that higher government spending and lower taxes stimulate aggregate demand to
some degree in the short run, that the multiplier is higher during recessions than during times of
full employment, and that the multiplier is higher if MPC is higher.
Using Policy to Stabilize the Economy
In this final section of the course we’ll first consider the ideal model of how fiscal and monetary
policy could be used to counteract the business cycle, and describe why most economists
believe that government policy could in principle stabilize the business cycle to avoid
depressions and reduce the great pain and waste created by boom and recession.
We’ll go on to explain why, in normal times at least, most economists are skeptical that active
fiscal policy is useful for stabilizing moderate fluctuations of the economy. We’ll see why many
economists are more inclined to rely on monetary policy for stabilization in normal times, and
why many others recommend against active policy of either type.
The Case FOR Active Stabilization Policy
The extremes of the business cycle are costly. High unemployment during recessions causes
great pain to millions of idled workers, causes their skills to deteriorate, and results in a loss of
production to society that can never be recovered. During extreme booms, excessive
speculation, bubbles, and poor investment decisions waste resources and set the stage for
failure. Stabilization policy can reduce the costs of boom and bust.
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Figure 6.23: Expansionary Policy to Reduce Unemployment and End a Recession
Figure 6.23 illustrates how expansionary fiscal or monetary policy can be used to end a
recession. Suppose the economy is in recession at point A. Production is at Y1, well below full
employment YFE, which means that the unemployment is above the natural rate. Classical
economists would say not to worry, in the long run price expectations and wages will adjust
downward, which will shift short run AS curve will shift to the right, which will end the recession
at point C in the long run. In some recessions, including the Great Recession of 2007-09,
though, the long run is very long indeed. Five years after the financial panic that brought on the
recession, the unemployment rate was still near 7%. As Keynes said, “in the long run we’re all
dead.” FDR’s advisor Harry Hopkins put it this way: “People don’t eat in the long run. They eat
every day.” Waiting for the long run adjustment is costly and painful.
If the long-run shift of the AS curve to point C is slow for some reason, expansionary monetary
or fiscal policy can intervene to move things along and put people back to work. A massive bond
purchase by the Federal Reserve, or a Congressional bill to increase in government spending or
give a tax cut, will shift the AD curve to the right. If the expansionary policy is measured
correctly it will shift the economy from point A to point C by moving the AD curve from AD0 to
AD1. At the cost of some inflation (price rises from P0 to P1), expansionary policy will drive real
GDP upward from Y0 to Y1 and unemployment will fall to its natural rate.
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That’s how expansionary fiscal policy works in an ideal world. Increased government spending
brings the economy back to full employment by replacing the decreased private spending that
drove it into recession. Tax cuts ameliorate the effect of depressed private spending by
stimulating consumption. Expansionary monetary policy offsets depressed AD by driving
interest rates down to stimulate investment. Whether it’s fiscal or monetary, expansionary policy
is designed to reduce or eliminate the impact of a recession.
Contractionary monetary and fiscal policy has exactly the opposite effect, and it is designed to
cool the economy off, to reduce or eliminate an excessive boom. (As longtime Fed Chair William
McChesney Martin put it, the Fed “is in the position of the chaperone who has ordered the
punch bowl removed just when the party was really warming up.”) If real GDP is greater than full
employment GDP, the correct fiscal stabilization policy would be contractionary, to reduce
government spending or raise taxes. If real GDP is greater than full employment GDP, the
correct monetary policy would be contractionary, to sell bonds so as to reduce the money
supply. In either case, contractionary policy reduces real GDP, which is a good thing if the
economy is overheated.
Test Your Understanding: Draw a diagram with the AS, AD, and LRAS curves
showing the economy in a boom with output above full employment. (Be sure to label
all curves, axes, YFE, and short-run equilibrium P and Y, and draw your AD and AS
curves so that initial short-run equilibrium output exceeds YFE.) Now show the effect of
contractionary policy in bringing the policy back to full employment. Contrast that policy
effect with the economy’s natural movement to full employment, which will occur as
price expectations adjust upward to reality. Does the policy adjustment or the natural
adjustment of the economy generate higher inflation?
Stabilization Policy and the Budget Deficit. Often Keynesian economists who advocate
active fiscal policy are accused of fiscal irresponsibility because expansionary fiscal policy
(increasing G, decreasing T) causes budget deficits (T – G > 0). Certainly, Keynesian
economists do recommend increasing the budget deficit during recessions, because increased
deficits are expansionary. On the other hand, they recommend that the government run a
budget surplus during excessive booms, since increased budget surpluses (G – T > 0) are
contractionary. Keynesian economists therefore recommend fiscal policies that balance
the budget over the business cycle, rather than balancing it every year.
Although Keynesian economists usually advocate active government stabilization policy to
counteract the business cycle, and Keynesian economists tend to be less skeptical of
government’s role in the economy than economists from many other schools of thought,
Keynesian theory is neutral with respect to the size of the government, and Keynesian
stabilization policy strictly applied would not increase government debt in the long run.
The Case AGAINST Active Stabilization Policy
The business cycle creates great pain and waste because it causes wasteful investment
spending and bubbles during booms and wasteful unemployment during recessions. If active
stabilization policy can reduce this pain and waste, why would anyone argue against it? There
are several strong arguments against active stabilization policy. The arguments against active
monetary policy are somewhat different (and weaker) than the arguments against active fiscal
policy.
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Arguments Against Active Fiscal Policy:
(1) Congress makes the decisions as to spending and taxation, and Congressmen are poorly
equipped to perform fiscal policy. First, Congressional leaders are rarely well trained in
either diagnosing the problems of the economy, and they even more rarely understand how
to formulate and implement the correct cures for the country’s economic problems.
Furthermore, Congressional decisions on spending and taxation are driven by many factors
other than economic stabilization. Congressmen want to be re-elected, and the easiest way
to get re-elected is to spend more on your constituents, and tax them less.
Some would even argue that the political system is biased toward implementing the wrong
policy. Income falls during recessions, and people become pessimistic about the future.
Active policy calls for increased government spending during recessions, but recessions
cause ordinary people to cut their spending, which makes them want to see government cut
its spending too. Such “austerity” arguments dominated the policy debates in the beginning
of the Great Depression (1929-32), again in 1937, and yet again in 2010-2014, making it
politically difficult to implement expansionary fiscal policy. Similarly, there is a tendency to
increase spending and cut taxes during optimistic boom times, for example during the late
1960s and 2001-06, making it politically difficult to implement the appropriate contractionary
policy.
(2) Even if Congress does implement the appropriate fiscal policy, it will often do so too late.
Congress takes a long time to act in normal times. By the time it passes a law, the economy
may have encountered new and different problems, or it may have naturally recovered from
the recession.
(3)
Even if Congress does implement the correct fiscal policy promptly, it is difficult to say how
long it will take for the policy to take effect. Individuals may not spend their tax cuts until
they are certain they are permanent. It may take years for a new highway project or a new
building project to progress from authorization through the planning stages to the point
where the money is being spent.
Arguments Against Active Monetary Policy
(1) Unlike fiscal policy, which is driven by distracted Congressional policy amateurs, monetary
policy is driven by Federal Reserve policy experts whose minds are always concentrated on
monetary policy. Still, even those experts at the Fed are driving the economy with a limited
set of information. In particular, they don’t know much about the future. It’s as if the Fed is
trying to drive a car with so much mud on its windshield that the driver must steer by looking
in the rearview mirror. It’s very easy for even an expert driver to do more harm than good in
these circumstances. A driver who can’t see ahead is well-advised to drive slowly,
cautiously, and predictably.
(2) Like fiscal policy, monetary policy takes effect only with a lag, and the length of the lag is
variable and uncertain. Remember, an increase in the money supply drives interest rates
down only if people decide to lend out their excess money balances.
(3) Under some circumstances (a “liquidity trap”), monetary policy is unable to stimulate the
economy. Sometimes (as in 2009-13) people and businesses decide to hold on to their
money rather than lend it. Also, expansionary monetary policy works by lowering short-term
nominal interest rates, and when nominal interest rates are very close to zero (as in 200913) they simply can not go any lower.
There’s another argument against fiscal policy that has intuitive appeal, but is most likely false
when the economy is in a deep recession. Sometimes you will hear the argument that “if the
government increases its spending, those dollars have to come from somewhere, and that
means that a dollar more of government spending implies a dollar less of private spending.” The
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problem with this line of argument is that it “proves too much.” That is, if it is true that increasd
government spending can not stimulate the economy, then it’s also true that increased private
spending can not stimulate the economy either, and for the same reason. For example, if all the
homebuilders in the country decide to spend an additional billion dollars on housing, “they have
to get those dollars from somewhere,” so the non-homebuilding part of the economy will have to
shrink by one billion dollars. If increased government spending can’t stimulate the economy,
then neither can increased private spending.
An increase in spending (public or private) can increase real GDP if it puts idle resources (such
as unemployed workers or idle machinery) to work. Employing more resources increases
output. Increased spending can therefore have a bigger stimulative effect if there are more
unused resources available, which is the case during recessions. How big this effect is in the
real world is a matter of active debate in the economics profession.
Some economists who oppose active stabilization policy argue that increased government
spending during a recession is a bad idea because government is too big, so increased
government spending is always a bad idea. This is a reasonable political position to take, and it
probably underlies much of the opposition to activist stabilization policy, but it is really an
argument about values, not about efficacy.
Often the same economists that are suspicious of activist government in general also argue that
Keynesian stabilization policy can too easily be used to justify especially wasteful government
spending. Keynesian theory does in fact suggest that even wasteful spending is expansionary,
but all economists agree that it is better to spend the money on needed infrastructure, such as
roads and airports and schools than on bridges to nowhere and monuments to politicians.
Finally, some economists argue that fiscal stabilization policy is a bad idea because recessions
perform a purging and cleansing function that makes the economy stronger in the long run. It is
true that recessions cause many poorly run businesses to fail, but they also cause many wellrun businesses to fail, and they idle many productive resources, including workers thrown into
unemployment. Accurately comparing the real costs of recessions to the possible benefits from
“macroeconomic purging” in recessions is impossible to do, and some skepticism is surely
justified when tenured economics professors claim that other people’s unemployment is a cost
worth bearing!
Automatic Fiscal Stabilizers
Some fiscal stabilization policies are already “built in” to the tax and spending system. These
policies are called “automatic stabilizers,” and they act like a thermostat to lessen the costs of
the business cycle. Two examples are progressive income taxes and unemployment insurance.
In a progressive income tax system such as the one in the United States, people with higher
incomes pay a higher percentage of their income in taxes. By the same token, people with lower
incomes pay less of their incomes in taxes. Incomes decline during recessions, so recessions
automatically cause taxes to decline as a percentage of national income. Tax cuts are
expansionary, and expansionary policy is appropriate during a recession, so if there is a
progressive income tax system then recessions trigger appropriate expansionary policy
automatically, without Congress or the President having to act. Similarly, the income tax system
automatically implements a contractionary tax increase during a boom.
Similarly, the government pays unemployment insurance only to workers who have been laid off
of work. Therefore, the layoffs that occur during a recession automatically cause an
expansionary increase in government spending. (A contractionary decrease in unemployment
insurance occurs automatically during boom times. Other programs to aid the poor have similar
stabilizing effects on the economy.
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Notice that automatic stabilizers do not have the problems with lags or doubtful management
that other fiscal stabilization policies do, because they are implemented promptly and
automatically.
The Great Recession and Policy Debate
Economists disagree vehemently on nearly everything concerned with stabilization policy. There
is broad agreement, however, that in normal times fiscal stabilization policy (other than
automatic stabilizers) is too uncertain and unstable and slow to be useful. Most economists
agree that if you are going to implement stabilization policy, in normal times it’s better to rely on
monetary policy than fiscal policy.
The onset of the Great Recession in 2008, and the subsequent slow recovery created an ideal
atmosphere for a loud and often acrimonious debate among economists and politicians about
stabilization policy. In the United States, in the spring of 2009 a Democratic-controlled Congress
and White House implemented expansionary fiscal policy by passing a stimulus bill, the
American Reinvestment and Recovery Act (ARRA) that included about $500 Billion in increased
spending and $300 Billion in tax cuts, spread over the next two years (mostly).
Meanwhile, the Fed pumped reserves into the banking system in the years following the
financial panic of 2008, causing the monetary base to expand at a rate of 28% per year 20082013. The money supply (M2) grew by a more modest 7% per year. Despite this increase in the
money supply, core inflation remained between 1% and 2% for nearly all of this period.
GDP fell nearly 3% in 2009, so automatic stabilizers kicked in even more quickly than the ARRA
did, and the federal government’s budget deficit consequently ballooned to almost 10% of GDP
by 2009. Unemployment maxed out at about 10% in October 2009, the highest in 26 years, but
well below the Great Depression level of 25%.
The debate over the effectiveness of ARRA and Fed policy has been bitter and partisan, even
among professional economists. By 2011 Republicans had taken over the House of
Representatives. Government spending and the deficit began declining (and tax collections
began increasing) as a percentage of GDP as the economy began its natural recovery and
fiscal policy shifted toward austerity and deficit reduction. Democrats and many Keynesian
economists partly blame the slow recovery on contractionary fiscal policies, though they also
note that recoveries from financial panics are typically slow in any case. Republicans and many
conservative economists doubt the effectiveness of the ARRA and believe that business
uncertainty created by dramatic fiscal and monetary (and regulatory) policies played a role in
slowing the recovery from the recession. A more mainstream view is that the ARRA and the
Fed’s policies had measurable expansionary effects. Whether because they were ineffective or
because they were too small, it is clear that expansionary fiscal and monetary policies were
unable to fully counteract the depressing effects of the largest financial panic in 80 years.