Laugher Curve
Aggregate Demand
Policy in Perspective
Problems with Fiscal Policy
• Top Five Reasons to Study Economics
5. When you get drunk, you can tell
everyone that you are just researching
the law of diminishing marginal utility.
Laugher Curve
Laugher Curve
• Top Five Reasons to Study Economics
4. You can talk about money without
having to make any.
3. You can say “trickle down” with a
straight face.
• Top Five Reasons to Study Economics
2. When you are in the unemployment
line, at least you know why you are
there.
1. If you rearrange the letters in
ECONOMICS, you get COMIC NOSE.
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Supply Side versus
Demand Side Policies
Supply Side versus
Demand Side Policies
• The interrelationship between AS and
AD is captured in the circular flow
diagram.
• AS (production by firms) creates output
and income, and hence AD (the
potential demand to buy that output.
• The AS/AD model separates long-run
aggregate supply from short-run
aggregate demand forces.
Supply Side versus
Demand Side Policies
Demand-Side and SupplySide Policies
• They can, and do, often emphasize
different interconnections.
LAS
Price Level
• Politicians are not constrained by
models.
– Demand-side policies (monetary and fiscal
policy) shift the AD curve.
– Supply-side policies work by increasing
potential output.
Supply-side policies
shift the LAS curve.
SAS
Demand-side policies
(monetary and fiscal
policies) shift the AD curve
YP
AD
Real output
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Problems with Fiscal
Policy
• Six assumptions of the AS/AD model lead to
problems with fiscal policy:
– Financing the deficit has no offsetting effects.
– The government knows what the situation is.
– The government knows potential income.
– The government has flexibility in changing
spending and taxes.
– The size of the government debt doesn’t matter.
– Fiscal policy doesn’t negatively affect other goals.
Financing the Deficit Doesn’t
Have Offsetting Effects
• Some economists believe that
government financing of deficit
spending offsets the deficit’s
expansionary effect.
• They believe that government
borrowing increases interest rates and
crowds out private investment.
Financing the Deficit Doesn’t
Have Offsetting Effects
Financing the Deficit Doesn’t
Have Offsetting Effects
• Crowding out – the offsetting of a
change in government expenditures by
a change in private expenditures in the
opposite direction.
• Some economists argue that the effect
of government expenditures is
negative.
• They consider private spending to be more
productive than government spending.
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• Crowding out also works in reverse in
contractionary fiscal policy.
– When the government runs a surplus, it buys
back bonds.
– Interest rates will drop, stimulating
investment.
Partial Crowding Out
Price Level
Financing the Deficit Doesn’t
Have Offsetting Effects
AD2 AD1
AD0
SAS
Partial crowding out
Net effect
Y0
Y2 Y1
Real output
Knowing What the
Situation Is
Knowing What the
Situation Is
• Data problems limit the use of fiscal
policy for fine tuning.
• Getting reliable numbers on the
economy takes time.
• We may be in the middle of a recession
and not know it.
• The government has large econometric
models and leading indicators to predict
where the economy will be in the near
future.
• Economic forecasting is still very much
an art and not a science.
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Knowing the Level of
Potential Income
Knowing the Level of
Potential Income
• No one knows for sure the level of
potential income.
• Potential income has been called the
full-employment level of income.
• Differences in estimates of potential
income often lead to different policy
recommendations.
Knowing the Level of
Potential Income
• In most cases, the U.S. economy is in
an ambiguous state.
• Some economists will call for expansionary
policy and others call for contractionary
policy.
The Government’s
Flexibility in Changing
Taxes and Spending
• Putting fiscal policy into place takes
time and has serious implementation
problems.
• Numerous political and institutional
realities in the U.S. today make it a
difficult task to implement fiscal policy.
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The Government’s
Flexibility in Changing
Taxes and Spending
• Squabbles between Congress and the
President may delay implementing
appropriate fiscal policy for months,
even years.
Size of the Government
Debt Doesn’t Matter
• These is no inherent reason why the
adoption of activists policies should
have caused high government deficits
year after year.
Size of the Government
Debt Doesn’t Matter
Size of the Government
Debt Doesn’t Matter
• Activist policy has led to an increase in
government debt because:
• If one believes that debt is harmful,
then there might be a reason not to
conduct expansionary fiscal policy,
even when the model calls for it.
– Early activists favored large increases in
government spending as well as favoring the
government's using fiscal policy.
– Politically, it is much easier for government to
increase spending and decrease taxes than
vice versa.
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Fiscal Policy Doesn’t
Negatively Affect Other
Government Goals
• An economy has many goals –
achieving potential income is only one
of those goals
• National economic goals often conflict.
Summary of the Problems
• While the six problems listed above do
not necessarily eliminate fiscal policy
altogether, they severely restrict it.
• Fiscal policy is a sledgehammer, not an
instrument for fine-tuning.
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