Economic Policy and the Aggregate
Demand/Supply Model
Macroeconomic Policy
• A. Policy in the Face of Demand Shocks
• B. Responding to Supply Shocks
Fiscal Policy – The Basics
• A. Taxes, Purchases of Goods and Services,
Government Transfers, and Borrowing
• B. The Government Budget and Total Spending
• C. Expansionary and Contractionary Fiscal
Policy
• A Cautionary Note: Lags in Fiscal Policy
Macroeconomic Policy
• The Long-Run adjustment back to Yp may take
a long time so most economists believe that
the government can help expedite the return
to full employment and stable prices.
• Stabilization Policy: The use of government
policy to reduce the severity of recessions and
rein in excessively strong expansions.
Macroeconomic Policy
• A. Policy in the Face of Demand Shocks
– Negative demand shock causes a recessionary
gap.
– The price level falls, but so does real GDP.
– Unemployment becomes a problem
– Government policy (both Fiscal and monetary) is
designed to reverse this decline in AD.
– This shortens the duration of a recession.
Macroeconomic Policy
– Positive demand shocks cause an inflationary gap.
– The price level rises and so does real GDP.
– Unemployment falls, but I inflation is the real
problem
– Again, government policy would be geared toward
reversing the increase in AD
– This shortens the duration of an inflationary
period.
Macroeconomic Policy
• Responding to Supply Shocks
– There is very little policy makers can do to reverse
a supply shock
– It is much easier to affect spending (through AD)
than it is to affect production (through AS)
– What if we tackled a negative supply shock by
trying to influence AD?
Macroeconomic Policy
• Negative Supply Shocks
– Suppose policy makers wanted to shift aD to the
right to fight unemployment.
– This would worsen the inflation.
– Or suppose policy makers wanted to shift AD to
the left to fight the inflation.
– That would only worsen the unemployment
– There are no good options here.
Fiscal Policy – The Basics
• A Key understanding to fiscal policy is to
understand its origins.
• Fiscal policy is all about taxation and government
spending.
• The President proposes a budget to Congress that
includes plans for spending and tax collection.
• Eventually Congress will amend and approve a
budget and it becomes law.
– This fundamentally differs from monetary policy
which is created by the Federal Reserve, the central
bank of the U.S.
Fiscal Policy – The Basics
• Taxes, Purchases of Goods and Services,
Government Transfers, and Borrowing
– The government plays a sizeable role in the
circular flow diagram
• Government Spending – Like households, the
government spends money on goods and
services.
• What are examples of goods and services
purchased by the government?
Fiscal Policy – The Basics
• Local: police cars in your city
• State: A system of State Parks
• Federal: The Military
Fiscal Policy – The Basics
• Transfer Payments
– The government also provides transfer payments
to some households.
– Examples of transfer payments:
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Social Security
Medicare
Medicaid
VA benefits,
Food Stamps
Etc.
Fiscal Policy – The Basics
• Tax Collection
– Like households, the government must collect
money in order to pay for this spending.
– The Government Collects Taxes
– What are some taxes that you or your parents
pay?
Fiscal Policy – The Basics
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Tax Collection (cont.)
Sales tax
Income tax
Property tax
Vehicle registration tax
Gas
Excise taxes (on liquor or tobacco)
Tax on corporate profits (dividends)
Fiscal Policy – The Basics
• Like households, the government can borrow
to make up for a shortfall in tax revenue that
does not pay for all of the spending.
• Government borrowing will be covered in
future sections of the course.
Government Budget and Total Spending
• How does the government affect AD?
• Remember, if we add up all of the spending in
an economy we get:
– C+I+G+(X-M)
– G: government purchases of goods and services
• This directly affects GDP and thus AD
Government Budget and Total
Spending
• Indirectly, the government can influence consumption
spending ( C) through taxes and transfers.
• Look at what goes into consumption spending:
– A person receives income Y from his/her job
– Taxes are paid to the government and sometimes transfer
payments are received by the government.
– What is left over is disposable income Yd
– Disposable income can now either be consumed or saved
– Yd = Y – taxes = C + S or
– C = Yd – S
• Remember, when Yd increases, so does C
Government Budget and Total
Spending
• So the government can indirectly increase C if
it can increase Yd
• How can it increase Yd?
– By cutting taxes or by increasing transfer
payments
– The government can affect investment spending
(I) through tax policy
Expansionary and Contractionary
Fiscal Policy
• (Two short-run states of an economy –
recessionary gap and an inflationary gap
• Recessionary GAP - fiscal policy should try to
shift AD to the right
– Expansionary Fiscal Policy normally takes one of
three forms:
• An increase in government purchases of goods and
services
• A cut in taxes
• An increase in government transfers
Expansionary and Contractionary
Fiscal Policy
• Inflationary Gap – Fiscal policy should try to
shift AD to the left.
• Contractionary fiscal policy, normally takes
one of three forms:
– A decrease in government purchases of goods and
services
– An increase in taxes
– A decrease in government transfers
A Cautionary Note:
Lags in Fiscal Policy
• Fiscal policy looks easy but in reality it is more
difficult because there are important time lags
in its use.
• Recognition Lag: The government has to
realize that the recessionary gap exists
because economic date takes time to collect
and analyze, and
• Recessions are often recognized only months
after they have begun.
A Cautionary Note:
Lags in Fiscal Policy
• Decision Lag: The government has to develop a
spending plan, which can itself take months, particularly
if politicians take time debating how the money should
be spent and passing legislation.
• Implementation Lag: It takes time to spend money.
• For example, a road construction project begins with
activities such as surveying that don’t involve spending
large sums.
• It may be quite some time before the big spending
begins.
• By this time, the economy might have already begun
self-correcting back to Yp.
In-Class Activities
• Practice Questions:
1. The economy is currently experiencing a recessionary
gap.
– List two fiscal policy options that would move the
economy closer to potential real GDP
– Describe how your policy would achieve the desired
result
2. The economy is currently at a level of output that
exceeds potential GDP (Yp).
– List two fiscal policy options that would move the
economy closer to potential real GDP.
– Describe how your policy would achieve the desired
result.