Section 4
What You
Will Learn
in this
Module
• Explain the difference between
short-run and long-run
macroeconomic equilibrium
• Describe the causes and effects of
demand shocks and supply shocks
• Determine if an economy is
experiencing a recessionary or an
inflationary gap and explain how to
calculate the size of an output gap
Section 4 | Module 19
The AS–AD Model
• The AS-AD model uses the aggregate supply
curve and the aggregate demand curve together
to analyze economic fluctuations.
Section 4 | Module 19
Short-Run Macroeconomic
Equilibrium
• The economy is in short-run macroeconomic
equilibrium when the quantity of aggregate output
supplied is equal to the quantity demanded.
• The short-run equilibrium aggregate price level is the
aggregate price level in the short-run macroeconomic
equilibrium.
• Short-run equilibrium aggregate output is the
quantity of aggregate output produced in the short-run
macroeconomic equilibrium.
Section 4 | Module 19
The AS–AD Model
Aggregate price
level
SRAS
P
E
E
SR
Short-run
macroecon
omic
equilibrium
AD
Y
E
Real
GDP
Section 4 | Module 19
Demand Shocks
(a) A Negative Demand Shock
Aggregate
price level
A negative
demand
shock...
(b) A Positive Demand Shock
Aggregate
price level
A positive
demand shock...
SRAS
SRAS
P1
P2
P
2
E
1
E
2
AD
2
Y2 Y1
...leads to a
P
lower
1
aggregate price
AD level and lower
1
aggregate
output.
Real
GDP
E
2
E
1
AD
1
Y1 Y2
...leads to a
higher
aggregate
price
level and
AD
higher
2
aggregate
output.
Real
GDP
Section 4 | Module 19
Supply Shocks
(a) A Negative Supply Shock
Aggregate
price level
A negative
supply shock...
SRAS
E2
2
Aggregate
price level
P
1
…leads to a
E1
lower
aggregate
output and a
AD
higher
aggregate price
level.
Y Y1
2
Real GDP
A positive
supply shock...
SRAS
SRA
S 1
P
2
P
1
(b) A Positive Supply Shock
P
2
1
E
1
E2
AD
Y Y2
1
SRA
S 2
...leads to a
higher
aggregate
output and
lower
aggregate
price level.
Real GDP
Section 4 | Module 19
Negative Supply Shocks
Stagflation is the combination of inflation and
stagnating (or falling) aggregate output.
“Stagnation plus inflation”
Section 4 | Module 19
Long-Run Macroeconomic
Equilibrium
• The economy is in long-run
macroeconomic equilibrium when the
point of short-run macroeconomic
equilibrium is on the long-run aggregate
supply curve.
Section 4 | Module 19
Long-Run Macroeconomic
Equilibrium
Aggregat
e
price
level
LRAS
SRAS
P
E
E
LR
Long-run
Macroeconomic
equilibrium
AD
Y
P
Potential
output
Real
GDP
Section 4 | Module 19
Short-Run Versus Long-Run Effects of a
Negative Demand Shock
Aggregat
e
price
level
P
1
P2
2. …reduces the
aggregate
price level and
aggregate
output and leads to
higher
unemployment in the
short run…
1. An initial
negative
demand
shock…
LRAS
SRAS
1
SRAS
2
E
1
E
2
P3
E
3
AD
1
AD
2
Y
2
Y
1
Poten
tial
Recessionary gap outpu
t
3. …until an
eventual
fall in nominal
wages
in the long run
increases
short-run
aggregate supply
and moves the
economy Real
back to
potential GDP
output.
11 of 17
Section 4 | Module 19
Short-Run Versus Long-Run Effects
of a Positive Demand Shock
Section 4 | Module 19
Long-Run Macroeconomic
Equilibrium
• There is a recessionary gap when aggregate output is
below potential output.
• There is an inflationary gap when aggregate output is
above potential output.
• The output gap is the percentage difference between
actual aggregate output and potential output.
Section 4 | Module 19
Long-Run Macroeconomic
Equilibrium
• The economy is self-correcting when
shocks to aggregate demand affect
aggregate output in the short run, but not
the long run.
Section 4 | Module 19
FY
I
Supply Shocks versus Demand Shocks in Practice
• Recessions are mainly caused by
demand shocks. But when a negative
supply shock does happen, the resulting
recession tends to be particularly severe.
• There’s a reason the aftermath of a
supply shock tends to be particularly
severe for the economy: macroeconomic
policy has a much harder time dealing
with supply shocks than with demand
shocks.
Section 4 | Module 19
Summary
1. In the AD–AS model, the intersection of the short-run
aggregate supply curve and the aggregate demand curve is
the point of short-run macroeconomic equilibrium. It
determines the short-run equilibrium aggregate price level
and the level of short-run equilibrium aggregate output.
2. A demand shock causes the aggregate price level and
aggregate output to move in the same direction as the
economy moves a long the short-run aggregate supply
curve.
3. A supply shock causes them to move in opposite directions
as the economy moves along the aggregate demand curve.
4. Stagflation is inflation and falling aggregate output and is
caused by a negative supply shock.
Section 4 | Module 19
Summary
5. Demand shocks have only short-run effects on aggregate
output because the economy is self-correcting in the long
run.
6. In a recessionary gap, an eventual fall in nominal wages
moves the economy to long-run macroeconomic
equilibrium, where aggregate output is equal to potential
output.
7. In an inflationary gap, an eventual rise in nominal wages
moves the economy to long-run macroeconomic
equilibrium.
8. The output gap is the percentage difference between actual
aggregate output and potential output
Section 4 | Module 19
Section 4
What You
Will Learn
in this
Module
• Discuss how the AS–AD model is
used to formulate macroeconomic
policy
• Explain the rationale for
stabilization policy
• Describe the importance of fiscal
policy as a tool for managing
economic fluctuations
• Identify the policies that constitute
expansionary fiscal policy and
those that constitute
contractionary fiscal policy
Section 4 | Module 20
Macroeconomic Policy
• Economy is self-correcting
in the long run.
• Stabilization policy is the
use of government policy to
reduce the severity of
recessions and rein in
excessively strong
expansions.
Section 4 | Module 20
Macroeconomic Policy
• Policy in the Face of Demand Shocks
– If policy were able to perfectly anticipate shifts of
the aggregate demand curve and counteract them,
the period of low aggregate output and falling
prices could be avoided.
– Price stability is generally regarded as a desirable
goal.
Section 4 | Module 20
Macroeconomic Policy
Responding to supply
shocks:
– There are no easy policies to
shift the short-run aggregate
supply curve.
– Policy dilemma: a policy that
counteracts the fall in
aggregate output by
increasing aggregate demand
will lead to higher inflation,
but a policy that counteracts
inflation by reducing
aggregate demand will
deepen the output slump.
Section 4 | Module 20
FY
I
Is Stabilization Policy Stabilizing?
• Has the economy actually become more
stable since the government began
trying to stabilize it?
• Yes. Data from the pre–World War II era
are less reliable than more modern
data, but there still seems to be a clear
reduction in the size of economic
fluctuations.
• It’s possible that the greater stability of
the economy reflects good luck rather
than policy.
• But on the face of it, the evidence
suggests that stabilization policy is
indeed stabilizing.
Section 4 | Module 20
Government Spending and Tax Revenue
for Some
High-Income Countries in 2012
Section 4 | Module 20
Taxes, Government Purchases of Goods and
Services, Transfers,
and Borrowing
• Funds flow into the government in the form
of taxes and government borrowing
• Funds flow out of the government in the
form of government purchases of goods and
services and government transfers to
households
Section 4 | Module 20
Sources of Tax Revenue in the U.S., 2013
Section 4 | Module 20
Government Spending in the U.S.,
2013
Section 4 | Module 20
The Government Budget and Total
Spending
• Fiscal policy is the use of taxes, government transfers, or
government purchases of goods and services to shift the
aggregate demand curve.
Section 4 | Module 20
Expansionary and Contractionary
Fiscal Policy
• Expansionary fiscal policy increases aggregate demand
and can take one of three forms:
– an increase in government purchases of goods and
services
– a cut in taxes
– an increase in government transfers
• Contractionary fiscal policy reduces aggregate demand
and can take one of three forms:
– a reduction in government purchases of
goods and services
– an increase in taxes
– a reduction in government transfers
Section 4 | Module 20
Expansionary and Contractionary
Fiscal Policy
Expansionary Fiscal Policy Can Close a
Recessionary Gap
Section 4 | Module 20
Expansionary and Contractionary
Fiscal Policy
Contractionary Fiscal Policy Can Eliminate an
Inflationary Gap
31 of 17
Section 4 | Module 20
A Cautionary Note: Lags in Fiscal
Policy
• In the case of fiscal policy, there is an important reason
for caution: there are significant lags in its use.
– Realize the recessionary/inflationary gap by collecting
and analyzing economic data  takes time
– Government develops a spending plan takes time
– Implementation of the action plan
(spending the money  takes time)
Will the stimulus come in time to be
worthwhile? President Barack Obama listens to
a question during a news conference in the East
Room of the White House in Washington, D.C.
Section 4 | Module 20
Summary
1. Many economists advocate active stabilization policy: using fiscal or
monetary policy to offset demand shocks.
2. Negative supply shocks pose a policy dilemma:
a policy that counteracts the fall in aggregate output by increasing
aggregate demand will lead to higher inflation, but a policy that
counteracts inflation by reducing aggregate demand will deepen the
output slump.
3. Fiscal policy is the use of taxes, government transfers, or government
purchases of goods and services to shift the aggregate demand curve.
4. Expansionary fiscal policy shifts the aggregate demand curve rightward.
5. Contractionary fiscal policy shifts the aggregate demand curve leftward.
Section 4 | Module 20
Section 4
What You
Will Learn
in this
Module
• Explain why fiscal policy has a
multiplier effect
• Describe how automatic stabilizers
influence the multiplier effect
Section 4 | Module 21
Using the Multiplier to Estimate
the Influence of Government Policy
• Fiscal policy has a multiplier effect on the
economy.
• Fiscal policy can take the form of changes
in taxes, transfers, and government
spending.
• Expansionary fiscal policy leads to an
increase in real GDP larger than the initial
rise in aggregate spending caused by the
policy.
• Conversely, contractionary fiscal policy
leads to a fall in real GDP larger than the
initial reduction in aggregate spending
caused by the policy.
Section 4 | Module 21
Using the Multiplier to Estimate the
Influence of Government Policy
The multiplier on changes in government purchases is
1/(1 − MPC).
Section 4 | Module 21
Multiplier Effects of Changes in
Taxes and Government Transfers
• Example: The government hands out $50 billion in the form of
tax cuts.
• There is no direct effect on aggregate demand by government
purchases of goods and services; GDP goes up only because
households spend some of that $50 billion.
• How much will they spend?
– MPC × $50 billion. For example, if MPC = 0.6, the firstround increase in consumer spending will be $30 billion
(0.6 × $50 billion = $30 billion).
– This initial rise in consumer spending will lead to a series
of subsequent rounds in which real GDP, disposable
income, and consumer spending rise further.
Section 4 | Module 21
Multiplier Effects of Changes in
Government Transfers and Taxes
Section 4 | Module 21
Multiplier Effects of Changes
in Government Transfers and Taxes
• The multiplier on changes in
taxes or transfers, MPC/(1 −
MPC), because part of any
change in taxes or transfers is
absorbed by savings.
• The results from changes in
taxes are complicated by the fact
that governments rarely impose
lump sum taxes.
• Changes in government
purchases have a more
powerful effect on the economy
than equal-sized changes in
taxes or transfers.
Section 4 | Module 21
How Taxes Affect the Multiplier
• Rules governing taxes and some
transfers act as automatic
stabilizers, reducing the size of the
multiplier and automatically
reducing the size of fluctuations in
the business cycle.
• In contrast, discretionary fiscal
policy arises from deliberate
actions by policy makers rather
than from the business cycle.
Section 4 | Module 21
FY
I
About That Stimulus Package . . .
• The U.S. economy needed a fiscal stimulus. There was, however, sharp
partisan disagreement about what form that stimulus should take.
• Republicans favored tax cuts on general political principles. Democrats
preferred transfer payments, especially increased unemployment benefits
and expanded food stamp aid.
• The eventual compromise gave most
taxpayers a flat $600 rebate, $1,200 for
married couples.
• Many economists believed that only a
fraction of the rebate checks would actually
be spent, so that the eventual multiplier
would be fairly low.
Section 4 | Module 21
Summary
1. Fiscal policy has a multiplier effect on the economy, the
size of which depends upon the fiscal policy.
2. Except in the case of lump-sum taxes, taxes reduce the
size of the multiplier. Expansionary fiscal policy leads to
an increase in real GDP, while contractionary fiscal
policy leads to a reduction in real GDP.
3. Because part of any change in taxes or transfers is
absorbed by savings in the first round of spending,
changes in government purchases of goods and
services have a more powerful effect on the economy
than equal-size changes in taxes or transfers.
Section 4 | Module 21
Summary
4. Rules governing taxes—with the exception of lump-sum
taxes—and some transfers act as automatic stabilizers,
reducing the size of the multiplier and automatically
reducing the size of fluctuations in the business cycle.
5. Discretionary fiscal policy arises from deliberate
actions by policy makers rather than from the business
cycle.
Section 4 | Module 21