I. Tools of fiscal policy
A. Taxes
B. Government Spending
Expansionary Policy on the graph
• During a recession, short run equilibrium is below full
employment level of output.
• AD is too low
• Government can increase AD by:
• Spending more (in the formula G )
• Cutting taxes (which means you will spend more
and in the formula C )
Contractionary Policy on the graph
• When there is inflation, short run equilibrium is above full
employment level of output.
• AD is too high
• Government can decrease AD by:
• Spending less (in the formula G )
• Raising taxes (which means you will spend less and
in the formula C )
https://www.
youtube.com
/watch?v=9B
-gIfhnyeo
Discretionary and Automatic Stabilizers
A. Discretionary
1. a specific action that has to be taken by
government
2. passing a law to change taxes or spending
B. Automatic stabilizers
1. policies or laws already in place
2. unemployment insurance – payments keep
AD from falling as much as they would otherwise
The Political Business Cycle
A. Fiscal policy happens in the political arena and is
handled by politicians
B. Election results are determined by the economy
C. Economic policy can be used to serve political ends.
D. Monetary policy in the hands of the Fed can be a
solution
https://www.yo
utube.com/watc
h?v=RZtaZTEO3j
A
Short Run Phillips Curve
A. Inverse relationship between inflation and unemployment
1. Low unemployment leads to rising wages which leads to inflation
2. high unemployment leads to falling wages which keeps inflation low
Phillips Curve
Example
Suppose:
• In the past the economy of Narvaizville has had 0% inflation
• The people of Narvaizville expect 0% inflation
• SRPC0 is Narvaizville’s short run Phillips curve
Inflation Rate
What will the unemployment rate be?
6%
5
4
3
2
1
0
1
2
3
Unemployment Rate
4
5
6
SRPC0
Inflation Rate
The economy is at point A
5
4
3
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC0
Suppose that the government of Narvaizville:
• Thinks 6% unemployment is too high
• Pursues fiscal policy to bring unemployment down to 4%
Inflation Rate
What will the inflation rate be?
2%
5
4
3
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC0
Inflation Rate
The economy is at point B
5
4
3
B
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC0
After spending some time at point B:
• The people of Narvaizville EXPECT a 2% inflation rate.
Inflation Rate
What will this expectation do to the SRPC?
Shift it to the right
5
4
3
B
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC0
Inflation Rate
If our current rate of 2% inflation persists what will be the
unemployment rate?
6%
5
4
3
B
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC2
SRPC0
The economy is at point C
The Government of Narvaizville STILL considers 6% unemployment too high so they will
continue fiscal policy that brings unemployment down to 4%.
Inflation Rate
If unemployment is 4% what is inflation?
4%
5
4
3
C
B
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC2
SRPC0
The economy is at point D
After spending some time at point D:
• The people of Narvaizville EXPECT a 4% inflation rate.
Inflation Rate
What will this expectation do to the SRPC?
Shift it to the right
5
D
4
3
C
B
2
1
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC2
SRPC0
Inflation Rate
If our current rate of 4% inflation persists what will be the
unemployment rate?
6%
5
D
4
3
C
B
2
1
SRPC4
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC2
SRPC0
The economy is at point E
A persistent attempt to keep unemployment lower accelerates inflation
Inflation Rate
To avoid increasing rising inflation over time, the unemployment rate must be high enough that
the actual rate of inflation matches the expected rate of inflation.
5
D
4
E
3
C
B
2
1
SRPC4
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC2
SRPC0
At what points does:
Expected inflation = actual inflation
6% is the unemployment rate at which inflation does not change over time.
LRPC = natural rate of unemployment
Inflation Rate
Long Run Phillips Curve
LRPC
5
D
4
E
3
C
B
2
1
SRPC4
A
0
1
2
3
Unemployment Rate
4
5
6
SRPC2
SRPC0
Long Run Phillips Curve
A in the long run there is no trade off between unemployment and inflation
B. People’s wages eventually adjust to the gap between
inflationary expectations and the actual rate of inflation.
C. LRPC is where EXPECTED inflation is equal to ACTUAL
inflation
D. Any rate of inflation is consistent with the natural rate
of unemployment
http://www.youtube.com/watch?
v=jFKZqi1Bl-k