Module 20
Economic Policy and the
Aggregate DemandAggregate Supply Model
KRUGMAN'S
MACROECONOMICS
for
AP*
odel
Margaret Ray and David Anderson
What you will learn
in this Module:
• How the AD-AS model is used to
formulate macroeconomic policy
• The rationale for stabilization policy
• Why fiscal policy is an important tool for
managing economic fluctuations
• Which policies constitute expansionary
fiscal policy and which constitute
contractionary fiscal policy
Macroeconomic Policy
Can the market fix itself or
does it need help from
government?
• Self-correction?
• Stabilization Policy
John Maynard Keynes
“Keynesian Economics”
Policy in the Face of Demand
Shocks
• Negative Demand
Shocks & Positive
Demand Shocks
• Why are they bad?
• Should policymakers
counteract?
Responding to Supply Shocks
• Supply shock
• Policy dilemma
Fiscal Policy: The Basics
2008
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
2008
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
2008
The Government Budget and Total
Spending
• GDP = C + I + G + X - M
• The effect of taxes and transfers
• Effects on Investment
Expansionary and
Contractionary Fiscal Policy
• Expansionary Fiscal
Policy
• increase G
• decrease T
• increase transfers
Expansionary and
Contractionary Fiscal Policy
• Contractionary Fiscal
Policy
• decrease G
• increase T
• decrease transfers
A Cautionary Note: Lags in Fiscal Policy
• Time lags
• Recognition lag
• Decision lag
• Implementation lag
• Lags make decision making more difficult
A Cautionary Note: Lags in Fiscal Policy
Recognition lag: The government has to realize that the
recessionary gap exists because economic data take time to
collect and analyze, and recessions are often recognized
only months after they have begun.
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.
Unnumbered Figure 20.1 Is Stabilization Policy Stabilizing?
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Figure 20.4 Expansionary Fiscal Policy Can Close a Recessionary Gap
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Figure 20.5 Contractionary Fiscal Policy Can Close an Inflationary Gap
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers