Module 20: Economic Policy & the AD/AS Model
Macroeconomic Policy:
Because the long-run adjustment back to LRAS can take a long time, some economists
believe that the government can help hurry-up the process, getting back to LR EQ.
Stabilization Policy – the use of government policy to reduce the severity of
recessions and to rein in excessively strong expansions.
Demand shocks can be reversed by government intervention but supply shocks are
not so easily manipulated.
The Basics of Fiscal Policy:
Government spending, transfers and taxation make up what we call fiscal policy.
Government Spending:
Local: Police cars for the city
State: the system of State Parks
Federal: military
Transfer Payments: (some households)
Social Security, Medicare, Medicaid, VA benefits, food stamps, etc.
Taxation:
Sales tax, income tax, property tax, vehicle registration tax, excise taxes (gas, alcohol,
tobacco), etc.
IMPORTANT NOTE: GDP & AD are “besties”, they always move together!
How does the government influence AD? G (government spending) affects GDP and
thus AD. They can also influence C (consumer spending) by changing transfers and
taxes.
Remember Yd (disposable income), when it changes, C will change in the same
direction. The gov’t can change Yd by changing taxes and gov’t transfers.
Expansionary and Contractionary Fiscal Policy
If we are find ourselves in a recessionary gap, fiscal policy should try to move AD to
the right.
Expansionary fiscal policy would be in order here.
 An increase in gov’t spending
 A cut in taxes
 An increase in gov’t transfers
If we are in an inflationary gap situation, fiscal policy should try to move AD to the
left.
Contractionary fiscal policy would do the trick here.
 A decrease in gov’t spending
 An increase in taxes
 A decrease in gov’t transfers
Lags in Fiscal Policy:
Things look nice and easy in the model, but reality is a bit more complicated.
Time lags can make this process pretty long.
Recognition lag: It takes time for the gov’t to even realize that the gap exists due to
getting good information (takes time to collect and analyze the data). Recessions are
usually only recognized months after they actually start.
Decision lag: Once the gap is recognized, it can take time to get a plan together and for
congress to pass any legislation to get the ball rolling to close the gap. (Look at
congress today, they can’t decide on anything!)
Implementation lag: Yes, it even takes time to spend $$! Bids have to be analyzed for
spending projects, roads have to be surveyed, etc.
By the time the spending begins, the economy could already be self-correcting and the
policy may push us to the other side of LRAS!