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
• Self-correction?
• Stabilization Policy
Policy in the Face of Demand
Shocks
• Negative Demand Shocks/
Positive Demand Shocks
• Why are they bad?
Create GDP Gaps:
change in output, change in
employment, change in price
level. Having price stability is
a good thing and a desirable
goal.
Should policymakers
counteract? Yes and No
Responding to Supply Shocks
• Supply shocks: Hard to
counter act. Can not easily
remedy
• Policy dilemma: How
can you shift the AS curve
back? Should you shift the
AD curve right instead?
Could limit unemployment,
but cause even higher
inflation
Fiscal Policy: The Basics
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
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: 3 Lags in fiscal policy
• Recognition lag: Government has to realize there is a
problem and a GDP gap has happened
• Decision lag: (Administrative lag): Government must
come up with a plan to correct the GDP gap and pass
legislation
• Implementation lag: (Operational lag): Once the policy is
approved, the effects take time to change the condition of
the economy.
** Lags make decision making more difficult**