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?
•Most economists agree that
in the long-run the economy
will self correct, but also
agree with John Maynard
Keynes, “In the long-run we
are all dead”
•Most economist recommend
the use of fiscal policy
(stabilization policy) to get
the economy back to potential
output
Policy in the Face of Demand
Shocks
Demand Shocks
Why are they bad?
Should policymakers
counteract?
Negative demand shocks
cause unemployment to
rise
Positive demand shocks
cause higher levels of
inflation
Responding to Supply Shocks
•Negative supply shocks
present policy dilemmas
• If AD is increased
to counter
unemployment,
price levels rise
• If AD is decreased
to counter inflation,
unemployment
increases
Fiscal Policy: The Basics
Although fiscal policy in the U.S. plays a smaller role
than in other countries, changes can have significant
impact
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
• G is a direct component of AD so any
changes lead to a change in AD and GDP
The effect of taxes and transfers
•Taxes and transfer payments affect
disposable income and therefore C
Effects on Investment
• Taxes on business profits affect investment
decisions and can change I
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-it takes time to collect and
gather data about the economy
• Decision lag-it takes more time to develop
spending and tax plans
• Implementation lag-it takes time for the
money to actually be spent
Lags make decision making more difficult