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and Stabilization

Fiscal Policy and

Aggregate Demand

Fiscal policy: the setting of the level of govt

spending and taxation by govt policymakers
Expansionary fiscal policy
an increase in G and/or decrease in T
shifts AD right

Contractionary fiscal policy

a decrease in G and/or increase in T
shifts AD left

Fiscal policy has two effects on AD.

What happens to the economy in the

short run with an increase in
government spending? Long run?

Budget Balance

Budget surplus an excess of tax revenue over

government spending
Budget deficit a shortfall of tax revenue from
government spending
Expansionary fiscal policy makes a budget
surplus smaller or a budget deficit bigger
Contractionary fiscal policy makes a budget
surplus bigger or a budget deficit smaller.
If taxes and government change by the same
amount, the government purchases will have a
larger effect on Real GDP than a change in taxes
Changes in a budget balance are the result not
the cause of fluctuations in the economy.

Business Cycle and the

Cyclically Adjusted Budget

During a recession, budget deficits tend to

During an expansion, budget surpluses
tend to occur.
The budget deficit almost always rises
when the unemployment rate rises and
falls when the unemployment rate falls.
Why does this happen?
Automatic stabilizers

During recessions tax revenue goes down and

unemployment benefits, food stamps go up

Cyclically adjusted budget


An estimate of what the budget balance

would be if real GDP were exactly equal to
potential output.
Takes into account extra tax revenue the
government would collect and transfers it
would save if a recessionary gap were
eliminated or the revenue the government
would lose and the extra transfers it would
make if an inflationary gap were eliminated.
Should the Budget be balanced?


Deficits, Surpluses, and


Fiscal year runs from October 1 to

September 30 and is labeled according to the
calendar year in which it ends.

Fiscal year 2009 began on October 1, 2008 and

ended on September 30, 2009.

Federal Debt continues to increase.

Public debt: government debt held by
individuals and institutions outside the
End of 2009, the federal governments public
debt was only $7.6 trillion or 53% of GDP

Problems Posed by Rising

Government Debt

1) Crowding out
2) Todays deficits, by increasing the governments
debts, place financial pressure on future budgets.

2009 federal government paid 2.7% of GDP or $383

billion in interest on its debt.
Greece pays 5.4% of GDP on the interest
Government has to use more and more of the budget on
the interest payment rather than important programs for
the people.
Governments have a hard time paying, they print more
money and the country suffers from inflation and an a
financial crisis.

Deficits and Debts

To assess the ability of governments to pay their

debt, we use the debt-GDP ratio, the government
debt as a percentage of GDP.
A country wants to avoid going over 90%.
The problem with the U.S. Debt is not the current
situation, but implicit liabilities spending
promises made by governments that are
effectively a debt despite the fact that they are not
included in the usual debt statistics.
Social Security and Medicare
Baby Boomers born between 1946 and 1964 are
retiring, so they stop paying taxes and start
collecting Social Security and Medicare.
2008 31 retirees receiving benefits for every 100
workers; 2030 46 per 100, 2050 48 per 100,
2080 51 per 100

Monetary Policy and the

Interest Rate

Fed increases MS, interest rates?

Fed decreases MS, interest rates?
Who decides the
interest rate?
The Fed sets target
federal funds rate,
desired level for the
federal funds rate.

Monetary Policy

Expansionary Monetary Policy: monetary

policy that increases aggregate demand

BLLL Increases MS, lowers interest rates,

increases C and I

Contractionary Monetary Policy:

monetary policy that decreases
aggregate demand

SHHH Decreases MS, raises interest rates,

decreases C and I

Taylor Rule

In 1993, economist John Taylor

suggested that monetary policy follow a
simple rule that took in account both the
business cycle and the inflation rate.
Taylor rule for monetary policy a
rule for setting the federal funds rate
that takes into account both the inflation
rate and the output gap.

Federal funds rate = 1 + (1.5 x inflation rate) + (0.5 x output

Fed uses some form of the Taylor rule.

Inflation Targeting

Fed wants inflation low, but positive.

Fed does not explicitly target inflation, but its
agreed upon that its about 2%.
Some central banks do explicitly target inflation.
Inflation targeting occurs when the central
bank sets an explicit target for the inflation rate
and sets monetary policy in order to hit that target.
Bank of England: 2%, New Zealand: 1to 3%
Advocates argue it creates greater transparency
and accountability
Critics argue there may be extreme circumstances
that call for the inflation rate to fall out of the
target area.

Money, Output, & Prices in

the Long Run

Central banks sometimes print money

not to fight a recessionary gap, but for a
government to pay its bills, this
destabilizes the economy.
In the long run, changes in the money
supply will effect the price level and not
change the real aggregate output.
In the short run, the money supply can
change aggregate output and price level.

The Effects of a Monetary


Assume that the economy is currently in equilibrium

and the Fed suddenly increases the supply of money.
The supply of money shifts to the right.
The equilibrium value of money falls and the price
level rises.
When an increase in the money supply makes
dollars more plentiful, the result is an increase in
the price level that makes each dollar less valuable.
Quantity theory of money a theory asserting
that the quantity of money available determines the
price level and that the growth rate in the quantity
of money available determines the inflation rate.

A Brief Look at the

Adjustment Process

The immediate effect of an increase in the money

supply is to create an excess supply of money.
People try to get rid of this excess supply in a
variety of ways

They may buy goods and services with the funds.

They may use these excess funds to make loans to
others. These loans are then likely used to buy goods
and services
In either case, the increase in the money supply leads
to an increase in the demand for goods and services.
Because the supply of goods and services has not
changed, the result of an increase in the demand for
goods and services will be higher prices.

The Classical Dichotomy

and Monetary Neutrality

In the 18th century, David Hume and other

economists wrote about the relationship between
monetary changes and important macroeconomic
variables such as production, employment, real
wages, and real interest rates.
They suggested and economic variables should
be divided into two groups: nominal variables
and real variables.
Nominal variables variables measured in
monetary units
Real variables variables measured in
physical units.

The Classical Dichotomy

and Monetary Neutrality

Classical dichotomy the theoretical

separation of nominal and real variables.
Prices in the economy are nominal, but relative
prices are real
Hume suggested that different forces influence
real and nominal variables.
According to Hume, changes in the money supply
affect nominal variables but not real variables.
Monetary neutrality the proposition that
changes in the money supply do not affect real

Velocity and the Quantity

Velocity of money the rate at which money
changes hands.
To calculate velocity, we divide nominal GDP by
the quantity of money
Velocity = nominal GDP/money supply
If P is the price level (the GDP Deflator), Y is real
GDP, and M is the quantity of money.
Velocity = P x Y
Rearranging, we get the quantity equation.

Velocity and the Quantity


Quantity equation the equation M x V

= P x Y, which relates the quantity of
money, the velocity of money, and the
dollar value of the economys output of
goods and services.

The quantity equation shows that an increase

in the quantity of money must be reflected in
one of the other three variables.
Specifically, the price level must rise, output
must rise, or velocity must fall.

Velocity and the Quantity


We can now explain how an increase in the

quantity of money affects the price level using
the quantity equation.

The velocity of money is relatively stable over time.

When the central bank changes the quantity of money
(M), it will proportionately change the nominal value of
output (P x Y)
The economys output of goods and services (Y) is
determined primarily by available resources and
technology. Because money is neutral, changes in the
money supply do not affect output.
This must mean that P increases proportionately with
the change in M.

Classical Model of the

Price Level

The real quantity of money is always at its long-run

equilibrium level.
Assume: the effect of a change in the money supply
on the aggregate price level takes place
instanteously rather than over a long period of time.
Assumption used when high inflation is occurring,
poor assumption in the short run.
Under periods of high inflation, expectations have
changed, and workers and firms are quick to change
prices and wages.
Hence the SRAS shifts rapidly when persistent high
inflation occurs.


Summer of 2008
achieved the worlds
highest inflation rate: 11
million percent a year

The Inflation Tax

Some countries use money creation to pay for spending

instead of using tax revenue
Inflation tax the revenue the government raises by
creating money, reduction in the value of money held by
the public caused by inflation.
The inflation tax is a tax on everyone who holds money.
Almost all hyperinflations follow the same pattern.
The government has a high level of spending and
inadequate tax revenue to pay for its spending
The governments ability to borrow funds is limited
As a result, it turns to printing money to pay for its
The large increases in the money supply lead to large
amounts of inflation
The hyperinflation ends when the government cuts its
spending and eliminates the need to create new


People will use something else for

medium of exchange
In Germany in the 1920s, they used
lumps of coal or eggs as a medium of

Cost-Push Inflation

Inflation that is caused

by a significant
increase in the price of
an input with economywide importance.
For example, the oil
crisis of the 1970s
which led to an
increase in energy
prices in the US,
causing a leftward shift
of the aggregate supply
curve, increasing the
price level.

Demand-Pull Inflation

Inflation that is caused by an

increase in aggregate demand.
Too much money chasing too few

Output Gap and the

Unemployment Rate

The percentage difference between the actual

level of real GDP and potential output is called
the output gap.
When the actual aggregate output is equal to
potential output, the actual unemployment rate
is equal to the natural rate of unemployment.
When the output gap is positive (inflationary
gap), the unemployment rate is below the
natural rate. When the output gap is negative
(a recessionary gap), the unemployment rate is
above the natural rate.

Inflation and
In the long
run, inflation & unemployment
are unrelated:

The inflation rate depends mainly on growth in

the money supply.
Unemployment (the natural rate) depends on
the minimum wage, the market power of unions,
efficiency wages, and the process of job search.

In the short run,

society faces a trade-off between
inflation and unemployment.

The Phillips Curve

Origins of the Phillips Curve

In 1958, an economists named Alban W. Phillips published an

article discussing the negative correlation between inflation
rates and unemployment rates in the United Kingdom.
American economists Paul Samuelson and Robert Solow
showed a similar relationship between inflation and
unemployment for the United States two years later.
The belief was that low unemployment is related to high
aggregate demand, and high aggregate demand puts upward
pressure on prices. Likewise, high unemployment is related to
low aggregate demand, and low aggregate demand pulls price
levels down.
Phillips Curve: a curve that shows the short-run tradeoff
between inflation and unemployment.
Samuelson and Solow believed that the Phillips curve offered
policymakers a menu of possible economic outcomes.
Policymakers could use monetary and fiscal policy to choose
any point on the curve.

Aggregate Demand,
Aggregate Supply, and the
The Phillips
curve shows
the combination

of inflation and unemployment that arise

in the short run due to shifts in the
aggregate demand curve.
The greater the aggregate demand for
goods and services, the greater the
economys output and the higher the price
level. Greater output means lower
unemployment. Whatever the previous
years price level happens to be, the
higher the rate of inflation.

Deriving the Phillips Curve

Suppose P = 100 this year.

The following graphs show two
possible outcomes for next year:
A. Agg demand low,
small increase in P (i.e., low inflation),
low output, high unemployment.
B. Agg demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.

Deriving the Phillips Curve

A. Low agg demand, low inflation, high u-rate









B. High agg demand, high inflation, low u-rate



Aggregate Demand,
Aggregate Supply, and the
Given that monetary and fiscal policy can
Phillips Curve
both shift the aggregate demand curve,
both shift the aggregate demand curve,
these types of policies can move the
economy along the Philips curve.

Increases in the money supply, increases in

government spending, or decreases in taxes
increase aggregate demand and move the
economy to a point on the Philips curve with
lower unemployment and higher inflation.
Decreases in the money supply, decreases in
government spending, or increases in taxes all
lower aggregate demand and move the
economy to a point on the Philips curve with
higher unemployment and lower inflation.

The Phillips Curve: A

Policy Menu?

Since fiscal and monetary policy affect

aggregate demand, the PC appeared to offer
policymakers a menu of choices:
low unemployment with high inflation
low inflation with high unemployment
anything in between

1960s: U.S. data supported the Phillips

Many believed the PC was stable and reliable.

Evidence for the Phillips

Curve? During
During the
the 1960s,

U.S. policymakers
opted for
for reducing
at the
the expense
expense of
higher inflation

Shifts in the Phillips Curve:

The Role of Expectations

The Long-Run Phillips Curve

Shows the relationship between unemployment and inflation

after expectations of inflation have had time to adjust to
In 1968, economist Milton Friedman argued that monetary
policy is only able to choose a combination of unemployment
and inflation for a short period of time. At the same time,
economist Edmund Phelps wrote a paper suggesting the
same thing.
This true because, in the long run, monetary growth has no
real effects. This means that it cannot affect the factors that
determine the economys unemployment rate.
Thus, in the long run, we would not expect there to be a
relationship between unemployment and inflation. This must
mean that, in the long run, the Philips curve is vertical.

Shifts in the Philips Curve:

The Role of Expectations

The Long-Run Phillips Curve

The vertical Phillips curve occurs because, in
the long run, the aggregate supply curve is
vertical as well. Thus, increases in aggregate
demand lead only to changes in the price
level and have no effect on the economys
level of output. Thus, in the long run,
unemployment will not change when
aggregate demand changes, but inflation will.
The long-run aggregate supply curve occurs
at the economys natural rate of output; thus,
the Phillips curve occurs at the natural rate of

The Vertical Long-Run

In the long run, faster money growth only causes
faster inflation.






natural rate
of output

natural rate of


Reconciling Theory and


Evidence (from 60s):

PC slopes downward.
Theory (Friedman and Phelps work):
PC is vertical in the long run.
To bridge the gap between theory and evidence,
Friedman and Phelps introduced a new variable:
expected inflation a measure of how much
people expect the price level to change.
Expected inflation is the most important factor,
other than the unemployment rate, affecting

People base their expectations about inflation on


The Phillips Curve


Short run
Fed can reduce u-rate below the
natural u-rate by making inflation
greater than expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate
whether inflation is high or low.

How Expected Inflation

Initially, expected
the PC
actual inflation = 3%,
unemployment =
natural rate (6%).


Fed makes inflation

2% higher than expected,
u-rate falls to 4%.
In the long run,
expected inflation
increases to 5%,
PC shifts upward,
unemployment returns to
its natural rate.








Expectations and the ShortRun Phillips Curve

The short-run aggregate supply curve is upward sloping because of

misperceptions about relative prices, sticky wages, and sticky prices. These
perceptions, wages, and prices adjust over time, so that the positive
relationship between the price level and the quantity of goods and services
supplied occurs only in the short run.
This same logic applies to the Phillips curve. The tradeoff between inflation
and unemployment holds only in the short run.
The expected level of inflation is an important factor in understanding the
difference between the long-run and the short-run Phillips curves. Expected
inflation measures how much people expect the overall price level to change.
The expected rate of inflation is one variable that determines the position of
the short-run aggregate-supply curve. This is true because the expected price
level affects the perceptions of relative prices that people form and the wages
and prices that they set.
In the short-run, peoples expectations are somewhat fixed. Thus, when the
Fed increases the money supply, aggregate demand increases along the
upward sloping short-run aggregate supply curve. Output grows
(unemployment falls) and the price level rises (inflation increases).
Eventually, however, people will respond by changing their expectations of
the price level. Specifically, they will begin expecting a higher rate of

Expectations and the

If policymakers
want to take
advantage of the short-run

tradeoff between unemployment

and inflation, it may lead to
negative consequences.
Suppose the economy is at point
A and policymakers wish to lower
the unemployment rate.
Expansionary monetary policy or
fiscal policy is used to shift
aggregate demand to the right.
The economy moves to point B,
with a lower unemployment rate
and a higher rate of inflation.
Over time, people get used to
this new level of inflation and
raise their expectations of
inflation. This leads to an upward
shift of the short-run Philips
curve. The economy ends up at
point C, with a higher inflation
rate than at point A, but the same
level of unemployment.








Nonaccelerating inflation
rate of unemployment

The unemployment rate at which inflation

does not change over time.
Trying to keep the unemployment rate below
the NAIRU will only lead to everaccelerating
inflation and will not be maintained.
Economists believe that there is a NAIRUA
and there is no tradeoff of the
unemployment rate and the inflation rate in
the short term.
NAIRU is another name for the natural rate
of unemployment.

The Natural Experiment for

the Natural-Rate
Natural-rate hypothesis the claim that unemployment eventually
returns to its normal,
or natural rate, regardless of the rate of inflation.
The figure on the next slide shows the unemployment rate and inflation

The figure on the next slide shows the unemployment rate and inflation
rate. It is easy to see the inverse relationship between these variables.
Beginning in the late 1960s, the government followed policies that
increased aggregate demand.
Government spending rose because of Vietnam War.
The Fed increased the money supply to try to keep interest rates
As a result of these policies, the inflation rate remained fairly high.
However, even though inflation remained high, unemployment did not
remain low.
The simple inverse relationship between the two variables began to
disappear in 1970.
This occurred because peoples inflation expectations adjusted to the
higher rate of inflation and the unemployment rate returned to its
natural rate of around 5 to 6 percent.
Government can NOT keep the unemployment rate low, it should try to
keep it stable at the natural rate.

The Breakdown of the

Phillips Curve
Early 1970s:

unemployment increased,
despite higher
higher inflation.
Friedman &
& Phelps
expectations were
catching up
up with

Shifts in the Phillips Curve:

The Role of Supply Shocks

In 1974, OPEC increased the price of oil sharply.

This increased the cost of producing many goods
and services and therefore resulted in higher
Supply shock an event that directly alters
firms costs and prices, shifting the economys
aggregate-supply curve and thus the Philips
Graphically, we could represent this supply shock
as a shift in the short-run aggregate-supply curve
to the left.
The decrease in equilibrium output and the
increase in the price level left the economy with

How an Adverse Supply Shock

Shifts the PC
SRAS shifts left, prices rise, output & employment fall.







Inflation & u-rate both increase as the PC shifts upward.

The 1970s Oil Price Shocks

Supply shocks
shocks &
& rising
rising expected
inflation worsened
worsened the
the PC
PC tradeoff.

Shifts in the Phillips Curve:

The Role of Supply Shocks

Given this turn of events, policymakers are left with a

less favorable short-run tradeoff between
unemployment and inflation.
If they increase aggregate demand to fight
unemployment, they will raise inflation further.
If they lower aggregate demand to fight inflation,
they will raise unemployment further.
The less favorable tradeoff between unemployment
and inflation can be shown by a shift of the short-run
Phillips curve. The shift may be permanent or
temporary, depending on how people adjust their
expectations of inflation.
During the 1970s, the Fed decided to accommodate
the supply shock by increasing the supply of money.
This increased the level of expected inflation.

The Cost of Reducing


Disinflation: a reduction in the

inflation rate
To reduce inflation,
Fed must slow the rate of money
growth, which reduces agg demand.
Short run: output falls and
unemployment rises.
Long run: output & unemployment
return to their natural rates.

Disinflationary Monetary

monetary policy moves
economy from A to B.
Over time,
expected inflation falls,
PC shifts downward.
In the long run,
point C:the natural rate
of unemployment,
and lower inflation.


natural rate of

The Cost of Reducing

To reduce
The the
inflation rate,
the Fed

must follow contractionary monetary

When the Fed slows the rate of growth
of the money supply, aggregate demand
This reduces the level of output in the
economy, increasing unemployment.

The Cost of Reducing

The economy moves Inflation:
point A along the short-run inflation
Philips curve
to point
which has a lower inflation
rate but a higher
unemployment rate.

Over time, people begin to

adjust their inflation
expectations downward and
the short-run Philips curve
shifts. The economy moves
from point B to point C,
where inflation is lower and
the unemployment rate is
back to its natural rate.


natural rate of

The Cost of Reducing

reduce inflation,

economy must suffer through a period of

high unemployment and low output.
Sacrifice ratio the number of
percentage points of annual output lost in
the process of reducing inflation by 1
percentage point
A typical estimate of the sacrifice ratio is
5. This implies that for each percentage
point inflation is decreased, output falls by
5 percent.

The Cost of Reducing

Rational expectations the theory according to
optimally use all
they have, including information about
government policies, when forecasting the future.
Proponents of rational expectations believe that

when government policies change, people alter

their expectations about inflation.
Therefore, if the government makes a credible
commitment to a policy of low inflation, people
would be rational enough to lower their
expectations of inflation immediately. This implies
that the short-run Philips curve would shift quickly
without any extended period of high

Rational Expectations, Costless


Rational expectations: a theory according to

which people optimally use all the information they
have, including info about govt policies, when
forecasting the future
Early proponents:Robert Lucas, Thomas Sargent,
Robert Barro
Implied that disinflation could be much less costly
The bottom line of the rational expectations theory
is that government intervention is not necessary or
useful for stabilizing the economy.

Rational Expectations, Costless


Suppose the Fed convinces everyone

it is committed to reducing inflation.
Then, expected inflation falls,
the short-run PC shifts downward.
Disinflations can cause less
than the traditional sacrifice ratio

The Cost of Reducing

Paul Volcker worked at reducing the level of inflation
Volcker Disinflation
the 1980s.
As inflation fell, unemployment rose. In fact, the United
States experienced its deepest recession since the Great
Some economists have offered this as proof that the idea of
a costless disinflation suggested by rational-expectations
theorists is not possible. However, there are two reasons
why we might not want to reject the rational-expectations
theory so quickly.

The cost (in terms of lost output) of the Volcker disinflation

was not as large as many economists had predicted.
While Volcker promised that he would fight inflation, many
people did not believe him. Few people thought that inflation
would fall as quickly as it did; this likely kept the short-run
Philips curve from shifting quickly.

The Volcker Disinflation

Disinflation turned
turned out
out to
to be
be very
very costly:

u-rate near
10% in

The Cost of Reducing

Greenspan became the chairman of the Federal Reserve in
1987. The Greenspan Era
In 1986, OPECs agreement with its members broke down
and oil prices fell. The result of this favorable supply shock
was a drop in both inflation and unemployment.
The rest of the 1990s witnessed a period of economic
prosperity. Inflation gradually dropped, approaching zero
by the end of the decade. Unemployment also reached a
low level, leading many people to believe that the natural
rate of unemployment has fallen.
The economy ran into problems in 2001 due to the end of
the dot.com stock market bubble, the 9-11 terrorist
attacks, and the corporate accounting scandals that
reduced aggregate demand. Unemployment rose as the
economy experienced its first recession in a decade.

The Greenspan Era: 19872006

Inflation and
and unemployment
were low
low during
during most
most of
Alan Greenspans
Greenspans years
as Fed
Fed Chairman.

Case Study: Why were

Inflation and
Unemployment so Low at
At the end of the 1990s, the unemployment rate
the inflation
than the United
States had seen in many years.
This likely implies that the short-run Philips
curve has drifted leftward, giving the United
States a more favorable tradeoff between
inflation and unemployment
Causes of this movement in the short-run Philips
curve include reductions in expected inflation,
lower commodity prices, changes in the stability
of the labor force, and technological

Favorable Supply Shocks

in the 90s

Declining commodity prices

(including oil)
Labor-market changes
(reduced the natural rate of
Technological advance
(the information technology boom of

1990s: The End of the

During Phillips
the 1990s, inflation
fell to

about 1%, unemployment fell to about

4%.Many felt PC theory was no longer
Many economists believed the Phillips
curve was still relevant; it was merely
shifting down:

Expected inflation fell due to the policies

of Volcker and Greenspan.

Three favorable supply shocks occurred.


A falling aggregate price level.

Causes the lender to gain while the borrower
loses since the borrower has to back the loan
with a dollar with a greater value.
Borrowers stop spending, lenders are less
likely to increase spending sharply. Causing
aggregate demand to decline decreasing prices
Debt deflation the reduction in aggregate
demand arising from the increase in the real
burden of outstanding debt caused by

Effects of Expected

Zero bound: nominal interest rate

cannot go below zero. So if deflation is
occurring lenders would rather hold on to
their cash rather than lend it out.
Zero bound can reduce the effectiveness
of monetary policy.
Liquidity trap: a situation in which
conventional monetary policy is
ineffective because nominal interest rates
are up against the zero bound.
2008 & 2009 the Fed was at zero bound.

Main Approaches to

1) Classical economics, which originated in 1776 with

Adam Smiths Wealth of Nations, was the dominant
economic thinking until the mid-1850s.
Uses a laissez-faire approach, meaning the government
should not interfere in the market because the market can
regulate itself.
Economists should focus on how to encourage savings and
investment in order to increase economic growth over the
The economy will fluctuate, and growth will slow down
from time to time. But no remedy by government can
improve on the performance of the market, fine-tuning
economy will backfire
The AS will shift back to equilibrium.
Believe the quantity theory of money both velocity and
the quantity of g&s sold per period are fairly stable
Classical economists also believe in Says Law.

Classical Economics

Says Law the idea that supply creates its own

demand. In other words, when supplying goods, workers
earn money to spend or save, and savings end up being
borrowed and spent on business investments.
There should be no problem finding demand for the
goods and services produced, because the income
from making them will be spent purchasing them.
This supports the classical contention that the
government does not need to concern itself with
policies that maintain demand at a desirable level.
Critics of Says law argue that savings might not
equal investment because the interest rate does not
fluctuate freely enough to clear the capital market.
Wages fluctuate quickly, flexible prices
Input and output prices will stay in line with each other,
as output prices change input prices will change quickly
Cannot be fooled by money illusion

Keynesian Economics

Great Depression cannot be explained by Classical

So an economist named John Maynard Keynes
develops a theory to explain it.
John Maynard Keynes published The General Theory
of Employment, Interest, and Money in 1936.
Believe fiscal policy is more effective than monetary
Keyness focus was on short-run economic issues.
He agreed with the classical approach only for when
the economy is at potential output. The general
theory he spoke of was that when the economy is not
producing at full output, laissez-faire approaches
will not work, because the economy can get stuck in
a rut, as was happening at the time with the Great

Keynesian Economics

The Paradox of Thrift: Keynesians point out that savings

will not always equal investment. If there is a recession,
then there is great uncertainty about what will happen in
the future, causing firms to reduce their investment
plans. When savings do not translate into investment, the
aggregate expenditures in the economy are reduced by
new savings, which moves the economy further into a
The classical economists would let wages drop because
they assume that all other things are equal, but Keynes
points out that all other things are not equal since a
decrease in wages leads to a decrease in income, which
leads to decreased aggregate demand, which means
decreased production from firms, which means less
output and even more unemployment.
Keynes argued that in order to get out of recessions and
have any chance for long-term economic growth, the
government must take an active role in encouraging
aggregate demand, by increasing government spending
or decreasing taxes.

Keynesian Economics

Keynes blamed the existence of unemployment and the inability

of the economy to self-adjust to full-employment output largely
on sticky wages, particularly in the downward direction.
Keynesians argue that wage contracts are typically adjusted no
more than once a year, and such influences as unions, tradition,
and a reluctance to threaten company morale effectively
prohibit decreases in wages. If wages cannot adjust to match
changes in price levels, deviations from full employment output
might persist until the government steps in with monetary or
fiscal policy to bolster or tame the economy. This is in contrast
with the classical economists preference of laissez-faire (hands
off) governmental policy.
Believe in liquidity trap: is a situation where monetary policy is
unable to stimulate an economy, either through lowering
interest rates or increasing the money supply. Liquidity traps
typically occur when expectations of adverse events (e.g.,
deflation, insufficient aggregate demand) make persons with
liquid assets unwilling to invest.

Keynesian Economics

Argued animal spirits (business confidence)

causes the change in the business cycle.
The ideas of Keynes lead to macroeconomic
policy activism the use of monetary and
fiscal policy to smooth out the business cycle.
Franklin Roosevelt engaged in deficit
spending, macroeconomic policy activism to
get the U.S. out of the Great Depression.
Eventually economists will realize the limits
to macroeconomic policy activism.

Government's proper economic

roles is to control the rate of
inflation by controlling the
amount of money in circulation
Money supply is the primary
tool to bring economic stability
Argued the Great Depression
occurred because of the
contraction of the money supply
Increase money supply at a rate
equal to the average growth in
real output (GDP increases by
3%, grow MS by 3%.
Fed allow the money supply to
grow at a constant rate. (Every
year regardless of business



Monetarism asserts that GDP will grow steadily if the

money supply grows steadily.
Not politicized, fiscal policy cut taxes, whose taxes get the
cut. Monetary policy lower the interest rates, everyone gets
a lower rate.
Believe fiscal and monetary policy intended to fine tune
economy, threatens to destabilize the economy.
Convinced economists the importance of monetary policy.
Changes in government spending will crowd out private
As money supply changes, interest rates change which
change many other factors that affect spending


Discretionary monetary policy the use of

changes in the interest rate or the money supply to
stabilize the economy.
Experiences lags, but smaller than the lags in
fiscal policy
Believe in the quantity theory of money, but believe V
and Y are stable in the short run, not constant like
Classical economist (Believed in a slow steady
growth of money)
Changes in the money supply can then change the Q.
Velocity of money in early 1980s becomes erratic due
to financial innovations and Monetarism takes a hit.

Hypothesis of Economics

Natural Rate Hypothesis

Political Business Hypothesis occurs
when politicians use macroeconomic
policy to serve political ends.
Winner of elections depends upon the state
of the economy. Incumbent wins if economy
is going well 6 months before election
If there is a tradeoff to exploit, politicians
can use expansionary policy a year before
election to guarantee victory.

Neoclassical Economics

Markets to be free & freedom creates greater opportunities

People have rational preferences among outcomes that can
be identified and associated with a value.
Individuals maximize utility and firms maximize profits
People act independently on the basis of full and relevant
New Classical Macroeconomics an approach to the
business cycle that returns to the classical view that shifts in
the aggregate demand curve affect only the aggregate price
level, not aggregate output
Combined rational expectations and the real business cycle

Rational Expectations

The view that individuals and firms make

decisions optimally, using all available
Long-term wage contracts will take into
account past inflation rates and the current
monetary and fiscal policies.
As a result high expected inflation should be
negotiated into the contract
Hence no tradeoff of unemployment and inflation
in the long run.

Monetary policy can only change the

unemployment rate if it comes as a surprise.

New Keynesian

Market imperfections can lead to

price stickiness for the economy as a
For example, monopolies do not
have to perfectly price an item since
if the price is too high they will sell
less but with more profit per sale.

Real Business Cycle

Claims that fluctuations in the rate of growth

of total factor productivity cause the business
Output is determined by the given level of
factor inputs
Slowdowns in productivity growth or a pause
in technological progress are the main causes
of recessions.
Initially did not believe aggregate demand
affected the output, today it includes an
upward sloping aggregate supply curve to this

Using Policy to Stabilize the


The Case for Active Stabilization Policy

Example: The government reduces its spending to cut
the budget deficit, lowering aggregate demand
(shifting the curve to the left).

The Fed can offset this government action by increasing the

money supply.
This would lower interest rates and boost spending, shifting
the aggregate-demand curve back to the right.

Policy instruments are often used in this manner to

stabilize demand. Economic stabilization has been an
explicit goal of U.S. policy since the Employment Act of

One implication of the Employment Act is that the government

should respond to changes in the private economy in order to
stabilize aggregate demand.
The second implication of the Employment Act is that the
government should respond to changes in the private economy
in order to stabilize aggregate demand.

Using Policy to Stabilize the


The Employment Act occurred in response to a book

by John Maynard Keynes, an economist who
emphasized the important role of aggregate demand
in explaining short-run fluctuations in the economy.
Keynes also felt strongly that the government should
stimulate aggregate demand whenever necessary to
keep the economy at full employment.
Keynes felt that aggregate demand responds
strongly to pessimism and optimism. When
consumers are pessimistic, aggregate demand is
low, output is low, and unemployment is increased.
When consumers are optimistic, aggregate demand
is high, output is high, and unemployment is low.
It is possible for the government to adjust monetary
and fiscal policy in response to optimistic or
pessimistic views. This helps stabilize aggregate
demand, keeping output stable at full employment.

The Case for Active

Stabilization Policy

Keynes: animal spirits cause waves of

pessimism and optimism among
households and firms, leading to shifts in
aggregate demand and fluctuations in
output and employment.
Also, other factors cause fluctuations, e.g.,

booms and recessions abroad

stock market booms and crashes

If policymakers do nothing, these

fluctuations are destabilizing to
businesses, workers, consumers.

The Case for Active

Stabilization Policy

Proponents of active stabilization policy

believe the govt should use policy
to reduce these fluctuations:

when GDP falls below its natural rate,

should use expansionary monetary or fiscal
policy to prevent or reduce a recession

when GDP rises above its natural rate,

should use contractionary policy to prevent or
reduce an inflationary boom

The Case Against Active

Stabilization Policy

Some economists believe that fiscal and monetary policy

tools should only be used to help the economy achieve longrun goals, such as low inflation and economic growth.
The primary argument against active policy is that these
policy tools may affect the economy with a long lag.
With monetary policy, the change in money supply leads
to a change in interest rates. This change in interest
rates affects investment spending. However, investment
decisions are usually made well in advance, so the
effects from changes in investment will not likely be felt
in the economy very quickly.
The lag in fiscal policy is generally due to the political
process. Changes in spending and taxes must be
approved by both the House and the Senate (after going
through committees in both houses).
By the time these policies take effect, the condition of the
economy may have changed. This could lead to even larger

The Case Against Active

Stabilization Policy

Monetary policy affects economy with a long lag:

firms make investment plans in advance,
so I takes time to respond to changes in r
most economists believe it takes at least
6 months for mon policy to affect output and

Fiscal policy also works with a long lag:

Changes in G and T require Acts of Congress.
The legislative process can take months or years.

The Case Against Active

Stabilization Policy

Due to these long lags,

critics of active policy argue that such
policies may destabilize the economy rather
than help it:
By the time the policies affect agg demand,
the economys condition may have changed.
These critics contend that policymakers
should focus on long-run goals, like
economic growth and low inflation.

Keynesians in the White

John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors
were followers of Keynes.

George W Bush pushed for a
tax cut that helped the economy
recover from a recession that
had just begun.

Automatic Stabilizers

Automatic stabilizers changes in fiscal policy

that stimulate aggregate demand when the
economy goes into a recession without
policymakers having to take any deliberate action.
The most important automatic stabilizer is the tax

When the economy falls into a recession, incomes and

profits fall.
The personal income tax depends on the level of
households incomes and the corporate income tax
depends on the level of firm profits.
This implies that the governments tax revenue falls during
a recession. This tax cut stimulates aggregate demand and
reduces the magnitude of this economic downturn.

Automatic Stabilizers

Government spending is also an

automatic stabilizer.

More individuals become eligible for

transfer payments during a recession.
These transfer payments provide
additional income to recipients,
stimulating spending.
Thus, just like the tax system, our system
of transfer payments helps to reduce the
size of short-run economic fluctuations.