Unit 5

Long-Run Consequences of Stabilization Policies: the one-page sheet

5.1 Fiscal and Monetary Policy Actions in the Short Run

In the short run, fiscal and monetary policy both work by shifting AD. Expansionary policy (more spending, lower taxes, a lower policy rate) closes a recessionary gap; contractionary policy closes an inflationary one. Each explanation names every link, states the reserves framework and its tool, and treats a policy mix carefully: when one variable is pushed two ways, its change is indeterminate.

A recessionary gap calls for expansionary policy: more government spending, lower taxes, or a lower policy rate. An inflationary gap calls for contractionary policy, every arrow reversed.
Name every link: tool, interest rate, interest-sensitive spending, AD, then real output, the price level and unemployment. For a tax change the first links are disposable income and consumption.
State the framework. Ample reserves: change the administered rates (interest on reserve balances); show it on the reserve market graph. Limited reserves: buy or sell bonds; show it on the money market graph.
The policy mix: two policies pushing AD the same way give a clear AD effect, but expansionary fiscal policy pushes interest rates up while expansionary monetary policy pulls them down. Policies pushing opposite ways make the AD effect indeterminate.

the policy rate falls loan rates and other interest rates fall investment and interest-sensitive consumption rise AD shifts right real GDP and the price level rise, and unemployment falls

policy mix: Fiscal and monetary policy used at the same time. When both push AD the same way the AD effect is clear but the interest rate effect may not be; when they push opposite ways the AD effect is indeterminate.
causal chain: The ordered links from a policy action to its result: for monetary policy, the tool, the policy rate, other interest rates, interest-sensitive spending, AD, then output, the price level and unemployment.

5.2 The Phillips Curve

The short-run Phillips curve slopes down: changes in AD trade unemployment for inflation along it. Supply shocks and changes in expected inflation shift it. The long-run Phillips curve is vertical at the natural rate of unemployment, matching LRAS, so in the long run unemployment returns to the natural rate and only inflation depends on what people expect.

Axes: Inflation rate on the vertical axis, Unemployment rate on the horizontal one. SRPC slopes down; LRPC is vertical at the natural rate of unemployment.
A change in AD is a movement along the SRPC: AD right means lower unemployment and higher inflation; AD left the reverse.
The SRPC shifts when SRAS shifts or expected inflation changes. A negative supply shock or higher expected inflation shifts it right; a positive supply shock or lower expected inflation shifts it left.
Where SRPC crosses LRPC, actual inflation equals expected inflation. LRPC matches LRAS: a change in the natural rate shifts LRPC.

real output rises and the price level rises faster unemployment falls below the natural rate the economy moves up and to the left along the SRPC expected inflation rises and nominal wages rise the SRPC shifts right, and unemployment returns to the natural rate at a higher inflation rate

short-run Phillips curve: The short-run Phillips curve: a downward-sloping curve showing the short-run trade-off between the inflation rate and the unemployment rate. A change in AD moves the economy along it.
long-run Phillips curve: The long-run Phillips curve: a vertical line at the natural rate of unemployment, showing that in the long run unemployment returns to the natural rate whatever the inflation rate.

5.3 Money Growth and Inflation

The quantity theory says M x V = P x Y. With velocity steady and real output fixed by resources and technology in the long run, the price level rises in proportion to the money supply, so sustained inflation comes from money growing faster than output. Money is neutral in the long run: it changes nominal variables, not real GDP or unemployment, although it can change output in the short run while wages are sticky.

The equation of exchange: $M \times V = P \times Y$ . M is the money supply, V velocity, P the price level and Y real output, so $P \times Y$ is nominal GDP.
Velocity is how often the average dollar is spent on final goods and services in a year: $V = \frac{P \times Y}{M}$ .
In the long run, V is steady and Y is set by resources and technology, so P moves with M. In growth rates: inflation $\approx$ money growth + velocity growth - real output growth.
Money neutrality: in the long run money changes nominal variables (the price level, nominal GDP, nominal wages and interest rates), not real GDP or unemployment. In the short run, sticky wages let money change output.

nominal spending, M x V, grows faster than output AD shifts right SRAS shifts left until output returns to full employment the price level is higher: faster money growth means higher inflation

quantity theory of money: The theory built on the equation of exchange, M x V = P x Y: if velocity and real output are steady, the price level moves in proportion to the money supply, so in the long run faster money growth means higher inflation.
velocity of money: The average number of times a dollar is spent on final goods and services in a year: nominal GDP divided by the money supply.
long-run neutrality of money: The idea that in the long run a change in the money supply changes only nominal variables, such as the price level and nominal GDP, and not real output, unemployment or the real interest rate.

5.4 Government Deficits and the National Debt

A budget deficit is one year's excess of government outlays over tax revenue; a surplus is the reverse. The government borrows to cover a deficit, so the national debt, a stock, rises by each deficit and falls only with a surplus. Expansionary fiscal policy and recessions widen deficits, contractionary policy and expansions narrow them, and interest on the debt is itself part of outlays.

Budget balance = tax revenue - outlays. Negative is a deficit, positive a surplus, zero a balanced budget. Outlays include spending, transfer payments and interest on the debt.
The national debt is the total owed: past deficits minus past surpluses. A deficit is a flow over one year; the debt is a stock at a point in time.
A smaller deficit still raises the debt. Only a surplus lowers it.
Expansionary fiscal policy and recessions (through automatic stabilizers) widen deficits; contractionary policy and expansions shrink them.

the government runs a budget deficit it borrows the difference by selling bonds the national debt rises by the amount of the deficit the deficit widens even with no new law

budget deficit: The amount by which a government's outlays (spending, transfer payments and interest) exceed its tax revenue in one year. Revenue above outlays is a budget surplus; revenue equal to outlays is a balanced budget.
national debt: The total amount a government owes at a point in time: the sum of its past deficits minus its past surpluses, owed to holders of its bonds.

5.5 Crowding Out

When a government borrows to pay for a deficit, the demand for loanable funds rises and the real interest rate rises. Private investment and other interest-sensitive spending fall, offsetting part of the boost to AD. Year after year, lower investment means a smaller capital stock and slower growth of potential output. Crowding out is strongest near full employment and is eased by more private saving.

Crowding out: government borrowing raises the real interest rate, and private investment falls.
Draw it on the loanable funds graph: Real interest rate (vertical), Quantity of loanable funds (horizontal); government borrowing shifts DLF right (or, in another view, lower public saving shifts SLF left). Either way the real rate rises.
In the short run crowding out shrinks the AD effect of deficit spending. In the long run it leaves a smaller capital stock, so potential output grows more slowly.
Crowding out is largest near full employment and smallest in a deep recession, when private borrowing is weak.

the demand for loanable funds shifts right the real interest rate rises private investment and interest-sensitive consumption fall part of the rise in AD from the deficit spending is offset the capital stock and potential output grow more slowly

crowding out: The fall in private investment (and other interest-sensitive spending) that happens when government borrowing to pay for a deficit raises the demand for loanable funds and the real interest rate.

5.6 Economic Growth

Long-run economic growth is a sustained rise in potential output and real GDP per capita. It comes from more physical capital, more human capital, better technology and more resources, all of which raise productivity. On the graphs, the PPC shifts out and LRAS shifts right. Living standards rise when output grows faster than population, and a choice of more capital goods today raises growth later.

Economic growth is a sustained rise in potential output and real GDP per capita, shown by the PPC shifting out and LRAS shifting right.
Its sources: more physical capital (machines, buildings), more human capital (skills, education, health), better technology, and more or better natural resources and labor.
Productivity, output per worker, is what lets living standards keep rising; per capita growth is roughly output growth minus population growth.
Choosing more capital goods today costs consumer goods now but shifts the PPC out further later. Moving from inside the PPC to the curve is recovery, not growth.

productivity (output per worker) rises potential output rises LRAS shifts right and the PPC shifts out real GDP per capita, the average standard of living, rises

human capital: The skills, knowledge, training and health that make workers more productive. Physical capital is the equipment, buildings and machines they work with; productivity is output per worker or per hour.

5.7 Public Policy and Economic Growth

Public policy can raise long-run growth by adding to physical capital, human capital, technology and infrastructure, or by strengthening incentives to work, save and invest (supply-side fiscal policy). Such policies aim at LRAS, though many also raise AD in the short run. Policies that only raise spending shift AD, and deficit-financed programs can lose part of their effect to crowding out.

Growth policy aims at the sources of growth: physical capital (investment incentives, smaller deficits that lower real interest rates), human capital (education, training, health), technology (research funding, patents) and infrastructure (roads, ports, power, networks).
Supply-side fiscal policy uses taxes and spending to raise incentives to work, save and invest. It aims at LRAS; how large the effect is remains debated among economists.
Many policies work on both sides: spending on schools or roads raises AD now and, once finished, can shift LRAS right later.
Spending that adds no capital, skills or technology, such as a cash transfer, shifts AD only. Deficit-financed programs can be partly offset by crowding out.

workers gain skills: human capital rises productivity rises potential output rises, so LRAS shifts right and the PPC shifts out real GDP per capita grows over time

growth policy: Government policy aimed at raising long-run growth by adding to physical capital, human capital, technology or infrastructure. Supply-side fiscal policy uses taxes and spending to raise incentives to work, save and invest, aiming to shift LRAS right.