1. Long-Run Macroeconomic Equilibrium And Government Policy

2. SRAS to LRAS  Economy is always at a point (PL & real GDP) on the SRAS curve.  If that point is not also on the LRAS curve, the SRAS curve will shift until it is. Let’s consider three scenarios…

3. Long-Run Macro Equilibrium (#1)  Economy on both SRAS and LRAS curves  Y E = Y P

4. Inflationary Gap (#2)  Aggregate output above potential output  Results from positive AD shift Self-Correcting in the Long Run…  Low unemployment will lead to nominal wages rising, along with other “sticky” costs  Producers decrease output, bringing the economy back into equilibrium (at a higher price level)

5. Recessionary Gap (#3)  Aggregate output below potential output  Results from negative AD or negative SRAS shift Self-Correcting in the Long Run…  High unemployment will cause nominal wages to fall, along with other “sticky” costs  Producers increase output, bringing the economy back into equilibrium (at a lower price level)

6. Analysis of Gaps  Output gap – The difference between actual aggregate output and potential output Output gap = Actual aggregate output – Potential output X 100 Potential output

7. The Purpose of Macroeconomic Policy  Most economists believe that it takes the economy a decade or longer to self-correct  Economists like Keynes believe in active stabilization, use of government policy to reduce the severity and length of recessions or to rein in excessive expansions

8. Response to Demand Shocks  Fall in demand is easiest to correct through policy  Unfortunately, policy measures to increase AD can increase deficits & may hinder long-run growth  Government tries to offset positive shocks too, as inflationary gaps have significant costs in the long-run

9. Response to Supply Shocks  No easy remedy for these, as they result from changes in production costs  A negative supply shock leads to rising prices and decreasing output (& employment)  Policy to fix one of these problems makes the other worse

10. Governmental Circular Flow  Inflows – Taxes and borrowing  Outflows – Government purchases and transfers

11. GDP = C + I + G + X - IM  Government directly controls G, but also indirectly influences C and I through fiscal policy  C is based on disposable income, which is directly related to transfers and taxes  I is influenced by business regulation

12. Expansionary Fiscal Policy  To address a recessionary gap, the government attempts to increase AD:  Increase government purchases AND/OR  Cut taxes AND/OR  Increase transfers

13. Contractionary Fiscal Policy  To address an inflationary gap, the government attempts to decrease AD:  Reduce government purchases AND/OR  Raise taxes AND/OR  Reduce transfers

14. Lags in Fiscal Policy  Many economists argue against extremely active stabilization policies  One caution for fiscal policy is time lag 1. Government must acknowledge gap 2. Government has to develop a plan 3. Plan implementation

15. Multiplier Effect of Increasing Government Purchases  Government spending is an autonomous increase in aggregate spending  Money is spent again and again, so it is subject to the multiplier  Also the same multiplier for reduction

16. Multiplier Effect of Changes in Government Transfers & Taxes  Smaller effect than government purchases  Instead, change in GDP results from household spending – so its initial infusion is subject to the multiplier

17. Taxes and the Multiplier  Taxes capture part of the increase in real GDP  As a result of tax structure, government revenue increases when real GDP does

18. Types of Government Stabilizers  The overall result of tax policies is to reduce the multiplier, creating greater stability – so these are known as automatic stabilizers  Some government transfers are also automatic stabilizers, but active policies are discretionary fiscal policies