Unit 6: Inflation, Unemployment, & Stabilization Policies Modules 30-36 20-30% of the AP Exam

Module 30 Key Terms & Review Long-Run Implications of Fiscal Policy: Deficits and the Public Debt Business cycle Government debt Fiscal year Public debt Implicit liabilities 1. 2. 3. 4. 5.

Budget Balance Government savings = Can we use the budget balance to determine if fiscal policy is occurring? Changes in G have a greater affect on the economy than changes in taxes and transfer payments An equal change in G and taxes will result in no change in the budget balance but have an expansionary effect on the economy

Business Cycle & the Budget Strong correlation: deficits during recessions / surpluses (or smaller deficits) during expansions Driven by automatic stabilizers (Module 21) and discretionary fiscal policy How do we know which has the bigger impact? Cyclically adjusted budget balance Estimate of what the balance would be if RGDP always equaled full employment output Takes into account what tax revenues/transfers would be if not for the recessionary/inflationary gap Lets economists know if a government’s policies are sustainable in the long-run

Do deficits matter? Requiring a balanced budget every year would eliminate the government’s ability to use fiscal policy to smooth out the business cycle

Long-run implications of Fiscal Policy Debt – accumulation of deficits & surpluses over time Fiscal year: October 1 – September 30 www.usdebtclock.org Public debt – debt held by people outside of the government Impact on the economy Crowding out effect (Can you draw it?) Pressure on future budgets Read Deficits and Debt in Practice, pgs. 299-302

Module 31 Key Terms & Review Monetary Policy & the Interest Rate Federal funds rate Taylor rule Inflation targeting Review Modules 28 & 29 1. 2. 3. 4. 5.

Review Money Market & Loanable Funds graphs! “In the short run, the interest rate is determined in the money market and the loanable funds market adjusts in response to changes in the money market.” (pg. 304)

Federal Funds Rate The FOMC uses open market operations to set Reserve requirement / discount window are rarely used Discount window was opened to non-banks after the 2008 financial crisis Read FYI “The Fed Reverses Course” pg. 306

Monetary Policy & AD AP Exam Tip: It is never enough to say “expansionary” or “contractionary” policy will solve a problem. Name a specific tool and how you would apply it.

Monetary Policy in Practice Fed must balance GDP growth & inflation 1990s: Fed did not raise interest rates despite positive GDP gap because inflation remained low Taylor rule Fed funds rate = 1 + (1.5 x inflation rate) + (0.5 x output gap)

Inflation targeting 2012 – Ben Bernanke announces Fed will try to maintain 2% inflation rate Pros: Con:

Module 32 Key Terms & Review Money, Output, and Prices in the Long Run Monetary neutrality 1. 2. 3. 4. 5.

Long run impact of monetary policy What if the Fed gets it wrong?

Expansionary monetary policy

Contractionary monetary policy

Monetary neutrality

Long run determination of interest rates Remember monetary neutrality!

Module 33 Key Terms & Review Types of Inflation, Disinflation, and Deflation Inflation tax Cost-push inflation Demand-pull inflation 1. 2. 3. 4. 5.

The Classical Model

Who is to blame for inflation? The Treasury issues bonds to finance debt The Federal Reserve monetizes the debt by creating money to buy bonds from the public & banks Creates an artificial demand for bonds via open market operations Government pays interest on debt owned by the Fed, but they turn most of it back over to the Treasury Seignorage – revenue generated by the government’s right to print money Inflation tax –

Types of inflation

And now let’s randomly talk about unemployment… Unemployment rate = Varies indirectly with the output gap Positive (inflationary) gap  Negative (recessionary) gap 

Module 34 Key Terms & Review Inflation & Unemployment: The Phillips Curve Nonaccelerating inflation rate of unemployment Disinflation Deflation 1. 2. 3. 4. 5.

Short-Run Phillips Curve 1955-1968

SRPC & Demand Shocks Okun’s law –

On this graph, up is bad & down is good. SRPC & Supply Shocks Note: On this graph, up is bad & down is good.

Short-Run Phillips Curve cont. Future expectations about inflation directly affect the current inflation rate

Long-Run Phillips Curve Expansionary fiscal / monetary policy: E0  A People begin to expect 2% inflation & SRAS decreases SRPC shifts up, E2 is the new normal If we still want lower unemployment, policies will continue to increase inflation, E2  B SRPC shifts up, E4 is the new normal

NAIRU Nonaccelerating inflation rate of unemployment

Disinflation & Deflation Disinflation – process of bringing down the rate of inflation Deflation – falling aggregate price level Debt deflation – reduction in AD because borrowers’ debts are a greater burden

The Fisher Effect (Module 29) Nominal interest rate = real interest rate + inflation premium

The Liquidity Trap Expected deflation affects the nominal interest rate just like expected inflation does

Module 35 Key Terms & Review History & Alternative Views of Macroeconomics Keynesian economics Monetarism Velocity of money Political business cycle Rational expectations Real business cycle theory 1. 2. 3. 4. 5.

Classical Macroeconomics

The Great Depression “In the long run we are all dead.” Keynesian Revolution!

Challenges to Keynesian Economics 1960s saw the rise of Monetarism, led by Milton Freedman Emphasized the importance of monetary policy Take power away from politicians (fiscal policy) and give it to the Federal Reserve GDP will grow steadily if the MS grows steadily Still emphasized the short-run, but said that due to lags, discretionary fiscal policy just led to booms after recessions If government attempts to boost the economy but the Fed holds the MS constant, the crowding out effect will lessen the effects of the fiscal policy

So what should monetary policy look like? Friedman suggested putting monetary policy on “autopilot”

Limits of policy activism Natural rate hypothesis Economists realized in the late1960s / early 1970s that there was a natural rate of unemployment Attempts to push AD beyond that only results in inflation Once inflation expectations are embedded in prices and wages, inflation will continue even in economy downturns (stagflation of the 1970s) Fiscal policy can be misused for political purposes, causing a political business cycle

NEW Classical Macroeconomics Return to the belief that shifts in AD do not affect output, only the price level Rational expectations If people think there will be inflation in the future, they immediately build it into their prices / wage negotiations NEW Keynesian economics – prices/wage are sticky Real business cycle theory Changes in the growth of technology / productivity cause the business cycle Vertical aggregate supply curve shifts left and right with these changes

Module 36 Key Terms & Review Consensus and Conflict in Modern Macroeconomics YOYO! Laffer Curve- pg. 356 1. 2. 3. 4. 5.

Laffer Curve Supply-side economics

Unit 6 Review – pgs. 361-2 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.