Unit 5: Long-Run Consequences of Stabilization Policies

Explain (using graphs as appropriate) the effects of combined fiscal and monetary policy actions.

• A combination of expansionary or contractionary fiscal and monetary policies may be used to restore full employment when the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap.
• A combination of fiscal and monetary policies can influence aggregate demand, real output, the price level, and interest rates. [For additional details on fiscal and monetary policy actions and how to demonstrate their effects graphically, see LO POL-1.A and LO POL-1.D.]
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

a. Define (using graphs as appropriate) the short-run Phillips curve and the long-run Phillips curve. b. Explain (using graphs as appropriate) short-run and long-run equilibrium in the Phillips curve model.

• The short-run trade-off between inflation and unemployment can be illustrated by the downward-sloping short-run Phillips curve (SRPC).
• An economy is always operating somewhere along the SRPC.
• The long-run relationship between inflation and unemployment can be illustrated by the long-run Phillips curve (LRPC), which is vertical at the natural rate of unemployment.
• Long-run equilibrium corresponds to the intersection of the SRPC and the LRPC.
• Points to the left of long-run equilibrium represent inflationary gaps, while points to the right of long-run equilibrium represent recessionary gaps.
• Enduring understanding MOD-3: The Phillips curve model is used to represent the relationship between inflation and unemployment and to illustrate how macroeconomic shocks affect inflation and unemployment.

Explain (using graphs as appropriate) the response of unemployment and inflation in the short run and in the long run.

• Demand shocks correspond to movement along the SRPC.
• Supply shocks correspond to shifts of the SRPC.
• Factors that cause the natural rate of unemployment to change will cause the LRPC to shift.
• Enduring understanding MOD-3: The Phillips curve model is used to represent the relationship between inflation and unemployment and to illustrate how macroeconomic shocks affect inflation and unemployment.

a. Explain (using graphs as appropriate) how inflation is a monetary phenomenon. b. Define the quantity theory of money. c. Calculate the money supply, velocity, the price level, and real output using the quantity theory of money.

• Inflation (deflation) results from increasing (decreasing) the money supply at too rapid of a rate for a sustained period of time.
• When the economy is at full employment, changes in the money supply have no effect on real output in the long run.
• In the long run, the growth rate of the money supply determines the growth rate of the price level (inflation rate) according to the quantity theory of money.
• Enduring understanding POL-3: There are long-run implications of monetary and fiscal policy.

a. Define the government budget surplus (deficit) and national debt. b. Explain the issues involved with the burden of the national debt.

• The government budget surplus (deficit) is the difference between tax revenues and government purchases plus transfer payments in a given year.
• A government adds to the national debt when it runs a budget deficit.
• A government must pay interest on its accumulated debt, thus increasing the national debt and increasingly forgoing using those funds for alternative uses. [See also LO POL-3.C on crowding out.]
• Enduring understanding POL-3: There are long-run implications of monetary and fiscal policy.

a. Define crowding out. b. Explain (using graphs as appropriate) how fiscal policy may cause crowding out.

• When a government is in budget deficit, it typically borrows to finance its spending.
• A loanable funds market model can be used to show the effect of government borrowing on the equilibrium real interest rate and the resulting crowding out of private investment. [See MKT-4]
• Crowding out refers to the adverse effect of increased government borrowing, which leads to decreased levels of interest-sensitive private sector spending in the short run.
• A potential long-run impact of crowding out is a lower rate of physical capital accumulation and less economic growth as a result.
• Enduring understanding POL-3: There are long-run implications of monetary and fiscal policy.

a. Define measures and determinants of economic growth. b. Explain (using graphs and data as appropriate) the determinants of economic growth. c. Calculate (using graphs and data as appropriate) per capita GDP and economic growth.

• Economic growth can be measured as the growth rate in real GDP per capita over time.
• Aggregate employment and aggregate output are directly related because firms need to employ more workers in order to produce more output, holding other factors constant. This is captured by the aggregate production function.
• Output per employed worker is a measure of average labor productivity.
• Productivity is determined by the level of technology and physical and human capital per worker.
• The aggregate production function shows that output per capita is positively related to both physical and human capital per capita.
• Enduring understanding MEA-2: The economy fluctuates between periods of expansion and contraction in the short run, but economic growth can occur in the long run.

Explain (using graphs as appropriate) how the PPC is related to the long-run aggregate supply (LRAS) curve.

• An outward shift in the PPC is analogous to a rightward shift of the long-run aggregate supply curve. [See LO MOD-2.I]
• Enduring understanding MOD-1: The production possibilities curve (PPC) model is used to demonstrate the full employment level of output and to illustrate changes in full employment.

a. Explain (using graphs as appropriate) public policies aimed at influencing long-run economic growth. b. Define supply-side fiscal policies.

• [For a description of economic growth and information about how to show it graphically, see LO MEA-2.B, LO MOD-1.B, and LO MOD-2.I] Public policies that impact productivity and labor force participation affect real GDP per capita and economic growth.
• Government policies that invest in infrastructure and technology affect growth.
• Supply-side fiscal policies affect aggregate demand, aggregate supply, and potential output in the short run and long run by influencing incentives that affect household and business economic behavior.
• Enduring understanding POL-4: Authorities and organizations institute policies that affect economic growth.