Download managing the economy

MANAGING THE ECONOMY
The multiplier tells us how much AD shifts
to the right when an autonomous element of
expenditure shifts. That is, if G or X or I
change (or if C or NT or M change, independent of
GDP changes) the increase will result in a larger shift
of AD to the right than the change in expenditure
The business cycle is caused by shifts in AD.
When AD shifts to the right, GDP rises. When
AD shifts to the left GDP falls.
We can predict the size of changes in investment
and exports on equilibrium income if we know
the size of the multiplier.
Changes in Government spending and in taxes
will also influence equilibrium income.
A rise in G shifts AD to the right by more than
the change in G. A cut in taxes or an increase in
transfer payments also shifts AD to the right, but
the multiplied impact is less than the impact of a
change in G because the consumer who receives
the money only spends part of it. Part of it is
saved.
So if a fall in I or X reduces AD and causes a
recession, a rise in G or a (bigger) tax cut or
transfer payment increase can return the
economy to full employment.
Government policy can stabilize the economy
and reduce the size of the business cycle.
The multiplier and the aggregate expenditure
diagram assume that prices remain constant.
Even in the short-run, some adjustment in output
prices reduces the size of the multiplier.
In the long-run, if prices and wages are flexible,
the economy would return to equilibrium
anyway. Since wages increase readily easily,
rising prices will return the economy to full
employment, but with considerable inflation.
The role for government intervention is even
stronger in a recession. Wages are sticky
downwards, so that it can take a very long time
indeed – far too long – for SAS to fall. In that
case, government action to shift AD is even
more important.
DISADVANTAGES OF FISCAL POLICY TO
REGULATE THE BUSINESS CYCLE
1. Getting the timing right.
a. First, the government must recognize
that a recession beginning.
b. Next the government must pass
legislation to alter G, Taxes or transfers
c. Then the actions must go into effect.
Tax changes or transfers can have an impact
fairly quickly.
2. Getting the politics and the budget right.
a. In the 1970s, the natural unemployment
rate increased and the government kept
shifting AD to the right, even though
prices were rising and GDP may have
been at or past LAS.
b. Governments that increase G or
transfers of cut taxes are usually more
popular than governments that cut
spending or increase taxes. The bias is
to over-stimulate the economy.