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Macroeconomic Policy and the AD-AS Model Stabilization Policies and Their Effects Aggregate Price Level Expansionary Fiscal Policy: Addressing Recessionary LRAS Gaps SRAS Suppose a negative demand shock has caused a recession. • Using fiscal policy, how could a government address this problem? P2 P1 E2 E1 The shift leads to a higher aggregate price level AND higher aggregate output. AD1 Y1 YP Recessionary gap Potential output AD2 Real GDP The government’s goal is to stabilize the economy by bringing it to long-run economic equilibrium (E2 in the figure above) Aggregate Price Level Contractionary Fiscal Policy: Addressing Inflationary GapsLRAS SRAS Suppose a positive demand P1 shock has caused high inflation. • Using fiscal policy, how could a government address this problem? E1 P2 E2 The shift leads to a lower aggregate price level AND lower aggregate output. AD2 Potential output YP Y1 Inflationary gap Real GDP AD1 The government’s goal is to stabilize the economy by bringing it to long-run economic equilibrium (E2 in the figure above) Hard Macroeconomic Choices: Recession Suppose a negative supply Caused by Supply Shocks shock has caused a LRAS Aggregate Price Level P2 P1 E1 E2 SRAS The shift leads to a higher aggregate price level AND higher aggregate output. recessionary gap. • Aggregate prices are higher and output lower than at long-run equilibrium (stagflation). In order to bring the economy back to long-run equilibrium, what if the government increases aggregate demand? AD1 Y1 YP Recessionary gap Potential Real GDP output The government has addressed the recessionary AD2 gap… but at what cost? What would have happened if the government tried to lower aggregate demand?
