Download AP Macro - Sect. 6 PP no bkgd

Sect. 6 - Inflation, Unemployment, & Stabilization Polices
Module 30 - Long-run Implications of Fiscal Policy
What you will learn:
• Why governments calculate the cyclically adjusted budget
balance
• Why a large public debt may be a cause for concern
• Why implicit liabilities of the government are also a cause for
concern
http://www.usdebtclock.org/
1
Sect. 6 - Inflation, Unemployment, & Stabilization Polices
Module 30 - Long-run Implications of Fiscal Policy
The Budget Balance - (savings by govt.)
The budget balance is measured in terms of surplus and deficit.
S govt. = T(taxes) - G (govt. Spending) - TR (transfers)
- Expansionary fiscal policy decreases Budget Balance
- Contractionary fiscal policy increases Budget Balance
Cyclical Adjusted Budget Balance Estimate of what the budget balance would be if real GDP were
equal to potential output (no recessionary or inflationary gaps)
3
4
5
Sect. 6 - Inflation, Unemployment, & Stabilization Polices
Module 30 - Long-run Implications of Fiscal Policy
The Budget Balance - (savings by govt.)
The budget balance is measured in terms of surplus and deficit.
S govt. = T(taxes) - G (govt. Spending) - TR (transfers)
- Expansionary fiscal policy decreases Budget Balance
- Contractionary fiscal policy increases Budget Balance
Cyclical Adjusted Budget Balance Estimate of what the budget balance would be if real GDP were
equal to potential output (no recessionary or inflationary gaps)
Problem of Rising Govt. Debt 1) “Crowding out” effect when Govt. borrows a larger portion of
loanable funds, there is less available at a higher interest rate
2) The larger the debt the higher the interest on the debt - how
will this effect future fiscal policy ($383 billion, 2.7% of GDP)
Debt - GDP Ratio Govt. debt as % of GDP (GDP growth rate vs. debt growth rate)
- GDP is a good indicator of potential tax revenue
7
8
10
11
12
Problem of Rising Govt. Debt 1) “Crowding out” effect when Govt. borrows a larger portion of
loanable funds, there is less available at a higher interest rate
2) The larger the debt the higher the interest on the debt - how
will this effect future fiscal policy ($383 billion, 2.7% of GDP)
Debt - GDP Ratio Govt. debt as % of GDP (GDP growth rate vs. debt growth rate)
- GDP is a good indicator of potential tax revenue
Implicit Liabilities Future spending promises that are debt but are not included in
debt statistics
- Soc. Sec., Medicare, Medicaid (appxt. 40% of govt. spending)
13
14
Problem of Rising Govt. Debt 1) “Crowding out” effect when Govt. borrows a larger portion of
loanable funds, there is less available at a higher interest rate
2) The larger the debt the higher the interest on the debt - how
will this effect future fiscal policy ($383 billion, 2.7% of GDP)
Debt - GDP Ratio Govt. debt as % of GDP (GDP growth rate vs. debt growth rate)
- GDP is a good indicator of potential tax revenue
Implicit Liabilities Future spending promises that are debt but are not included in
debt statistics
- Soc. Sec., Medicare, Medicaid (appxt. 40% of govt. spending)
15
Module 31 - Monetary Policy & the Interest Rate
What you will learn:
• How the Federal Reserve implements monetary policy
• Why monetary policy is the main tool for stabilizing the economy
16
Module 31 - Monetary Policy & the Interest Rate
Target Federal Funds Rate The interest rate the Fed sets to achieve the desired monetary
policy goal - uses open market operations to shift money supply
17
18
19
Module 31 - Monetary Policy & the Interest Rate
Target Federal Funds Rate The interest rate the Fed sets to achieve the desired monetary
policy goal - uses open market operations to shift money supply
Expansionary Monetary Policy Policy that increases demand which increases Real GDP
Increase in money supply
lowers interest rate
more
investment and consumer spending
increase in AG demand
increase in Real GDP
20
21
Module 31 - Monetary Policy & the Interest Rate
Target Federal Funds Rate The interest rate the Fed sets to achieve the desired monetary
policy goal - uses open market operations to shift money supply
Expansionary Monetary Policy Policy that increases demand which increases Real GDP
Increase in money supply
lowers interest rate
more
investment and consumer spending
increase in AG demand
increase in Real GDP
22
Contractionary Monetary Policy Policy that decreases demand which decreases Real GDP
Decrease in money supply
raises interest rate
less
investment and consumer spending
decrease in AG demand
decrease in Real GDP
23
24
Contractionary Monetary Policy Policy that decreases demand which decreases Real GDP
Decrease in money supply
raises interest rate
less
investment and consumer spending
decrease in AG demand
decrease in Real GDP
Taylor Rule for Monetary Policy Rule for setting the federal funds rate that includes the inflation
rate and output gap
Target Federal Funds Rate =
1+ (1.5 x inflation rate) + (0.5 x output gap)
Ex: Infl. Rate = 3% x 1.5 = 4.5
Output Gap = - 4% x 0.5 = - 2
1 + 4.5 + - 2 = 3.5%
25
26
Contractionary Monetary Policy Policy that decreases demand which decreases Real GDP
Decrease in money supply
raises interest rate
less
investment and consumer spending
decrease in AG demand
decrease in Real GDP
Taylor Rule for Monetary Policy Rule for setting the federal funds rate that includes the inflation
rate and output gap
Target Federal Funds Rate =
1+ (1.5 x inflation rate) + (0.5 x output gap)
Ex: Infl. Rate = 3% x 1.5 = 4.5
Output Gap = - 4% x 0.5 = - 2
1 + 4.5 + - 2 = 3.5%
27
Inflation Targeting Setting monetary policy to target a particular inflation rate
- the Fed does not target a certain rate of inflation but prefer 2%
The Taylor Rule sets goals based on past inflation
- Inflation Targeting sets goal based on future expected inflation
28
Module 32 - Money, Output & Prices in the Long-run
What you will learn:
• The effects of an inappropriate monetary policy
• Monetary neutrality and its relationship to the long-term
economic
effects of monetary policy
29
Module 32 - Money, Output & Prices in the Long-run
Short & Long-run Effects of an Increase in the Money Supply In the short-run:
- increase in aggregate demand & increase in price level
In long-run:
- increase in aggregate price level
30
31
32
Module 32 - Money, Output & Prices in the Long-run
Short & Long-run Effects of an Increase in the Money Supply In the short-run:
- increase in aggregate demand & increase in price level
In long-run:
- increase in aggregate price level
Monetary Neutrality If money supply is increased by 10% the price level rises 10%
in the long-run
- changes in the money supply have no real effect on the economy
Changes in Money Supply and Interest Rates in the Long-run
In the short-run an increase in the money supply leads to a fall
in interest rate - in the long-run the interest rate is not effected
33
34
Module 32 - Money, Output & Prices in the Long-run
Short & Long-run Effects of an Increase in the Money Supply In the short-run:
- increase in aggregate demand & increase in price level
In long-run:
- increase in aggregate price level
Monetary Neutrality If money supply is increased by 10% the price level rises 10%
in the long-run
- changes in the money supply have no real effect on the economy
Changes in Money Supply and Interest Rates in the Long-run
In the short-run an increase in the money supply leads to a fall
in interest rate - in the long-run the interest rate is not effected
35
36
Module 33 - Types of Inflation, Disinflation, and Deflation
What you will learn:
• The classical model of the price level
• Why printing money can lead to high inflation and even
hyperinflation
• Types of inflation: cost-push and demand pull
37
Module 33 - Types of Inflation, Disinflation, and Deflation
Classical Model of Price Level The real quantity of money is always at its long-run equilibrium
level
38
39
Module 33 - Types of Inflation, Disinflation, and Deflation
Classical Model of Price Level The real quantity of money is always at its long-run equilibrium
level
The Inflation Tax The reduction in the value of money held by the public caused
by inflation - 5% inflation rate imposes a 5% “inflation tax”
Hyperinflation When the government prints a large quantity of money imposing a larger inflation tax - to cover a large budget deficit
40
41
Module 33 - Types of Inflation, Disinflation, and Deflation
Classical Model of Price Level The real quantity of money is always at its long-run equilibrium
level
The Inflation Tax The reduction in the value of money held by the public caused
by inflation - 5% inflation rate imposes a 5% “inflation tax”
Hyperinflation When the government prints a large quantity of money imposing a larger inflation tax - to cover a large budget deficit
42
43
44
Module 33 - Types of Inflation, Disinflation, and Deflation
Classical Model of Price Level The real quantity of money is always at its long-run equilibrium
level
The Inflation Tax The reduction in the value of money held by the public caused
by inflation - 5% inflation rate imposes a 5% “inflation tax”
Hyperinflation When the government prints a large quantity of money imposing a larger inflation tax - to cover a large budget deficit
45
Cost Push Inflation Input costs increase, causing a leftward shift in supply
47
Demand Pull Inflation A rightward shift in Aggregate demand
49
Module 34 - Inflation and Unemployment: The Phillips Curve
What you will learn:
• What the Phillips curve is and the nature of short-run inflation
and unemployment
• Why expansionary policies are limited due to the effects of
expected inflation
• Why deflation is a problem for economic policy
50
Module 34 - Inflation and Unemployment: The Phillips Curve
Short-run Phillips Curve (SRPC) Negative relationship between the unemployment rate & the
inflation rate
51
52
53
54
Module 34 - Inflation and Unemployment: The Phillips Curve
Short-run Phillips Curve (SRPC) Negative relationship between the unemployment rate & the
inflation rate
Nonaccelerating Inflation Rate of Unemployment (NAIRU) The unemployment rate at which inflation does not change over
time
55
56
Module 34 - Inflation and Unemployment: The Phillips Curve
Short-run Phillips Curve (SRPC) Negative relationship between the unemployment rate & the
inflation rate
Nonaccelerating Inflation Rate of Unemployment (NAIRU) The unemployment rate at which inflation does not change over
time
Long-Run Phillips Curve Shows relationship between unemployment and inflation
including expectations of inflation
57
58
Module 34 - Inflation and Unemployment: The Phillips Curve
Short-run Phillips Curve (SRPC) Negative relationship between the unemployment rate & the
inflation rate
Nonaccelerating Inflation Rate of Unemployment (NAIRU) The unemployment rate at which inflation does not change over
time
Long-Run Phillips Curve Shows relationship between unemployment and inflation
including expectations of inflation
59
Cost of Disinflation Attempting to bring down inflation at the cost of reduced GDP
and high unemployment
60
Cost of Disinflation Attempting to bring down inflation at the cost of reduced GDP
and high unemployment
Deflation Period of falling prices usually associated with recession and
increasing unemployment
Debt Deflation Reduces aggregate demand due to increase in real outstanding
debt caused by deflation
62
Liquidity Trap Conventional monetary policy is ineffective at controlling
deflation because nominal interest rates cannot go below zero
63
Liquidity Trap Conventional monetary policy is ineffective at controlling
deflation because nominal interest rates cannot go below zero
66
Module 35 - History & Alternative Views of Macroeconomics
What you will learn:
• Why classical macroeconomics wasn’t adequate for the
problems of the Great Depression
• How Keynes and the Great Depression legitimized
Macroeconomics activism
• What monetarism is and its views about the limits of
discretionary monetary policy
67
Module 35 - History & Alternative Views of Macroeconomics
Classical Macroeconomics As previously noted increase in the money supply leads to a
proportional increase in price level only in the long-run
Believe in lassiez faire economic philosophy
Keynesian Economic theory -
The Great Depression showed that a prolonged economic
downturn might not right itself
“Macroeconomic Policy Activism” - the use of monetary and fiscal
policy is necessary to recover in the short-run
68
Monetarism Milton Friedman led the movement called “monetarism” that
opposed monetary and fiscal policy activism
Maintained that the Fed should only target a constant rate of
money supply growth
- GDP will grow steadily if the money supply grows steadily
69
Monetarism Milton Friedman led the movement called “monetarism” that
opposed monetary and fiscal policy activism
Maintained that the Fed should only target a constant rate of
money supply growth
- GDP will grow steadily if the money supply grows steadily
Discretionary Monetary Policy Changes in interest rate and money supply to stabilize the
economy
Quantity Theory of Money -
The positive relationship between the money supply and price
level
71
Velocity of Money Ratio of GDP to the Money Supply
MxV=PxY
M = Money Supply
V = Velocity
P = Price Level
Y = GDP
72
Velocity of Money Ratio of GDP to the Money Supply
MxV=PxY
M = Money Supply
V = Velocity
P = Price Level
Y = GDP
Natural Rate of Unemployment Natural Rate Hypothesis proposes that unemployment must be
high enough that actual inflation rate equals expected inflation rate
74
75
Political Business Cycle When politicians use macroeconomic policy to serve political
agenda - timing activist economic policy to elections
New Classical Macroeconomics In the 1970s and 80s a return to classical economics - idea that
increase in money supply and AG demand only affect price level
Rational Expectations Popular since the 1970s - individuals and firms make decisions
based on all available data to anticipate future economic changes
- alters the effect of the economic policy
76
Real Business Cycle Theory Claims that business cycle is caused by fluctuations in the
growth of productivity - usually caused by technological progress
77
Module 36 - The Modern Economic Concensus
What you will learn:
• The elements of the modern economic consensus
• The remaining disputes
78
Module 36 - The Modern Economic Concensus
Is Expansionary Monetary Policy Effective in Fighting
Recessions? -
Most economists today agree that monetary policy is effective
at shifting aggregate demand and stabilizing the economy
Is Expansionary Fiscal Policy Effective in Fighting
Recessions? -
Most economists today agree that fiscal policy is effective at
shifting aggregate demand and stabilizing the economy
- can’t be concerned with a balanced budget
79
Can Monetary or Fiscal Policy Reduce Unemployment in the
Long run?
Classical and monetarists believe fiscal policy is not effective
Keynesians still believe it is
Most believe monetary and fiscal policy can’t keep unemployment
below the natural rate in the long-run
Should Fiscal Policy be Used in a Discretionary Way? Most believe tax cuts and spending increases are somewhat
effective in increasing aggregate demand
80
Should Monetary Policy be Used in a Discretionary Way? Most believe monetary policy should play the main role in
stabilization policy
Disagreement in how monetary policy should be implemented
Central Bank Targets Many central banks in the world use specific goals and targets
to set monetary policy - The Federal Reserve does not
Belief is that the Fed needs to remain flexible to address
unanticipated economic events as they happen
Asset Prices -
Opinion is split on whether the Fed should act when particular
asset prices are viewed as being inflated (stocks, housing)
81
Unconventional Monetary Policies In recent years the Fed has engaged in unconventional actions
in an attempt to counter a severe recession
- loaning large sums of money to financial institutions, purchases
of private assets & business debt, and home mortgage assets
- controversial but many believe necessary
82
The End
83