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>> Aggregate Demand and
Aggregate Supply
Krugman/Wells
©2009  Worth Publishers
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WHAT YOU WILL LEARN IN THIS CHAPTER
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How the AS–AD model is used to formulate
macroeconomic policy
The rationale for stabilization policy
Why fiscal policy is an important tool for managing
economic stabilization
Which policies constitute expansionary fiscal policy
and which constitute contractionary fiscal policy
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Macroeconomic Policy
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Economy is self-correcting in the long run.
Most economists think it takes a decade or longer!!!
John Maynard Keynes: “In the long run we are all
dead.”
Stabilization policy is the use of government
policy to reduce the severity of recessions and rein
in excessively strong expansions.
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FOR INQUIRING MINDS
Keynes and the Long Run
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The British economist Sir John Maynard Keynes (1883–
1946), probably more than any other single economist,
created the modern field of macroeconomics.
In 1923 Keynes published A Tract on Monetary Reform, a
small book on the economic problems of Europe after World
War I.
In it he decried the tendency of many of his colleagues to
focus on how things work out in the long run:
“This long run is a misleading guide to current affairs. In
the long run we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us that when the storm is long past the
sea is flat again.”
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Macroeconomic Policy
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The high cost — in terms of unemployment
— of a recessionary gap and the future
adverse consequences of an inflationary gap
 Active stabilization policy, using fiscal
or monetary policy to offset shocks.
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Macroeconomic Policy
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Policy in the face of demand shocks:
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If policy were to perfectly anticipate shifts in AD
and counteract them, it could short-circuit
adjustment process.
Policy dilemma: a policy that counteracts the
fall in aggregate output by increasing aggregate
demand will lead to higher inflation, especially if
they increase budget deficits could have long-run
costs of lower economic growth. Without perfect
information the policy could do more harm than
good.
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Macroeconomic Policy
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Policy in the face of supply shocks:
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There are no easy policies to shift the short-run
aggregate supply curve.
Policy dilemma: a policy that counteracts the
fall in aggregate output by increasing aggregate
demand will lead to higher inflation, but a policy
that counteracts inflation by reducing aggregate
demand will deepen the output slump.
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►ECONOMICS IN ACTION
Is Stabilization Policy Stabilizing?
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Has the economy actually become more stable since the
government began trying to stabilize it?
Yes. Data from the pre–World War II era are less reliable
than more modern data, but there still seems to be a clear
reduction in the size of economic fluctuations.
It’s possible that the greater stability of the economy reflects
good luck rather than policy.
But on the face of it, the evidence suggests that
stabilization policy is indeed stabilizing.
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Why a large public debt may be a cause for
concern
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Why implicit liabilities of the government are also
a cause for concern
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Government Spending and Tax Revenue for Some
High-Income Countries in 2006
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Sources of Tax Revenue in the U.S., 2007
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Government Spending in the U.S., 2007
Social insurance
programs are government
programs intended to
protect families against
economic hardship.
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The Government Budget and Total Spending
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Fiscal policy is the use of taxes, government
transfers, or government purchases of goods and
services to shift the aggregate demand curve.
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Investment Tax Credits
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An investment tax credit is a tax break given to firms based
on their investment spending. This increases the incentive
for investment spending.
Investment tax credits are often temporary, applying only to
investment spending within a specific period.
Like department store sales that encourage shoppers to
spend a lot while the sale is on, temporary investment tax
credits tend to generate a lot of investment spending when
they’re in effect. Even if a firm doesn’t think it will need a
new computer server or lathe for another year or so, it may
make sense to buy it while the tax credit is available, rather
than wait.
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Expansionary and Contractionary Fiscal Policy
Expansionary Fiscal Policy Can Close a Recessionary Gap
Expansionary fiscal
policy increases
aggregate demand.
Recessionary gap
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Expansionary and Contractionary Fiscal Policy
Contractionary Fiscal Policy Can Eliminate an Inflationary Gap
Contractionary fiscal policy
reduces aggregate demand.
Inflationary gap
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A Cautionary Note: Lags in Fiscal Policy
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In the case of fiscal policy, there is an important
reason for caution: there are significant lags in its
use.
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Realize the recessionary/inflationary gap by collecting
and analyzing economic data  takes time
Government develops a spending plan takes time
Implementation of the action plan (spending the money
 takes time
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SUMMARY
1. The high cost—in terms of unemployment—of a
recessionary gap and the future adverse consequences of an
inflationary gap lead many economists to advocate active
stabilization policy: using fiscal or monetary policy to offset
demand shocks. There can be drawbacks, however, because
such policies may contribute to a long-term rise in the budget
deficit and crowding out of private investment, leading to lower
long-run growth. Also, poorly timed policies can increase
economic instability.
2. Negative supply shocks pose a policy dilemma: a policy that
counteracts the fall in aggregate output by increasing
aggregate demand will lead to higher inflation, but a policy that
counteracts inflation by reducing aggregate demand will
deepen the output slump.
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The End of Module 20
coming attraction:
Module 21:
Fiscal Policy & Multiplier
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