Stabilization Policies

20-30% Inflation, Unemployment, and Stabilization Policies

A. Fiscal and monetary policies

1. Demand-side effects

2. Supply-side effects

3. Policy mix

4. Government deficits and debt

B. Inflation and unemployment

1. Types of inflation

a. Demand-pull inflation

b. Cost-push inflation

2. The Phillips curve: short run versus long run

3. Role of expectations


Fiscal Policy and Stimulus: Crash Course Economics #8

Legislative Mandates

Employment Act of 1946 – required government to act to improve economic conditions where it could – including dealing with unemployment, inflation and using fiscal tools to attack these problems.

CEA and JEC – economic advisory groups for the President (Committee of Economic Advisors) and Congress (Joint Economic Committee)

Fiscal Policy

•Using Taxes and Government spending to stabilize the economy.

•Controlled by the President and Congress

•Discretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented.

•Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.


EXCEPT when the question specifically states there is a change in business taxes.

Types of Fiscal Policy


•Used to Fight a Recession




•Used to fight Inflation



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Fiscal Policy and the Aggregate Demand-Aggregate Supply Model

Expansionary Fiscal Policy: expansionary is a $.50 word for growing. The purpose of expansionary policy is to make the economy grow. Fiscal means that it has to do with tax and spending policy – i.e. the government budgetary process. Therefore, expansionary fiscal policy concerns making the economy grow by using tax and spending policy.

  • budget deficits – expansionary fiscal policy is designed to spend more than the government takes in through taxes – so budget deficits are expected (and in fact by definition are required) to do expansionary fiscal policy.

Methods of Expansionary Policy

Increased Government Spending

The first method or tool that government has at its disposal is government spending. This is the same government spending that we used to find AE and AgD. If we increase government spending, (G), we expect that AE will rise, and AgD will shift to the right.

The graph below shows how when G increases (from G to G’), the AE curve rises (from AE to AE’) giving us a greater level of GDP (from GDP to GDP’). At the same time, that means that the level of GDP must be rising in the AgD-AS graph too (there can be only one level of GDP at any one time). Inthe lower graph, AgD (which also depends on G) shifts in response to the increase in G.

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Tax Reductions

Tax deductions work differently, but the graph looks almost identical. When a tax cut is given (ceteris peribus – i.e. no matching decrease in G), the effect is felt through changes in the disposable income of individual consumers and businesses.

(decrease) T --> ­ (increase) YD --> (increase) ­ C --> (increase) AE --> ­(increase) GDP or Y

Here the tax cut gives people more disposable income (YD), which can be spent or saved (a portion of which is spent if MPC > 0), that shifts AE up and increases GDP

(decrease) T --> (increase) ­ profit margins --> (increase) ­ I --> (increase) ­AE --> (increase) ­GDP or Y

Tax Multiplier [-MPC/MPS]

•Remember, if the government decreases taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut.

•The Tax Multiplier = -MPC /MPS

•Example: If the MPC is .8 and the MPS is .2

•Spending Multiplier = 1/.2 or 5

•Tax Multiplier = -.8 /.2 or -4

Macro 4.7- Loanable Funds & Crowding Out

Crowding-Out Effect

•An Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates.

•At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT (I)

•At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well.

•This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.

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Net Export Effect & Expansionary Fiscal Policy

•Government spending has led to an increase in interest rates.

•At higher interest rates, foreigners demand more U.S. dollars to invest in bonds.

•This leads to an appreciation of the U.S. dollar.

•This leads to a decrease in Net Exports, as foreigners now have to exchange more of their currency for the U.S. dollar to buy exports.

•This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.

Contractionary Fiscal Policy

Contractionary means to shrink. So Contractionary Fiscal policy is designed to shrink the economy ((decrease) GDP). Why would you ever want to shrink GDP? We can see why in the AgD-AS graph. Look what happens to the level of PL as we shift from AgD’ to AgD’’. The PL falls as GDP shrinks. That means that one way to defeat inflation is to create a recession (falling GDP). Have we ever done this? Yes, we have.

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Methods of Contractionary Policy

Decreased Government Spending

(decrease) G --> (decrease) AE --> (decrease) GDP or Y --> (decrease) PL

A decrease in government spending causes the AE curve to shift down, leading to lower GDP and PL (decreases inflation)

Macro 3.7- Fiscal Policy: Non-discretionary vs Discretionary "AP Macro"

Tax Increases

(increase) T --> (decrease) YD --> (decrease) C --> (decrease) AE --> (increase) GDP or Y --> (decrease) PL

Increases in taxes leave less money in the hands of individuals (YD), so they spend less ((decrease) C), and that causes AE to fall, creating less GDP. But the PL also falls

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Net Export Effect & Contractionary Fiscal Policy

•A decrease in government spending has led to a decrease in real interest rates.

•At lower interest rates, foreigners demand less U.S. dollars to invest in bonds.

•This leads to a depreciation of the U.S. dollar.

•This leads to an increase in Net Exports, as foreigners now have to exchange less of their currency for the U.S. dollar to buy exports.

•This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.

Deficits & Debts: Crash Course Economics #9

Financing of Deficits and Disposing of Surpluses

What do we do with the surpluses? Can we use them to pay off the debt? Generally, the answer is “no”. If we simply take that money and pay off debts by calling in government bonds, then money is injected into the system (Incomes rise). That would cause GDP to rise again – and PL with it.

Borrowing vs New Money

Borrowing from the Public: The government borrows from the public by issuing government bonds. When you buy a government bond, you’ve lent the government your money - which they promise to pay back with interest. You are acting as a bank. The more they borrow from you, the less you have in cash, on hand.

­(increase) Government borrowing from the public --> (decrease) YD --> (decrease) C --> (decrease) AE --> (decrease) GDP or Y

It also does the same to businesses through consumers having less left to save:

­ (increase) Government borrowing from the public --> (decrease) YD --> (decrease) S --> (increase) i --> (decrease) I --> (decrease) AE --> ­(increase) GDP or Y --> (decrease) PL

Money Creation: printing money seems like a painless way to pay debt – but when you print money to pay off government’s bills, more money is in the hands of the public (which they can then spend). This causes C to rise – increasing AE and GDP.

Debt Retirement vs Idle Surplus

  • Debt Reduction
  • Idel Surplus

Policy Options: G or T?

Built in Stability -

  • Automatic Stabilizers
  • Economic Importance
  • Tax Progressivity
    • Progressive Tax system
    • Regressive Tax System
    • Proportional Tax System

Criticisms of Fiscal Policy

Timing Problems

Recognition Lag: identifying recession or inflation

Administrative Lag: getting Congress/President to agree to take action

Operational Lag: Time needed to see the results of the fiscal policy

Political Business Cycles: Politicians may take inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes

Monetary Policy

The Federal Reserve System (FED)

•Control Monetary Policy

•Headquartered in Washington D.C.

•12 Federal Reserve Districts

•Board of Governors (7 members) is the central authority

•Members are appointed by the President and confirmed by the Senate

Federal Open Market Committee (FOMC)

•Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate)

•Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates

Tools of Monetary Policy

Open-market operations

These are the most important means the Fed has to control the money supply. It refers to the buying and selling of government bonds (securities) by the Federal Reserve Banks. *Buying bonds increases the money supply; selling them decreases it.

More Detail

*If the Fed buys or sells securities to the public, the money supply will increase/decrease less than if the Fed buys or sells them to banks. This is shown in the following examples:

**Let’s assume that the required reserve ratio is 0.2. The money multiplier is then 5.

If the Fed buys $1000 worth of securities from commercial banks, the excess reserves

will increase by $1000. Then, the money supply will increase by $1000*5=$5000.

If they buy securities from the public, the public gets more money, and when they

deposit it into banks (whether directly or indirectly), bank reserves increase. However,

since the required reserve ratio is 0.2, the bank needs to put $200 of the money in the

Federal Reserve Bank, and so excess reserves only increase by $800. Then, the money

supply will increase by $800*5=$4000.

**If the Fed sells $1000 worth of securities to commercial banks, then excess reserves

will decrease by $1000, so the money supply will decrease by $1000*5=$5000.

If the Fed sells $1000 of securities to the public, then after the transaction is cleared,

the bank will have $1000 less in securities. $200 of that money can be taken from

Federal reserves, and so excess reserves only decrease by $800, causing the money

supply to decrease by $800*5=$4000.

The reserve ratio

The Fed can also increase or decrease the Reserve ratio. Increasing the Reserve ratio decreases banks’ excess reserves, causing the money supply to decrease.

* Decreasing it increases banks’ excess reserves, increasing the money supply.

This is really powerful, and so it is not used very often.

The discount rate

The discount rate is the rate that Federal Reserve Banks charge for loans to commercial banks. When commercial banks borrow from FRBs, their reserves increase.

* Therefore, if the discount rate increases, banks are less encouraged to borrow, keeping their excess reserves the same and therefore restricting money supply.

Easy Money and Tight Money

Easy Money Policy (Expansionary Monetary Policy):

Your book uses the term “easy money policy”, but it is usually called “expansionary fiscal policy”. Just like expansionary fiscal policy – it’s aim is to expand the economy (make GDP grow). But this time, it is accomplished my means of the money market.

***Buy Securities: puts money in people’s hands in return for this asset

--> MS shifts out (from MS to MS’)
--> which causes i rates to fall (from i to i’) (decrease)
--> which causes I to (increase)­ (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)

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Lower the Reserve ratio

Leaves banks with excess reserves, which they can pull out (to use to make loans that make profits for them. Reserves at the FED do not earn the banks any interest, so they won’t leave large excess reserves with the FED)

--> MS shifts out (from MS to MS’)
--> which causes i rates to fall (from i to i’) (decreases)
--> which causes I to ­ (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)

Lower the Discount Rate

Allows banks to take low interest loans from the FED – freeing up reserves that they used to borrow from other banks. They may also borrow more funds to then turn around and lend these out (at slightly higher rates) knowing that this lower rate will increase the number of loans that private industry is willing to take out.

--> MS shifts out (from MS to MS’)
--> which causes i rates to fall (from i to i’) (decreases)
--> which causes I to ­ (increase) (from I to I’)
--> which drives up AE (from AE to AE’) and AgD (from AgD to AgD’)
--> this increases GDP (and the PL)

Effects of an Easy Money Policy


•The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well.

•These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect


Just the opposite reactions occur when the FED uses one of these three tools in the opposite direction to decrease the MS. This causes the economy to contract (GDP to fall). Usually the purpose is to stop inflation.

Sell Securities:

When the FED sells securities, they take in a illiquid asset and introduce more money into the economy. People have cash in their hands instead of a bond.

--> MS shifts back (from MS to MS’’)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)

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Increase the Reserve Ratio:

Increasing the reserve ratio causes banks to send more money to the FED to satisfy that requirement. This leaves less for them to loan out. With less loanable funds, competition for what there is increases:

--> MS shifts back (from MS to MS’’)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)

Raise the Discount Rate:

Raising the discount rate means that fewer banks would be willing to borrow money from the FED – instead borrowing from each other or calling in loans to meet the reserve requirement without the assistance of a loan.

--> MS shifts back (from MS to MS’’)
--> which causes i rates to rise (from i to i’’) (decreases)
--> which causes I to (decrease) (from I to I’’)
--> which drives AE down (from AE to AE’’) and AgD (from AgD to AgD’’)
--> this decreases GDP (and the PL)

Effects of a Tight Money Policy

•At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease.

At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS.

Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy

Both fiscal and monetary

Summary: recessionary

Fiscal policy: increase government spending, decrease taxes

Monetary policy: loose money policy – buy government securities, lower reserve ratio,

lower discount rate

Summary: inflationary

Fiscal policy: decrease government spending, increase taxes

Monetary policy: tight money policy – sell government securities, raise reserve ratio,

raise discount rate

Economic Philosophies


•Believes that the government SHOULD NOT interfere in the economy. And believes in self-correction of economic problems.

“Old” Classical theory

They believe that the AS curve is vertical and it is the only factor in determining real output. The AD curve is still downsloping, and classical economists view it as stable when the money supply is onstant. Also, domestic output doesn’t change when price level decreases; it’s only the AD curve moving down. They believe in Say’s law, which says that supply creates its own demand.

“New” Classical theory

Their theory is that when the economy occasionally diverges from its full-employment output, internal mechanisms within the economy automatically move it back to that output. In their opinion, if a change in AD moves the equilibrium outside of ASLR, there will be a change in AS that will bring it back.

Supply-side economics

They believe that changes in aggregate supply are active forces in determining the levels of both inflation and unemployment. Economic disturbances can be generated on both the supply side and the demand side of the economy. They also contend that certain government policies have reduced the growth of aggregate supply over time, and if these policies were reversed, the economy could achieve low levels of unemployment without producing rapid inflation.

**Supply-siders also say that the US tax-transfer system has “eroded” productivity and decreased incentives to work, invest, innovate, and assume entrepreneurial risks. If taxes were decreased, people would have more money after taxes and they would have more of an incentive to work.

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Introduction to Supply-side Policies


•Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are Keynesians

Rational Expectations

•Believes that monetary and fiscal policy have certain effects on the economy and take action to make these policies ineffective.

Fight of the Century: Keynes vs. Hayek Round Two