Unit 5 Stabilization Policies: Short-Run Demand Management and Long-Run Inflation Tradeoffs

Stabilization policy

Government actions aimed at reducing the size of business-cycle fluctuations (recessions and booms), mainly by influencing aggregate demand in the short run.

Sticky wages/prices

The idea that many wages and other input prices adjust slowly, allowing real GDP to deviate from potential output in the short run.

Potential output (full-employment output)

The level of real GDP produced when the economy is at full employment; the long-run “normal” level of output.

Aggregate demand (AD)

Total planned spending on domestic output at each price level; a curve that typically shifts with changes in consumption, investment, government spending, and net exports.

Short-run aggregate supply (SRAS)

An upward-sloping curve showing that, in the short run, firms supply more real output when the price level rises, partly because input prices (like wages) are sticky.

Long-run aggregate supply (LRAS)

A vertical line at potential output, reflecting that in the long run real GDP is determined by resources and technology, not the price level.

Recessionary gap

A situation where real GDP is below potential output (high unemployment); typically addressed with expansionary policy to raise AD.

Inflationary gap

A situation where real GDP is above potential output (the economy is overheating); typically addressed with contractionary policy to reduce AD.

Fiscal policy

The use of government spending (G) and taxation (T), set by Congress and the President, to influence aggregate demand and overall economic activity.

Expansionary fiscal policy

Fiscal actions that increase AD to fight a recessionary gap, such as increasing government spending and/or decreasing taxes.

Contractionary fiscal policy

Fiscal actions that decrease AD to cool an inflationary gap, such as decreasing government spending and/or increasing taxes.

Crowding out

When higher government borrowing (often from larger deficits) raises interest rates and reduces private investment, offsetting some of the increase in AD from expansionary fiscal policy.

Automatic stabilizers

Budget features that automatically act countercyclically without new laws (e.g., progressive income taxes and unemployment insurance) to soften recessions and booms.

Discretionary fiscal policy

Deliberate changes to government spending or taxes that require new legislation (not automatic).

Monetary policy

The central bank’s management of the money supply and interest rates; in the U.S., conducted by the Federal Reserve.

Open market operations (OMO)

The Fed’s buying and selling of government securities: buying increases bank reserves and the money supply; selling decreases reserves and the money supply.

Reserve requirement

The fraction of deposits banks must hold as reserves; lowering it can increase money creation, while raising it can reduce money creation.

Discount rate

The interest rate the Fed charges banks for loans; lowering it encourages borrowing from the Fed, while raising it discourages borrowing.

Monetary transmission mechanism

The chain in which a change in money supply affects interest rates, which changes investment (and other interest-sensitive spending), shifting AD and affecting real GDP and the price level in the short run.

Natural rate of unemployment

The unemployment rate consistent with potential output (full employment), made up of frictional and structural unemployment (not cyclical unemployment).

Short-run Phillips curve (SRPC)

A typically downward-sloping relationship showing that, in the short run, lower unemployment is often associated with higher inflation (and vice versa).

Long-run Phillips curve (LRPC)

A vertical curve at the natural rate of unemployment, showing that in the long run there is no stable tradeoff between inflation and unemployment.

Expected inflation

The inflation rate people anticipate; when it rises, wage and price setting adjust so that the SRPC shifts upward (higher inflation at each unemployment rate).

Stagflation

A situation where inflation rises while unemployment rises (and output falls), often caused by a negative supply shock; associated with an SRAS shift left and an SRPC shift up/right.

Quantity equation of money (MV = PY)

An identity linking money supply (M) and velocity (V) to the price level (P) and real output (Y); in growth-rate form, inflation is tied to money growth, velocity changes, and real GDP growth.