Unit 5: Long-Run Consequences of Stabilization Policies

Fiscal and Monetary Policy Actions in the Short Run

To understand the long-run consequences of economic policies, we must first master how fiscal and monetary policies impact the economy in the short run. These policies primarily target Aggregate Demand (AD) to close recessionary or inflationary gaps.

Policy Tools Recap

  • Fiscal Policy: Changes in government spending ($G$) or taxation ($T$) conducted by the legislative branch (e.g., Congress).
  • Monetary Policy: Changes in the money supply and interest rates conducted by the Central Bank (e.g., the Federal Reserve). Tools include the Reserve Requirement, Discount Rate, and Open Market Operations.

Short-Run Effects on AD/AS

When policymakers enact expansionary or contractionary policies, the immediate effect is a shift in the Aggregate Demand curve.

  1. Expansionary Policy (Gov Spending $\uparrow$, Taxes $\downarrow$, Money Supply $\uparrow$)
    • Shifts AD to the right.
    • Result: Real GDP ($Y$) increases, Price Level ($PL$) increases, Unemployment decreases.
  2. Contractionary Policy (Gov Spending $\downarrow$, Taxes $\uparrow$, Money Supply $\downarrow$)
    • Shifts AD to the left.
    • Result: Real GDP ($Y$) decreases, Price Level ($PL$) decreases, Unemployment increases.

AD/AS Model shifting AD

The Crowding Out Effect

A critical concept in AP Macroeconomics is Crowding Out, which is an unintended side effect of expansionary fiscal policy (specifically deficit spending).

  • Mechanism: When the government increases spending ($G$) without raising taxes, it runs a budget deficit. To fund this, the government borrows money by selling bonds.
  • Loanable Funds Market: This borrowing increases the Demand for Loanable Funds.
  • Result: The equilibrium Real Interest Rate rises.
  • Impact: Higher interest rates make borrowing expensive for private businesses. Therefore, Private Investment ($I_g$) decreases.

Key Takeaway: Crowding out broadens the government sector at the expense of the private sector, potentially dampening the long-term growth rate of capital stock.

Crowding Out in Loanable Funds Market

The Phillips Curve

The Phillips Curve is one of the most frequently tested models in Unit 5. It illustrates the short-run trade-off between inflation and unemployment.

The Short-Run Phillips Curve (SRPC)

The SRPC represents a negative (inverse) relationship between the unemployment rate and the inflation rate.

  • Shape: Downward sloping.
  • Logic: When AD increases, prices rise (inflation $\uparrow$) and output rises (unemployment $\downarrow$). This creates a movement up/left along the curve.
  • Equation Concept: $\text{Inflation} = \text{Expected Inflation} - B(\text{Unemployment} - \text{Natural Rate}) + \text{Supply Shock}$.

The Long-Run Phillips Curve (LRPC)

In the long run, there is no trade-off between inflation and unemployment. The economy returns to full employment regardless of the price level.

  • Shape: Vertical line located at the Natural Rate of Unemployment (NRU).
  • Logic: Monetary policy can change the inflation rate in the long run, but it cannot change the natural rate of unemployment (dependent on structural/frictional factors).

Long Run and Short Run Phillips Curve

Shifts vs. Movements

Mastering why the curve moves is essential for the AP exam:

  1. Movement Along the SRPC:

    • Caused by shifts in Aggregate Demand (AD).
    • If AD shifts Right $\rightarrow$ Move Up/Left along SRPC (High Inflation, Low Unemployment).
    • If AD shifts Left $\rightarrow$ Move Down/Right along SRPC (Low Inflation, High Unemployment).

  2. Shift of the SRPC:

    • Caused by shifts in Short-Run Aggregate Supply (SRAS).
    • Negative Supply Shock (Stagflation): SRAS shifts Left $\rightarrow$ SRPC shifts Right (Higher Inflation AND Higher Unemployment at every point).
    • Inflation Expectations: If people expect higher inflation, the entire SRPC shifts upward.

  3. Shift of the LRPC:

    • Caused by changes in the Natural Rate of Unemployment (e.g., changes in labor market laws, unemployment benefits, or structural changes).

Shift of the SRPC due to Supply Shock

Money Growth and Inflation

In the long run, we assume prices are flexible. This leads to the concept that monetary policy focuses on price stability rather than output.

The Quantity Theory of Money

This theory links the money supply to inflation using the equation of exchange:

M \times V = P \times Y

Where:

  • $M$ = Money Supply (M1)
  • $V$ = Velocity of Money (average times a dollar is spent per year)
  • $P$ = Price Level
  • $Y$ = Real GDP (Output)
  • $(P \times Y)$ = Nominal GDP

The Monetary Equation Implications

To see the effects of Money Growth:

  1. Assume $V$ is stable/constant (institutional factors regarding how we pay for things don't change rapidly).
  2. Assume $Y$ is fixed in the long run (determined by technology and resources, not money).

Therefore:
\Delta M = \Delta P

An increase in the Money Supply ($M$) leads to a proportional increase in the Price Level ($P$) (Inflation) in the long run, with no change to Real GDP ($Y$).

Monetary Neutrality

This is the principle that changes in the money supply affect nominal variables but not real variables in the long run.

  • Nominal Variables (Affected): Price Level, Nominal Wages, Nominal GDP.
  • Real Variables (Unaffected): Real GDP, Unemployment Rate, Real Interest Rate (in the long run).

Fisher Effect

Because money is neutral in the long run, an increase in inflation does not change the Real Interest Rate. We use the Fisher Equation:

Real\ Interest\ Rate \approx Nominal\ Interest\ Rate - Inflation\ Rate

Start with the Real Rate (determined by loanable funds). If the Central Bank increases the money supply, Inflation rises. To keep the Real Rate constant, the Nominal Interest Rate must rise.

Common Mistakes & Pitfalls

  • Confusing Shifts vs. Movements on the Phillips Curve:

    • Mistake: Thinking an increase in Government Spending shifts the SRPC.
    • Correction: Spending shifts AD, causing a movement along the SRPC. Only Supply Shocks or Inflation Expectations shift the SRPC.

  • Bond Prices vs. Interest Rates:

    • Mistake: Thinking they move in the same direction.
    • Correction: They are inversely related. If the Fed buys bonds, demand for bonds rises $\rightarrow$ Price of bonds rises $\rightarrow$ Interest Rate falls.

  • Real vs. Nominal in Long Run:

    • Mistake: Thinking printing money increases wealth (Real GDP) in the long run.
    • Correction: Due to Monetary Neutrality, printing money only creates inflation (higher prices and wages), leaving purchasing power roughly the same.

  • Crowding Out Causality:

    • Mistake: Thinking Crowding Out is caused by higher taxes.
    • Correction: It is caused by deficit spending (borrowing), which increases the demand for loanable funds.