Chapter 9 Flashcards
in the long run, total output is determined only by…
potential output
in the long run, the price level is determine by…
aggregate demand
in the long run, permanent increases in real GDP are possible only if…
potential output is increasing
between 2006-2012, the Canadian government reduced both personal and corporate income taxes. is this a demand-side or supply-side policy?
both
since in this situation the tax cut increases desired consumption and investment expenditures
and it also increases the return to working (as opposed to leisure)
the larger the value of the simple multiplier, the ________ the AD curve
FLATTER
larger value of z = steeper aggregate expenditure line
for given change in price, the steeper the aggregate expenditure line, the greater the change in equilibrium national income for the price change, and the FLATTER the aggregate demand line
the _______ the AD curve, the less stable real GDP in the presence of AS shocks
flatter
the ________ the multiplier, the smaller the size of the shift in the AD curve for any given change in autonomous expenditure
smaller
the economy’s automatic stabilizers do what to the size of the multiplier?
they REDUCE THE SIZE of the multiplier
the larger the value of z, the steeper the aggregate expenditure line. for a given change in price, the steeper the aggregate expenditure line, the greater the change in equilibrium national income for the price change, and the flatter the aggregate demand line.
in the long run, if there was a decrease in the net tax rate as opposed to an increase in government spending…
there could be a POSITIVE EFECT on the LEVEL and GROWTH RATE of POTENTIAL OUTPUT
fiscal expansion created by a reduction in income taxes has a similar effect on real GDP
adjustment process between the short and long runs
Y eventually returns to Y*
factor prices adjust and technology remains constant
long run: changes in what determines changes in Y?
changes in Y* (potential output)
factor prices have adjusted and technology changes
short run versus adjustment of factor prices versus long run
SHORT RUN
1. factor prices assumed to be constant
2. technology and factor supplies assumed to be constant
ADJUSTMENT OF FACTOR PRICES
1. factor prices are flexible
2. technology and factor supplies are constant
LONG RUN
1. factor prices have fully adjusted
2. technology and factor supplies are changing (potential output is changing)
explain the process of closing an inflationary output gap
- demand for labour (and other factor services) is high
- high profits for firms and unusually large demand for labour (wages and unit costs tend to rise)
- increase in factor prices increases firms’ unit costs
- as unit costs rise, firms will need higher prices in order to supply any given level of output
- AS shifts up
- Y moves back towards Y* - inflationary gap begins to close
explain the process of closing a recessionary output gap
- demand for labour (and other services) is relatively low
- low profits for firms and low demand for labour
- wages and unit costs tend to fall
- reduction in factor prices will reduce firm’s unit costs
- as unit costs decrease, firms require lower prices in order to supply any given level of output
- AS shifts down
- Y moves back towards Y* - recessionary gap begins to close
adjustment asymmetry
- inflationary output gaps typically raise wages rapidly
- recessionary output gaps often reduce wages only slowly (downward wage stickiness)
what summarizes the general adjustment asymmetry process?
the Phillips curve
shows that with higher rates of unemployment, there are lower rates of change of wages
in Canada, high unemployment can persist for…
quite long periods without causing decreases in wages and prices of sufficient magnitude to remove the unemployment
in Canada, booms and labour shortages/production beyond normal capacity, persist for…
short periods of time before causing increases in wages and the price level
what was the Phillips curve originally drawn as?
drawn as the NEGATIVE RELATIONSHIP between the unemployment rate and the rate of change in nominal wages
- Y > Y* means unemployment falls and wages rise
- Y < Y* means unemployment rises and wages fall
- Y = Y* means no excess supply/demand and wages stay constant
potential output as an “anchor”
suppose an AD or AS shock pushes Y away from Y* in the short run
as a result, wages and other factor prices will adjust until Y returns to Y*
speed of adjustment: flexible versus sticky wages
- FLEXIBLE WAGES: wages will fall rapidly whenever there’s unemployment, and the resulting shift in the AS curve could quickly eliminate recessionary gaps
- STICKY WAGES: average supply curve shifts more slowly. in such cases the recessionary gap may have to be closed with an expansion in AD (increase private sector demand or government stabilization policy)
what can be done to solve the problem of sticky wages?
sticky wages occur in recessionary gaps
the AD has decreased and price levels need to decrease further in order to shift the AS curve rightward and close the recessionary gaps
but wages take a long time to fall
SO AN EXPANSION IN AD CAN CLOSE THE GAP
^ increase in private sector demand
^ government stabilization policy
what would cause stagflation?
a contractionary aggregate supply (AS) shock
ie. an increase in the price of oil
AS shifts up, prices increase and GDP falls
recessionary gap opens
in inflationary gaps, what role do business cycle dynamics play in bringing the economy back to Y = Y*?
- when Y > Y*, SHORTAGES eventually arise and restrict further expansion
- REVISION of firm’s expectations so they REDUCE their DESIRED INVESTMENT
- reduction CONSUMER’S CONFIDENCE = reduction in desired consumption
(real GDP tends to move back toward Y*)
in recessionary gaps, what role do business cycle dynamics play in bringing the economy back to Y = Y*?
- when Y < Y*, consumer’s durable goods become obsolete
- normal replacement expenditures and firm’s replacement investments recover
- revival of favourable expectations
(real GDP rises back toward Y*)
when is economy in a state of long run equilibrium?
when factor prices are no longer adjusting to output gaps
Y = Y*
vertical line at Y* is sometimes called…
long-run aggregate supply curve (LRAS)
classical aggregate supply curve
in the long run, is there a relationship between price level and potential output?
no
what is Y determined by in the long run?
only by potential output
what is P determined by in the long run?
aggregate demand
for a given AD curve, long-run growth in Y* results in what?
a lower price level
what’s the motivation for fiscal stabilization policy?
to reduce the volatility of aggregate outcomes
when an AD or AS shock pushes Y away from Y*, the options are what?
- use fiscal stabilization policy
- wait for recovery of private sector demand (shift in AD curve)
- wait for economy’s adjustment process (shift in AS curve)
what curve does the economy’s adjustment process concern?
the AS curve
ie. with shortages, the AS curve shifts up
ie. with surpluses, the AS curve shifts down
how can a recessionary gap be closed?
- by a downward shift of the AS curve which decreases prices and increases output
^ FALLING WAGES AND OTHER FACTOR PRICES
- by an upward shift of the AD curve which increases prices and increases output
^ FISCAL EXPANSION
how can an inflationary gap be closed?
- by a leftward shift of AS curve
^ RISING WAGES AND OTHER FACTOR PRICES
- by a leftward shift in AD
^ CONTRACTIONARY FISCAL POLICY
advantage of fiscal policy in closing a recessionary gap
fiscal policy used to increase AD
may SHORTEN an otherwise long recession
disadvantage of fiscal policy in closing a recessionary gap
fiscal policy used to increase AD
may stimulate the economy before private-sector recovery, and economy may OVERSHOOT its Y* - creates instability
Canada’s fiscal response to the 2008-2009 recession
- US housing problem - soon became a global financial crisis
- Sharp decline in the flow of credit - essential input for firms who need credit
- Decline in US economic activity - affected Canada via reduced exports
- Coordination among leaders of the world’s major economies - measures to restore financial and economic activity + fiscal actions to provide economic activity
- Canada:
a) infrastructure spending
b) targeted income-tax reductions
c) expansion of EI
fiscal policy in the Great Depression
the Great Depression, usually dated as beginning with massive stock market crash in 1929, was one of the most dramatic economic events of the 20th century
its depth and duration were worsened by fundamental mistakes in policy
1932 - Canadian PM said “to maintain our credit we must practice the most rigid economy and not spend a single cent”
deficit increased, fall in real GDP
paradox of thrift
in the short run, an increase in desired savings leads to a reduction in GDP (through leftward shift of AD curve)
what may be good for any individual in isolation, ends up being undesirable for economy as a whole
major and persistent recession can be battled by encouraging governments, firms and households to increase their spending
what can a major/persistent recession be battled by?
by encouraging governments, firms and households to increase their spending
does the paradox of thrift apply in the long run?
no
in the long run, AD doesn’t influence the level of GDP
the increase in savings has the long run effect of increasing investment and therefore increasing potential output
2 types of fiscal policy
- discretionary
- automaticd
discretionary fiscal policy
occurs when the GOVERNMENT ACTIVELY CHANGES G and/or T
in an effort to steer real GDP
automatic fiscal policy
occurs naturally because of the design of the TAX and TRANSFER SYSTEM
- as Y changes, net tax revenue changes
- the size of the simple multiplier is reduced
- the output response to shocks is dampened
the lower is the net tax rate (T), the ______ is the simple multiplier
larger
and thus the less stable is real GDP in response to shocks to autonomous spending
we can change T to…
to help keep closer to potential output
increasing T means Z is smaller and AE is flatter
automatically makes the economy more stable
how do most economists feel about automatic fiscal stabilizers?
most economists agree that automatic fiscal stabilizers are desirable and generally work well
(but they have concerns about discretionary fiscal policy)
concerns about discretionary fiscal policy come from where?
- long and uncertain lags
- temporary versus permanent changes in policy
- the impossibility of fine tuning
limit of discretionary fiscal policy: uncertain lags
- DECISION LAG: period of time between perceiving some problem and reaching a decision on what to do about it
(should we increase G? which taxes can we reduce?)
- EXECUTION LAG: the time it takes to put policies in place after a decision has been made
and, once new policies are in place, it can still take time for their economic consequences to be felt
uncertain lags make it possible that by the time a given policy decision…
has any impact on the economy, CIRCUMSTANCES WILL HAVE CHANGED such that the policy is no longer appropriate
limit of discretionary fiscal policy: temporary versus permanent changes in policy
temporary changes in taxation are generally LESS EFFECTIVE than measures that are expected to be permanent
people are smart - if gov reduces taxes, they know the gov will have to finance this in some way - so they’ll increase their consumption, but less than the gov desires
(if people perceive policies as temporary, they’ll realize taxes will be increased eventually to repay the tax deduction)
the more forward looking households are, the smaller the effects of what are perceived as…
temporary changes in taxes
limit of discretionary fiscal policy: the impossibility of “fine tuning”
fine tuning: attempting to maintain output at its potential by frequent changes in fiscal policy
really hard to do
gross tuning
use of macroeconomic policy to stabilize the economy such that large deviations from potential output don’t persist for extended periods of time
fiscal stabilization policy: an increase in G
- increase in G temporarily increases real GDP
- adjustment: Y will return to Y* but at higher prices
- GDP composition will be altered (recall: Y = C + I + G + NX)
^ higher G and lower private investment
- slower rate of accumulation of capital
(this may reduce rate of growth of potential output)
increase in G can crowd out private investment!
risk of fiscal stabilization policy that increases G
increased gov spending means the supply of funds will decrease
means we have less savings in the economy
lower NS means a HIGHER INTEREST RATE
some firms will decide not to borrow and invest because of the higher interest rate
SO INCREASE IN G CAN CROWD OUT PRIVATE INVESTMENT
but what if gov is spending more because it’s investing in the economy?
increases G but uses this to build schools, infrastructure, healthcare…
gov is increasing G, but it’s investment that’s changing Y*
if G contains investment that’s productive, then maybe there’s no trade off in the long run
fiscal policy - reducing t
- a decrease in t temporarily increases real GDP
- adjustment: Y will return to Y* but at higher prices
- long-run effect: lower corporate income tax rates make investment more profitable to firms
- any increase in investment will tend to increase future growth rate of potential output
APPEARS TO BE NO TRADE OFF BETWEEN SHORT AND LONG RUN
although decreasing t appears to have no trade-off between the short and long run…
this does mean LESS PUBLIC SPENDING on many things that citizens value
ie. national parks, public education, health care, roads etc
