Feb 12 Flashcards
we use the simple multiplier when we have only…
aggregate demand in the picture
it ignores aggregate supply - useful only when AS is flat
because acting on assumption that prices won’t change (if AS is positively sloped, assumption is that prices will change)
why is the multiplier smaller with the AS curve?
AS curve has positive slope
producers only produce more output if prices are higher
so effect on equilibrium will be smaller
change in output is smaller
is there a formula for the multiplier?
no (unlike the simple multiplier)
you have to know the AE to calculate where the new equilibrium is
short run versus adjustment of factor prices versus long run assumptions
SHORT RUN:
1. factor prices are assumed to be constant
2. technology and factor supplies are assumed to be constant
ADJUSTMENT OF FACTOR PRICES:
1. factor prices are FLEXIBLE
2. technology and factor supplies are assumed to be constant
LONG RUN:
1. factor prices have FULLY ADJUSTED
2. TECH and FACTOR SUPPLIES are CHANGING
what happens to GDP in the short run, during adjustment and in the long run?
SHORT RUN:
^ real GDP (Y) is determined by AS and AD
ADJUSTMENT PROCESS:
^ factor prices adjust to output gaps; real GDP eventually returns to Y*
LONG RUN:
^ potential GDP (Y*) grows over the long run
recessionary gap
when Y < Y*
inflationary gap
when Y > Y*
when Y > Y*, the demand for labour…
is relatively high
during an inflationary output gap there are:
- HIGH PROFITS for firms
- UNUSUALLY LARGE LABOUR DEMAND
what tend to rise during an inflationary gap?
wages and unit costs
inflationary output gap formation and closing
FORMATION:
increase in factor prices - increases firms’ unit costs
as unit costs increase, firms will require higher prices in order to supply any given level of output
AS shifts up
CLOSING:
Y moves back towards Y*
inflationary gap begins to close
when Y < Y*, the demand for labour…
is relatively low
low profits for firms, low demand for labour
what happens to wages and unit costs when in a recessionary output gap?
wages and unit costs tend to fall
adjustment asymmetry
inflationary output gaps typically RAISE WAGES QUICKLY
recessionary output gaps often REDUCE WAGES SLOWLY (downward wage stickiness)
what curve summarizes the adjustment process after output gaps?
the Phillips curve
fact about unemployment in Canada
high unemployment can persist for quite long periods without causing decreases in wages and prices of sufficient magnitude to remove the unemployment
fact about booms in Canada
booms, along with other labour shortages and production beyond normal capacity, don’t persist for long periods without causing increases in wages and price level
what was the Phillips curve originally drawn as?
as a NEGATIVE RELATIONSHIP between unemployment rate and rate of change in nominal wages
Y > Y* = excess demand for labour = wages rise
Y < Y* = excess supply for labour = wages fall
Y = Y* = no excess supply or demand = wages constant
Phillips curve shows what relationship?
inverse relationship between INFLATION and UNEMPLOYMENT
when unemployment is LOW, inflation tends to be HIGH
when unemployment in HIGH, inflation tends to be LOW
Phillips curve - why is inflation high when unemployment is low?
because when labour market is tight (low unemployment), workers have more BARGAINING POWER and employers RAISE WAGES to ATTRACT/RETAIN TALENT
higher wages = higher production costs = higher prices (inflation)
NAIRU
natural rate of unemployment
occurs when Y = Y*
caused by STRUCTURAL and FRICTIONAL unemployment
Y* is what for output?
an anchor
ie. AD or AS shock pushes Y away from Y* in short run
as a result, wages and other factor prices will adjust until Y returns to Y*
why is recovery from a contractionary AD shock slower?
because of “sticky downward wages”
price level takes longer to fall (hard to reduce wages)
contractionary AD shocks: if wages are flexible…
wages will fall rapidly whenever there’s unemployment
the resulting shift in AS curve would quickly eliminate recessionary gaps
contractionary AD shocks: if wages are sticky…
AS curve shifts more slowly
in such cases the recessionary gap may have to be closed with an EXPANSION IN AD
(ie. increase private sector demand or gov stabilization policy)
stagflation
happens when AS shifts up
prices increase and GDP falls
following either a demand or supply shock, the speed that output return to Y* depends on…
wage flexibility
flexible wages provide an adjusmtent process that quickly pushes economy back to potential output
but if wages are slow to adjust, the economy’s adjustment process is slugging and thus output gaps persist
business cycle brining economy from Y > Y* back to Y = Y
when Y > Y*, SHORTAGES eventually arise and RESTRICT FURTHER EXPANSION
firm’s expectations are revised, REDUCED INVESTMENT
reduction of CONSUMER CONFIDENCE, reduced desired consumption
^ real GDP tends to move back toward Y*
business cycle brining economy from Y < Y* back to Y = Y
when Y < Y*, consumer’s durable goods become OBSOLETE
normal replacement expenditures recover
firm’s replacement investments also recover
revival of favourable expectations
^ real GDP rises back toward Y*
when is the economy in long run equilibrium?
when factor PRICES are NO LONGER ADJUSTING to output gaps
Y = Y*
the vertical line at Y* is sometimes called…
the long-run aggregate supply curve
the classical aggregate supply curve
is there a relationship in the long run between the price level and potential output?
no
because in the long run, potential output is determined by factors like technology, capital, labour and resources
changes in price level (inflation/deflation) can lead to short-term adjustment in output but in the long run, prices don’t affect the economy’s fundamental capacity to produce goods and services
long run aggregate supply curve (LRASC)
it’s vertical
meaning that, in the long run, output is independent of the price level
economy’s output in the long run is fixed by the availability of factors of production and the level of technology
in the long run, Y is determined only by ____ ______
potential output
what determined P in the long run?
aggregate demand
do AD shocks have effects on long-run output?
no
AD shocks have no long run effect on output
for a given AD curve, long run growth in Y* results in what?
a lower price level
because AD curve is negatively sloped
so as real GDP increases, prices get lower
what’s the motivation for fiscal stabilization policy?
to reduce the volatility of aggregate outcomes
what are the options when an AD or AS shock pushes Y away from Y*?
- use FISCAL STABILIZATION policy
- wait for the recovery of PRIVATE SECTOR DEMAND (shift in the AD curve)
- wait for the ECONOMY’S ADJUSTMENT PROCESS (shift in the AS curve)
2ways to close a recessionary gap
- closed by FALLING WAGES and other FACTOR PRICES
^ shift of supply curve to the right, to meet the demand curve at Y*
^ slower
- closed by FISCAL EXPANSION
^ shift of the demand curve to the right, to meet AS curve at Y*
2 ways to close an inflationary gap
- closed by RISING WAGES and other FACTOR PRICES
^ shift of supply curve up and to the right, to meet the demand curve at Y*
- closed by CONTRACTIONARY FISCAL POLICY
^ leftward shift of demand curve, to meet the supply curve at Y*
a recessionary gap may be closed by what 3 things?
- a rightward shift of AD due to recovery of private sector demand
- a (possibly slow) rightward shift in AS curve
- a rightward shift in AD due to expansionary fiscal policy
advantage and disadvantage of using fiscal stabilization policy to close a recessionary gap
- ADVANTAGE: it may SHORTED what might otherwise be a long recession
- DISADVANTAGE: may stimulate the economy before private sector recovery and economy may OVERSHOOT its Y* - creating instability and maybe inflation
explain the effects: during WW2, military spending increased by more than 30%
economists agree this helped bring about the RISE IN OUTPUT and the FALL IN UNEMPLOYMENT
explain the effects: 2008 global recession
increases in spending
economists agree that fiscal stimulus contributed to real GDP growth during 2009-2010 period
explain the effects: response to COVID-19
dramatic increase in spending (19.7% of GDP): health system, direct aid to households and firms, liquidity to support firms through tax deferrals
liquidity
company’s ability to convert assets to cash or acquire cash
through a loan or money in the bank
to pay its short term obligations or liabilities
5 points on 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 more firms who need credit
- decline in US economic activity > affected Canada (REDUCING EXPORTS)
- coordination among leaders of world’s major economies > measures to restore financial and economic activity + FISCAL ACTIONS
- Canada: infrastructure spending, targeted income-tax reductions, expansion of the employment insurance program
Canada’s fiscal response to the 2008-2009 global recession
expansionary fiscal policy
- infrastructure spending
- targeted income-tax reductions
- expansion of the employment insurance program
fiscal policy in the great depression
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
depth and duration made worse by FUNDAMENTAL MISTAKES in POLICY
1932, CAD prime minister said: “we’re now faced with the most real crisis in the history of Canada. To maintain our credit we must practice the most rigid economy and not spend a single cent.”
DEFICIT INCREASED BUT NOT CAUSED BY A POLICY DECISION TO REDUCE TAX RATES, INSTEAD CAUSED BY A REAL FALL IN GDP
1932 quote from Cad PM
in context of great depression
“to maintain our credit we must practice the most rigid economy and not spend a single cent”
Cad policy response had what affect?
increased the deficit
and not caused by decision to reduce tax rates
instead caused by a real fall in GDP
Paradox of Thrift
- IN SHORT RUN, INCREASE IN DESIRED SAVINGS LEADS TO REDUCTION IN GDP
^ shifting AD to the left reduces GDP
^ what may be good for a single individual in isolation ends up being undesirable for the economy as a whole
^ major/persistent recession can be battled by encouraging govs, firms, households to increase their spending
- PARADOX OF THRIFT DOESN’T APPLY IN THE LONG RUN
^ in the long run AD doesn’t influence level of GDP
^ increase in savings has long run effect of increasing investment and therefore increasing potential output
paradox of thrift: major and persistent recession can be battled how?
battled by ENCOURAGING GOVS, FIRMS and HOUSEHOLDS to INCREASE SPENDING
does the paradox of thrift apply in the long run?
no it doesn’t
in the long run, AD doesn’t influence level of GDP
increase in savings has long run effect of INCREASING INVESTMENT and therefore INCREASING POTENTIAL OUTPUT
discretionary fiscal stabilization
occurs when government ACTIVELY CHANGES G and/or T in an effort to steer real GDP
ie. raising T to keep output closer to potential
automatic fiscal stabilization
occurs because of the design of the TAX and TRANSFER system
tax and transfer system
mechanism behind automatic fiscal stabilization
- as Y changes, net tax revenue changes
- the size of the multiplier is reduced (presence of t means AE is flatter)
- the output response to shocks is dampened
the ______ is the net tax rate (t), the ______ is the simple multiplier
the LOWER is the net tax rate (t), the LARGER is the simple multiplier
and thus the LESS STABLE is the real GDP in response to shocks to autonomous spending
taxes mean that the gov keeps a fraction of output produced - means that z is smaller and AE becomes flatter - so the economy is automatically more stable - the same shock will make output fluctuate less
algebra behind the fact that the lower the net tax rate (t), the larger the simple multiplier
marginal propensity to spend on national income:
z = MPC (1 - t) - m
simple multiplier = 1 / (1 - z)
most economists agree that ________ fiscal stabilizers are desirable and generally work well, but they have concerns about _________ fiscal policy
agree that AUTOMATIC fiscal stabilizers work well
but they have concerns about DISCRETIONARY fiscal policy
limitations of discretionary fiscal policy
- long and uncertain lags
- temporary versus permanent changes in policy
- the impossibility of “fine tuning”
discretionary fiscal policy: uncertain lags
DECISION LAGS: the period of time between perceiving some problem and reaching a decision on what to do about it
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
discretionary fiscal policy - uncertain lags TAKEAWAY
it’s 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
ie. AD and AS curve may have moved
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 this action will have to be financed in some way (taxes will be increased eventually to repay the tax reduction) - so people will increase their consumption but less than the gov desires
the more FORWARD-LOOKING the households are, the SMALLER will be the effects of what are perceived to be temporary changes in taxes
discretionary fiscal policy - the impossibility of “fine tuning”
FINE TUNING: attempt to MAINTAIN output at its potential level by means of FREQUENT FISCAL POLICY CHANGES
^ this is hard to do - G and t aren’t super effective at dealing with small gaps
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
do some argue that fiscal policy shouldn’t be used for economic stabilization in any circumstances?
yes, some do argue for this
they believe that G and t should be the outcome of PUBLIC CHOICES regarding the long term size and financing of the public sector
consequences of fiscal policy increasing G
- increase in G temporarily increases real GDP
- adjustment: Y will return to Y* but at HIGHER PRICES
- GDP composition will be altered: problem if investment is lower in the new long-run equilibrium (because higher G means lower I in our equation)
- slower rate of accumulation of capital - may reduce rate of growth of potential output
consequences of fiscal policy decreasing t
- decrease in t temporarily increases real GDP
- adjustment: Y will return to Y* but at higher prices
- long run effect: ie. lower corporate income tax rates makes 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
increasing G or decreasing t - which presents more of a trade off?
increasing G
because can decrease investment relative to G
the short run stimulative benefits of increase in G must be weighed against…BUT
the possible long run costs of lower growth
BUT some of the rise in G may be GOVERNMENT INVESTMENT
then, the overall effect on the path of Y* depends on the productivity of PUBLIC INVESTMENT versus the PRIVATE investment that was CROWDED OUT
fiscal policy: decrease in t - tradeoff?
decrease in t appears to carry no trade off between the short and long run
BUT this means less public spending on many of the things that citizens value: national parks, public education, health care, roads etc
although decreasing t doesn’t have a short to long run tradeoff like increasing G does…
it does mean less public spending on many of the things that citizens value: national parks, public education, health care, roads etc
