Short-Run & Long-Run Effects on the economy. A.P. Economics Unit 5: Stabilization Policies Ms. Trimels

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1 Short-Run & Long-Run Effects on the economy A.P. Economics Unit 5: Stabilization Policies Ms. Trimels

2 Short-run effects on Aggregate Demand Aggregate Demand will either increase or decrease following any change in fiscal or monetary policy. This will change: Level of Output Employment Price Levels Fiscal and monetary policies are generally described as demand-side policies

3 Expansionary Policies LRAS Expansionary policies are to be used during: PL1 Recessions Periods of high unemployment Periods of deflation Increase in AD 1. Increase in the price level 2. Increase in employment 3. Increase in total output AD1

4 Expansionary Policies Fiscal Policy: 1. Reduce taxes 2. Increase government spending Monetary Policy: 1. Lower RRR 2. Lower DR 3. OMO (Fed buys bonds)

5 Expansionary policies should not be used when the economy is producing at or beyond its full employment level. LRAS Increase in AD AD1 1. Little or no increase in employment 2. Little or no increase in output 3. A large increase in the price level

6 LRAS Contractionary Policies PL1 Contractionary policies are to be used during AD1 Periods of high inflation When unemployment is at or below the natural rate (NRU) Decrease in AD 1. Decrease in the price level 2. Decrease in employment 3. Decrease in total output

7 Contractionary Policies Fiscal Policy: 1. Increase taxes 2. Decrease government spending Monetary Policy: 1. Raise RRR 2. Raise DR 3. OMO (Fed sells bonds)

8 LRAS Contractionary policies should not be used when the economy is producing at a level of output below its full employment level, or when the economy is in a recession. AD1 Decrease in AD 1. Large increase in unemployment 2. Large decrease output 3. A small decrease in the price level

9 Short-run effects on Aggregate Supply Even though fiscal and monetary policies are generally described as demand-side policies, they may also have an effect on aggregate supply in the short-run. Expansionary Fiscal Policy increase gov t spending Gov t spending w/a tax cut = less gov t revenue Less gov t revenue = necessity of borrowing money Loanable funds market Crowding-Out Effect higher interest rates less investment increase costs faced by firms

10 Increased costs faced by firms Reduction in aggregate supply Decrease in SRAS 1. Reduction in output 2. Reduction in employment 3. Increase in price level PL1 LRAS SRAS1

11 Expansionary Monetary Policy expands money supply Downward pressure on interest rates interest rates are lower Firms borrow more funds for investment Firms are able to hire more workers production of output increases supply increases Increase in SRAS 1. Increase in output 2. Increase in employment 3. Decrease in price level Yf e

12 In periods of high inflation and low unemployment: - Workers real wages will decline (As prices rise, purchasing power decreases) - In the long-run, they will demand higher nominal wages - This will increase the cost to firms Long-Run Effects of Fiscal and Monetary Policy In periods of deflation and high unemployment: - Workers real wages will increase (As prices lower, purchasing power increases) - In the long-run, they will accept lower nominal wages - This will reduce the cost to firms

13 Expansionary Policies Following the implementation of any expansionary policy, there will be a short-run change in Output Price level Employment In the Long-Run, however, output will always return to its full- employment level. Why? A nation can t sustainably produce beyond the maximum amount of resources it has.

14 Ex: Expansionary policies increase AD Beyond Full-Employment In the Short-Run, AD Output increases Price levels increase Employment increases However, greater demand for nation s scarce resources will make it so that AD1 prices rise real wages are reduced unemployment falls below NRU increased competition for workers puts upward pressure on nominal wages Nominal wages will rise and increase cost to firms increase in the price of inputs (labor) decrease in supply PL2 PL1 LRAS SRAS1

15 Can Expansionary Policies ever increase the Long-Run Level of Full-Employment? PL2 PL1 LRAS LRAS LRAS1 LRAS1 SRAS1 If the Expansionary Policies are only demand- side; NO. However, if there are supply-side effects, it may increase the full-employment level of output in the long run. 1 AD1 What type of expansionary policy could positively affect the supply? 1 Expansionary Monetary Policy Lower ir more investment more economic growth increased level of output in the long-run

16 Contractionary Policies Following the implementation of any contractionary policy, there will be a short-run change in Output In the Long-Run, however, output will always return to its full- employment level. Why? Eventually, we will be able to use all of our resources again.

17 Ex: Contractionary policies and the decrease in AD In the Short-Run, AD Output decreases Price levels decrease Employment decreases LRAS SRAS1 However, lower demand for nation s scarce resources will make it so that prices lower real wages raise unemployment rises What is the political problem posed by this scenario? PL1 PL2 the high number of unemployed workers puts downward pressure on nominal wages Nominal wages will fall and reduces cost to firms price of inputs becomes cheaper (labor) supply begins to recover AD1

18 Can Contractionary Policies ever Decrease the Long-Run Level of Full-Employment? PL1 PL2 LRAS1 LRAS 1 AD1 SRAS 1 If the Contractionary Policies are only demand- side; NO. However, if contractionary policy reduces spending on a nation s productive resources (such as infrastructure, education, and health), then the productivity of a nation s resources in the long-run may decline. What type of contractionary policy could damage our economy? Contractionary Monetary AND Fiscal Policy Higher ir less investment less economic growth decreased level of output in the long-run