AP Macroeconomics

Class 5

Problems with fiscal policy

• Unemployment and inflation
• the twin evil cannot be solved simultaneously with fiscal policy.

• Stagflation
• The kind of inflation that cannot be solved by fiscal policy.

• Rational expectation
• When people are expecting for an inflation, the effect of expansionary
policy will be undermined.

• Crowding out
• Increased government lending will cause real interest rate rise and
“crowd out” private consumption and investment.
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 • Use the Phillips curve to show the nature of the
short-run trade-off between inflation and
unemployment
• Explain why there is no long-run trade-off between
What You Will inflation and unemployment
• Discuss why expansionary policies are limited due
Learn in this to the effects of expected inflation

Module • Explain why even moderate levels of inflation can

be hard to end
• Identify the problems with deflation that lead
policy makers to prefer a low but positive inflation
rate

Section 6 | Module 34

Short-run Phillips Curve

• The short-run Phillips curve is the negative short-run relationship between
the unemployment rate and the inflation rate.

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Unemployment and Inflation,
1955-1968

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The Short-Run Phillips Curve

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 The AD-AS Model and the Short-Run Phillips Curve

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The Short-Run Phillips Curve and Supply Shocks

Inflation
rate
A negative supply
shock shifts
SRPC up.

0
SRPC Unemployment
1
rate
SRPC 0

A positive supply
shock shifts SRPC
2
SRPC down.

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 AD/AS and the Phillips Curve
Price LRAS
Inflation
Level
AS

PL2
PL2
PL1
PL1 AD2

AD1 SRPC

Y1 Y2 GDPR U2 U1 Unemployment
Section 6 | Module 34

AD/AS and the Phillips Curve

Price LRAS
Inflation
Level
AS

PL1 PL1
PL2 PL2
AD1 SRPC
AD2
Y2 Y1 YP GDPR U1 U2 Unemployment
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 AD/AS and the Phillips Curve

Price LRAS
Inflation
Level
AS2
AS1
PL2 PL2
PL1 PL1
SRPC2
AD SRPC1

Y2 Y1 GDPR U1 U2
Unemployment
Section 6 | Module 34

AD/AS and the Phillips Curve

Price LRAS Inflation

Level AS1

AS2
PL1 PL1

PL2 PL2
SRPC1

AD
SRPC2
Y1 Y2 GDPR U2 U1 Unemployment
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 The Long-Run Phillips Curve
Inflation
rate • The Phillips Curve Is
8% vertical in the long run
7 since changes in
C
6 aggregate demand affect
5 only prices in the long-
B E
4 4 run.
3 • The long-run Phillips
A E
2 2 SRPC
4 curve is vertical at the
1 natural rate of
E SRPC
2
0 0 unemployment.
3 4 5 6 7 8% Unemployment
–1 rate
–2 Natural rate of SRPC
unemployment 0
–3
Section 6 | Module 34

AD/AS and the Phillips Curve

Price LRAS LRPC
Inflation
Level

PL2

PL1
AD2

AD1

YP GDPR UY
Unemployment
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 Putting LR and SR Philips curves together

LRPC • Inflation
Inflation • Inflation rate > expected
inflation rate
• Unemployment < natural
rate of unemployment
Expected
inflation • Recession
• Inflation rate < expected
SRPC inflation rate
• Unemployment > natural
Natural Unemployment rate of unemployment
Rate Section 6 | Module 34

Check Point

The Phillips curve:

A. Shows how government spending and tax collections are related.
B. Is upward sloping from left to right.
C. Indicates that inflation will be high when unemployment is low.
D. Shows how the equilibrium price level is related to fiscal policy.
E. Shows how output and prices are related.

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Summary

1. At a given point in time, there is a downward-sloping relationship between

unemployment and inflation known as the short-run Phillips curve. This
curve is shifted by changes in the expected rate of inflation.
2. The long-run Phillips curve, which shows the relationship between
unemployment and inflation once expectations have had time to adjust, is
vertical. It defines the non-accelerating inflation rate of unemployment, or
NAIRU, which is equal to the natural rate of unemployment.
3. Once inflation has become embedded in expectations, getting inflation back
down can be difficult since disinflation can be very costly.

Section 6 | Module 34

Rational Expectations

• In 1995 Robert Lucas of the University of Chicago won the Nobel Prize in
economics “for having developed and applied the hypothesis of rational
expectations, and thereby having transformed macroeconomic analysis
and deepened our understanding of economic policy.”
• This hypothesis is based on the idea that households and businesses will
use all the information available to them when making economic
decisions.
• This seems like a logical and harmless assumption, but carried to its logical
conclusion, rational expectations implies that fiscal policy will be
ineffective at changing the quantity of output.

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 Rational Expectations
Price LRPC
LRAS Inflation • What would you do if you
Level AS2 know that there is going
AS1 to be an inflation?
PL3 PL3

PL2 PL2
PL1 PL1
AD2 SRPC2

AD1 SRPC1

Y1 YP GDPR UY U1
Unemployment
Section 6 | Module 34

Check Point

The theory of rational expectations:

A. Assumes that consumers and businesses anticipate rising prices when
the government pursues an expansionary fiscal policy.
B. Implies that fiscal policy will be effective even during stagflation.
C. Supports the notion of a Phillips trade-off.
D. Assumes that consumers and businesses do not use all the information
available to them.
E. Was developed by Keynes as a remedy for the Great Depression.

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 Crowding-Out Effect
Government spending might cause unintended effects that weaken the impact
of the policy.
Example:
•We have a recessionary gap
•Government creates new public library. (AD increases)
•Now but consumer spend less on books (AD decreases)

Another Example:
•The government increases spending but must borrow the money (AD
increases)
•This increases the price for money (the interest rate).
•Interest rates rise so Investment to fall. (AD decreases)
•The government “crowds out” consumers and/or investors
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Crowding-Out Effect
Real
Interest
rate

An increase in the
demand for loanable
r funds . . .
2
. . . leads to a rise
in the equilibrium
interest rate. r
1
• When the government
increases borrowing,
D2 the real interest rate
will increase.
D1

Quantity of loanable funds

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 Crowding-Out Effect
Price LRAS
Level • The government increases spending but
AS must borrow the money (AD increases)
• This increases the price for money (the
PL2 interest rate).
PL3 • High interest rate discourages
PL1
AD2 Consumption and Investment. (AD
AD3 decreases)
AD1 • The government “crowds out”
consumers and/or investors
Y1 Y3 YP GDPR
Section 6 | Module 34

Check Point

Crowding out:
A. Is one reason fiscal policy is so effective.
B. Occurs when interest rates fall due to government borrowing.
C. Occurs when consumers and firms spend less offsetting
expansionary fiscal policy.
D. Causes the aggregate demand curve to shift to the right.
E. Occurs when rising interest rates cause cuts in government
spending.

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Summary

1. Rational expectations suggests that even in the short run there might not
be a trade-off between inflation and unemployment because expected
inflation would change immediately in the face of expected changes in
policy.

2. The crowding out effect is a theory that suggests that increased

government spending ultimately decreases private sector spending.

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Difference between Classical and Keynesian

• “Flexible price/ wage” – Classical theory

• Recession → ↓ wage/rent → ↓cost of production → ↑AS → back
to long-run equilibrium
• Inflation → ↑ wage/rent → ↑ cost of production → ↓ AS → back
to long-run equilibrium

• “Sticky wage” – Keynesian theory

• Once the price is increased it is not likely to decrease so AS cannot
shift freely as classical theory suggested. The government should
use fiscal policy to shift the AD.

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 Classical during negative demand shock
2. …reduces the aggregate
Aggregate price level and aggregate
price level output and leads to higher
unemployment in the short run…
LRAS
SRAS
1

SRAS
2

P E
1 1
1. An initial
P2 negative 3. …until an eventual
demand shock… E fall in nominal wages
2
in the long run increases
P3 E short-run aggregate
3 AD supply and moves the
1 economy back to
AD potential output.
2
Y Y
2 1 Potential Real GDP
output
Recessionary gap
27 of 17 Section 4 | Module 19

Classical during positive demand shock

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 Keynesian

• “Sticky wage” – Keynesian

theory
• Once the price is no
flexible so AS cannot shift
freely as classical theory
suggested. The
government should use
fiscal policy to shift the
AD.

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Summary

1. When there is “flexible price” in the question, remember to apply classical

theory.

2. When there is “sticky price” or “Price is not flexible” in the question,

always apply Keynesian theory.

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 Check Point
A country’s economy is in a short-run equilibrium with an output level less than
the full-employment output level. It increased the military expenditure by 100
billion.
a) Using a correctly labeled graph of the short-run Phillips curve, show the
effect of the increased military expenditures in the short run, labeling the initial
point as A and the new point as B.

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Check Point
b) If the marginal propensity to consume is equal to 0.75, calculate the
maximum possible change in real GDP that could result from the $100 billion
increase in government spending.

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 Check Point
c) Using a correctly labeled graph of the loanable funds market, show the effect
of the $100 billion increase in government spending on the real interest rate.

d) Based on the real interest rate change in part (c), what is the effect on the
long-run economic growth rate? Explain.

Section 6 | Module 35

Check Point

e) Now assume that instead of financing the $100 billion increase in

government spending by borrowing, the United States government increases
taxes by $100 billion. With this equal increase in government spending and
taxes, will the real GDP increase, decrease, or remain the same? Explain.

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