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Economics for Management Studies
Ata Mazaheri

ECMA06 –The AS-AD Model (Part 1) 1 Fiscal Policy & The Aggregate Supply – Aggregate Demand Model (Part 1) Outline  Discuss the concepts like inflationary gap, deflationary gap, and full-employment level of output.  The relationship between budget balance and national debt.  The link between budget balance and output gaps.  The use of fiscal policy to smooth out business cycles.  Develop the AS-AD model – bringing price into the model. ECMA06 –The AS-AD Model (Part 1) 2 Full-Employment Level of Output and Output Gaps Full-employment level of output, Y FE 1)When the economy is operating at its full potential, then we 1 can say that the economy is at its full employment .  The level of output consistent with “full employment” is called the full-employment level of output, Y FE  It is also the level of output that the economy will converge to in the long run.  The unemployment rate at Y is called the non-accelerating FE inflation rate of unemployment (NAIRU) or natural rate of unemployment (NRU). AE Y = AE AE 45 Y Y FE 1You can interpret the term “full employment” as  “Good/productive” workers find it “easy” to find a job.  “Young/inexperienced” workers find it “easy” to find their first job.  “Old” workers are not forced out of the labour force if they lose their jobs (no discouraged workers). ECMA06 –The AS-AD Model (Part 1) 3  As discussed in week 2, Full employment DOES NOT mean that everyone is working because  The labour market is dynamic (people constantly move in and out of the labour market).  Frictional unemployment – unemployment that results from the turnover in the labour market as workers move between jobs.  Structural unemployment – a mismatch between the skills or locations of workers and the skill or location requirements of job openings.  There are “frictions” in the economy (some industries/regions expand while some industries/regions contract). ECMA06 –The AS-AD Model (Part 1) 4 Recessionary or Deflationary Gap  It occurs when the equilibrium level of output (Y*) is less than the full-employment level, i.e., YFE< Y .  This means that the economy is producing less output than is normally associated with full employment. AE Y = AE AE 45 Y Y* YFE  When the economy has lots of unemployed workers, we say we are in a recession  Recessionary gap.  If the gap is large enough, there will be pressure for prices to fall  Deflationary gap. ECMA06 –The AS-AD Model (Part 1) 5 Inflationary Gap  It occurs when the equilibrium level of output (Y*) is greater than the full-employment level, i.e.,FE* > Y .  This means that the economy is producing more output than is normally associated with full employment. AE Y = AE AE The economy overheats (excess demand at FE)  pressure for price to   Inflationary gap 45 Y YFE Y* ECMA06 –The AS-AD Model (Part 1) 6 Endogenous Budget Balance  Let we turn our focus to fiscal policy.  We will start by discussing endogenous budget balance. Our Extended Model – the Budget Balance Again  Our extended model (let IM = 00 and hold r & E constant): AE = AE + 0 Y,Y where AE = C + I + G + X + c TR – c T 0 0 0 0 1 0 1 0 cY= [c (1 – t 1 tr 1 – im 1 1 Y* = AE 0 = AE 0M 1c Y BB = (T –0TR – G0 + (t + t1 )Y 1 Observations:  The budget balance is ENDOGENOUS!  Holding all else constant, BB  when Y . Similarly, BB  when Y . ECMA06 –The AS-AD Model (Part 1) 7  A change in G, T , or TR has TWO effects on the BB. 0 0 Proof: 1)When T , 0R , or0G , this will cause (T – TR – 0) 0 to fall  BB . 2)When T , 0R , or0G , this leads to a higher level of AE  Y   (t + tr )Y   BB . 1 1 Structural Deficit vs. Cyclical Deficit  Given the budget balance changes automatically when Y changes, we need to separate a deficit during a recession from a persistent deficit even the economy is operating at full employment.  Structural deficit – The government runs a budget deficit when Y = Y  this is bad! FE  Cyclical deficit – BB = 0 when Y = Y , but the FE government runs occasional budget deficit when Y < Y . FE  this is natural and we should not worry about it.  Ideally, we should run surpluses during good times (when Y > Y )FEand deficits during bad times (when Y < Y ). FE ECMA06 –The AS-AD Model (Part 1) 8 Relationship between Budget Balance and National Debt  Recall, if BB < 0, the government runs a budget deficit. If BB > 0, the government runs a budget surplus.  However, each time when the government runs a budget deficit, it needs to find ways to finance its deficit.  In Canada, the federal government finances its deficit mainly by borrowing from the public (i.e., issuing bonds).  The problems of running persistent budget deficits:  Accumulate national debt.  This debt must be “serviced”, i.e., the government has to pay interest on its debt, so This may use up some tax revenues needed to run public programs. The government has to cut its services provided. The government may have to raise taxes.  All these hurt Canadians. * Let’s agree that persistent budget deficits are bad since national debt . ECMA06 –The AS-AD Model (Part 1) 9 Relationship between Output Gaps and Budget Balances  To show that when the economy is in an inflationary/deflationary gap, the government can bring Y back to YFEby adjusting its budget (i.e., fiscal policy can be used to smooth out business cycles). Assumption: There is no structural deficit, i.e., BB = 0 when Y = Y FE Case 1 – Deflationary/Recessionary Gap (Y* < Y ) FE AE Y = AE AE 0 A 45 Y* Y FE Y ECMA06 –The AS-AD Model (Part 1) 10 Case 2 – Inflationary Gap (Y* >FE ) AE Y = AE AE 0 A 45 Y FE Y* Y  Lesson: The government can run counter-cyclical fiscal policy to bring Y back toFE . Lags in Policy Formulation and Implementation  It seems it is relatively easy for the government to fine-tune the economy. But, why don’t the government do this?  Answer: The problems of lags for short run fluctuations  Lag in determining that there is a problem.  Lag in deciding what policy should be adopted and in implementing that policy.  It takes time for that policy to work their way into AE. ECMA06 –The AS-AD Model (Part 1) 11  Implications: If the recession is short enough (i.e., if the sum of all these lags exceeds the length of the business cycle), then it is possible that by the time the policy takes effect the recession has passed and the policy may no longer be appropriate.  Question: Is there a way to go around this problem?  Answer: Yes, this requires the government to make forecast about the economic conditions that are likely to prevail when the policy takes effect.  Unfortunately, it is extremely difficult to make accurate forecast.  Implication: Policy to fine-tune the economy is probably impossible, and we should only focus explicit policy on “big” events such as the recent financial crisis. ECMA06 –The AS-AD Model (Part 1) 12  There are two big changes in the economy since the 1930s that help to prevent recessions, and these changes are not related to “explicit” counter-cyclical fiscal policy. They are:  Automatic stabilizers – There are elements of the existing tax and transfer system that reduce the responsiveness of output to changes in autonomous expenditure. This happens even if the government makes
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