Lecture notes for week 5

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

FISCAL POLICY AS AN AUTOMATIC STABILIZER AND THE AS-AD MODEL Outline N Discuss the concepts like inflationary gap, deflationary gap, and full-employment level of output. N The use of fiscal policy to smooth out business cycles. N Develop the AS-AD modelbringing price into the model. Our Extended Modelthe Budget Balance Again N Our extended model (let IM = 0 and hold r & E constant): 0 C = C 0+ c1DI T = T 0+ t1Y, 1 > 1 > 0 TR = TR tr Y, 1 > tr > 0 0 1 1 I = 0 G X = X 0 IM = im 1 AE = AE 0 + cYY, where AE 0 C +0I +0G + X + c0TR 1c T0 1 0 cY= [c 11 t1 tr1) im1] BB = (T 0 TR 0 G) + (t 1 tr 1 Y N Question: What happens to the budget balance when Y changes? N Answer: Holding all else constant (T , TR , and G are all held constant), when Y increases, BB increases. Similarly, when Y 0 0 decreases, BB decreases. The budget balance is ENDOGENOUS (it responds to a change in Y)! o A change in G, T 0, or TR0would have TWO effects on the BB. Why? BB = (T 0 TR 0G) + (t + 1r )1Y o When T 0 decreases, TR 0ncreases, or G increases, this will cause (0 TR0 G) to decrease BB decreases. (FIRST ROUND EFFECT) o When T decreases, TR increases, or G increases (change in AE ), this leads to a higher level of AE Y increases (t + 0 0 0 1 tr1) Y increases BB increases. (SECOND ROUND EFFECT) o First round effect dominates the second round effect. Full-Employment Level of Output and Output Gaps Full-Employment Level of Output, Y FE N It is the level of output consistent with full employment. N The term full employment means o Good (productive) workers find it easy to find a job. o Young (inexperienced) workers find it easy to find their first job. o Old (experienced) workers are not forced out of the labour force if they lose their jobs (i.e., no discouraged workers). N In other words, when the economy is operating at its normal pace (not too fast and not too slow), then we can say that the economy is at its full employment. N The unemployment rate at Y FE is called theon-accelerating inflation rate of unemployment (NAIRU) or natural rate of unemployment (NRU). N Full employment DOES NOT mean that everyone is working because o Frictional unemploymentunemployment that results from the turnover in the labour market as workers move between jobs. o Structural unemploymentlong-term and chronic unemployment arising from imbalances between the skills and other characteristics of workers in the market and the needs of employers. o The labour market is dynamic (people move in and out of the labour market). o There are frictions in the economy (some industriesregions expand while some industriesregions contract). Recessionary or Deflationary Gap N It occurs when the equilibrium level of output (Y*) is less than the full-employment level, i.e., Y* < Y . FE N This means that the economy is producing less output than is normally associated with full employment. N How? Firms lay off their workers (i.e. many unemployed workers). www.notesolution.com
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