Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: Alesina, Alberto, and Francesco Giavazzi. Using evidence-based automatic “triggers” to alter the course of spending would be a more-effective way to … Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Aggregate demand and aggregate supply do not always move neatly together. Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP. This is sometimes known as an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation. Furman argues that fiscal policy is an essential tool to support aggregate demand and should not be subordinate to monetary policy, as many considered it to be before the Great Recession. Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. What is the difference between expansionary fiscal policy and contractionary fiscal policy? The Macroeconomic Perspective, Introduction to the Macroeconomic Perspective, 19.1 Measuring the Size of the Economy: Gross Domestic Product, 19.2 Adjusting Nominal Values to Real Values, 19.5 How Well GDP Measures the Well-Being of Society, 20.1 The Relatively Recent Arrival of Economic Growth, 20.2 Labor Productivity and Economic Growth, 21.1 How the Unemployment Rate is Defined and Computed, 21.3 What Causes Changes in Unemployment over the Short Run, 21.4 What Causes Changes in Unemployment over the Long Run, 22.2 How Changes in the Cost of Living are Measured, 22.3 How the U.S. and Other Countries Experience Inflation, Chapter 23. In addition, the price level would rise back to the level P1 associated with potential GDP. As shown in Figure 3, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP. Monet… Over that time frame, the unemployment rate doubled from 5% to 10%. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Last modified February 14, 2013. http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. At the equilibrium (E0), a recession occurs and unemployment rises. Chicago: University Of Chicago Press, 2013. In a time of recession, can monetary policy alone help the economy get out of the slump? It is the changes in interest rates and money supply to expand or contract aggregate … Economists sometimes call this an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation. Think about what causes shifts in aggregate demand over time. Brookings. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. http://research.stlouisfed.org/publications/es/12/ES_2012-01-06.pdf. “From Free-fall to Stagnation: Five Years After the Start of the Great Recession, Extraordinary Policy Measures Are Still Needed, But Are Not Forthcoming.” Economic Policy Institute. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. A recession is a significant decline in economic activity that goes on for more than a few months. The choice between whether to use tax or spending tools often has a political tinge. Issues in Labor Markets: Unions, Discrimination, Immigration, Introduction to Issues in Labor Markets: Unions, Discrimination, Immigration, Chapter 16. Most modern economies only use the interest rate policy to help them out of a recession… In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve. To keep prices from rising too much or too rapidly. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. The choice between whether to use tax or spending tools often has a political tinge. The monetary policy and the federal government combined together had a big impact on the economic recession … Last modified February 14, 2013. http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply. The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. As these occur, the government may choose to use fiscal policy to address the difference. By the end of this section, you will be able to: Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. “The Role of Fiscal Stimulus in the Ongoing Recovery.” Last modified July 6, 2012. http://www.brookings.edu/blogs/jobs/posts/2012/07/06-jobs-greenstone-looney. Chicago: University Of Chicago Press, 2013. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small. Fiscal Policy: Headwind or Tailwind?” Last modified July 2, 2012. http://www.frbsf.org/economic-research/publications/economic-letter/2012/july/us-fiscal-policy/. What happens to government spending and taxes? Increasing spending quickly could lead to a shallower and shorter recession. A recession results in a recessionary gap � meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. With the increase in private investment, aggregate demand will increase (that is, aggregate demand curve will shift upward) which will raise the equilibrium level of employment… Globalization and Protectionism, Introduction to Globalization and Protectionism, 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers, 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions, 34.3 Arguments in Support of Restricting Imports, 34.4 How Trade Policy Is Enacted: Globally, Regionally, and Nationally, Appendix A: The Use of Mathematics in Principles of Economics. 1.1 What Is Economics, and Why Is It Important? As these occur, the government may choose to use fiscal policy to address the difference. Here are my thoughts on how to use fiscal policy to address the pandemic. Monetary policy can offset a downturn because lower interest rates reduce consumers’ cost of borrowing to buy big-ticket items such as cars or houses. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one. Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. The model only argues that, in this situation, the government needs to reduce aggregate demand. In a bipartisan effort to address the extreme situation, the Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending. To keep prices from rising too much or too rapidly. A very recent example of the expansionary monetary policy was during the Great Recession in the United States. 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