UNIT 5: STABILIZATION POLICIES WHAT CAN THE GOVERNMENT AND THE FEDERAL RESERVE DO TO FIX RECESSIONARY AND INFLATIONARY GAPS?

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1 UNIT 5: STABILIZATION POLICIES WHAT CAN THE GOVERNMENT AND THE FEDERAL RESERVE DO TO FIX RECESSIONARY AND INFLATIONARY GAPS?

2 FISCAL POLICY

3 CLASSICAL ECONOMICS Adam Smith Invisible Hand It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages." A free market is self-regulating. There may be periods of inflation and unemployment, but in the long run, the economy will bring itself back to equilibrium.

4 KEYNESIAN ECONOMICS John Maynard Keynes ( Canes ) In the long run we are all dead. Believed in times of economic distress, the government could jump start the economy by increasing its spending (shift the AD), which would then encourage production, which would increase employment, which would lead to spending and the cycle would continue.

5 How does the government stabilize the economy? The government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress and the president to adjust to the G and C in aggregate demand. 2. Monetary Policy- Actions by the Federal Reserve Bank (our central bank) to adjust the money supply

6 What can the federal gov t do to stabilize the economy? Automatic Stabilizers - policies that are already set in place that automatically reduce the size of fluctuations in the business cycle Unemployment benefits. If the economy goes into a recession and people are laid off, this payment helps to keep aggregate demand from falling to steeply. Marginal tax brackets when incomes increase so do tax payments; when incomes decrease so do tax payments. Welfare and transfer programs transfer payments tend to rise when the economy is contracting and fall when the economy is expanding.

7 Discretionary Stabilizer (Fiscal Policy) When the government deliberately makes changes to its spending and/or taxes to deal with an economic downturn. KEYNESIAN ECONOMICS John Maynard Keynes ( Canes ) In the long run we are all dead. Believed in times of economic distress, the government could jump start the economy by increasing its spending (shift the AD), which would then encourage production, which would increase employment, which would lead to spending and the cycle would continue.

8 DISCRETIONARY FISCAL POLICY Expansionary Fiscal Policy - stimulate growth by increasing consumer and business spending and employment. To increase aggregate demand, the gov t can: increase in government purchases of goods and services cut in taxes increase in government transfer payments

9 DISCRETIONARY FISCAL POLICY Contractionary Fiscal Policy - slow economic growth to fight inflation. To decrease aggregate demand that is too high, the gov t can: reduce government purchases of goods and services increase in taxes reduce government transfers payments

10 Contractionary Expansionary

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12 Objective for Aggregate Demand Action on Taxes Action on Gov t Spending Effect on Budget The national unemployment rate rises to 12% Inflation is strong and its rate is now 14% per year. Survey shows consumers are losing confidence in the economy, retail sales are weak, and business inventories are increasing rapidly. Business sales and investment are expanding rapidly, and economist believe strong inflation lies ahead. Inflation persists while unemployment stays high.

13 STAGFLATION Any policy that shifts the aggregate demand curve helps one problem but makes the other problem worse. If the government acts to increase aggregate demand and limit the rise in unemployment, it reduces the decline in output but causes even more inflation. If it acts to reduce aggregate demand, it curbs inflation but causes a further rise in unemployment. The true solution to stagflation is to get the SRAS to shift back to the right. This can be accomplished by making resources more available or a technological advance.