Fiscal policy in the AS-AD model. Screen 1

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Alberta Howard
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1 Fiscal policy in the AS-AD model Screen 1 In this presentation we look at the impact of fiscal policy in the short and medium run as reflected by AS-AD model. Make sure that you are familiar with the following: What is fiscal policy? Expansionary and contractionary fiscal policy The AS curve A movement along an AS curve Shifts of an AS curve The AD curve A movement along the AD curve Shifts of the AD curve Short and medium term Screen 2 Analysing the impact of fiscal policy with reference to the AS-AD model involves tracing its impact on the goods market, the financial market and the labour market in the short run, during which the expected price level is fixed, and medium run, during which the expected price level changes.

2 The following AS-AD model will be used to explain the impact of an expansionary and contractionary fiscal policy in the short and medium run.

3 At point a the price level is P 1 and the level of output equals the natural level of output Yn. At this point the expected price level P e also equals the current price level P 1, and all our markets are in equilibrium, meaning that in the financial market, the demand for money equals the supply of money, while in the goods market the demand for goods equals the output level and in the labour market the bargained real wage equals the price-determined real wage. Let s first deal with the impact of a contractionary fiscal policy which may be the result of a budget deficit reduction induced by a decrease in government spending or an increase in taxation to reduce the demand for goods and, therefore, the output level. Let s consider the impact of a decrease in government spending as reflected by the AS-AD model.

4 In the short run the initial impact of a lower government spending is on the goods market where decreased government spending erodes the demand for goods and, consequently lowers output. On the financial market lower output lessens the demand for money for transaction purposes and the interest rate declines. In turn a lower interest rate affects the goods market with the result that investment spending increases. However, the decline in output causes a decline in investment spending which renders investment spending uncertain. What is not uncertain is that the output level is lower since government spending is lower. In the labour market lower output erodes employment and fuels unemployment, thus decreasing the nominal wage and therefore the price level as well, since prices are determined by a markup over nominal wage cost. The AS-AD model reflect this as a leftward shift of the AD curve to a short-run equilibrium at point b, which in relation to point a, shows a lower price level, due to lower nominal wages, and the level of output is lower, due to a reduced demand for goods.

Some of our other variables show a lower government spending, which lowers the demand for goods, thus reducing employment so that unemployment rises causing a lower nominal wage.

5 Some of our other variables show a lower government spending, which lowers the demand for goods, thus reducing employment so that unemployment rises causing a lower nominal wage. The interest rate is also lower due to a decline in the demand for money. At point b the current price level P 2, is lower than the expected price level. This discrepancy between actual and the expected price level will cause the economy to move into the medium run. Let s see what happens in the medium run. Screen 3 In the medium run the expected price level is adjusted downwards by labour. On the labour market the lower expected price level lowers nominal wage demands, and therefore the price level decreases. This decrease in the price level spills over into the financial market where the real money supply increases and the interest rate declines. In the goods market lower interest rate leads to more investment spending which increases the demand for goods and therefore output rises.

6 The AS-AD model reflects the lower wage rate, caused by the lower expected price level as a downward shift of the AS curve. The change in the financial and goods markets are shown by a downward movement along the AD curve. This downward shift and movement along the AD curve continue up to the medium run equilibrium at point c, where the expected price level equals the actual price level.

One way of looking at the impact of a contractionary fiscal policy in the medium run is to compare position a, that is before the decrease in government spending, with position c, that is the medium

7 One way of looking at the impact of a contractionary fiscal policy in the medium run is to compare position a, that is before the decrease in government spending, with position c, that is the medium run position after the decrease in government spending. This we will do by looking at what happened to the nominal variables and the real variables in the model. Screen 4 In this model the nominal variables are: the nominal money supply M, the nominal wage W and the price level P. The real variables are: government spending, the real money supply M/P, the interest rate, investment spending, demand for goods, output level and the real wage. Let s see what happens to these variables during the short and medium terms. In terms of the nominal variables the nominal money supply is the same. The nominal wage is lower due to a lower expected price level. The actual price level is also lower due to the lower nominal wage.

8 In terms of the real variables we will see some changes, unlike the case of monetary policy where all the real variables were unchanged. Government spending is lower by assumption, the real money supply is higher due to the decrease in the price level. The interest rate is lower due to a higher real money supply. The level of investment spending is higher, due to the lower interest rate. The demand for goods and the output level first decrease, due to lower government spending and then increase due to more investment spending, so the economy returns to the natural output level. Screen 5 In this particular model a contractionary fiscal policy does not change the level of output in the medium and long run but it does change the composition of the demand for goods and output level. Government spending is lower and investment spending is higher. Higher investment spending makes up for lower government spending. Let s look at the impact of an expansionary fiscal policy. Screen 6

An expansionary fiscal policy calls for higher government spending or a decrease in taxation to increase the demand for goods and the level of output.

9 An expansionary fiscal policy calls for higher government spending or a decrease in taxation to increase the demand for goods and the level of output. Let s consider the impact of an increase in government spending. In the short run the initial impact of an increase in government spending is on the goods market where government spending increases which causes an increase in the demand for goods and thus the output level rises. On the financial market the increase in output stimulates the demand for money for transaction purposes, causing a higher interest rate. The higher interest rate in turn affects the goods market where investment spending declines. But then the higher output stimulates investment spending and the change in investment spending is uncertain. It is certain though, that output rises with increased government spending. In the labour market the higher output level increases employment so that unemployment falls which exert upward pressure on the nominal wage and as the nominal wage increases the price level rises, since prices are determined by a markup over nominal wage cost.

10 The AS-AD model reflects this as a rightward shift of the AD curve up to a short-run equilibrium at point b which, in relation to point a, shows a higher price leveldue to the increase in the nominal wage, and the output level is higher, due to the higher demand for goods. Some of our other variables show higher government spending, which stimulates a higher demand for goods thus raising employment and decrease unemployment which causes a higher nominal wage. The interest rate is higher due to a greater demand for money. At this point the current price level P 2 is also higher than the expected price level. It is this discrepancy between the actual and the expected price level that will cause the economy to move into the medium run. Let s see what happens in the medium run. Screen 7

In the medium run the expected price level is adjusted upwards by labour so that on the labour market the higher expected price level causes labour to negotiate for a nominal wage increase, which is

11 In the medium run the expected price level is adjusted upwards by labour so that on the labour market the higher expected price level causes labour to negotiate for a nominal wage increase, which is followed by an increase in the price level. This increase in the price level spills over into the financial market where the real money supply decreases and the interest rate rises. In the goods market the higher interest rate causes a decrease in investment spending which decreases the demand for goods so that output falls. The AS-AD model reflects the increase in the wage rate caused by the higher expected price level as an upward shift of the AS curve. The change in the financial and the goods markets are reflected as an upward movement along the AD curve. This upward shift and upward movements along the AD curve continue until the medium runequilibrium position is reached at point c where the expected price level equals the actual price level.

12 In terms of the nominal variables the nominal money supply is the same. The nominal wage is higher due an increase in the expected price level. The price level is also higher due to the higher nominal wage. In terms of the real variables we will see some changes, unlike the case of monetary policy where all the real variables were unchanged. Government spending is higher by assumption, the real money supply is lower due to the increase in the price level. The interest rate is higher due to a lower real money supply. The level of investment spending is lower, due to the increase in the interest rate. The demand for goods and the output level are unchanged. It first increases due to the higher government spending and then decreases due to the decrease in investment spending and the economy returns to the natural level of output. The real wage is also unchanged. The increase in the nominal wage is offset by an increase in the price level.

In this particular model an expansionary fiscal policy does not change the level of output in the medium and long run but it changes the composition of the demand for goods and

13 In this particular model an expansionary fiscal policy does not change the level of output in the medium and long run but it changes the composition of the demand for goods and the output level. The level of government spending is higher and investment spending is lower. The higher government spending replaces investment spending and crowding out occurs.

Fiscal policy in the goods market. Screen 1

Fiscal policy in the goods market Screen 1 In this presentation we look at the impact of fiscal policy on the goods market. Make sure that you are thoroughly familiar with the goods market before you start