AD-AS Model and Policy Relations

Overview

Lecture covers AD-AS model, fiscal and monetary policy, supply and demand shocks, and budget concepts.
Focus on relationships among inflation, aggregate output, and policy tools.
Key formulas and definitions provided for GDP, multipliers, and budget balance.

AD shows relation between inflation and quantity of aggregate output demanded.
Downward sloping because lower inflation raises quantity demanded.
Components: Consumption (C), Investment (I), Government purchases (G), Exports (X), Imports (IM).
GDP formula (context of AD): GDP = C + I + G + X - IM.
Interest-rate effect: Higher inflation reduces lending money, raises interest rates, lowers spending.
Factors that shift AD: expectations, wealth, physical capital stock, fiscal policy, monetary policy.
Rightward AD shifts: higher optimism, rising real asset values, increased G or tax cuts, higher money supply.
Leftward AD shifts: lower optimism, falling asset values, decreased G or tax hikes, lower money supply.
Demand shock: any event shifting AD; AD and output/inflation move same direction.

AS shows relation between inflation and quantity of output producers supply.
Short-Run AS (SRAS): upward sloping; many production costs are fixed.
Why SRAS slopes upward: sticky wages and input prices raise profits when inflation rises.
SRAS shifts caused by commodity prices, nominal wages, productivity.
SRAS right shift: lower commodity prices, lower nominal wages, higher productivity.
SRAS left shift: higher commodity prices, higher nominal wages, lower productivity.
Long-Run AS (LRAS): vertical at potential output when all prices flexible.
LRAS shifts: labor force size, physical capital stock, technology, labor productivity.
Supply shock: event shifting AS; positive supply shock raises output and lowers inflation; negative supply shock raises inflation and unemployment.

Fiscal policy tools: government purchases, taxes, transfers.
Fiscal policy affects AD directly (G) and indirectly (disposable income).
Expansionary fiscal policy: increase G, cut taxes, or increase transfers to raise AD.
Contractionary fiscal policy: decrease G, raise taxes, or reduce transfers to lower AD.
Automatic stabilizers: built-in spending/tax rules that stabilize economy without new policy.
Discretionary fiscal policy: deliberate policy actions (e.g., stimulus).
Lags: fiscal policy faces implementation and effect delays.
Crowding out: government spending crowds out private spending only at full employment.
Ricardian equivalence: suggests consumers save more if they expect future taxes; unlikely in practice.

Spending multiplier formula: 1 / (1 - MPC).
Transfer multiplier formula: MPC / (1 - MPC).
Lump-sum taxes: do not change multiplier (rare).
Non-lump-sum taxes: reduce multiplier size by capturing part of income increase.
Change in AD from government spending = change in G × spending multiplier.
Taxes/transfers change AD less than equal change in G because they act indirectly through disposable income.
Increasing G by $100 stimulates economy more than cutting taxes by $100.

Budget balance formula: T - G - TR (tax revenues minus government purchases minus transfers).
Deficit: shortfall in a single year (spending + transfers > tax revenue).
Debt: accumulated deficits over time.
Cyclically adjusted budget balance: estimated balance if GDP equaled potential output.
Rising debt increases interest payments and may crowd out private investment.
Implicit liabilities: government spending promises acting like future debt.
Debt-GDP ratio: assesses ability to service debt.
Running a surplus: tax revenue exceeds government spending and transfers.
Expansionary fiscal policy reduces budget balance (increases deficit).
Borrowing to pay interest risks a debt spiral.

Active stabilization rationale: reduce recession severity and rein in inflation.
Demand shocks move AD and change inflation/output in same direction.
Supply shocks create trade-offs (stagflation: rising inflation, falling output).
Appropriate fiscal response:
- Recessionary gap: expansionary fiscal policy to raise AD.
- Inflationary gap: contractionary fiscal policy (e.g., higher taxes).
Historical note: high government borrowing (Recovery Act 2009) did not automatically raise interest rates.

Review formulas: GDP, spending multiplier, transfer multiplier, budget balance.
Practice AD-AS diagrams showing shifts from demand and supply shocks.
Work problems on fiscal multipliers with different MPC values.
Study examples of fiscal policy timing and lags to assess real-world effectiveness.