Inflation, Unemployment, and Stabilization Policies

A . Fiscal and monetary policies

1 . Demand-side effects

2 . Supply-side effects

3 . Policy mix-accomodating policies that match the economic issue.

4 . Government deficits and debt-deficits are within a fiscal year and debt is the total of borrowing over the history of a country.


RECESSION (Short-run) INFLATION (Short-run)

Fiscal Policy:

Recessionary Gap-Decrease taxes & increase spending (deficit)-AD INCREASES

Inflationary Gap-Increase taxes & decrease spending (surplus)-AD DECREASES

Monetary Policy:

Recessionary Gap-Fed can buy bonds, decrease the discount rate (Fed to bank loans), decrease the reserve requirement. AD INCREASES

Inflationary Gap-Fed can sell bonds, increase the discount rate, and/or increase the reserve requirement. AD DECREASES


Fed Funds Rate (money supply)

Buying bonds increases the money supply and decreases the NOMINAL interest rate.

Selling bonds decreases the money supply and increases the NOMINAL interest rate.


Banks and Customers

Nominal Interest=Expected inflation PLUS Real Interest Rate

When the Fed increases the money supply the supply of loanable funds increases which decreases the REAL interest rate.

When the Fed decreases the money supply the supply of loanable funds decreases which increases the REAL interest rate.

Long Run--the economy is at full employment.

Pushing the economy PAST full employment causes all of the following to occur:

1. AD increases-unemployment decreases and inflationary pressure increases.

2. Firms increase production along the SRAS.

3. Workers begin to notice inflation and take steps to increase their nominal wages.

4. Increased wages increase production costs and SRAS decreases.

5. The economy returns to full employment with no growth and higher prices (inflation)

Inflationary pressure increases the demand for money causing interest rates to return to their long run level.

Real interest rates are the nominal interest rate minus inflation.

B . Inflation and unemployment

1 . Types of inflation

a. Demand-pull inflation-AD increases (shifts right)

b. Cost-push inflation-SRAS decreases (shifts left)

2 . The Phillips curve: short run

When AD increases inflation increases and unemployment decreases-that is shown as movement from one point to another ALONG the SRPC.

When AD decreases, inflation decreases and unemployment increases-that is shown as a movement from one point to another ALONG the SRPC.

When SRAS increases (positive supply shift), the SRPC shifts downward.

When SRAS decreases (negative supply shock), the SRPC shift upward.

The Phillips curve: long run

Any point to the right of the LRPC is considered recessionary.

Any point to the left of the LRPC is considered inflationary.

3 . Role of expectations

Inflation expectations change investment. In high inflation times people spend as quick as they earn. When low inflation is expected longer decisions regarding credit are possible.