AP EXAM REVIEWUNIT 4 STABILIZATION

I. Tools of fiscal policyA. TaxesB. Government Spending

• During a recession, short run equilibrium is below full employment level of output.

• AD is too low• Government can increase AD by:

• Spending more (in the formula G )• Cutting taxes (which means you will spend more

and in the formula C )

Expansionary Policy on the graph

• When there is inflation, short run equilibrium is above full employment level of output.

• AD is too high• Government can decrease AD by:

• Spending less (in the formula G )• Raising taxes (which means you will spend less and

in the formula C )

https://www.youtube.com/watch?v=9B-gIfhnyeo

Contractionary Policy on the graph

Discretionary and Automatic Stabilizers A. Discretionary

1. a specific action that has to be taken by government

2. passing a law to change taxes or spending B. Automatic stabilizers

1. policies or laws already in place2. unemployment insurance – payments keep AD from falling as much as they would otherwise

The Political Business Cycle A. Fiscal policy happens in the political arena and is handled by politicians B. Election results are determined by the economy C. Economic policy can be used to serve political ends. D. Monetary policy in the hands of the Fed can be a solution

https://www.youtube.com/watch?v=RZtaZTEO3jA

Short Run Phillips Curve A. Inverse relationship between inflation and unemployment

1. Low unemployment leads to rising wages which leads to inflation2. high unemployment leads to falling wages which keeps inflation low

Phillips CurveExample

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6

Suppose:• In the past the economy of Narvaizville has had 0% inflation• The people of Narvaizville expect 0% inflation• SRPC0 is Narvaizville’s short run Phillips curve

What will the unemployment rate be?6%

SRPC0

0

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

The economy is at point A

A0

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

Suppose that the government of Narvaizville:• Thinks 6% unemployment is too high• Pursues fiscal policy to bring unemployment down to 4%

What will the inflation rate be?2%

0

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

The economy is at point B

0

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0

After spending some time at point B:• The people of Narvaizville EXPECT a 2% inflation rate.

What will this expectation do to the SRPC?Shift it to the right

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0SRPC2

If our current rate of 2% inflation persists what will be the unemployment rate?

6%

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0SRPC2

C

The economy is at point CThe Government of Narvaizville STILL considers 6% unemployment too high so they will continue fiscal policy that brings unemployment down to 4%.

If unemployment is 4% what is inflation?4%

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0SRPC2

C

The economy is at point D

D

After spending some time at point D:• The people of Narvaizville EXPECT a 4% inflation rate.

What will this expectation do to the SRPC?Shift it to the right

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0SRPC2

C

D

SRPC4

If our current rate of 4% inflation persists what will be the unemployment rate?

6%

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0SRPC2

C

D

SRPC4

E

The economy is at point EA persistent attempt to keep unemployment lower accelerates inflation

To avoid increasing rising inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation.

Infla

tion

Rate

Unemployment Rate

1

1

2

2

3

3

4

4

5

5 6SRPC0

A

B

0SRPC2

C

D

SRPC4

E

At what points does:Expected inflation = actual inflation

Long Run Phillips CurveLRPC

6% is the unemployment rate at which inflation does not change over time. LRPC = natural rate of unemployment

Long Run Phillips Curve A in the long run there is no trade off between unemployment and inflation B. People’s wages eventually adjust to the gap between inflationary expectations and the actual rate of inflation. C. LRPC is where EXPECTED inflation is equal to ACTUAL inflation D. Any rate of inflation is consistent with the natural rate of unemployment

http://www.youtube.com/watch?v=jFKZqi1Bl-k