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Chapter 20 Appendix Policy Disputes Using the Self-Correcting Aggregate Demand and Supply Model

Chapter 20 Appendix Policy Disputes Using the Self-Correcting Aggregate Demand and Supply Model. Survey of Economics Irvin B. Tucker. Lecture Slides. What will I learn in this appendix?. How to evaluate contrasting fiscal and monetary policies using the self-correcting AD-AS model.

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Chapter 20 Appendix Policy Disputes Using the Self-Correcting Aggregate Demand and Supply Model

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  1. Chapter 20 AppendixPolicy Disputes Using the Self-Correcting Aggregate Demand and Supply Model Survey of EconomicsIrvin B. Tucker Lecture Slides

  2. What will I learn in this appendix? • How to evaluate contrasting fiscal and monetary policies using the self-correcting AD-AS model

  3. What is the classical view of expansionary policy? • The economy closes a recessionary gap through the self-correction process. Consequently, fiscal and monetary policy should be noninterventionist rather than activist

  4. What is the key classical assumption during a recession? • Nominal wages are flexible and fall as a result of competition from unemployed workers

  5. What is the result? • The short-run aggregate supply curve (SRAS) shifts rightward and the economy automatically adjusts to long-run macro full employment

  6. Exhibit 20A-1 Opposing Anti-Recession Theories (a) Classical Theory 300 LRAS SRAS1 250 SRAS2 200 E1 Price Level(CPI) 150 100 E2 50 AD1 Full employment 0 2 4 6 8 10 14 16 18 20 22 12 Real GDP(trillions of dollars per year)

  7. What is the Keynesian view of expansionary policy? • The federal government should follow an activist approach and use discretionary fiscal policy to increase spending or cut taxes • The Fed should also follow an activist approach and use monetary policy tools to stabilize the economy

  8. What is the key Keynesian assumption during a recession? • Nominal wages are fixed in the short run regardless of competition from unemployed workers

  9. What is the result? • Activist fiscal and monetary policy shift the aggregate demand curve (AD) rightward and the economy achieves macro full employment

  10. How does activist monetary policy work? • The Fed can increase the money supply, which lowers the interest rate and increases business investment spending downward along the investment curve. Since investment (I) is a component of the AD curve, it shifts rightward.

  11. Exhibit 20A-1 Opposing Anti-Recession Theories (b) Keynesian Theory 300 LRAS SRAS1 250 200 E2 E1 Price Level (CPI) 150 100 AD2 50 AD1 Full employment 0 2 4 6 8 10 14 16 18 20 22 12 Real GDP(trillions of dollars per year)

  12. Comparing Exhibits 20A-1 (a) and (b), what happens to the price level? • If classical theory is correct, the price level falls • If Keynesian theory is correct, the price level rises

  13. What is the classical view of contractionary policy to fight inflation? • The economy closes a inflationary gap through the self-correction process

  14. What is the key classical assumption? • Nominal wages are flexible and rise

  15. What is the result? • The short-run aggregate supply curve (SRAS) shifts leftward and the economy automatically adjusts to long-run macro full employment

  16. Exhibit A-2 Opposing Anti-Inflation Theories (a) Classical Theory 300 LRAS SRAS2 250 E2 SRAS1 200 Price Level (CPI) 150 E1 100 AD 50 Full employment 0 2 4 6 8 10 14 16 18 20 22 12 Real GDP(trillions of dollars per year)

  17. What is the Keynesian view of contractionary policy to fight inflation? • The federal government uses discretionary fiscal policy to cut spending or increase taxes

  18. What is the key Keynesian assumption? • Nominal wages are fixed in the short run and the SRAS curve will not shift leftward

  19. What is the result? • The aggregate demand curve (AD) shifts leftward and the economy achieves macro full employment

  20. How does activist monetary policy work? • The Fed can decrease the money supply, which increases the interest rate and decreases business investment spending upward along the investment curve. Since investment (I) is a component of the AD curve, it shifts leftward.

  21. Exhibit A-2 Opposing Anti-Inflation Theories (b) Keynesian Theory 300 LRAS 250 SRAS1 200 Price Level (CPI) 150 E1 100 E2 AD1 50 AD2 Full employment 0 2 4 6 8 10 14 16 18 20 22 12 Real GDP(trillions of dollars per year)

  22. Comparing 20A-2 (a) and (b), what happens to the price level? • If classical theory is correct, the price level rises • If Keynesian theory is correct, the price level falls

  23. What is the conclusion? • The classical approach to a recessionary or inflationary gap is to let market forces restore the economy to full employment

  24. And the Keynesians? • The Keynesian approach to cure a recession or inflation is to use discretionary fiscal and monetary policy to achieve full employment

  25. END

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