Unit 5: Long-Run Consequences of Stabilization Policies

Policy Framework & Goals

• Stabilization policy uses fiscal and monetary instruments to influence aggregate demand around potential output. The long-run benchmark is full-employment real GDP \(Y^{*}\) with unemployment at the natural rate \(u^{*}\) and low, predictable inflation. The curriculum treats these as macro goals distinct from the tools that implement them.
• The short run features sticky wages and prices, so nominal spending changes move real output through SRAS. The long run features fully flexible wages and prices, so the economy returns to \(Y^{*}\) while the aggregate price level adjusts. This horizon split implies different consequences for the same policy across periods.
• Policy analysis is mapped consistently across three diagrams: the money market, the loanable funds market, and AD–AS. The money market uses the nominal interest rate \(i\) and the quantity of money \(M\), while the loanable funds market uses the real rate \(r\) and the quantity of funds. The Fisher relationship \( r \approx i - \pi^{e} \) links nominal and real rates for cross-model statements.
• Output gaps classify deviations of actual output from potential. A recessionary gap is \(YY^{*}\). These labels determine whether stabilization aims to shift AD right or left.
• Purely demand-driven policy changes are neutral for real output in the long run. After expectations and nominal wages adjust, SRAS shifts until equilibrium returns to \(Y^{*}\). The lasting effect is on the aggregate price level rather than on \(Y\).
• Policies are categorized as discretionary changes in \(G\), \(T\), or the money stock, and automatic stabilizers embedded in tax and transfer rules. Automatic stabilizers move net taxes with income and dampen aggregate demand fluctuations without new legislation. Discretionary actions are explicit instrument changes aimed at correcting identified gaps.
• Goals, targets, instruments, and indicators are distinct elements in the framework. Targets are controllable policy variables such as a short-run policy interest rate or a money stock path. Instruments include open market operations and fiscal parameters, while indicators include observed inflation, unemployment, and output.
• Self-correction operates through expected price level \(P^{e}\) and nominal wage adjustments. When \(Y>Y^{*}\), rising \(P^{e}\) shifts SRAS left, and when \(Y

Fiscal Policy: Short-Run vs. Long-Run Effects

• Fiscal policy changes government purchases \(G\), taxes \(T\), and transfers \(TR\) to influence aggregate demand. In the AD–AS model, these instruments shift the AD curve at a given aggregate price level. Short-run analysis holds wages and input costs sticky, so output \(Y\) responds to AD shifts.
• Expansionary fiscal policy raises \(G\), lowers \(T\), or raises \(TR\) and shifts AD right. With upward-sloping SRAS, the short-run equilibrium shows higher real output \(Y\) and a higher price level \(P\). If a recessionary gap exists, the new equilibrium moves toward potential output \(Y^{*}\).
• Contractionary fiscal policy lowers \(G\), raises \(T\), or lowers \(TR\) and shifts AD left. With upward-sloping SRAS, the short-run equilibrium shows lower \(Y\) and a lower \(P\). If an inflationary gap exists, the new equilibrium moves toward \(Y^{*}\).
• Short-run effects are summarized by the spending multiplier \( k=\frac{1}{1-\text{MPC}} \) and the lump-sum tax multiplier \( k_T=-\frac{\text{MPC}}{1-\text{MPC}} \). These formulas assume a fixed price level, no imports, and no excess saving beyond the stated \(\text{MPS}\). When SRAS is upward sloping or leakages exist, realized changes in \(Y\) are smaller than the simple formulas imply.
• A simultaneous equal change in purchases and taxes yields the balanced-budget multiplier. Under lump-sum taxes and fixed prices, the net effect on output equals the change in purchases, so the multiplier equals one. With proportional taxes or import leakages, the balanced-budget multiplier falls below one.
• Higher government borrowing associated with expansionary fiscal policy shifts the demand for loanable funds right. The equilibrium real interest rate \(r\) rises and reduces interest-sensitive private investment \(I\). This attenuation of \(I\) partially offsets the rightward AD shift and is called crowding out.
• Automatic stabilizers alter net taxes with income through progressive taxation and income-contingent transfers. They reduce the size of output fluctuations by lowering the effective multiplier during expansions and recessions. The cyclically adjusted budget isolates the structural stance by evaluating the balance at \(Y^{*}\).
• In the long run, nominal wages and input prices adjust so that output returns to potential \(Y^{*}\). Purely demand-based fiscal actions therefore leave long-run real output unchanged while the price level differs. LRAS does not shift unless policy changes affect resources, technology, or institutions.
• Changes in the composition of \(G\) can affect long-run capacity only if they alter factor accumulation or productivity. Such effects are represented as shifts of LRAS rather than as movements along existing curves. Demand-management analysis in this unit treats these composition effects as outside the baseline unless specified.
• Persistent primary deficits raise the stock of public debt and the associated interest obligations. Higher debt service can influence future fiscal choices and the path of public saving in the loanable funds framework. However, AD shifts occur only when \(G\), \(T\), or \(TR\) change, not from the existence of debt by itself.

Monetary Policy: Short-Run vs. Long-Run Effects

• Monetary policy changes the money supply to influence the nominal interest rate and aggregate demand. In this unit, the central bank’s instruments shift money supply in the money market diagram. The analysis distinguishes short-run effects with sticky inputs from long-run neutrality results.
• In the money market, an increase in money supply shifts the vertical \(MS\) curve right and lowers the equilibrium nominal interest rate \(i\). A decrease in money supply shifts \(MS\) left and raises \(i\). These are comparative-static statements holding money demand determinants fixed.
• Lower \(i\) increases interest-sensitive planned expenditure in \(AD \equiv C+I+G+X_n\) at a given price level. Aggregate demand shifts right and short-run equilibrium shows higher \(Y\) and higher \(P\) with upward-sloping \(SRAS\). Higher \(i\) reverses these directions and shifts \(AD\) left.
• In the long run, nominal wages and input prices adjust and shift \(SRAS\) until output returns to potential \(Y^{*}\). Purely demand-based monetary changes are neutral for real output and employment in the long-run equilibrium. The lasting effect is on the aggregate price level rather than on \(Y\).
• The Fisher relationship links rates as \( r \approx i - \pi^{e} \), where \(r\) is real and \(\pi^{e}\) is expected inflation. For a given \(r\), a higher \(\pi^{e}\) requires a higher \(i\) to maintain the same real stance. If \(\pi^{e}\) changes and \(i\) is not adjusted, the real rate changes and alters \(AD\).
• On the Phillips diagrams, a monetary expansion moves the economy along a given \(SRPC(\pi^{e})\) toward lower unemployment and higher inflation in the short run. As expectations adjust, \(SRPC\) shifts upward and the economy returns to the vertical \(LRPC\) at \(u^{*}\). There is no long-run tradeoff between inflation and unemployment in this framework.
• Under interest-rate targeting, the central bank offsets money-demand shifts to keep \(i\) at its target. Under quantity targeting, \(MS\) is fixed and \(i\) varies with money demand. Both implementations map into \(AD\) shifts through the same interest-sensitivity channels.
• Policy effects depend on the interest sensitivity of \(C\) and \(I\) and on leakage parameters in multiplier conditions. Lower sensitivity or larger leakages produce smaller \(AD\) shifts for a given change in \(i\). Higher sensitivity produces larger \(AD\) shifts for the same change in \(i\).
• At very low nominal interest rates, money demand can be highly interest-elastic in a region of the diagram. An increase in \(MS\) then changes the quantity of money but produces little change in \(i\). The implied shift of \(AD\) is correspondingly limited in this model.
• The quantity equation \(MV=PY\) implies in growth rates \( \mu + \nu = \pi + g \), where \( \mu \) is money growth, \( \nu \) is velocity growth, \( \pi \) is inflation, and \( g \) is real output growth. With approximately constant velocity \((\nu \approx 0)\), sustained higher money growth implies higher long-run inflation with \(Y\) at \(Y^{*}\). This restates long-run neutrality of money and the price-level consequence of monetary policy.

Phillips Curves & Expectations

• The short-run Phillips curve (SRPC) shows an inverse relationship between unemployment \(u\) and inflation \(\pi\) for a given expected inflation \(\pi^{e}\). Holding \(\pi^{e}\) constant, lower \(u\) is associated with higher \(\pi\), and higher \(u\) with lower \(\pi\). This tradeoff is conditional on expectations and is not permanent.
• Movements along a given SRPC are caused by aggregate demand disturbances with \(\pi^{e}\) held fixed. A rightward AD shift lowers \(u\) and raises \(\pi\), moving the economy upward along the SRPC. A leftward AD shift raises \(u\) and lowers \(\pi\), moving it downward along the SRPC.
• Changes in expected inflation shift the entire SRPC without changing its slope. An increase in \(\pi^{e}\) shifts the SRPC upward by the same amount at every \(u\). A decrease in \(\pi^{e}\) shifts the SRPC downward by the same amount at every \(u\).
• The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment \(u^{*}\). There is no long-run tradeoff between \(u\) and \(\pi\) because expectations adjust and output returns to potential \(Y^{*}\). Every SRPC with different \(\pi^{e}\) intersects the LRPC at \(u=u^{*}\).
• When policymakers attempt to keep \(u
• When policymakers allow \(u>u^{*}\), actual inflation falls short of expected inflation and lowers \(\pi^{e}\) over time. The SRPC shifts downward until \(u\) returns to \(u^{*}\) at a lower ongoing \(\pi\). This process describes disinflation with temporary unemployment above \(u^{*}\).
• Supply shocks shift the SRPC independently of \(\pi^{e}\). An adverse supply shock (leftward SRAS shift) moves the SRPC up and right, yielding higher \(\pi\) at any \(u\). A favorable supply shock (rightward SRAS shift) moves the SRPC down and left, yielding lower \(\pi\) at any \(u\).
• The natural rate \(u^{*}\) corresponds to full-employment output \(Y^{*}\) in AD–AS with a vertical LRAS. Structural changes that alter matching efficiency, labor participation, or productivity can shift the LRPC by changing \(u^{*}\). Pure demand changes do not shift the LRPC because they do not change long-run capacity.
• Expected inflation enters the textbook relation \(\pi = \pi^{e} - \alpha\,(u - u^{*})\) for \(\alpha>0\) at AP scope. Holding \(\pi^{e}\) fixed, a one-unit decrease in \(u\) raises \(\pi\) by \(\alpha\). Shifts in \(\pi^{e}\) translate the SRPC vertically in this linear form.
• Disinflation strategies are interpreted as policies that reduce \(\pi^{e}\) and shift the SRPC downward. In the transition, unemployment typically rises above \(u^{*}\) until expectations realign and the economy returns to the LRPC. The long-run outcome is lower inflation with unemployment at \(u^{*}\).

Inflation, Disinflation, and Deflation (Costs & Dynamics)

• Inflation is a sustained increase in the aggregate price level, with rate \( \pi_t = \frac{P_t - P_{t-1}}{P_{t-1}} \times 100\% \). Disinflation is a fall in the inflation rate while \(P\) continues to rise. Deflation is a sustained decrease in \(P\) so that \( \pi < 0 \).
• Demand-pull inflation arises from a rightward shift of AD, raising \(Y\) and \(P\) in the short run. Cost-push inflation arises from a leftward shift of SRAS, lowering \(Y\) and raising \(P\). Stagflation refers to the cost-push case with higher inflation and lower output.
• Unexpected inflation redistributes purchasing power because ex post real return equals \( i - \pi \). Lenders lose and borrowers gain when \( \pi > \pi^{e} \), with the reverse when \( \pi < \pi^{e} \). These redistributions do not change total real income but alter who receives it.
• Anticipated inflation imposes resource costs without redistribution from surprise. Menu and shoe-leather costs reflect price adjustment and money-holding responses. Relative price variability can distort signals when firms change prices at different times.
• Disinflation reduces \( \pi \) by aligning actual inflation with lower \( \pi^{e} \). In the SRPC framework, \(\pi^{e}\) falls and the SRPC shifts downward over time. Transitional unemployment above \(u^{*}\) is the typical short-run cost at AP scope.

Policy Lags and Limitations

• Recognition lag is the time to detect a gap between \(Y\) and \(Y^{*}\). Decision lag is the time to authorize a policy change in \(G\), \(T\), or the operating stance of money. Implementation lag is the time to execute the authorized change.
• Transmission lag is the time for interest-rate or tax-and-transfer changes to affect components of \(AD\). Monetary transmission operates through \(i\) to interest-sensitive \(C\) and \(I\). Fiscal transmission operates directly through \(G\) and indirectly through \(Y_d\) to \(C\).
• Interest sensitivity limits the size of the \(AD\) response to a given change in \(i\). Low sensitivity of \(I\) or a highly interest-elastic money demand reduces movement in real activity. In a low-nominal-rate region, additional money may change \(M\) more than \(i\).
• Leakages reduce multiplier size and thereby the output effect of demand management. With proportional taxes and imports, the spending multiplier becomes \( k = \frac{1}{\text{MPS} + \text{MPC}\cdot t + m} \). A steeper SRAS also channels a larger share of an \(AD\) shift into \(P\) rather than \(Y\).
• Forecast uncertainty and overlapping shocks can cause policy to miss the intended target. Acting after conditions change can produce over- or under-correction relative to the current gap. Long-run neutrality implies that persistent demand stimulus does not raise \(Y^{*}\).

Budget Deficits, Public Debt, and Long-Run Considerations

• The budget balance is \( \text{BB} \equiv T - G - TR \), with a deficit when \( \text{BB} < 0 \) and a surplus when \( \text{BB} > 0 \). The primary balance excludes interest payments on existing debt. Public debt is the cumulative stock of past deficits minus surpluses.
• The cyclically adjusted (structural) balance evaluates the budget at \(Y^{*}\). This removes automatic stabilizer effects from \(T\) and \(TR\). It isolates the discretionary fiscal stance for comparison across periods.
• The debt-to-GDP ratio scales the debt stock by nominal GDP. Its change depends on the primary balance and the difference between the nominal interest rate and nominal GDP growth. A rising ratio indicates debt growing faster than the economy’s nominal income.
• In loanable funds, a deficit is negative public saving that shifts the demand for funds right. The real interest rate \(r\) rises and private investment \(I\) is reduced, a mechanism labeled crowding out. A surplus shifts supply right, lowering \(r\) and supporting \(I\).
• Persistent deficits can slow capital accumulation by reducing \(I\) over time. Slower accumulation can limit growth in potential output \(Y^{*}\) and shift LRAS rightward more slowly. Composition effects that raise productivity would shift LRAS, but demand changes alone do not.

Supply-Side and LRAS

• Long-run aggregate supply (LRAS) is vertical at potential output \(Y^{*}\) because wages and input prices are fully flexible. Changes in the aggregate price level \(P\) do not alter the long-run quantity of real output. The LRAS position summarizes the economy’s productive capacity.
• Determinants of LRAS are summarized by the production function \( Y = A \cdot F(K,L,H,N) \). Increases in total factor productivity \(A\), physical capital \(K\), labor \(L\), human capital \(H\), or resources \(N\) shift LRAS right. Decreases in these factors shift LRAS left.
• Supply-side policies affect \(Y^{*}\) only if they change resources, incentives, or productivity. Examples include measures that raise labor-force participation, capital formation, education quality, or innovation intensity. Such changes are depicted as LRAS shifts rather than movements along existing curves.
• Economic growth is represented as a rightward shift of LRAS and an outward shift of the PPC. This depiction indicates a higher sustainable level of real output at full employment. The growth statement is independent of aggregate demand at this horizon.
• Temporary cost or expectation changes shift SRAS, not LRAS, in the course framework. Persistent technology or resource changes shift LRAS by altering productive capacity. Proper classification separates short-run cost disturbances from long-run structural movements.