Unit V Inflation, unemployment, and stabilization policies

Phillips Curve
-Inflation and unemployment are inversely related. This is shown through the short run Philips Curve. As shown below, a Movement along the Short run aggregate supply curve occurs simultaneously with a movement along the short run Phillips Curve. What happens is that the inflation rate increases while the unemployment rate decreases, and SRAS is moving up and to the right along the curve, thus increasing the quantity of output, as well as raising the price level. This makes sense because as fewer people are unemployed, more can be produced. However, in the long run, there is no tradeoff between inflation and unempolyment, causing it to be a vertical line.

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Stabilization Policies

According to businessdictionary.com, stabilization policy is monetary policy aimed at reducing fluctuations in inflation and unemployment levels, while simultaneously maximizing national income. Such policies (out of favor in the era of globalization) attempt to expand demand when unemployment is high, and to curtail demand when inflation accelerates.

Fiscal and Monetary Policies
1. Supply Side Effects- Supply side policies aim to create a faster rage of growth of real national output. To many governemts, the idea that supply-side performance can lead to consistent economic growth without a rise in inflation is a widely accepted view. This, however is not possible if aggregate demand is not high enough to reach productive capacity. Fiscal policies focus on 2 approaches to the supply side: product markets and labor markets.

Product markets attempt to increase competiton and efficiency. When productivety improves, LRAS shifts to the right.
Labor markets attempt to improve the quality and quantity of the supply of labor available to the economy. They try to make the labor market more flexible so that it can match the labor force to the demands placed upon it by employers and reduce the risk of structural unemployment.


Demand Side Effects- The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. The tax multiplier is the magnification effect of a change in taxes on aggregate demand. Balanced budget multiplier refers to the magnification effect on aggregate demand of a simultaneous change in government purchases and taxes that leaves the budget balance unchanged. It is always a positve number because the government purchases multiplier is larget than the tax multiplier.


Policy Mix- When combined, monetary and fiscal policy can condition the pattern of the business cycle, set up imbalances in the economic behavior, and lay the ground-work for future economic performance. In the 1980's, the open econmy with flexible exchange rates caused higher nominal and real interest rates than otherwise would ahve been impossible without policy change. The currency was very strong, inflation rates were lower, there was a large and growning trade deficit, unbalanced compositon of economic activity across sectors and industries, and a depressed industrial sector.


Government deficits and debt- Deficits occur when total expenditures in a given fiscal year exceed total revenues. As a result, the government must borrow money. Also, a surplus occurs. A good way to easure the size of a deficit is to compare the total size of the economy to the debt. The sum of all the borrowing done by the government is the national debt. So the deficit is the yearly shortfall, and the debt is the total amount that the government owes to its creditors from whom it borrowed to make up those shortfalls. Treasuries are borrowed from the public. The government can also borrow from itsself. These come from the Trust Fund. The total debt is the known as the gross federal debt.

  • Budget deficits are not always a good or a bad thing. Borrowing in order to invest in infrastructure, education, or other projects can improve economic growth over the long run. However, too much borrowing can cause problems. For example, interest rates and inflation could be jacked up as a result of this borrowing. To reduce the deficit, the government would have to decrease spending, increase income, or both.


Demand Pull Inflation and Cost Push Inflation- When there is a decrease in AS of goods and services stemming from increase of costs of production, cost push inflation occurs. The price has been pushed up, and all the factors of production cost more. The companies cannot maintain profit by producing the same amount of goods and services, so the costs are passed on to consumers, causing inflation. Demand pull inflation happens when AD increases. When the four sectors of the macroeconomy want to purchase more output than the economy is capable of, they compete for a limited amount of goods and services. Buyers reaise prices, causing inflation. Thhis is common for an expanding economy.
Role of expectations on inflation-Inflation expectations are what affects people's bhavior in ways that have a long-term economic impact. Modern monetary policy tries to control inflation expectations, because this is the fist step to controlling inflation. However, it is hard to gauge people's expectations. It is done by inflation-indexed government bonds, inflation swaps, and surveys.