Module 20

Economic Policy and the

Aggregate Demand-
Aggregate Supply Model
KRUGMAN'S
odel MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• How the AD-AS model is used to formulate
macroeconomic policy

• The rationale for stabilization policy

• Why fiscal policy is an important tool for

managing economic fluctuations

• Which policies constitute expansionary fiscal

policy and which constitute contractionary
fiscal policy
 Macroeconomic Policy
•Self-correction?
•Most economists agree that in
the long-run the economy will
self correct, but also agree with
John Maynard Keynes, “In the
long-run we are all dead”
•Most economist recommend the
use of fiscal policy
(stabilization policy) to get the
economy back to potential
output
Policy in the Face of Demand
Shocks

• Negative Demand
Shocks & Positive
Demand Shocks

• Why are they bad?

• Should policymakers
counteract?
Responding to Supply Shocks

• Supply shock

• Policy dilemma
Fiscal Policy: The Basics
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
The Government Budget and Total Spending

• GDP = C + I + G + X - M

• The effect of taxes and transfers

• Effects on Investment
Expansionary and Contractionary
Fiscal Policy

• Expansionary Fiscal
Policy

• increase G

• decrease T

• increase transfers
Expansionary and Contractionary
Fiscal Policy

• Contractionary Fiscal
Policy

• decrease G

• increase T

• decrease transfers
A Cautionary Note: Lags in Fiscal Policy

• Time lags

• Recognition lag

• Decision lag

• Implementation lag

• Lags make decision making more difficult