This unit shows what stabilization policy does over time: fiscal and monetary policy used together, the Phillips curve, money growth and inflation, deficits and debt, crowding out, and long-run economic growth. It carries the most weight on the exam, 20–30% of the multiple-choice questions. Many questions ask you to separate what happens in the short run from what happens in the long run.
- policy mix
- Using fiscal and monetary policy together to close an output gap: both expansionary for a recessionary gap, both contractionary for an inflationary gap.
- Example: In a deep recession, lawmakers cut income taxes while the central bank lowers its policy rate, and both shift AD right.
- short-run Phillips curve (SRPC)
- A downward-sloping curve, inflation rate (vertical axis) against unemployment rate (horizontal axis), showing the short-run trade-off: lower unemployment comes with higher inflation. The economy is always on it.
- Example: On its SRPC, a country can trade 6% unemployment with 2% inflation for 4% unemployment with 5% inflation.
- quantity theory of money
- The theory that, in the long run, the growth rate of the money supply determines the inflation rate. Increasing the money supply too fast for a sustained period causes inflation.
- Example: A government that prints money to grow the money supply 40% a year, while output grows 2%, ends up with high inflation.
- budget deficit
- The amount by which government purchases plus transfer payments exceed tax revenues in a given year.
- Example: Taxes $3.0 trillion, purchases $2.2 trillion and transfers $1.3 trillion leave a $0.5 trillion deficit.
- government borrowing
- Selling bonds to finance a budget deficit. In the loanable funds model it shifts demand right (or, as lower public saving, shifts supply left) and raises the real interest rate.
- Example: To cover a $400 billion deficit, the Treasury sells $400 billion of new bonds to investors.
- economic growth
- A sustained rise in an economy's output, measured as the growth rate of real GDP per capita over time.
- Example: If real GDP per person rises from $30,000 to $45,000 over 20 years, the country has experienced economic growth.
- supply-side fiscal policy
- Tax and spending policies that change incentives to work, save and invest. They affect aggregate demand, aggregate supply and potential output in both the short run and the long run.
- Example: Lowering marginal income tax rates lets people keep more of each extra dollar they earn, encouraging more work and saving.
- conflicting policy effects
- When combined fiscal and monetary policies push a variable in opposite directions, its change is indeterminate: it depends on which effect is larger, so the model can't predict it.
- Example: Expansionary fiscal policy raises interest rates and expansionary monetary policy lowers them; used together, output rises but the interest rate's change is indeterminate.
- long-run Phillips curve (LRPC)
- A vertical line at the natural rate of unemployment. In the long run there's no trade-off: unemployment returns to the natural rate at any inflation rate.
- Example: With a 5% natural rate, the LRPC stands at 5% unemployment whether inflation runs at 2% or 8%.
- equation of exchange
- MV = PY: the money supply times velocity equals the price level times real output. Both sides equal nominal GDP.
- Example: If M is $500 billion and V is 6, total spending (PY) is $3 trillion.
- budget surplus
- The amount by which tax revenues exceed government purchases plus transfer payments in a given year. A surplus can be used to pay down the national debt.
- Example: Strong job growth lifts tax revenue to $900 billion while purchases and transfers total $850 billion: a $50 billion surplus.
- crowding out
- The adverse effect of increased government borrowing: a higher real interest rate reduces interest-sensitive private spending, such as business investment, in the short run.
- Example: Government borrowing pushes the real interest rate from 3% to 5%, and a bakery chain cancels its loan for new ovens.
