I) Neoclassical Aggegate supply and demand curve
a) Best represenation is on Page 320 in your book
b) The goal of this graph is to combine the insights of the classical and keynesian viewpoints. So we have a
1) long run aggregate supply curve
2) short run aggregate supply curve
3) aggregate demand curve
II) What should the fiscal and monetary authorities do?
1) recessionary gap (make sure you know graph)
i) cut taxes
ii) increase government spending
2) inflationary gap (make sure you know graph)
i) raise taxes
ii) decrease government spending.
3) at equilibrium - have the budget balanced
4) automatic stabilizers - unemployment benefits, progressive tax code
b) monetary policy
1) The Fed has a dual mandate: maintain price stability and full employment. Accomplishing these goals require conflicting policy actions. Here is a rough guide as to what the fed should do.
2) recessionary gap (ditto)
i) open market purchase of government bonds (cut in fed funds rate)
ii) cut discount rate
iii) cut in reserve requirement ratio
3) inflationary gap (ditto)
i) open market sale of government bonds (raise in fed funds rate)
ii) raise discount rate
iii) rase the reserve requirement ratio
III) Critiques of fiscal and monetary policy
1) Fiscal policy
a) Time lag
b) government failure (rational ignorance, biased voters)
c) ricardian equivalence (i.e. rational expectations)
2) Monetary policy
a) Monetary policy may be unable to affect interest rates (liquidity trap)
b) Long term rates may not respond to policy changes.
IV) Examples of policy action
1) 2001 recession, 2003 Fed policy to counteract possible deflation.
2) 2004-2006 rate hikes by Federal reserve in order to prevent inflation
3) 1980 disinflationary action by Volker