Week_5 - ECMA06 Fiscal Policy and the AS-AD Model 1 Fiscal...

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ECMA06 – Fiscal Policy and the AS-AD Model 1 Fiscal Policy as an Automatic Stabilizer and the AS-AD Model Outline Discuss the concepts like inflationary gap, deflationary gap, and full-employment level of output. The use of fiscal policy to smooth out business cycles. Develop the AS-AD model –bringing price into the model. Our Extended Model – the Budget Balance Again Our extended model (let IM 0 = 0, and hold r & E constant): C = C 0 + c 1 DI T = T 0 + t 1 Y TR = TR 0 – tr 1 Y I = I 0 G X = X 0 IM = im 1 Y
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ECMA06 – Fiscal Policy and the AS-AD Model 2 AE = AE 0 + c Y Y, where AE 0 = C 0 + I 0 + G + X 0 + c 1 TR 0 – c 1 T 0 c Y = [c 1 (1 – t 1 – tr 1 ) – im 1 ] Y* = Y 0 c 1 AE BB = (T 0 – TR 0 – G) + (t 1 + tr 1 )Y Question: What happens to the budget balance when Y changes? Answer: Holding all else constant, when Y BB . Similarly, when Y BB . The budget balance is ENDOGENOUS! A change in G, T 0 , or TR 0 would have TWO effects on the BB. Why? BB = (T 0 – TR 0 – G) + (t 1 + tr 1 )Y When T 0 , TR 0 , or G , this will cause (T 0 – TR 0 G) to fall BB . When T 0 , TR 0 , or G , this leads to a higher level of AE Y (t 1 + tr 1 )Y BB .
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ECMA06 – Fiscal Policy and the AS-AD Model 3 Full-Employment Level of Output and Output Gaps Full-employment level of output, Y FE It is the level of output consistent with “full employment”. The term “full employment” means “Good” workers find it “easy” to find a job “Young” workers find it “easy” to find their first job. “Old” workers are not forced out of the labour force if they lose their jobs (i.e., no discouraged workers). In other words, when the economy is operating at its normal pace (not too fast and not too slow), then we can say that the economy is at its full employment. The unemployment rate at Y FE is called the non-accelerating inflation rate of unemployment (NAIRU) or natural rate of unemployment (NRU).
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ECMA06 – Fiscal Policy and the AS-AD Model 4 Full employment DOES NOT mean that everyone is working because Frictional unemployment – unemployment that results from the turnover in the labour market as workers move between jobs. Structural unemployment – long-term and chronic unemployment arising from imbalances between the skills and other characteristics of workers in the market and the needs of employers. The labour market is dynamic (people move in and out of the labour market) There are frictions in the economy (some industries/regions expand while some industries/regions contract)
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ECMA06 – Fiscal Policy and the AS-AD Model 5 Recessionary or Deflationary Gap It occurs when the equilibrium level of output (Y*) is less than the full-employment level, i.e., Y* < Y FE .
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This note was uploaded on 06/18/2011 for the course ECMA 06 taught by Professor Dr.atamazaheri during the Spring '10 term at University of Toronto.

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Week_5 - ECMA06 Fiscal Policy and the AS-AD Model 1 Fiscal...

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