AD-AS:

7. DIFFERENT APPROACHEs TO
39

No Country, no matier how well

itea States,
STABLILISATION POLICY:
into Germany, and Japanmanaged, is immune
from rccessions. In the
tingering downturns in which the three
strongest economies in the worldcart; ty
yathoi outpui and prices is job growth stopped and shppet
-a

demand But policies to detcmined by the interaction incomes fell. we know that ine
77Ect on aggregate stabilize the business cycle must of aggregate supply and
demand agerega
operate primarily through
ihus, we need tei
unenpioyment. The dernand-managemeni
policy makers policies to prevent the iluct
inoiunlary unemployment, policy know the
full-employ men! uiiti
level of outpui. f theres
economists are not in makers can use a mode! for its
agreement in respect of the root of eradication. Howevei,
agreemeini is
respect of is relation with output and a unemploymeni,
-

but they ere irn

disagreement in the cause of departure from the

fale. ihe nalural
Cradication of cyclical unemployment is the seed of different thoughts and theoriecs for
unemployment. Wc are analyzing the following thoughts in this
contexi
amewyo
ork
. Stability-management throeh IS M:
When recession threns icican help to slow the emerging
cvils. In the carly s conomists emphasized fiscal
policyas the most 3nd management.

LM (M . deses the effect of an increase

shilts
s. Here the !S curve
9INOEVerwn
1899 1S, io Conomy moves fror E, io
i cqbrium rate of interest, F
brium oulpui leve! increcases
ymarket adjustment and ihe
ng out effect move the economy
h e oulput levei decines to y.
Iro over the
CinCss f the policy varies

busthess cycle siCE Crowding-cut eifect aries

{S!udenls r e actsd
sc9 to
10
IS-IA
s r Sunpke-e) hosiaii &vcirciet: witn the cycical posiion. /Sf1:dents
agS1t10n.
Flniier
expendture mupc
".ts Li in 1S-iM for a
cifeci , s Is-4.AX 4U
read comparative static analysis
X AG
G SKeá
detailedd vien]
effect of cui in
Figure-2 describes the
a

M (Mo, Po) the IS curve shifts from

the lump sum tax. Here moves from E, to E.
IS, to IS. and the economy
Fig-2 at ihe initia' cquitibrium
rate of interest,
incresses
ouiput levei
Eventuay the equilibrium
adjustmeni and the
tiomto y. 49ncy markei
fron
Oraduaily, shortcomings ot fiscal policy became
imtng. potitics, macroeconomic apparent ihe shortcomis stem
n e concern is that theory, and the fiscal delicil tiscil.
the time span bciwcen
iong and
growing longer. To begin with, it takes timccyclica! shock and eftective response is
cychcai urning poini has been belore ceonomisls can recognize inat a
reached.
response lag while the authorily decides then, in addition to the
recognition lag, ihere 1s a
what to do and the conccrned
measure.
inally even when taxaiion or spending is authority passerS the
before the economy changcd, ihere is an elfeciiveness tag
While
responds
recognition, and cffectiveness lags are
policy and fiscal policy. theresponse, present for both monetary
useless for stabilization. response lag for fiscal policy can be so long that i becomes

Another dilliculty is that it is casicr to cut 1axes

spending than to cut it. than o raise them, and easier 10 raise
in addition, even when put into action
Tnacroeconomists once thought. For speedily, fiscal policy can not work as well as
ta cuts during recessions and example, many economists used to advocate temporary
OV crheated and temporary lax incrcases when the economy becomes
inflation looms. However, studies indicatc that
changes are temporary and do not consumers realize that the tax
change
temporary tax changes have little cffect
their spending patterns very much, since the
upon iheir
biggest impediment of all to fiscal pemancni
But the incornes.

budget deficit. With a large structural deficit, policy simpiy the enomous
is
size of the
cul taxcs even when lawmakers are reluctant to boost spending and
Fiscal
unemployment is high.
policy is no longer a major tool of stabilizalton policy.
Compared to liscal policy, monetary policy operates much more
economY Whercas an expansive fiscal policy puis more money right intoindirecily on ihe
the hands of the
consumers and businesses,
monetary policy affects spending by
condiions, exchange rates, and asset prices. In the early yecars of aliering
interest rales. credit
macroeconomists were skeptical aboul ihe eflectiveness of monetary Keynesian revolution, some
policy, jusi as ihey were
enthusiastic about the newtound tool of fiscaB policy. Bui OVCr ycars the scenario appeared to
be dilfeent. The central banking conduct is much better placed to conduct stabilization
Dolicy. (f course, to stabilize the ecoaomy, the ccntra! bank has to apply the righi amount of
mnelary stimulus or restraini. The uscfulness of the polic, depends on wheiher the siatistical
coTelations which held in the past wili siill be true in the future. Monciary economisis stress
h e i n p a c t s oi monctary poicy are uictai aid i d ven thang& oCr tine as ihc
6COiomy evolves.
Figure-3 describes the effect of an
LM, (Mo Po) increase in the real supply of money (may be
LM, (M, Po)
achieved by 1aising the nominai supply of money
*** at the shori-run slicky price. Po. through open
Fig-3 market purchase of securities. or by reducing the
discount raic, required reserve railo). Here
or the
to LM and
*** ihe M c u e suits fron M
COnsqucnil inC0nony 10ves irom
, tu
fhe : ' h r i m rateof nierest. in
 AD-AS: 41

for goos ard

dem serves. / ludents are tiulyised to read cunipurave
S-i A Jo
u delatled vieni s1a t

n ierns Ol siaoitZaiun
pulicy, monctary
Lew doubi the eitectiveness ol monctary polic policy is 1oday the
in determining only ganie
aggrcgaBe i
detnand
the
impacts have long and variacle lags.
AnOE way 0i denard managciment policy is the desired fi_cal-monctary . h
to
efers ine reialvt sirength of fiscal and monetary policies and their effect on thc d'etc
sectors Oi
Ine economy.The basic idca is that fiscal and monelay
substituiCs n demand ma1agement. Bui whie altemativépolicy
combinations o and
fisca! po1Ces can be used to stabilize the
economy, they have dilferent impaes o
c o r n g o o n or ouipu. By varying the mix of taxes. government spcading, and monelany

pocy, ne governmeni can change the fraction of GDP devoied to business investmen.
consumption, iet exporis, and government purchases of goods and services.

the iS shifls upward

/LM (Ma. Po) In figurc-4, curve

from ISg to IS, following an expansioinary isca

policy (increase in govemmeni policy/
cul i taxCs
moves
and the econiny
ransfer nayments) is held
fro when the stock of mdney
fo Ei rises from y, to
Co1san uilibrium output level
of interest also rises
the uilibrium rale
but the naturc
to ere output level rises
reduces the fraction
of
TR
wAWSRO policy
devoted io GDP.
vae inEsttnot
D.R
SINCE
P19

gure-5, an accomnodaiing
monetary poBicy is foltovcdby ihe
Apaig fisScal
ith an expansionary
gove aiong
and adequate exps0n of
An exact
can keep ihe rate of
ennina! Suppiy of money
iev The
interest ved at the initial equilibrium
to iM vith the
LM curve shifts îrom LM,
and thus the
accommodating nmonetary policy
the rate ol interest
outcome is expansionary but
GIDP devoied
remains fixed at t, and ihe fraction of
to business investrneni rematns unchanged

ALM, (M, <Mo. Po) in iigure-6, an aconnodating

ioitowcd b the
oeli0nary monetary po1ICy
is
/LM (M,. Pa)
OVCInei alg n ail cpan:si tsea

n e
 AD-AS: 42
Cngmsis
Peaks and_troughs bu
i the b ncss COLRtIcsshould 1
iorccast cycles and
take the cyie. Other cconomistspractcc 1ak Sps i0 stids
CHcludes that iighi slep al the ight ime are
skeplical ol our ihe
io act govemment can not be for the right reason. abiluy to
shculd be sitictly trusted 1o make tiis second
tor
limied goud economie group
poliey So its lrocdom
exampie, iscal conscrr atives
spcnding and cut laxes ihan io wOFTy thai i is
easter tor the
deticit dwng do the reversc. staie io nerease
recessions bui That neans it is casy io
booms, as a uch harder lo iun inciease the budget
1ade seVeral countercychcal iiscal policy wouid
around and shrink the deficit
attempis i t hc ability of
to requirc. For thal rcason, coservativesagain during
delicit ihe state to havc
approprraic new funds or
inciease lhe
A the same time,
bank
through a monetary conscrvalives would like to ie the
igh-povwered money nionctary-growin or output-1argeting hands of the cenirat
rule For example. insiead of
increase or decrease
condilions-- to lean supply 1n response lo havng
the money the
hat the central against the winds as measued eeonomic
bank follow a by the
would have the policy cf increasing the supplycentral
of
bank monetar1sts
propOse
the advanlage elminating uncertainty in the
of
credibility of the cenirai bank
money
at a
sicady stat. This
financiaB markets and
At the most as an
inílation
fighier. enhancing
whether the general level, the debate aboul
advantages of flexibiity in decision "rules versaus
diseretion" boils dowus io
and potential abuse in unconstrained making are ouiweighed by the unvetanties
inherently unstable and complex and that decisions. Those who believe that ihe
ecomomy is
policy makers widegoveriments
comioriable with giving generally make wise decistons are
economy. Those discretion to react
who believe that the
goverament is ihe
aggressively to siabilize the
economy and those major destabilizing foroe in
hands of the iiscal andpolicymakers
are the
prone to
misjudgmenis or venality favous iying
monctary authoriies. the

Deruna managernnent is ae
hen
Ompanied by the sapply wdjusiment of the eronony.
2 Stability-management through AD-AS
Fluctuations in the economy as a whole come Irom
denand et us analyse hov changes in aggregate
supply aggregate or
iit demaid shock or
supply shork disrupt economic weil-being
y ushing ouinut and enOi aent 2way fronm heir nathrat rates {ne
the goat of the modet
is o show how shocks cause ironomic iuctuari0ns. Another
goal of he modei is to evaluate
ow macroeconomic policy can respond to these shocks.
We can consider an expansionary moneiary poiicy in this cuntext since demand
maragement poliey argues its supcriorily over the fiscal expansion. We can consider the
introduction and expanded availability of credit cards in this context. We know thet credit
card is a more convenient way io make purchases than using cash and ihus it reduces the
quazntity of rmoney that people tho0se to hold. Ihis reduction in money demand is equivalent
to an increase in the velocity of noney. When cach people hoids less money. the sensitivity
of transactions demand for money. k al. This mears that cach mit of money meee fro
nand to hand snore quckiy su velociy of meney, V if the money supply is hetd
1se i d ihe aEgreyi iemand
n t , ihe incase n vela:ty catA'Ss TUmTI Spendi2
 AD-AS: 43

hen the short-run supply

curve is fixed horizontally:
LRAS

STOcks to aggregate demand: The very shor-

un aggregate supply curve is fixed horizontally
and the increase in demand pushes the economy
from E, to E. Ihis movement raises the output
SRAS Of the economy from yo to ys and causes an
economie boom. At the old prices. firms now sell
AD more output. Therefore. they hire more workers,
AD existing workers can increase their work hours.
and make greater use of their potential capacity.
Overtime. the high level of aggregate
LRtrend demand pulis up wages and prices. As the price
evel rises, the quantity of output demanded
SR evcle declines. and the economy gradually approaches
the natural rate of production. But during the

the higher price level. the

Suon to

The central bankFig-2 cotonm output is higher than the natural

ime rale.

the change in
can
red monetpplyar the increase in velocity. Offsetting
ois
velocity
even eliminate the
cansta mand. us, the central bank can
reduce or
ct employment if it skill fully
controi
odemana shocks on pupan can

the money su aANS.

shocks to ageregale su Supply shock4s 'sh to th economy that alters the
cost
of production
ofods and Eicesahd.as a pest he pris that firms charge. Because
shocks have direc called price shocks. Adverse
h prislCEtheruresoietim
supply shocks (e.gi d rops. a ne chvro mental protection. an increase
nal destt and
in union
aggressivess. t ation 9 itiona oil cartel, etc.) push costs
prices upward. A fapurabid dTices.
Both the short-run
Figure-8 shows enesupply shock affees the economy. be
a elongfun aggregate supply curves may
an adverse supply shock. The short-
PA
pply curve shètts upward and the long-run
LRAS
supply curre may shiti to the left n ith ar adverse
supply shock. Here we are ignoring the latter
SRAS, effect for simplicity. which can upset the natural
level of output by lowering it. The economy
moves from Ey to Es. over the business cycle, as
-SRAS
the short-Tun aggregate supply curve shifts from

AD
SRAS, to SRAS;. The price level rises and the
output level falls below the natural rate. - i.e. the
y economy falls into stagflation.
SR eycle
Faced with an adverse supply
R trend shock. the central bank has a ditficult choice
hciween i' options. The fitst optiwn. implit in
fig- io hoii ayyregate deniand cmsint

(
Fig-
 AD-AS: 44

to bring the
The second option, illustrated in figure-9, is to expand aggregate demand
natural rate more
economy toward the
LRAS Tf the increase in aggregate
quickly.
demand coincides with the shock to

the economy goes

aggregate supply,
E1. In this case,
SRAS, immediately from Ey to

the ceniral bank is said to accommodate

drawback of this
-SRAS% the supply shock. The
the price level is
AD option. ol course, is that
There is no way to
AD permanently higher.
demand to maintain full
adjusi aggregate
level
. R trend
employment and keep the price
stable.
S.R eycle

Fig-9 Time

N.B: Fiscal expansionand adiustment with LRAS: LRAS and a fiscal expans
We may concentrate on the movement
from E, to E of figure-9 considering the
of fiscal policy in the
described above. This describes the analogy
that shifts the AD curve in the same way
classical framework. This
but (say) government spending is higher.
Here output remains fixed at the full employment level, This leads to the
the private sector: There is full, or complete, crowding out effect.
must imply less spending by full crowding out effect. We
increased real government spending leads to
conclusion that in the classical case here. Figure-9.a shows the IS-LM
mechanism through which the crowding oul
effect occurs
now explain the The initial equilibrium point is at Eo.
level of output.
augmented with the line yr at the full employment lIS schedule
diagram, The fiscal expansion shifts the
clears and planned spending equals output.
where the money market meet the increase in demand by
level, and assuming firms were to
from ISo to 1S1. At an unchanged price But this is not possible under classical supply assumptions.
we would move to point Es.
expanding production, The price increase, in
firms end up raising prices rather than output.
excess demand for goods,
Faced with an
Prices will increase until the excess demand
therefore shifts the LM schedule up.
reduces real balances and a new equilibrium point EL
is
turn. schedule shifts up and to left until
been eliminated. That means the LM
has
at the full
reached. At EL the goods market clears
Interest rates have increased
LM employment level of output. that increase in
E, and
compared with the initial equilibrium to make room for
LMo interest rates has reduced private spending
A notable point is that
the
increased government purchases.
and income are
money market
is also in equilibrium. Output
rate reduces the
E. the higher interest
Fig-9.a the same as at point decline in the real
demand for real balances,
matching the
money stock.
IS1
ISo
o YF
effect is full when the LM curve
analysis we observed that the crowding out
F In the IS-LM
i.e. when the economy is boom
in
is vertical,
out effect is tull. This iholds in

another situation where the erowding

h esame explains
the AD-AS analy sts.
ii.At
vertical M curve. in
eliect is full hecause of the
analh sis crowding
out
nISI
11rest 2est
Crs h e c e moedemand brIei
Cse. rmdng i m t s tola altUl
C l
hec.itlb auregale s
s
 AD-AS: 45
hen the short-i
supply curve is sloped
prominent modelspositively:
here arc inee
odel cl. the stcky -Wage and ihe of short-run
augregate supply: the
pilual origin
oneepiuai orignn
supply iunction
Dut
they are imperfect-information
in
agreemeni in the
model. The three stick)-PIo
models difter in
ce
their
common fom of the shoit-run aggngate
yta(P P')
Wherc
. The sensitivity of output (y)
aBong the
business cycle per unii of deviation of
expected price (P') of the labourers from
ihe actual price (P),
s
-
a posiiive constant,
y: The naturaB rate of outpul.
deviations ofcqualionn
states that
the price level deviations of ouiDut from the natural rate are
expected price level, output from the expected
price level. If the price level is
retacu the
price level, output fal!s shortexceeds its natural rate. If price level is lower thanhigner u
1S Telated tio a
of its natural rate. ihe
Here the short-run aggregate suppiy expe
run
particular value of P", A chanee in uncto
the expected price level (P) shilts tne
aggregate supply funetion st
LRAS SRS Suy the initial short-run aggregate supply
funotion SRAS that corresponds to the
excted price P. SRAS, cuis the long-

P regatupply (LRAS) function at Ea. At

Ps ANSAhis p onomy grows at the natural rate
P-P thuspect ions are actualized. -i.c. actual
P D.Bprig. P PLet us now consider an
se in the supply money of and
SINCEnAP
T0the conseaentutward shilt of the aggregate

3350 inct In the short-run, the economy

alonge short-run aggregate supply
unct So) from point o
lo E. The
the actual
demand raises
ngrcas in aggregale
yCIC ce leyt lirom Po to Ps. Because people did not
per this increase in ihe price level the
expected price level remains at P and oulput
TIses from yr io ye, -causing econome heom
Time
Eig-10
ises to catch up with reality. causing the
In the long-run, ihe expected price level
shift upward. As expected price level rises from Pto
shorl-run aggregate supply curve to
from E, to E. The actual price level rises from P
Pthe equilibrium of the economy moves returms to the natural level,
from ys to yi. In other words, the economy
to P and output falls
but at a much higher price leve.

N.B:
ihat holds for each ot the three models ofaggregate suppiy is that the long
EAn important principie 1Onieuiratiy arc periectly conatible. Shoit-run monetar
neutraliiy ana sihort-run monetary
In nionetary ioi t0 Es. a Ong-tu moaeia tcutrality is
nonneutrality is represcrfet
iRCTe Dy
nC OVenent
(econeile ine short ) Ard he mg-ru, ilet,! Hney y

renresenied by the movcmeni iti to 0

W