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Macroeconomics Unit 5: Long-run consequences of stabilization policies

In the long run, policy affects prices more than output; the Phillips curve tradeoff disappears, and growth depends on productivity.

Covers: Fiscal and monetary policy in the short and long run, the Phillips curve, money growth and inflation, government deficits and national debt, crowding out, economic growth and productivity

Study guide

In the short run, fiscal and monetary policy can change real output and unemployment. In the long run, wages and prices adjust, so the economy returns to potential output; policies that push AD beyond that mainly raise the price level. Policymakers must also consider combined effects: for example, expansionary fiscal policy plus contractionary monetary policy definitely raises interest rates.

The Phillips curve shows the relationship between inflation and unemployment. The short-run Phillips curve (SRPC) slopes downward: an increase in AD lowers unemployment but raises inflation, a movement along the curve. Supply shocks and changes in expected inflation shift the SRPC. The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment, matching the vertical LRAS, so there's no long-run tradeoff.

The quantity theory of money explains long-run inflation: MV = PQ, where M is the money supply, V is velocity, P is the price level and Q is real output. If velocity and output are stable, increases in the money supply cause proportional increases in the price level, so money is neutral in the long run. Rapid money growth causes high inflation or hyperinflation.

A budget deficit occurs when government spending exceeds tax revenue in a year; the national debt is the accumulated total of past deficits. Persistent deficits can raise real interest rates and crowd out private investment, slowing growth, and the debt creates interest burdens. Long-run economic growth, shown as rightward shifts of LRAS and the PPC, depends on increases in physical capital, human capital, technology and the rule of law. Productivity (output per worker) is the key to rising living standards, and policies supporting education, research and infrastructure promote growth.

The SRPC crosses the LRPC at the natural rate of unemployment and the currently expected inflation rate. When expected inflation rises, the whole SRPC shifts up, and when it falls, the curve shifts down. That's how the economy returns to the natural rate in the long run. If people form rational expectations and prices are flexible, they anticipate policy-induced inflation right away. Even in the short run, policy then changes only inflation and not unemployment, so there's no usable tradeoff.

A rightward AD shift is a movement up and to the left along the SRPC (higher inflation, lower unemployment). A leftward SRAS shift (supply shock) shifts the SRPC to the right, raising both inflation and unemployment.

Key ideas

• Policy affects real output in the short run but mainly prices in the long run.
• The short-run Phillips curve shows an inflation-unemployment tradeoff.
• The long-run Phillips curve is vertical at the natural rate.
• MV = PQ links money growth to inflation.
• Long-run growth depends on productivity from capital, skills and technology.

Formulas and rules

Common mistakes

• Confusing the deficit (one year) with the debt (accumulated total).
• Thinking the long-run Phillips curve slopes downward.

Words to know

Short-run Phillips curve

A downward-sloping curve showing an inflation-unemployment tradeoff.

Long-run Phillips curve

Vertical at the natural rate of unemployment.

Expected inflation

The inflation rate people anticipate, which shifts the SRPC.

Quantity theory of money

MV = PQ.

Velocity of money

How many times a dollar is spent in a year.

Money neutrality

Money affects only prices, not real output, in the long run.

Hyperinflation

Extremely rapid inflation, usually from excessive money growth.

Budget deficit

Government spending exceeds revenue in a year.

Budget surplus

Revenue exceeds spending in a year.

National debt

The total of past deficits minus surpluses.

Crowding out

Deficits raising interest rates and reducing private investment.

Economic growth

Sustained increases in real GDP per capita.

Productivity

Output per worker or per hour of work.

Physical capital

Tools, machines and buildings used in production.

Human capital

Workers' knowledge and skills.

Supply-side policy

Policies that increase LRAS, like education and research incentives.

Sample practice questions

11 more questions like these, from level 1 to 5, are in the practice set.