Unit 5: Long-Run Consequences of Stabilization Policies

Unit 5 asks what happens after the dust settles. Units 3 and 4 showed how fiscal and monetary policy move aggregate demand in the short run. This unit follows those policies into the long run, covering the inflation-unemployment tradeoff and its limits, why sustained inflation is a monetary phenomenon, what deficits do to the national debt and to private investment, and what actually drives economic growth.

5.1 The Phillips Curve

The Phillips curve restates the AD-AS model in the language of inflation and unemployment. The short-run Phillips curve (SRPC) slopes downward, with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. Lower unemployment comes with higher inflation, and higher unemployment comes with lower inflation, as long as expectations and supply conditions do not change.

That tradeoff is driven by aggregate demand. When AD rises, firms sell more output, bid up input prices, and hire more workers, so the price level rises while unemployment falls. On the graph, the economy moves up and to the left along a fixed SRPC. When AD falls, the economy moves down and to the right, with falling inflation and rising unemployment. Demand-pull inflation is this movement along the curve, and it always pairs higher inflation with lower unemployment.

A supply shock moves the SRPC itself. When input prices jump, as in an oil price spike, short-run aggregate supply shifts left: the price level rises while output falls and unemployment rises. That combination of rising inflation and rising unemployment is stagflation. On the Phillips curve graph it appears as a shift of the whole SRPC up and to the right, so that every unemployment rate now pairs with higher inflation. A favorable supply shock, such as a productivity gain or a fall in input prices, shifts the SRPC down and to the left.

The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment. In the long run, wages and expectations fully adjust, so unemployment returns to its natural rate at any inflation rate, and there is no lasting tradeoff. Attempts to hold unemployment below the natural rate do not buy permanently lower unemployment. They buy accelerating inflation.

The SRPC crosses the LRPC at the expected rate of inflation. If people expect 2 percent inflation, the economy rests at the natural rate of unemployment with 2 percent inflation, and that point lies on both curves. When expected inflation rises to 4 percent, workers bargain for higher wages and firms set higher prices at every unemployment rate, so the SRPC shifts straight up by 2 points. Reducing expected inflation works in reverse: the economy must travel down along the higher SRPC, enduring temporarily higher unemployment, until expectations fall and the curve shifts back down. The lost output and higher unemployment endured while bringing inflation down is called the sacrifice ratio.

5.2 Money Growth and Inflation

The quantity theory of money starts from an identity: M times V equals P times Y. M is the money supply, V is the velocity of money (the average number of times each dollar is spent in a year), P is the price level, and Y is real GDP. The left side is total spending in the economy, and the right side is the dollar value of everything produced. Rearranged, the price level equals MV divided by Y.

The theory becomes a prediction with two assumptions. First, velocity is stable over time, changing slowly if at all. Second, in the long run real GDP is set by real factors such as labor, capital, and technology, so it grows at its own pace regardless of the money supply. Then money growth that outpaces real output growth has nowhere to go except into the price level. The inflation rate is approximately the money supply growth rate minus the real GDP growth rate. A sustained rise in prices is, in the long run, a monetary phenomenon. Inflation persists only if the money supply keeps growing faster than output.

In the short run, faster money growth is not neutral. It raises aggregate demand, pushing output above potential and moving the economy up along the SRPC to lower unemployment and higher inflation. But once wages and expectations catch up, output settles back at potential and only the higher price level remains. Money affects real variables in the short run and only the price level in the long run.

5.3 Government Deficits and the National Debt

The budget deficit and the national debt measure different things. The deficit is a flow: the amount by which government spending exceeds tax revenue in a single year. A budget surplus is the opposite, revenue exceeding spending. The national debt is a stock: the accumulation of all past deficits minus all past surpluses. Running a deficit this year adds the amount of that deficit to the debt.

Deficits arise whenever spending outpaces revenue, and recessions widen them automatically: tax revenue falls as incomes fall while spending on programs such as unemployment benefits rises. To cover a deficit, the government sells bonds, which is borrowing from the public, and that borrowing is what increases the national debt.

The debt carries costs. Interest payments on the debt must come out of future budgets, leaving less room for everything else the government wants to do. Heavy borrowing also absorbs national saving and can push up interest rates, which reduces private investment. That last effect is crowding out, covered in topic 5.4. Economists usually scale the debt to the size of the economy: a rising debt-to-GDP ratio means the debt is outgrowing the economy's ability to carry it.

A government that borrows in its own currency cannot be forced into default the way a household can, but the debt is not free. Repaying it falls on future taxpayers, and the borrowing that builds it can squeeze the investment that future growth depends on. Debt held domestically is owed by residents to residents, while debt held abroad sends interest payments out of the country.

5.4 Crowding Out

The loanable funds market is where saving meets borrowing, and the real interest rate is the price that balances the two sides. The supply of loanable funds comes from national saving, which is private saving plus public saving (tax revenue minus government spending). The demand comes from private investment plus government borrowing.

When the government runs a deficit, public saving falls, so the total supply of loanable funds shrinks. The same story can be told from the demand side: government borrowing adds to the demand for loanable funds, shifting the demand curve to the right. Both descriptions end in the same place. The real interest rate rises, and private investment falls. That fall in private investment is crowding out: the government is competing with businesses for a limited pool of savings, and businesses lose.

Crowding out partly undoes expansionary fiscal policy. Government spending rises, but higher interest rates discourage business spending on factories, equipment, and research, so aggregate demand rises by less than the fiscal stimulus alone would imply. The policy still expands the economy, just by less than the simple multiplier suggests.

Economists disagree about the size of the effect. The classical view treats crowding out as complete: investment falls dollar for dollar with the deficit, aggregate demand does not move, and fiscal stimulus changes the composition of spending without changing its total. The Keynesian view holds that in a deep recession, with idle resources and already low interest rates, crowding out is small. The central bank can also offset it by expanding the money supply to hold interest rates down while the government borrows.

5.5 Economic Growth

Economic growth is a sustained increase in real GDP over time, and it comes from the supply side of the economy. An economy grows when it has more or better inputs and better ways of combining them. The sources are growth in physical capital, growth in the labor force, improvements in human capital (the education, skills, and health of workers), technological progress, and the institutions that make productive activity worthwhile, such as secure property rights, the rule of law, stable money, and openness to trade.

On the graphs, growth is a rightward shift of long-run aggregate supply, or equivalently an outward shift of the production possibilities curve. This is different from a short-run recovery. A recovery closes a recessionary gap by moving the economy back toward its existing LRAS or PPC, using capacity that was sitting idle. Growth expands capacity itself.

The measure that tracks living standards is real GDP per capita, not total real GDP. If output and population grow at the same rate, the average person is no better off. Sustained growth in real GDP per capita is what raises incomes and consumption from one generation to the next.

The rule of 70 gives the doubling time for anything growing at a steady rate. Divide 70 by the annual growth rate in percent. An economy growing at 2 percent per year doubles in about 35 years; at 3.5 percent, in about 20 years. Because growth compounds, small differences in the growth rate produce very large differences in living standards over a few decades.

Confusions That Cost Points

Practice Questions

Original questions written for this guide in the style of the AP exam. Answers and explanations are on the next pages, so complete the questions before checking them.

Answer Key

An increase in aggregate demand moves the economy up and to the left along the fixed SRPC: firms raise prices and hire more workers, so inflation rises while unemployment falls. A describes a decrease in aggregate demand, the opposite policy. B is wrong because changes in AD move the economy along the SRPC rather than shifting it. D is wrong because the LRPC is fixed at the natural rate of unemployment and never responds to aggregate demand.

A leftward shift of SRAS is an adverse supply shock. It produces stagflation, which appears on the Phillips curve graph as an upward and rightward shift of the SRPC. A describes a demand-driven movement along the curve, but nothing about aggregate demand changed here. C is wrong because a temporary oil shock does not change the natural rate of unemployment, so the LRPC does not move. D describes a favorable supply shock, the opposite of what happened.

The SRPC crosses the LRPC at the expected inflation rate, so lower expected inflation shifts the SRPC straight down: each unemployment rate now pairs with lower inflation. A shifts the curve in the wrong direction; that is what higher expected inflation does. B confuses the SRPC with the LRPC, which is the vertical curve. C is wrong because expected inflation never moves the LRPC.

With stable velocity, the inflation rate is approximately the money supply growth rate minus the real GDP growth rate: 7 minus 2 is 5 percent. B adds the two rates instead of subtracting. C uses only the output growth rate and ignores the money supply. D uses only the money growth rate, forgetting that some of the new money is absorbed by a larger real economy.

Each year's deficit is added to the debt, so the national debt rises by the $400 billion shortfall. A confuses the flow with the stock: $400 billion is this year's addition to the debt, not the accumulated total. B gets the direction backwards; financing a deficit by borrowing increases the debt. D states the classic mix-up: the deficit is one year's shortfall, while the total amount the government owes is the debt.

Deficit borrowing raises the demand for loanable funds, which pushes the real interest rate up and makes borrowing more expensive for firms, so private investment falls. That is crowding out. A shifts the wrong curve in the wrong direction; deficits shrink public saving rather than expanding the supply of funds. C reverses the effect: investment falls, not rises. D ignores the loanable funds market entirely; government borrowing directly competes with private borrowers for the same pool of savings.

The rule of 70 divides 70 by the annual growth rate in percent: 70 divided by 2 is 35 years. A multiplies 70 by 2 instead of dividing. B forgets to divide by the growth rate at all. C divides 70 by 5, which would be the answer for a 5 percent growth rate, not 2 percent.

Long-run growth expands productive capacity, which is a rightward shift of LRAS. B describes a demand-driven expansion that moves the economy along a fixed LRAS and raises the price level without expanding capacity. C is a contractionary supply shock, the opposite of growth. D describes a short-run movement along the Phillips curve, which changes unemployment without expanding the economy's productive capacity.

One-Page Recall Check

Say each answer out loud before you look back, and mark the ones you cannot finish. Anything you cannot say out loud yet belongs in your flashcard deck. In Rycal, add those items to the Long-Run Consequences of Stabilization Policies deck and let spaced review bring them back over the next few days.

• Sketch the SRPC and LRPC, label the axes, and mark the natural rate of unemployment.
• Explain why the SRPC slopes downward, using aggregate demand.
• Distinguish a movement along the SRPC from a shift of the SRPC, with an example of each.
• Show how an oil price spike produces stagflation on both the AD-AS and Phillips curve graphs.
• Explain how a change in expected inflation shifts the SRPC, and why the LRPC does not move.
• Write the quantity theory equation, define each variable, and derive the approximate inflation formula.
• Explain why sustained inflation is a monetary phenomenon in the long run.
• Contrast demand-pull and cost-push inflation by cause, curve story, and effect on unemployment.
• Define the deficit and the debt, and explain how one changes the other.
• Trace a government deficit through the loanable funds market to the change in private investment.
• Compare the classical and Keynesian views of crowding out.
• List the sources of long-run economic growth and show growth on the LRAS and PPC graphs.
• Explain the difference between a short-run recovery and long-run growth.
• Use the rule of 70 to find a doubling time, and explain why real GDP per capita measures living standards.

Key terms for this unit

Short-run Phillips curve (SRPC), Long-run Phillips curve (LRPC), Natural rate of unemployment, Expected inflation, Stagflation, Sacrifice ratio, Quantity theory of money, Velocity of money, Neutrality of money, Demand-pull inflation, Cost-push inflation, Budget deficit, Budget surplus, National debt, Debt-to-GDP ratio, Loanable funds market, Real interest rate, National saving, Public saving, Crowding out, Economic growth, Real GDP per capita, Human capital, Institutions, Rule of 70.

About this guide. Written for Rycal and aligned to the College Board AP Macroeconomics course framework, Unit 5. All questions and explanations are original Rycal writing. Rycal is independent and is not affiliated with or endorsed by the College Board.