Unit 5 Policies & Growth (Macro)

Unit 5 Overview & Video Lesson: Top 10 things you need to know about classical theory, Keynesian theory, monetarism, crowding out effect, short-run and long-run Phillips curves, loanable funds market, and economic growth. This is geared toward college-level principles of macro courses and students enrolled in AP Economics. Below the Top 10 video, you will find mini lessons, essential questions, graphs and models on specific concepts. Take notes and pause when necessary.

Top 10 concepts discussed in this video: 

#1. Classical vs. Keynesian Economics

#2. Criticisms of Fiscal & Monetary Policy

#3. Long-Run Economic Growth

#4. Real Interest Rates & Growth

#5. Loanable Funds – Crowding Out Effect

#6. Loanable Funds – Savings

#7. Phillips Curve – Aggregate Demand

#8. Phillips Curve – Aggregate Supply

#9. Phillips Curve – Inflation Expectations

#10. Phillips Curve in the Long Run

What is the crowding out effect?

The crowding out effect is an unintended consequence of expansionary fiscal policy. When the government increases spending or cuts income taxes, it runs a budget deficit. The government borrows from the loanable funds market causing real interest rates to rise. The increase in interest rates causes households and businesses to cut back on spending. This means that consumption and gross investment is "crowded out" by the expansionary fiscal policy that caused real interest rates to rise.

How does savings affect the loanable funds market?

The loanable funds market shows the relationship between the real interest rate and quantity of loanable funds.

More savings: If there is an increase in savings by the private sector, the supply of loanable funds increases (shifts right) causing the real interest rate to fall. When the real interest rate decreases, investment spending increases. This is good for the growth of capital stock and long run economic growth.

Low real interest rates also depreciate the value of currency as foreigners are not attracted to the lower returns on bonds. When the currency depreciates, net exports increase as the goods look cheaper to foreigners. 

Less savings: If there is a decrease in savings by the private sector, the supply of loanable funds decreases (shifts left) causing the real interest rate to rise. When the real interest rate increases, investment spending decreases. This is bad for the growth of capital stock and slows down the rate of long run economic growth.

High real interest rates also appreciate the value of currency as foreigners are more attracted to the higher returns on bonds. When the currency appreciates, net exports decrease as the goods look more expensive to foreigners.

How do you illustrate economic growth using the AD/AS model and a production possibilities graph?

Economic growth can be measured as a sustained increase in real GDP, real GDP per capita, and increases in potential real output. You can easily illustrate long-run economic growth in two ways: 

1) Rightward shift of the long run aggregate supply curve

2) Outward shift of a nation's production possibilities curve

What is a Phillips curve?

The short-run Phillips curve is a downward sloping curve that shows an inverse relationship between inflation and unemployment. Inflation is on the Y-axis and unemployment is on the X-axis. When aggregate demand shifts to the right, inflation increases and unemployment falls. This means that the economy moves point-to-point leftward along the short-run Phillips curve.

In the long run, there is no tradeoff between inflation and unemployment. The long-run Phillips curve is vertical at the natural rate of unemployment (or the NAIRU).

How do inflation expectations affect the Phillips curve?

Inflation expectations are a determinant of the short-run aggregate supply curve. When the short-run aggregate supply curve shifts one direction, the short-run Phillips curve shifts the opposite direction. 

If inflation expectations rise, SRAS shifts leftward raising the price level and unemployment (stagflation). To illustrate an increase in inflation and unemployment with a Phillips curve, shift the short-run Phillips curve to the right.

If inflation expectations fall, SRAS shifts rightward lowering the price level and unemployment. To illustrate a decrease in inflation and unemployment with a Phillips curve, shift the short-run Phillips curve to the left. 

Inflation expectations do not affect the vertical long-run Phillips curve.