Long-Run Consequences of Stabilization Policies

Fiscal and monetary policy can work together (both expansionary to close a recessionary gap, or both contractionary to close an inflationary gap), or they can pull in different directions. To analyze a mix, trace each policy's effect on AD, real GDP, the price level and interest rates. For example, expansionary fiscal policy tends to push interest rates up while expansionary monetary policy pushes them down, so if both are used, the change in interest rates depends on which effect is bigger.

The Phillips curve graph puts the inflation rate (%) on the vertical axis and the unemployment rate (%) on the horizontal axis. The short-run Phillips curve (SRPC) slopes downward, the long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment, and long-run equilibrium is where they cross. A point on the SRPC to the left of that crossing means an inflationary gap, and a point to the right means a recessionary gap. A change in AD moves the economy along the SRPC (more AD means higher inflation and lower unemployment). A supply shock or a change in expected inflation shifts the SRPC (a negative supply shock shifts it right), and a change in the natural rate shifts the LRPC.

The quantity theory of money uses the equation of exchange, M × V = P × Y: the money supply times velocity (how many times each dollar is spent in a year) equals the price level times real output, which is nominal GDP. If velocity is stable and real output is set by the economy's full-employment capacity in the long run, then growing the money supply faster mainly raises prices. So in the long run, money growth sets the inflation rate.

A government runs a budget deficit in a year when its spending plus transfer payments is more than its tax revenue; a surplus is the reverse. The national debt is the total it owes from past borrowing, and every deficit adds to it. The government must pay interest on that debt, which adds to future spending and is money it can't use for other things.

When the government borrows to cover a deficit, the demand for loanable funds shifts right (DLF1 to DLF2) and the real interest rate rises from r1 to r2. (Some teachers show this as the supply of loanable funds shifting left instead; either way the real interest rate rises, and AP scoring accepts both.) The higher rate makes firms and households borrow less for investment and other interest-sensitive spending; that's crowding out. Over time, less private investment can mean a smaller stock of physical capital and slower growth.

Economic growth means real GDP per person rising over time. You show it as the PPC shifting outward, or as LRAS shifting right (LRAS1 to LRAS2) on a graph with the price level on the vertical axis and real GDP on the horizontal axis. Growth comes mainly from higher productivity (output per worker), which rises with more physical capital and human capital per worker and better technology. The aggregate production function shows this link between inputs and output.

Governments try to boost long-run growth with policies that raise productivity and labor force participation, such as funding education and job training, building infrastructure, and supporting research and new technology. Supply-side fiscal policies, such as tax changes meant to strengthen incentives to work, save and invest, aim to shift aggregate supply and potential output (LRAS) to the right, and they can affect AD too. Economists disagree about how big these effects are, so focus on the direction the model predicts.