128 ❯ Step 4. Review the Knowledge You Need to Score High
Are Prices Sticky?
Do prices fall, as Figure 10.2 seems to indicate? One of the points of contention is whether
the price level can fall. Many economists (Keynesians) predict that prices are fairly inflex-
ible, or “sticky” in the downward direction, so efforts to fight inflation are really efforts to
slow inflation, not to actually lower the price level. Conversely, Classical school economists
believe that the long-run economy naturally adjusts to full employment, and so they see
the AS curve as vertical. This argument implies that prices are flexible and can rise and fall,
as seen in Figure 10.2.Deficits and Surpluses
When the government starts to adjust spending and/or taxation, there is an effect on the
budget. A budget deficit exists if government spending exceeds the revenue collected from
taxes in a given period of time, usually a year. A budget surplus exists if the revenue col-
lected from taxes exceeds government spending.The Difference Between Deficit and Debt
An annual budget deficit occurs when, in one year, the government spends more than is
collected in tax revenue. To pay for the deficit, the government must borrow funds. When
deficits are an annual occurrence, a nation begins to accumulate a national debt. The national
debt is therefore an accumulation of the borrowing needed to cover past annual deficits.Expansionary Policy
If the economy is in a recession, the appropriate fiscal policy is to increase government
spending or lower taxes. When the government spends more, or collects less tax revenue,
budget deficits are likely. There are two ways to finance the deficit, and each has the poten-
tial to weaken the expansionary policy.
• Borrowing. If a household wants to spend beyond its means, it enters the market for loan-
able funds as a borrower. The borrowed funds provide a short-term ability to purchase
goods and services, but must be paid back, with interest, when the loan is due. The same
is true when the government borrows, but when an entity as large as the federal govern-
ment is borrowing from the banking system, the public, or foreign lenders, in the form
of Treasury bonds, it increases the demand for loanable funds. This, in turn, increases
the real rate of interest and reduces the quantity of funds available for private investment
opportunities. So what? Well, if the goal is to expand the macroeconomy, then borrow-
ing to finance the deficit slows down the expansion by increasing interest rates. This
crowding-out effect is examined in the next section of this chapter.
• Creating money. The creation of new money to fund a deficit can avoid the higher inter-
est rates caused by borrowing. The primary disadvantage of creating more money is the
risk of inflation, which can also lessen the effectiveness of expansionary fiscal policy. The
effect that inflation has on the multiplier was illustrated in the previous chapter, and
more detailed effects of expanding the money supply are looked at in the next chapter.Contractionary Policy
If the economy is operating above full employment, the appropriate fiscal policy is to lower
government spending or raise taxes. When the government spends less, or collects more tax
revenue, a budget surplus can occur. The effectiveness of the contractionary fiscal policy
depends upon what is done with the surplus.
• Pay down debt. If the government pays down debt and retires bonds ahead of schedule,
the demand for loanable funds decreases, decreasing interest rates. Lower interest ratesKEY IDEA