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Economics: Timing Problems and the AD/AS Model


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About this Lesson

  • Type: Video Tutorial
  • Length: 6:58
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 74 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Monetary and Fiscal Policy (17 lessons, $27.72)
Economics: Fiscal Policy: The Mainstream (5 lessons, $7.92)

This economics video lesson will teach you about Timing Problems and the Aggregate Demand/Aggregate Supply (AD/AS) Model. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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When we do fiscal policy in our model, it looks really simple. But in reality it's a lot more complex. On the paper it's as easy as shifting the aggregate demand curve back out any time it shifts inwards. Suppose due to a reduction in consumer spending, the aggregate demand curve shifts inwards and whenever the economy adjusts to its new equilibrium, we have a lower price level and a lower level of output. This is a recession. Output is shrinking, the economy is contracting, unemployment is occurring, prices are falling and we wind up with unemployment and other costs of recession. Well, in our simple model what you do is you shift the aggregate demand curve back outwards either by cutting taxes or increasing government spending or offering other incentives that stimulate consumer spending and business spending. Aggregate demand curve goes in, and you just shift it back out and the problem is solved. Well, that makes controlling the economy look awfully easy. In reality, however, fiscal policy goes through Congress, and Congress is a bunch of human beings that are subject to political pressures and uncertainty, and because of all of this, the process ends up taking a lot more time than it does to shift a curve. Let's consider now some of the lags that are involved in implementing fiscal policy and see how the lags make fiscal policy so difficult that, in fact, we would actually not want to use it in many cases to try to fine tune the economy.
Lag #1 is called the recognition lag. How long does it take for you to look at the data and figure out that you're actually in a recession, that is, how long does it take to figure out that the aggregate demand curve has shifted inward because of a change in consumer and business behavior that requires a correction recognizing that the economy has actually flipped into recession. It takes a while to see that income is down and is going to stay there. It takes a while to collect the statistics that verify that we've moved from Y0 to Y1. So the recognition lag is associated with collecting the data needed to diagnose the situation.
Now not only do you want to diagnose the situation, but you want to diagnose that it's not something temporary, that is, you don't want the government stepping in to increase government spending if consumer or business spending is only down temporarily. If it's going to bounce back next week or next month, then government spending on top of that would lead to overshooting and more instability. So diagnosis, recognition, what's the problem, is it going to persist, is this a case that calls for fiscal policy.
Second, the administrational act. How long does it take to get Congress to actually take the action to cut the taxes or increase the spending or offer the incentives that would in theory shift the aggregate demand curve outwards. The administrative lag we could call the problem of red tape. First of all, you've got the politics which is getting Congress to actually vote on a tax cut or vote on a budget that increases government spending and this is no trivial matter because if Congress decides that spending increases would stimulate the economy, there's going to be 500 different opinions in Congress about what Congress should spend money on. Everybody wants it in their district; everybody wants projects that benefit the industries that support them, so there's all kinds of administrative problems that have to be solved. Then once Congress has decided what it wants to spend on, there's the matter of voting on things, sending the orders to the appropriate divisions that implement the policy and all of that. So the administrative lags or the red tape lags are a problem that's just basically rooted in politics.
The third kind of lag is called the operational lag. How long does it take from the date in which the policy is voted on until the date when it actually takes effect? Suppose Congress votes on Wednesday, January 12th to enact a spending package that includes building lots of new roads. How long will it take before the road projects actually get started and the construction workers actually start drawing paychecks. I mean, it could be April or July or who knows how long. Therefore, by the time the curve actually begins to shift out from the government spending, it may be that consumers and businesses have already changed their minds about the economy and the curve is shifted back of its own power. So the operational lag or the time it takes to actually implement the government policy may render fiscal policy ineffective.
Now there's another problem with fiscal policy and that is government spending and government tax incentives create constituencies, that is, people who make money off of them, people who benefit from them. And the people who benefit from government subsidies and tax breaks and spending projects certainly don't want to see them go away. So if the curve shifts in from consumers not wanting to spend and the government shifts it back out with some nifty spending programs and tax breaks, well, then if consumers decide they want to spend more money, then the government can't just cut these old programs because now they'll be taking candy away from people who may have become quite used to it and this becomes politically sensitive. When the projects create a constituency, that may be then that when consumer spending goes back to its original level, the aggregate demand curve shifts way past its original position because the government has spent money or given tax breaks that it can't retract. This is just the nature of politics. Once you give people something they kind of decide that they're use to it.
Well, all of this makes fiscal policy complex. We still have policies that are in place from the Great Depression. The spending plans that the government enacted on the advice of John Maynard Keynes' writings have created constituencies in the form of agriculture and subsidies to different industries that are almost impossible for us to dismantle now, whether or not they're still required. Certainly trying to figure out when the government should spend the money, on what, under what circumstances government stimulates is actually going to do some good makes the real story a lot more difficult than the pictures that we've been drawing in our models. So, in conclusion, let's say that fiscal policy comes with a lot of complexity, the recognition lag, the lag of implementation, administration, all of this makes it more difficult to use government spending, taxes and other incentives to fine tune the economy than it would appear in theory.
Monetary and Fiscal Policy
Fiscal Policy: The Mainstream
Timing Problems and the AD/AS Model Page [2 of 2]

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