1 Sect. 6 - Inflation, Unemployment, & Stabilization Polices Module 30 - Long-run Implications of Fiscal Policy What you will learn: Why governments calculate the cyclically adjusted budget balance Why a large public debt may be a cause for concern Why implicit liabilities of the government are also a cause for concern

Sect. 6 - Inflation, Unemployment, & Stabilization Polices Module 30 - Long-run Implications of Fiscal Policy The Budget Balance - (savings by govt.) The budget balance is measured in terms of surplus and deficit. S govt. = T(taxes) - G (govt. Spending) - TR (transfers) - Expansionary fiscal policy decreases Budget Balance - Contractionary fiscal policy increases Budget Balance Cyclical Adjusted Budget Balance - Estimate of what the budget balance would be if real GDP were equal to potential output (no recessionary or inflationary gaps)

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Sect. 6 - Inflation, Unemployment, & Stabilization Polices Module 30 - Long-run Implications of Fiscal Policy The Budget Balance - (savings by govt.) The budget balance is measured in terms of surplus and deficit. S govt. = T(taxes) - G (govt. Spending) - TR (transfers) - Expansionary fiscal policy decreases Budget Balance - Contractionary fiscal policy increases Budget Balance Cyclical Adjusted Budget Balance - Estimate of what the budget balance would be if real GDP were equal to potential output (no recessionary or inflationary gaps)

7 Problem of Rising Govt. Debt - 1) “Crowding out” effect when Govt. borrows a larger portion of loanable funds, there is less available at a higher interest rate 2) The larger the debt the higher the interest on the debt - how will this effect future fiscal policy ($383 billion, 2.7% of GDP) Debt - GDP Ratio - Govt. debt as % of GDP (GDP growth rate vs. debt growth rate) - GDP is a good indicator of potential tax revenue

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13 Problem of Rising Govt. Debt - 1) “Crowding out” effect when Govt. borrows a larger portion of loanable funds, there is less available at a higher interest rate 2) The larger the debt the higher the interest on the debt - how will this effect future fiscal policy ($383 billion, 2.7% of GDP) Debt - GDP Ratio - Govt. debt as % of GDP (GDP growth rate vs. debt growth rate) - GDP is a good indicator of potential tax revenue Implicit Liabilities - Future spending promises that are debt but are not included in debt statistics - Soc. Sec., Medicare, Medicaid (appxt. 40% of govt. spending)

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15 Problem of Rising Govt. Debt - 1) “Crowding out” effect when Govt. borrows a larger portion of loanable funds, there is less available at a higher interest rate 2) The larger the debt the higher the interest on the debt - how will this effect future fiscal policy ($383 billion, 2.7% of GDP) Debt - GDP Ratio - Govt. debt as % of GDP (GDP growth rate vs. debt growth rate) - GDP is a good indicator of potential tax revenue Implicit Liabilities - Future spending promises that are debt but are not included in debt statistics - Soc. Sec., Medicare, Medicaid (appxt. 40% of govt. spending)

16 Module 31 - Monetary Policy & the Interest Rate What you will learn: How the Federal Reserve implements monetary policy Why monetary policy is the main tool for stabilizing the economy

17 Module 31 - Monetary Policy & the Interest Rate Target Federal Funds Rate - The interest rate the Fed sets to achieve the desired monetary policy goal - uses open market operations to shift money supply

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20 Module 31 - Monetary Policy & the Interest Rate Target Federal Funds Rate - The interest rate the Fed sets to achieve the desired monetary policy goal - uses open market operations to shift money supply Expansionary Monetary Policy - Policy that increases demand which increases Real GDP Increase in money supply lowers interest rate more investment and consumer spending increase in AG demand increase in Real GDP

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22 Module 31 - Monetary Policy & the Interest Rate Target Federal Funds Rate - The interest rate the Fed sets to achieve the desired monetary policy goal - uses open market operations to shift money supply Expansionary Monetary Policy - Policy that increases demand which increases Real GDP Increase in money supply lowers interest rate more investment and consumer spending increase in AG demand increase in Real GDP

23 Contractionary Monetary Policy - Policy that decreases demand which decreases Real GDP Decrease in money supply raises interest rate less investment and consumer spending decrease in AG demand decrease in Real GDP

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25 Contractionary Monetary Policy - Policy that decreases demand which decreases Real GDP Decrease in money supply raises interest rate less investment and consumer spending decrease in AG demand decrease in Real GDP Taylor Rule for Monetary Policy - Rule for setting the federal funds rate that includes the inflation rate and output gap Target Federal Funds Rate = 1+ (1.5 x inflation rate) + (0.5 x output gap) Ex: Infl. Rate = 3% x 1.5 = 4.5 Output Gap = - 4% x 0.5 = = 3.5%

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27 Contractionary Monetary Policy - Policy that decreases demand which decreases Real GDP Decrease in money supply raises interest rate less investment and consumer spending decrease in AG demand decrease in Real GDP Taylor Rule for Monetary Policy - Rule for setting the federal funds rate that includes the inflation rate and output gap Target Federal Funds Rate = 1+ (1.5 x inflation rate) + (0.5 x output gap) Ex: Infl. Rate = 3% x 1.5 = 4.5 Output Gap = - 4% x 0.5 = = 3.5%

28 Inflation Targeting - Setting monetary policy to target a particular inflation rate - the Fed does not target a certain rate of inflation but prefer 2% The Taylor Rule sets goals based on past inflation - Inflation Targeting sets goal based on future expected inflation

29 Module 32 - Money, Output & Prices in the Long-run What you will learn: The effects of an inappropriate monetary policy Monetary neutrality and its relationship to the long-term economic effects of monetary policy

30 Module 32 - Money, Output & Prices in the Long-run Short & Long-run Effects of an Increase in the Money Supply - In the short-run: - increase in aggregate demand & increase in price level In long-run: - increase in aggregate price level

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33 Module 32 - Money, Output & Prices in the Long-run Short & Long-run Effects of an Increase in the Money Supply - In the short-run: - increase in aggregate demand & increase in price level In long-run: - increase in aggregate price level Monetary Neutrality - If money supply is increased by 10% the price level rises 10% in the long-run - changes in the money supply have no real effect on the economy Changes in Money Supply and Interest Rates in the Long-run - In the short-run an increase in the money supply leads to a fall in interest rate - in the long-run the interest rate is not effected

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35 Module 32 - Money, Output & Prices in the Long-run Short & Long-run Effects of an Increase in the Money Supply - In the short-run: - increase in aggregate demand & increase in price level In long-run: - increase in aggregate price level Monetary Neutrality - If money supply is increased by 10% the price level rises 10% in the long-run - changes in the money supply have no real effect on the economy Changes in Money Supply and Interest Rates in the Long-run - In the short-run an increase in the money supply leads to a fall in interest rate - in the long-run the interest rate is not effected

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37 Module 33 - Types of Inflation, Disinflation, and Deflation What you will learn: The classical model of the price level Why printing money can lead to high inflation and even hyperinflation Types of inflation: cost-push and demand pull

38 Module 33 - Types of Inflation, Disinflation, and Deflation Classical Model of Price Level - The real quantity of money is always at its long-run equilibrium level

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40 Module 33 - Types of Inflation, Disinflation, and Deflation Classical Model of Price Level - The real quantity of money is always at its long-run equilibrium level The Inflation Tax - The reduction in the value of money held by the public caused by inflation - 5% inflation rate imposes a 5% “inflation tax” Hyperinflation - When the government prints a large quantity of money - imposing a larger inflation tax - to cover a large budget deficit

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42 Module 33 - Types of Inflation, Disinflation, and Deflation Classical Model of Price Level - The real quantity of money is always at its long-run equilibrium level The Inflation Tax - The reduction in the value of money held by the public caused by inflation - 5% inflation rate imposes a 5% “inflation tax” Hyperinflation - When the government prints a large quantity of money - imposing a larger inflation tax - to cover a large budget deficit

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45 Module 33 - Types of Inflation, Disinflation, and Deflation Classical Model of Price Level - The real quantity of money is always at its long-run equilibrium level The Inflation Tax - The reduction in the value of money held by the public caused by inflation - 5% inflation rate imposes a 5% “inflation tax” Hyperinflation - When the government prints a large quantity of money - imposing a larger inflation tax - to cover a large budget deficit

47 Cost Push Inflation - Input costs increase, causing a leftward shift in supply

49 Demand Pull Inflation - A rightward shift in Aggregate demand

50 Module 34 - Inflation and Unemployment: The Phillips Curve What you will learn: What the Phillips curve is and the nature of short-run inflation and unemployment Why expansionary policies are limited due to the effects of expected inflation Why deflation is a problem for economic policy

51 Module 34 - Inflation and Unemployment: The Phillips Curve Short-run Phillips Curve (SRPC) - Negative relationship between the unemployment rate & the inflation rate

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55 Module 34 - Inflation and Unemployment: The Phillips Curve Short-run Phillips Curve (SRPC) - Negative relationship between the unemployment rate & the inflation rate Nonaccelerating Inflation Rate of Unemployment (NAIRU) - The unemployment rate at which inflation does not change over time

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57 Module 34 - Inflation and Unemployment: The Phillips Curve Short-run Phillips Curve (SRPC) - Negative relationship between the unemployment rate & the inflation rate Nonaccelerating Inflation Rate of Unemployment (NAIRU) - The unemployment rate at which inflation does not change over time Long-Run Phillips Curve - Shows relationship between unemployment and inflation including expectations of inflation

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59 Module 34 - Inflation and Unemployment: The Phillips Curve Short-run Phillips Curve (SRPC) - Negative relationship between the unemployment rate & the inflation rate Nonaccelerating Inflation Rate of Unemployment (NAIRU) - The unemployment rate at which inflation does not change over time Long-Run Phillips Curve - Shows relationship between unemployment and inflation including expectations of inflation

60 Cost of Disinflation - Attempting to bring down inflation at the cost of reduced GDP and high unemployment

62 Cost of Disinflation - Attempting to bring down inflation at the cost of reduced GDP and high unemployment Deflation - Period of falling prices usually associated with recession and increasing unemployment Debt Deflation - Reduces aggregate demand due to increase in real outstanding debt caused by deflation

63 Liquidity Trap - Conventional monetary policy is ineffective at controlling deflation because nominal interest rates cannot go below zero

66 Liquidity Trap - Conventional monetary policy is ineffective at controlling deflation because nominal interest rates cannot go below zero

67 Module 35 - History & Alternative Views of Macroeconomics What you will learn: Why classical macroeconomics wasn’t adequate for the problems of the Great Depression How Keynes and the Great Depression legitimized Macroeconomics activism What monetarism is and its views about the limits of discretionary monetary policy

68 Module 35 - History & Alternative Views of Macroeconomics Classical Macroeconomics - As previously noted increase in the money supply leads to a proportional increase in price level only in the long-run Believe in lassiez faire economic philosophy Keynesian Economic theory - The Great Depression showed that a prolonged economic downturn might not right itself “Macroeconomic Policy Activism” - the use of monetary and fiscal policy is necessary to recover in the short-run

69 Monetarism - Milton Friedman led the movement called “monetarism” that opposed monetary and fiscal policy activism Maintained that the Fed should only target a constant rate of money supply growth - GDP will grow steadily if the money supply grows steadily

71 Monetarism - Milton Friedman led the movement called “monetarism” that opposed monetary and fiscal policy activism Maintained that the Fed should only target a constant rate of money supply growth - GDP will grow steadily if the money supply grows steadily Discretionary Monetary Policy - Changes in interest rate and money supply to stabilize the economy Quantity Theory of Money - The positive relationship between the money supply and price level

72 Velocity of Money - Ratio of GDP to the Money Supply M x V = P x Y M = Money Supply V = Velocity P = Price Level Y = GDP

74 Velocity of Money - Ratio of GDP to the Money Supply M x V = P x Y M = Money Supply V = Velocity P = Price Level Y = GDP Natural Rate of Unemployment - Natural Rate Hypothesis proposes that unemployment must be high enough that actual inflation rate equals expected inflation rate

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76 Political Business Cycle - When politicians use macroeconomic policy to serve political agenda - timing activist economic policy to elections New Classical Macroeconomics - In the 1970s and 80s a return to classical economics - idea that increase in money supply and AG demand only affect price level Rational Expectations - Popular since the 1970s - individuals and firms make decisions based on all available data to anticipate future economic changes - alters the effect of the economic policy

77 Real Business Cycle Theory - Claims that business cycle is caused by fluctuations in the growth of productivity - usually caused by technological progress

78 Module 36 - The Modern Economic Concensus What you will learn: The elements of the modern economic consensus The remaining disputes

79 Module 36 - The Modern Economic Concensus Is Expansionary Monetary Policy Effective in Fighting Recessions? - Most economists today agree that monetary policy is effective at shifting aggregate demand and stabilizing the economy Is Expansionary Fiscal Policy Effective in Fighting Recessions? - Most economists today agree that fiscal policy is effective at shifting aggregate demand and stabilizing the economy - can’t be concerned with a balanced budget

80 Can Monetary or Fiscal Policy Reduce Unemployment in the Long run? Classical and monetarists believe fiscal policy is not effective Keynesians still believe it is Most believe monetary and fiscal policy can’t keep unemployment below the natural rate in the long-run Should Fiscal Policy be Used in a Discretionary Way? - Most believe tax cuts and spending increases are somewhat effective in increasing aggregate demand

81 Should Monetary Policy be Used in a Discretionary Way? - Most believe monetary policy should play the main role in stabilization policy Disagreement in how monetary policy should be implemented Central Bank Targets - Many central banks in the world use specific goals and targets to set monetary policy - The Federal Reserve does not Belief is that the Fed needs to remain flexible to address unanticipated economic events as they happen Asset Prices - Opinion is split on whether the Fed should act when particular asset prices are viewed as being inflated (stocks, housing)

82 Unconventional Monetary Policies - In recent years the Fed has engaged in unconventional actions in an attempt to counter a severe recession - loaning large sums of money to financial institutions, purchases of private assets & business debt, and home mortgage assets - controversial but many believe necessary

83 The End