ECON 521 Special Topics in Economic Policy CHAPTER TWO

First: Overview This chapter -- looks at Economic Policy, overt intervention taken to improve a economy currently operating with problems. Economic Policy -- “medicine” given to cure a “sick” economy. Emphasizes Fluctuations Strategy, Get Y* closer to a given YN. Steps follow- Diagnosing the Economy, Policy Strategy, Choosing Policy Type, Policy Objective

Diagnosing the Economy – A Quick Review Y < YN -- sluggish economy Y > YN -- economy with accelerating inflation Y = YN -- economy with constant inflation rate (desired)

Strategies for (Fluctuations) Economic Policy Expansionary Policy -- Policy designed to address a sluggish economy (Y* < YN). Contractionary Policy -- Policy designed to address an overstimulated, or accelerated inflation economy (Y* > YN).

Types of Economic Policy Monetary Policy -- The Federal Reserve changing the supply of financial capital to promote investment (and possibly durable goods consumption). Fiscal Policy – The Federal Government changing the government budget position (G-T). Trade Policy -- Trying to managing the economy through changing exports (X) and imports (M). Exchange Rate Policy -- Trying to managing the exchange rate for influencing the local economy.

The Intent & Method of Economic Policy Intent -- to move Y* closer to YN. Expansionary Policy (policy for Y* < YN), seeks to increase spending on goods and services, shifting the AD curve rightward. Contractionary Policy (policy for Y* > YN), seeks to decrease spending on goods and services, shifting the AD curve leftward.

Second: Challenges to Using Economic Policy (1) Can the economy cure itself instead? (2) Avoiding excessive expansion and the wage-price spiral. (3) Reacting to adverse supply shocks.

Challenge (1): Can The Economy Cure Itself? Short-Run Perspective (equilibrium in AD-AS model): Y* does not necessarily equal YN due to market failure in the labor market. Therefore, the economy needs policy (interventionist position). Long-Run Perspective (equilibrium in AD-LAS model): Y* = YN . Therefore, it can cure itself and there is no need for policy (non-interventionist position).

The Long-Run: A Graphical Description Let’s return to the Labor Market -- the demand and supply for labor employment. In this case, let’s consider the Aggregate Labor Market, or the total demand and supply for labor. Labor Market Equilibrium (N*) -- where labor demand equals labor supply across the economy. At N*, there is no demand-deficient unemployment. So at N*, Y* = YN and u = uN.

The Economy Curing Itself in the The Long-Run Example 1 -- sluggishness (Y < YN), and correspondingly, demand-deficient unemployment. Problem -- wage rate (W) is too high. Solution -- allow W to decrease, until N = N*. When that occurs, simultaneously Y* = YN.

Example 2 -- accelerating inflation (Y > YN), and correspondingly, having u < uN. Problem -- wage rate (W) is too low. Solution -- allow W to increase, until N = N*. When that occurs, simultaneously Y* = YN.

The Economy in the The Short-Run (Market Failure) Example 1 -- sluggishness (Y* < YN), and correspondingly, demand-deficient unemployment. Problem -- W is too high. Key -- W does not decrease due to market failure (e.g. labor contracts). Therefore, Y* stays less than YN. Problem persists without policy.

Example 2 – overstimulated, accelerating inflation economy (Y* > YN). Problem -- W is too low. Key -- W does not increase due to market failure (e.g. labor contracts). Therefore, Y* stays greater than YN. Problem persists without overt policy.

Challenge (2): Avoiding the Wage-Price Spiral Excessive demand policy -- shifts the AD curve rightward too far , Y* > YN, accelerates inflation, increases inflation expectations. Labor seeks above-normal increases in nominal wage rates to protect themselves, AS curve shifts leftward.

As a result, Y* returns to previous level, call for further expansionary policy. Process keeps repeating itself.

Avoiding the Wage-Price Spiral Use expansionary policy with caution. Be careful of overshooting where Y* exceeds YN, don’t arouse inflation fears. Be watchful for nominal wage rate increases when deciding to use policy. Avoid expansionary policy if nominal wage increases are larger than normal.

Challenge (3): Reacting to Adverse Supply Shocks Most dramatic US Experiences -- 1973 and 1978. Adverse supply shock -- large increase in the price of energy (PE), shifts AS curve leftward. As a result, Y* decreases and P* increases. Both represent problems in the economy.

Reacting to Adverse Supply Shocks -Lessons Learned: Don’t react -- standard policy will not help the situation. Calls for alternative strategy, such as energy policy. Or wait it out – inherent instability of cartels.