16 Macro Policy Debate: Active or Passive? © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Does government intervention do more harm than good? Does the economy work fairly well on its own, or does it require active government intervention? Does government intervention do more harm than good? If people expect government to intervene when the economy falters, does this expectation affect people’s behavior? Does this expectation affect government behavior? Is there a relationship between unemployment and inflation in the short run and in the long run? © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Active Policy vs. Passive Policy Active approach Economy is relatively unstable Government intervention is necessary Discretionary fiscal or monetary policy Passive approach Economy is relatively stable Natural market forces work Automatic stabilizers are all that’s needed © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing a Recessionary Gap Passive approach Self-correcting forces of the economy Wages and prices are flexible enough High unemployment – decrease in wages and production costs Increase SRAS Potential output Automatic stabilizers No discretionary policy © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing a Recessionary Gap Active approach Prices and wages are not flexible Unemployment above natural rate Market forces may be too slow to respond Stimulate aggregate demand Fiscal policy Monetary policy Increase in price level © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing a Recessionary Gap Exhibit 1 Closing a Recessionary Gap (a) The passive approach (b) The active approach Potential output LRAS Potential output LRAS Price level 105 110 100 Price level 105 110 AD′ SRAS110 SRAS110 AD AD SRAS100 c a a b Real GDP 17.0 16.8 Real GDP 17.0 16.8 At point a in both panels, the economy is in short-run equilibrium, with unemployment exceeding its natural rate. According to the passive approach, shown in panel (a), high unemployment eventually causes wages to fall, reducing the cost of doing business. The decline in costs shifts the short-run aggregate supply curve rightward from SRAS110 to SRAS100, moving the economy to its potential output at point b. In panel (b), the government employs an active approach to shift the aggregate demand curve from AD to AD’. If the active policy works perfectly, the economy moves to its potential output at point c. © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing a Recessionary Gap Active response to the Great Recession Tried to revive a troubled economy President Barack Obama’s $831 billion stimulus plan Approved by Congress in February 2009 Aimed at counteracting the deep recession triggered by the financial crisis © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing a Recessionary Gap Active response to the Great Recession The most concentrated attempt to boost aggregate demand ever Possible costs of using discretionary policy to stimulate aggregate demand Inflation Increase the budget deficit, from $459 billion in 2008 to $1.4 trillion in 2009 The deficit exceeded $1 trillion in each of the next three years © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing an Expansionary Gap Passive approach Self-correcting forces Negotiate higher wages Higher production costs Decrease SRAS Potential output Higher price level Automatic stabilizers No discretionary policy © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing an Expansionary Gap Active approach Prices and wages are not flexible Decrease aggregate demand Fiscal policy Monetary policy Lower price level © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing an Expansionary Gap Exhibit 2 Closing an Expansionary Gap (a) The passive approach (b) The active approach Potential output LRAS Potential output LRAS Price level 115 120 110 AD″ Price level 115 110 AD″ SRAS120 AD′ SRAS110 SRAS110 e d d c c Real GDP 17.0 17.2 Real GDP 17.0 17.2 At point d in both panels, the economy is in short-run equilibrium, producing $17.2 trillion, which exceeds the economy’s potential output. Unemployment is below its natural rate. In the passive approach reflected in panel (a), the government makes no change in policy, so natural market forces eventually bring about a higher negotiated wage, increasing firm costs and shifting the short-run supply curve leftward to SRAS120. The new equilibrium at point e results in a higher price level and lower output and employment. An active policy reduces aggregate demand, shifting the equilibrium combination in panel (b) from point d to point c, thus closing the expansionary gap without increasing the price level. © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Closing an Expansionary Gap The correct discretionary policy Can relieve the inflationary pressure associated with an expansionary gap Fed: cool down an overheated economy By increasing its target interest rate In 17 steps between mid-2004 and mid-2006 Active monetary policy Soft-landing Gently slow the rate of growth before that growth triggered unacceptably high inflation © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Problems with Active Policy Timely adoption and implementation Identify potential output and natural rate of unemployment Forecast AD and AS, passive approach Tools needed to achieve results quickly Predict effects of active policy Coordination Implementation Timing lags © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Problem of Lags Recognition lag Decision-making lag Time needed to identify a macroeconomic problem and assess its seriousness Decision-making lag Time needed to decide what to do once a macroeconomic problem has been identified Implementation lag Time needed to introduce a change in monetary or fiscal policy Longer for fiscal policy © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Problem of Lags Effectiveness lag Lags obscure active policy Time needed for changes in monetary or fiscal policy to affect the economy Lags obscure active policy The more variable the lags, the harder it is to predict when a particular policy will take hold and what the state of the economy will be at that time © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

A Review of Policy Perspectives Active policy advocates See a high cost of not using discretionary policy Despite the lags involved, they prefer action Discretionary fiscal policy Discretionary monetary policy Some combination of the two © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

A Review of Policy Perspectives Passive policy advocates Believe that uncertain lags and ignorance about how the economy works undermine active policy Rather than pursue a misguided activist policy Sit back and rely on the economy’s natural ability to correct itself just using automatic stabilizers © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Presidential Politics 1990, recession, sluggish recovery Monetary policy only 1992, $300 billion deficit G. H. W. Bush vs. Clinton election Clinton – active approach Clinton claimed Bush had not done enough to revive the economy Clinton said Bush could not be trusted Because he broke the pledge of “no new taxes” © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Presidential Politics Clinton – active approach Clinton argued that Bush and Ronald Reagan were responsible for the sizable federal deficits Clinton wanted to raise tax rates on the rich and cut them for the middle class Clinton wanted to create jobs through government spending programs that would “invest in America” Advocated stronger role for government © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Presidential Politics Bush – passive approach Noted the economy was growing again Hard sell with unemployment averaging 7.6% during the six months leading up to the election Stronger role for the private sector Clinton won 1992 elections G.W. Bush took office in 2001 Fiscal policy of tax cuts Aggressive monetary policy of federal funds rate cuts © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Presidential Politics 2008 election, McCain vs. Obama Joint statement, September 2008, both support TARP McCain Favored extending all the Bush tax cuts Tax incentive to increase health coverage © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Presidential Politics Obama proposed more active policies Extend the Bush tax cuts only for those making less than $250,000 a year Proposed broad health insurance mandates with more government regulations Proposed creating millions of new jobs by investing in “green energy” programs © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Role of Expectations Rational expectations People form expectations based on all available information Including the likely future actions of government policy makers © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Role of Expectations Potential output, natural rate of unemployment Fed policy pronouncements Sustain potential output Stable price level Fed actions: unexpected expansionary policy Higher equilibrium output Higher price level © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Short-Run Effects of an Unexpected Expansionary Policy Exhibit 3 Short-Run Effects of an Unexpected Expansionary Policy Potential output LRAS At point a, workers and firms expect a price level of 110; supply curve SRAS110 reflects that expectation. But an unexpected expansionary policy shifts the aggregate demand curve out to AD’. Output in the short run (at point b) exceeds its potential. In the long run, costs increase, shifting the SRAS leftward until the economy produces its potential output at point c (the resulting supply curve is not shown). The short-run effect of an unexpected expansion is greater output, but the long-run effect is just a higher price level, or inflation. Price level 115 110 122 AD′ SRAS110 AD c b a Real GDP (trillions of dollars) 17.0 17.2 © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Role of Expectations Time-inconsistency problem When policy makers have an incentive to announce one policy To influence expectations But then pursue a different policy Once those expectations have been formed and acted on © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Anticipating Policy Potential output; High price level Fed policy pronouncements Sustain potential output and stable price level Firms – don’t trust Fed Expect higher price level Fed actions: expected expansionary policy Potential output Higher price level © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Short-Run Effects: a More Expansionary Policy Than Announced Exhibit 4 Short-Run Effects: a More Expansionary Policy Than Announced Price level 127 122 132 Potential output LRAS The Fed announces it plans to keep prices stable at 122. Workers and firms, however, expect monetary policy to be expansionary. The short-run aggregate supply curve, SRAS132, reflects their expectations. If the Fed follows the announced stable-price policy, short-run output at point d is less than the economy’s potential output of $17.0 trillion. To keep the economy at its potential, the Fed must stimulate aggregate demand as much as workers and firms expect (shown by point e), but this is inflationary. SRAS132 AD″ AD′ e d c Real GDP (trillions of dollars) 17.0 16.8 © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Anticipating Policy If the economy is already producing its potential A fully anticipated expansionary policy Has no effect on output or employment, not even in the short run. Only unanticipated expansionary policy Can temporarily push output beyond its potential © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Policy Credibility Economy: potential output Hyperinflation Unexpected expansionary policy Temporary increase output, employment Costs: inflation in the long term, loss of credibility Hyperinflation Anti-inflation policy: cold turkey Announce and execute tough measures to reduce high inflation © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Central Bank Independence and Price Stability Most independent central banks Germany, Switzerland Lowest inflation Least independent central bank Spain, New Zeeland, Australia, Italy Highest inflation (4 times higher) U.S. central bank Relatively independent © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Central Bank Independence and Price Stability U.S. inflation Double that of the most independent countries Half that of the least independent countries Trend worldwide Greater central bank independence European Central Bank Price stability Policy: not reducing the interest rate if inflation exceeds 2% © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Central Bank Independence and Price Stability Low inflation targets European Central Bank The Bank of England Swiss National Bank Many central banks U.S. Federal Reserve © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Policy Rules Versus Discretion Active approach Economy is unstable Needs discretionary policy to cut cyclical unemployment when it arises Passive approach Economy is stable enough Discretionary policy Unnecessary May worsen economic fluctuations © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Policy Rules Versus Discretion Passive approach Fiscal policy: automatic stabilizers Unemployment insurance Progressive income tax, Transfer payments Monetary policy Allow the money supply to grow at a predetermined rate Maintain interest rates at some predetermined level Keep inflation below a certain rate © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Policy Rules Versus Discretion Limitations on discretion Complex interactions among economic aggregates Lags Rules and rational expectations Fully anticipated monetary policy No effect on output Change price level © 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.