Stabilization Policy Lecture 23 Dr. Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. April 23, 2018 1

Optional Problem Set Offer This problem is worth 50 MEL points if turned in on time (points will be added in May to our master Excel grade sheet, if you need it). Due: In class on Wednesday May 2 - Absolutely NO extensions or makeups or late submissions! Please do not even ask. An answer key will be posted after class on the 2nd. Here is the problem: Suppose the following equations for a macro model with no money market and no inflation: Consumption C = A + aYd  where Yd = disposable income Desired Investment Id = B + bY Government Expenditures G = D + dY Exports EX = E + eY Imports IM = F + fY Taxes T = H + hY Find the following: The equation for Y*. The multipliers for A, B, D, E, F, and H. The balanced budget multiplier. Why might one argue that the variable "d" is probably a negative number?

The Phelps/Friedman “Take” Two famous Nobel laureate economists: Ned Phelps (1967) – won in 2006 Milton Friedman (1968) – won in 1976 Their Twist: Traditional Phillips Curve is only a SR concept. In the LR the Phillips Curve is vertical at U*, the Natural Rate of Unemployment. Think of U* as being the level of unemployment at YFE/YPot Expectations play a key role. There are several SR Phillips Curves based on expectations about inflation.

Expectations & the Phillips Curve Expectations are self-fulfilling. Wage inflation is affected by expectations of future price inflation, since workers care about real wages! Price expectations that affect wage contracts eventually affect prices themselves. Changes in inflationary expectations shift the SR Phillips Curve. Expect higher inflation – shift right Expect lower inflation – shift left Note: Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s and into the 1980s.

The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment When output is pushed above potential GDP (Y0), there is upward pressure on costs. Rising costs shift the SR-AS curve to the left. The quantity supplied will end up back at Y0. If the LR-AS curve is vertical, so is the Long Run Phillips Curve.

NAIRU—The NonAccelerating Inflation Rate of Unemployment and U* actual inflation rate Long Run Phillips Curve (actual inflation = expected inflation) ↑G or ↑Ms or... 4% 2% 0% unemployment rate 3% 5% = U*=UFE SR-PC with expected inflation rate = 4% SR-PC with expected inflation rate = 2%

i>clicker question Suppose you loan me $1,000 today with the promise that I will pay you back $1,050 a year from now. Suppose you expect there to be no inflation between this year and next. The nominal interest rate you charged me is 5%. Suppose ex post it turns out there was 2% inflation over the year. Question: The real interest rate you earned on loaning me money is now A = more than 5% B = less than 5% C = still 5%

Next Up: Stabilization Policy & The Business Cycle Recall: An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise. Recall: A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall. Recall: A positive trend line indicates long run growth. MACRO QUESTIONS Can we smooth the cycle? Can we facilitate growth? Can we do both? 8

FIGURE 5.2 U.S. Aggregate Output (Real GDP), 1900–2014 The periods of the Great Depression and World Wars I and II show the largest fluctuations in aggregate output.

FIGURE 5.5 Unemployment Rate, 1970 I–2014 IV The U.S. unemployment rate since 1970 shows wide variations. The five recessionary reference periods show increases in the unemployment rate.

FIGURE 5.6 Inflation Rate (Percentage Change in the GDP Deflator, Four-Quarter Average), 1970 I–2014 IV Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV. Inflation between 1983 and 1992 was moderate. Since 1992, it has been fairly low.

FIGURE 14.1 The S&P 500 Stock Price Index, 1948 I–2014 IV

FIGURE 14.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2014 IV The S&P/Case-Shiller Home Price Indices are the leading measures of U.S. residential real estate prices, tracking changes in the value of residential real estate both nationally as well as in 20 metropolitan regions.

Consider Two Possible Time Paths for GDP or Y* i>clicker question Which path is more stable? Path A Path B

Stabilization Policy Stabilization Policy: attempts to employ both monetary and fiscal policy to smooth out fluctuations in output and employment and to keep prices as stable as possible. Business Cycle Policy Counter-the-Cycle Policy Countercyclical Policy Will it work? What’s Important? What depends on what...! various sensitivities  efficacy of policy lags political realities

Time Lags Regarding Monetary & Fiscal Policy The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump. The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. The implementation lag for monetary policy is generally much shorter than for fiscal policy. The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. E.g., The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

Stabilization Woe: “The Fool in the Shower” Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a “fool in the shower.” The government is constantly stimulating or contracting the economy at the wrong time.

“The Fool in the Shower” An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.

“The Fool in the Shower” Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). Income varies more widely than it would have if no policy had been implemented. If the government is the fool, can the Fed help control it?

The Typical Fed Response to the State of the Economy The Fed is likely to lower the interest rate (via an increase the money supply) during times of low output and low inflation. easy money This shifts AD to the right. When the economy is on the flat portion of the AS curve, an increase in the money supply will lead to an increase in output with very little increase in the price level.

The Typical Fed Response to the State of the Economy On the other hand… The Fed is likely to increase the interest rate (via a decrease the money supply) during times of high output and high inflation. tight money This shifts AD to the left. When the economy is on the relatively steep portion of the AS curve, contraction of the money supply will lead to a decrease in the price level, with little decrease in output. Famous/Funny quote by Harry S. Truman on what kind of economist he wants... “Give me a one-handed economist! All my economists say, On the one hand,... and on the other.”