Chapter Economic Policy zThis chapter -- looks at Economic Policy, overt intervention taken to improve a economy currently operating with problems. zEconomic Policy -- “medicine” given to cure a “sick” economy. zEmphasizes Fluctuations Strategy, Get Y* closer to a given Y F.

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

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

Types of Economic Policy zMonetary Policy -- The Federal Reserve changing the supply of financial capital to promote investment (and possibly durable goods consumption). zFiscal Policy – The Federal Government changing the government budget position (G-T). zTrade Policy -- Trying to managing the economy though changing exports (X) and imports (M).

The Intent and Method of Economic Policy zIntent -- to move Y* closer to Y F. zExpansionary Policy (policy for Y* < Y F ), seeks to increase spending on goods and services, or shift the AD curve rightward. zContractionary Policy (policy for Y* > Y F ), seeks to decrease spending on goods and services, or shift the AD curve leftward.

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? zShort-Run Perspective (equilibrium in AD-AS model): Y* does not necessarily equal Y F due to market failure in the labor market. Therefore, the economy needs policy (interventionist position). zLong-Run Perspective (equilibrium in AD-LAS model): Y* = Y F because the “nice assumptions” are satisfied and the economy is at GCE. Therefore, it can cure itself and there is no need for policy (non-interventionist position).

The Long-Run: A Graphical Description zLet’s return to the Labor Market -- the demand and supply for labor employment. zIn this case, let’s consider the Aggregate Labor Market, or the total demand and supply for labor.

Labor Market Equilibrium and the Economy zLabor Market Equilibrium (N*) -- where labor demand equals labor supply across the economy. zAt N*, there is no demand- deficient unemployment. zSo at N*, Y* = Y F and u = u N.

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

The Economy Curing Itself in the The Long-Run zExample 2 -- accelerating inflation (Y > Y F ), and correspondingly, having u < u N. zProblem -- wage rate (W) is too low. zSolution -- allow W to increase, until N = N*. When that occurs, simultaneously Y* = Y F.

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

The Economy in the The Short-Run (Market Failure) zExample 2 – overstimulated, accelerating inflation economy (Y* > Y F ). zProblem -- W is too low. zKey -- W does not increase due to market failure (e.g. labor contracts). zTherefore, Y* stays greater than Y F. Problem persists without overt policy.

Why Do We Call For Policy? The Relevant Short-Run zJohn Maynard Keynes’ famous quote. zThe Great Depression and the Employment Act of zThe 1992 election -- (George H.W.) Bush versus Clinton. zPolicy successes -- Volcker (1980s) and Greenspan ( ).

Challenge #2 -- Avoiding the Wage-Price Spiral zUS -- Late 1960s-Early 1970s. zExcessive demand policy -- shifts the AD curve rightward too far, Y* > Y F, accelerates inflation, increases inflation expectations. zLabor seeks above-normal increases in nominal wage rates (W) to protect themselves, AS curve shifts leftward.

The Wage-Price Spiral, Continued zAs a result, Y* returns to previous level, call for further expansionary policy. zProcess keeps repeating itself.

Avoiding the Wage-Price Spiral zUse expansionary policy judiciously. Be careful of overshooting where Y* exceeds Y F, don’t arouse inflation fears. zBe watchful for nominal wage rate increases when deciding to use policy. Refrain from expansionary policy if nominal wage increases are larger than normal.

Challenge #3 -- Reacting to Adverse Supply Shocks zMost dramatic US Experiences and zAdverse supply shock -- large increase in the price of energy (P E ), shifts AS curve leftward. zAs a result, Y* decreases and P* increases. zBoth represent problems in the economy.

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

Examining the Different Types of Economic Policy zMonetary Policy-- Chapter 16. zFiscal Policy-- Chapter 17. zTrade Policy-- Chapter 18.