1 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano w/Shelly Tefft CASE  FAIR  OSTER PRINCIPLES OF ECONOMICS E L E V E N T H E D I T I O N PEARSON

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3 of 23 © 2014 Pearson Education, Inc. CHAPTER OUTLINE 28 Cost Shocks in the AD/AS Model Fiscal Policy Effects Fiscal Policy Effects in the Long Run Monetary Policy Effects The Fed’s Response to the Z Factors Shape of the AD Curve When the Fed Cares More about the Price Level than Output What Happens When There is a Zero Interest Rate Bound? Shocks to the System Cost Shocks Demand-Side Shocks Expectations Monetary Policy since 1970 Inflation Targeting Looking Ahead

4 of 23 © 2014 Pearson Education, Inc. The level of net taxes, T (taxes minus transfer payments) is an important fiscal policy variable along with government spending. The political debate in 2012 was more about taxes and transfers than about government spending. Earlier, we learned that the tax multiplier is smaller in absolute value than is the government spending multiplier. The main point for this chapter is that both a decrease in net taxes and an increase in government spending increase output (Y). Both result in a shift of the AD curve to the right. Fiscal Policy Effects

5 of 23 © 2014 Pearson Education, Inc.  FIGURE 28.1 A Shift of the AD Curve When the Economy is on the Nearly Flat Part of the AS Curve This is the case in which an expansionary fiscal policy works well. There is an increase in output with little increase in the price level. When the economy is producing on the nearly flat portion of the AS curve, firms are producing well below capacity, and they will respond to an increase in demand by increasing output much more than they increase prices.

6 of 23 © 2014 Pearson Education, Inc. Here, an expansionary fiscal policy does not work well. The output multiplier is close to zero. Output is initially close to capacity, and attempts to increase it further mostly lead to a higher price level. With a higher price level, the Fed increases the interest rate (r), and in this case, there is almost complete crowding out of planned investment.  FIGURE 28.2 A Shift of the AD Curve When the Economy is Operating at or Near Capacity

7 of 23 © 2014 Pearson Education, Inc. If the shift in the AD curve in Figure 28.2 is caused by a decrease in net taxes, it is consumption, not government spending that causes the crowding out of investment. When the economy is on the flat part of the AS curve, as in Figure 28.1, there is very little crowding out of planned investment. Output expands to meet the increased demand. Because the price level increases very little, the Fed does not raise the interest rate much, and so there is little change in planned investment.

8 of 23 © 2014 Pearson Education, Inc. Fiscal Policy Effects in the Long Run If wages adjust fully to match higher prices, then the long-run AS curve is vertical. In this case it is easy to see that fiscal policy will have no effect on output. The key question, much debated in macroeconomics, is how fast wages adjust to changes in prices. If wages are slower to adjust, the AS curve might retain some upward slope for a long period and one would be more confident about the usefulness of fiscal policy. While most economists believe that wages are slow to adjust in the short run and therefore that fiscal policy has potential effects in the short run, there is less consensus about the shape of the long-run AS curve. New classical economists believe, for example, that wage rate changes do not lag behind price changes. The new classical view is consistent with the existence of a vertical AS curve, even in the short run. At the other end of the spectrum is what is sometimes called the simple “Keynesian” view of aggregate supply. Those who hold this view believe there is a kink in the AS curve at capacity output

9 of 23 © 2014 Pearson Education, Inc. Monetary Policy Effects The Fed’s Response to the Z Factors The interest rate value that the Fed chooses (r) depends on output (Y), the price level (P), and other factors (Z). Z is outside of the AS/AD model (that is, exogenous to the model). An increase in Z, like an increase in consumer confidence, shifts the AD curve to the left. Remember that an increase in Z is a tightening of monetary policy in that the interest rate is set higher than what Y and P alone would call for. Similarly, a decrease in Z shifts the AD curve to the right. This is an easing of monetary policy. Monetary policy in the form of changes in Z has the same issues as does fiscal policy in the form of changes in G and T.

10 of 23 © 2014 Pearson Education, Inc. A zero interest rate poses challenges for a Fed that wants to further stimulate the economy. In his December 2012 remarks to Congress, Ben Bernanke mentioned two alternative policies the Fed was pursuing to stimulate the economy. First, the Fed was purchasing long-term government securities with the aim of driving down long-term interest rates (which, unlike short-term interest rates, were not zero). Second, the Fed was engaging in what Bernanke called “forward guidance.” Not only does the Fed now say at regular intervals what its current interest-rate policy is, but it gives guidance as to what it will do in the future. For example, the Fed indicated that interest rates would stay close to zero as long as the unemployment rate was over 6.5 percent and inflation was less than 2.5 percent. E C O N O M I C S I N P R A C T I C E Alternative Tools for the Federal Reserve THINKING PRACTICALLY 1.Does the Fed’s choice of 6.5 percent for the unemployment rate in its statement suggest that it thinks that the full employment unemployment rate is 6.5 percent?

11 of 23 © 2014 Pearson Education, Inc. Shape of the AD Curve When the Fed Cares More About the Price Level than Output Aggregate Supply Curve In the equation representing the Fed rule, we used a weight of α for output and a weight of β for the price level. If α is small relative to β, this means that the Fed has a strong preference for stable prices relative to output. In this case, when the Fed sees a price increase, it responds with a large increase in the interest rate. The AD curve is relatively flat, as the Fed is willing to accept large changes in Y to keep P stable.  FIGURE 28.3 The Shape of the AD Curve When the Fed Has a Strong Preference for Price Stability Relative to Output

12 of 23 © 2014 Pearson Education, Inc. What Happens When There is a Zero Interest Rate Bound? Suppose the conditions of the economy in terms of output, the price level, and the Z factors are such that the Fed wants a negative interest rate. In this case, the best that the Fed can do is to choose zero for the value of r.  FIGURE 28.3 The Shape of the AD Curve When the Fed Has a Strong Preference for Price Stability Relative to Output zero interest rate bound The interest rate cannot go below zero.

13 of 23 © 2014 Pearson Education, Inc. Suppose the conditions of the economy in terms of output, the price level, and the Z factors are such that the Fed wants a negative interest rate. In this case, the best that the Fed can do is to choose zero for the value of r. zero interest rate bound The interest rate cannot go below zero. binding situation State of the economy in which the Fed rule calls for a negative interest rate.  FIGURE 28.4 Equilibrium In the Goods Market When the Interest Rate is Zero. In a binding situation changes in P and Z do not shift the r = 0 line.

14 of 23 © 2014 Pearson Education, Inc.  FIGURE 28.5 The AD Curve in a Binding Situation. In a binding situation the interest rate is always zero. In a binding situation the AD curve is vertical. In order for the AD curve to have a slope, the interest rate must change when the price level changes, which does not happen in the binding situation. Note also that changes in Z do not shift the AD curve in a binding situation. You should note that changes in government spending (G) and net taxes (T) still shift the AD curve even if it is vertical. In fact, since there is no crowding out of planned investment or consumption when G increases or T decreases because the interest rate does not increase, the shift is even greater. With a vertical AD curve, fiscal policy can be used to increase output, but monetary policy cannot.

15 of 23 © 2014 Pearson Education, Inc. Costs to the System Cost Shocks The shift of the AS curve to the left leads to lower output and a higher price level. The increase in P leads the Fed to raise the interest rate, which lowers planned investment and thus output. The extent of the changes in output and the price level depend on the shape of the AD curve. cost-push, or supply-side, inflation Inflation caused by an increase in costs. stagflation Occurs when output is falling at the same time that prices are rising.  FIGURE 28.6 A Negative Cost Shock

16 of 23 © 2014 Pearson Education, Inc. In 2012, the Indian monsoons came with less rain than normal. For the rice crop, this was a large and adverse shock. The result for India, which is a large consumer of rice, was a substantial increase in the price of rice. For a country like the United States, a rise in rice prices would likely have little effect on overall prices. There are many substitutes for rice in the United States and rice plays a small role in the average household budget. For India, the weather shock on rice threatened to increase the overall inflation rate, which at 10 percent was already high by U.S. standards, and the Indian government struggled to try to manage this (supply) shock. E C O N O M I C S I N P R A C T I C E A Bad Monsoon Season Fuels Indian Inflation THINKING PRACTICALLY 1.What two features of the Indian economy meant that an increase in rice prices was likely to spread through the economy and influence the overall inflation rate?

17 of 23 © 2014 Pearson Education, Inc. Demand-Side Shocks When macroeconomics was just beginning, John Maynard Keynes introduced the idea of “animal spirits” of investors. Keynes’ animal spirits were his way of describing a kind of optimism about the economy that helped propel it forward. Within the present context, an improvement in animal spirits—for example, a rise in consumer confidence—can be thought of as a “demand-side shock.” Instead of being triggered by a fiscal or monetary policy change, the demand increase is triggered by something outside of the model. Any price increase that results from a demand-side shock is also considered demand-pull inflation. demand-pull inflation Inflation that is initiated by an increase in aggregate demand.

18 of 23 © 2014 Pearson Education, Inc. Expectations Animal spirits can be considered expectations of the future. They are hard to predict or to quantify. However formed, firms’ expectations of future prices may affect their current price decisions. An increase in future price expectations may shift the AS curve to the left and thus act like a cost shock. Expectations can get “built into the system.” If every firm expects every other firm to raise prices by 10 percent, every firm will raise prices by about 10 percent. Every firm ends up with the price increase it expected. If prices have been rising and if people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—firms may continue raising prices even if demand is slowing or contracting. Given the importance of expectations in inflation, the central banks of many countries survey consumers about their expectations.

19 of 23 © 2014 Pearson Education, Inc. Remember by monetary policy we mean the interest rate behavior of the Fed. Stagflation is particularly bad news for policy makers. No matter what the Fed does, it will result in a worsening of either output or inflation. Should the Fed raise the interest rate to lessen inflation at a cost of making the output situation worse, or should it lower the interest rate to help output growth at a cost of making inflation worse? In the 1979–1983 period, the Fed generally raised the interest rate when inflation was high—even when output was low. Had the Fed not had such high interest rates in this period, the recession would likely have been less severe, but inflation would have been even worse. Paul Volcker, Fed chair at that time, was both hailed as an inflation-fighting hero and pilloried for what was labeled the “Volcker recession.” The Fed acted aggressively in lowering the interest rate during the 1990–1991 recession and again in the 2001 recession. Near the end of 2007, the Fed began lowering the interest rate in an effort to fight a recession that it expected was coming. The recession did come, and the Fed lowered the interest rate to near zero beginning in 2008 IV. The period 2008 IV–2012 IV is a “binding situation” period. Since the end of 2008, there has been a zero interest rate bound. Monetary Policy since 1970

20 of 23 © 2014 Pearson Education, Inc. The Fed generally had high interest rates in the two inflationary periods and low interest rates from the mid 1980s on. It aggressively lowered interest rates in the 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II recessions. Output is the percentage deviation of real GDP from its trend. Inflation is the 4- quarter average of the percentage change in the GDP deflator. The interest rate is the 3-month Treasury bill rate.  FIGURE Output, Inflation, and the Interest Rate 1970 I–2012 IV

21 of 23 © 2014 Pearson Education, Inc. Inflation Targeting inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. If a monetary authority behaves this way, it announces a target value of the inflation rate. There has been much debate about whether inflation targeting is a good idea. It can lower fluctuations in inflation, but possibly at a cost of larger fluctuations in output. When Ben Bernanke was appointed chair of the Fed in 2006, some wondered whether the Fed would move in the direction of inflation targeting. Bernanke had argued in the past in favor of inflation targeting. There is, however, no evidence that the Fed has done this. But the Fed began lowering the interest rate in 2007 in anticipation of a recession, which doesn’t look like inflation targeting. Also, as noted earlier in this chapter, the Fed is prevented by law from doing so.

22 of 23 © 2014 Pearson Education, Inc. Looking Ahead We have so far said little about employment, unemployment, and the functioning of the labor market in the macroeconomy. The next chapter will link everything we have done so far to this third major market arena—the labor market—and to the problem of unemployment.

23 of 23 © 2014 Pearson Education, Inc. binding situation cost-push, or supply-side inflation demand-pull inflation inflation targeting stagflation zero interest bound R E V I E W T E R M S A N D C O N C E P T S