© 2005 Thomson C hapter 28 Can Government Really Stabilize the Economy?

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The classical school of employment and inflation The Keynesian school of employment and inflation The neo-Keynesian school of employment and inflation

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The rational expectations school of employment and inflation The supply-side school of employment and inflation

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Economic Principles Phillips curve analysis Automatic stabilizers

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e The Nature of Economic Advice Economists live in a world of limited information, and so their analysis leads to different and sometimes even highly conflicting conclusions and recommendations.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e The Classical School Classical economics The school of thought that emphasizes the natural tendency for an economy to move toward equilibrium at full employment without inflation. It argues against government intervention.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e The Classical School According to the classical school, unemployment is only a temporary phenomenon, caused by wage rates climbing above the equilibrium rate.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e The Classical School Persistently high unemployment, according to the classical school, occurs because labor unions and policy makers interfere with the competitive process, preventing wages from reaching equilibrium.

© 2005 Thomson 9 EXHIBIT 1CLASSICAL DETERMINATION OF UNEMPLOYMENT

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Exhibit 1: Classical Determination of Unemployment 1. What happens in Exhibit 1 if policy makers establish a $10 minimum wage? There will be an excess labor supply (unemployment) of 4,000 workers.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e Exhibit 1: Classical Determination of Unemployment The equilibrium wage rate is $6. 2. What is the equilibrium wage rate in Exhibit 1, and what is the level of unemployment at the equilibrium wage rate?

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e Exhibit 1: Classical Determination of Unemployment 2. What is the equilibrium wage rate in Exhibit 1, and what is the level of unemployment at the equilibrium wage rate? At the equilibrium wage rate of $6 the quantity of labor demanded equals the quantity of labor supplied.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e The Classical School Stabilization policy The use of countercyclical monetary and fiscal policy by the government and the Fed to stabilize the economy.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e The Classical School 1. What is the quantity theory of money equation? P = MV/Q

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e The Classical School 1. What is the quantity theory of money equation? P = MV/Q P is the price level, M is the money supply, V is money velocity, and Q is the quantity of goods and services produced.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e The Classical School 2. What is the relationship between the money supply M and the price level P in the quantity theory of money equation? If resources are fully employed and if money velocity V is constant, then the price level P depends on the quantity of money M.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e The Classical School If the growth rate of M equals the Q growth rate, then the price level remains unchanged. 3. How does the classical school use the quantity theory of money equation to find the money supply growth rate that is consistent with zero inflation?

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e The Classical School 3. How does the classical school use the quantity theory of money equation to find the money supply growth rate that is consistent with zero inflation? In this view, inflation occurs when the annual rate of growth in the money supply exceeds the annual rate of growth of full- employment real GDP.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e The Keynesian School Keynesian economics The school of thought that emphasizes the possibility that an economy can be in equilibrium at less than full employment (or with inflation). It argues that with government intervention, equilibrium at full employment without inflation can be achieved by managing aggregate demand.

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e The Keynesian School Keynesian economics rejects the classical economists’ basic premise concerning competitive markets and flexible prices.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e EXHIBIT 2KEYNESIAN VIEW OF DEMAND AND PRICES IN THE SWIMSUIT MARKET

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e Exhibit 2: Keynesian View of Demand and Prices in the Swimsuit Market How does the price of swimsuits change as demand decreases from D to D′? Price remains at $30 since the swimsuit supply curve is horizontal.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e EXHIBIT 3AAGGREGATE DEMAND, GDP, AND EMPLOYMENT

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e EXHIBIT 3BAGGREGATE DEMAND, GDP, AND EMPLOYMENT

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Exhibit 3: Aggregate Demand, GDP, and Employment Note that the AD-AS equilibrium in Exhibit 3 occurs at less than full employment. If aggregate demand does not change, unemployment is chronic.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Exhibit 3: Aggregate Demand, GDP, and Employment 1. Why is the Keynesian aggregate supply curve a horizontal line up to the full- employment level of real GDP? It reflects the Keynesian view that the price level does not rise as long as there is any unemployment.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Exhibit 3: Aggregate Demand, GDP, and Employment 2. If aggregate demand increases from AD′ to AD″ in panel a, what must occur in panel b? The aggregate expenditure curve must shift upwards from AE′ to AE″.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Exhibit 3: Aggregate Demand, GDP, and Employment 2. If aggregate demand increases from AD′ to AD″ in panel a, what must occur in panel b? The aggregate expenditure curve must shift upwards from AE′ to AE″. The vertical distance between AE′ and AE″ is the resulting inflationary gap.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e The Keynesian School If equilibrium occurs at less than the full-employment output level, Keynesians argue that fiscal policy stimulus should be used to increase aggregate demand.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e The Keynesian School Keynesian countercyclical policy calls for deficit-spending and expansionary monetary policy during recessions, and surplus budgets and contractionary monetary policy during times of prosperity.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e The Neo-Keynesian School Traditional Keynesian policy was ill-prepared for the combination of high unemployment rates and high inflation rates (“stagflation”) in the 1970s and early 1980s.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e The Neo-Keynesian School Phillips curve A graph showing the inverse relationship between the economy’s rate of unemployment and rate of inflation.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e EXHIBIT 4THE PHILLIPS CURVE

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Exhibit 4: The Phillips Curve Economist A.W. Phillips found an inverse relationship between inflation and unemployment after studying data for in Britain.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e The Neo-Keynesian School Neo-Keynesian economics The school of thought that emphasizes the possibility that an economy can be in equilibrium at less than full employment with inflation. It argues that by managing aggregate demand, government can achieve the most acceptable combination of unemployment and inflation.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e EXHIBIT 5THE NEO-KEYNESIAN AGGREGATE SUPPLY CURVE

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e Exhibit 5: The Neo-Keynesian Aggregate Supply Curve How does the Phillips curve relate to the neo-Keynesian aggregate supply curve? Development of the Phillips curve caused neo-Keynesians to modify the formerly flat portion of the aggregate supply curve at output levels below full employment.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Exhibit 5: The Neo-Keynesian Aggregate Supply Curve How does the Phillips curve relate to the neo-Keynesian aggregate supply curve? The Phillips curve reflects a new intermediate, upward-sloping segment of the Keynesian aggregate supply curve up to the full-employment output level.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e EXHIBIT 6THE PHILLIPS CURVE DURING THE 1960s

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Exhibit 6: The Phillips Curve During the 1960s Were the data from the 1960s consistent with the predicted shape of the Phillips curve? Yes. Data from the 1960s reveal the inverse relationship between inflation and unemployment rates.

© 2005 Thomson 41 The Neo-Keynesian School According to the neo-Keynesians, why does a fall in the rate of unemployment cause the rate of inflation to rise? During periods of rapid economic growth when unemployment rates are low, firms are more likely to accept workers’ demands for higher wages.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e The Neo-Keynesian School According to the neo-Keynesians, why does a fall in the rate of unemployment cause the rate of inflation to rise? That occurs because firms can more easily pass along higher costs to consumers in the form of higher prices during times of economic prosperity.

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e The Neo-Keynesian School Many economists attribute the stagflation of the 1970s and early 1980s to the OPEC oil price increases, which acted as adverse supply shocks.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e The Neo-Keynesian School The Humphrey-Hawkins Act of 1978 initially identified a 4 percent rate of unemployment and a 3 percent rate of inflation as acceptable and reasonable policy targets.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e EXHIBIT 7RATES OF INFLATION AND UNEMPLOYMENT: 1970–90

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Exhibit 7: Rates of Inflation and Unemployment: Were the data from consistent with the predicted shape of the Phillips curve? No. The scatter of points seem to bear no resemblance to the well-defined Phillips curve of the 1960s, as shown in Exhibit 6.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e EXHIBIT 8SHIFTING PHILLIPS CURVES

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Exhibit 8: Shifting Phillips Curves How did neo-Keynesians manage to make the data from consistent with the predicted shape of the Phillips curve? They argued that the data are consistent with a Phillips curve that shifts over time.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e EXHIBIT 9SHIFTING PHILLIPS CURVES

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Exhibit 9: Shifting Phillips Curves According to neo-Keynesian theory, why do Phillips curves shift over time? Expansionary policy that reduces unemployment and raises inflation (along a given Phillips curve) also raises costs and lowers profit, causing firms to cut production and employment.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Exhibit 9: Shifting Phillips Curves According to neo-Keynesian theory, why do Phillips curves shift over time? Therefore the unemployment rate increases at the new, higher rate of inflation, putting the economy on a new, higher Phillips curve.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e The Neo-Keynesian School In the long run the rate of unemployment remains unchanged in spite of government stabilization policy, but the dynamics of the economic activity that the government sets in motion generates accelerating rate of inflation.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e The Rational Expectations School Rational expectations The school of thought that emphasizes the impossibility of government reducing the economy’s rate of unemployment by managing aggregate demand.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e The Rational Expectations School Rational expectations economists believe that workers are not only rational but also smart enough to learn from experience how best to overcome the effects of the government’s fiscal policy.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e EXHIBIT 10RATIONAL EXPECTATIONS MODEL

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Exhibit 10: Rational Expectations Model According to rational expectations theory, why does the Phillips curve fail to hold? Workers correctly anticipate a higher rate of inflation from expansionary policy and demand higher wages.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Exhibit 10: Rational Expectations Model According to rational expectations theory, why does the Phillips curve fail to hold? These wage demands erase any short- term profit that firms would have made. As a result, the unemployment rate remains unchanged, but the rate of inflation increases.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e EXHIBIT 11U.S. RATES OF UNEMPLOYMENT AND INFLATION: 1992–99 Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000).

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e Supply-Side Economics Supply-side economics The school of thought that emphasizes the possibility of achieving full employment without inflation.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e Supply-Side Economics Supply-side economics It argues that through tax reductions, spending cuts, and deregulation, government creates the proper incentives for the private sector to increase aggregate supply.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e EXHIBIT 12THE LAFFER CURVE

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Exhibit 12: The Laffer Curve According to the Laffer curve, what happens to total tax revenue if relatively high tax rates are reduced? Reductions in high tax rates increase after-tax profit, which induces suppliers to increase aggregate supply, and workers to work longer.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Exhibit 12: The Laffer Curve According to the Laffer curve, what happens to total tax revenue if relatively high tax rates are reduced? The increase in real GDP is proportionately larger than the decline in the tax rate.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Exhibit 12: The Laffer Curve According to the Laffer curve, what happens to total tax revenue if relatively high tax rates are reduced? Consequently, total tax revenues increase when relatively high tax rates are reduced, because the high tax rates stifle incentive.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e Supply-Side Economics To supply-siders, the myriad of government regulations affects almost every industry in the economy, reducing productivity and undermining industrial efficiency.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e Supply-Side Economics Crowding out A fall in private investment spending caused by an increase in government spending.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e EXHIBIT 13SUPPLY-SIDE EFFECTS ON UNEMPLOYMENT AND INFLATION

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e Exhibit 13: Supply-Side Effects on Unemployment and Inflation According to supply-side economists, what causes aggregate supply to increase in Exhibit 13? If government reduces its spending, more investment capital would be made available at lower rates of interest to private sector suppliers.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e Exhibit 13: Supply-Side Effects on Unemployment and Inflation According to supply-side economists, what causes aggregate supply to increase in Exhibit 13? Combined with lower tax rates and less government regulation, lower government spending shifts the AS curve outward, reducing prices and increasing output.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Is There a Consensus? Real-world events of the 1970s, 1980s, and 1990s have brought macroeconomists together.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Automatic Stabilizers Automatic stabilizers Structures in the economy that tend to add to aggregate demand when the economy is in recession, and subtract from aggregate demand when the economy is inflationary.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Automatic Stabilizers Automatic stabilizers Unemployment insurance payments and benefits and the progressive income tax are two such automatic stabilizers.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e Automatic Stabilizers How does our personal income tax structure work to automatically stabilize the macroeconomy? Because the personal income tax is progressive, as incomes grow, tax revenues grow even faster, which reduces disposable income and thus consumption spending.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e Automatic Stabilizers How does our personal income tax structure work to automatically stabilize the macroeconomy? During a recession incomes fall, and income tax revenues fall even faster, which reduces the decline in disposable income and thus in consumption spending.