Economic Policy -- Background and Challenges 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 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 ).

Economic Policy in More Formal Terms zPurpose -- 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, economy needs policy (interventionist position). zLong-Run Perspective (equilibrium in AD-LAS model): Y* = Y F economy can cure itself, no need for policy (non- interventionist position).

Movement to the Long-Run: Graphical Description zConsider the Labor Market -- the demand and supply for labor employment. zDemand for Labor (N D ) -- firms desire to hire workers based upon the wage rate and other causes. W   N D 

zSupply of Labor (N S ) – peoples desire to offer their labor services based upon the wage rate and other causes. W   N S  zLabor Market Equilibrium (N*) -- where labor demand equals labor supply. At N*, there is no demand- deficient unemployment.

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

Why Do We Call For Policy? The Relevant Short-Run zKeynes famous quote – “In the Long-Run, We’re All Dead”. zThe Great Depression and the Employment Act of zThe 1992 election -- 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 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 zUS Experience 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. zPressure for expansionary policy to “fix economy”.

zExpansionary policy shifts AD curve rightward, creates further inflation, arousing inflation fears as well. zLabor seeks higher above-normal increases in the nominal wage rate (W) to protect themselves, shifting the AS curve leftward. zThe wage-price spiral again.

Reacting to Adverse Supply Shocks -- Lessons Learned. zDon’t react -- standard demand policy will not help the situation. zCalls for alternative strategy -- energy policy.

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