Chapter 36 Current Issues in Macro Theory and Policy McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Alternative perspectives on macroeconomic instability Equation of exchange and monetarism New classical economists and self-correction Rules vs. discretion in conducting stabilization policy 36-2

Causes of Macro Instability Mainstream view Held by most economists Price stickiness Unexpected demand shocks Variable investment spending Unexpected supply shocks 36-3

Causes of Macro Instability Monetarist view Government interference is the problem Equation of exchange MV = PQ Stable velocity Monetary causes of instability Inappropriate monetary policy 36-4

Causes of Macro Instability Real-business-cycle view Shifts in long-run aggregate supply ASLR2 ASLR1 Price Level P1 AD1 AD2 Q2 Q1 Real Domestic Output 36-5

Causes of Macro Instability Coordination failures Fourth modern view Limited information Expectations and self-fulfilling prophecy Unemployment equilibrium Inflation equilibrium 36-6

Self-Correction New classical view Automatic correction will occur Rational expectations theory Monetarists Automatic correction will occur Speed of adjustment Unanticipated price-level changes Fully anticipated price-level changes 36-7

Self-Correction New Classical View of Self-Correction Price Level ASLR AS2 AS1 P3 c Price Level P2 b P1 a AD2 AD1 Q1 Q2 Real Domestic Output 36-8

Self-Correction New Classical View of Self-Correction Price Level ASLR AS1 AS3 Price Level f P1 a P4 d P5 e AD1 AD3 Q4 Q3 Q1 Real Domestic Output 36-9

Self-Correction Mainstream view Downward wage inflexibility Efficiency wage theory Greater work effort Lower supervision costs Reduced job turnover Insider-outsider relationships 36-10

Rules or Discretion? In support of policy rules Reduce macro instability Monetary rule Shift AD to keep up with AS Price stability achieved Inflation targeting Balanced budget 36-11

Rationale for Monetary Rule ASLR1 ASLR2 Price Level P1 AD2 P2 AD1 Q1 Q2 Real Domestic Output, GDP 36-12

Rules or Discretion? In defense of discretionary stabilization policy Discretionary monetary policy Velocity is not stable Discretionary fiscal policy Useful during recession Increased macro stability 36-13

The Taylor Rule Rules: passive monetary policy Discretion: active monetary policy Hybrid policy rule to dictate Fed actions Policy responds to changes in real GDP and inflation Use the interest rate Fed explains deviations from the rule Increase Fed credibility and reduce uncertainty 36-14

Key Terms monetarism equation of exchange velocity real-business-cycle theory coordination failures rational expectations theory new classical economics Taylor rule price-level surprises efficiency wage insider-outsider theory monetary rule inflation targeting 36-15

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