1 © ©1999 South-Western College Publishing PowerPoint Slides prepared by Ken Long Principles of Economics by Fred M Gottheil

2 Chapter 28 Can Government Really Stabilize the Economy? 9/15/2015 © ©1999 South-Western College Publishing

3 What are the basic Schools of Economic Thought? Classical Keynesian Monetarism Rational Expectations © ©1999 South-Western College Publishing Supply-side neo-Keynesian

4 Classical theory Saw the economy as self-correcting Felt that a lack of aggregate demand was unlikely If aggregate demand fell, adjustments in prices, wages, and interest rates would occur to return the economy to full employment

5 What is the main conclusion of Classical Economics? Because the economy is always tending toward a full employment equilibrium, there is no need for government intervention

6 What are the two propositions of Classical Economics? 1. All markets are basically competitive 2. All prices are flexible

7 Another important element of classical theory…. Say’s Law, Supply creates its own demand Supplying output creates the income needed to demand the output Thus seen as unlikely for the economy to suffer a “glut” of unsold goods

8 What about savings in classical theory? Leads to the classical theory of savings and investment, belief that all savings will get invested in the economy

9 Classical theory of savings and investment Savings--higher interest rates encourage more savings Investment, lower interest rates encourage business investment

10 Investment demand Supply of savings Classical model of savings and investment 10 Interest Rates Savings and Investment i1i1 S = I

11 Investment demand Supply of savings, S 1 Classical model of savings and investment 11 Interest Rates Savings and Investment i1i1 i2i2 Q1Q1 Q2Q2 Note that S=I at Q 1 and Q 2 S2S2

12 How do the Classical Economists explain unemployment? Unemployment is a temporary situation caused by wage rates that are above the equilibrium level © ©1999 South-Western College Publishing

13 What about the long-run? Wage rates will adjust, bringing about full employment in the long-run © ©1999 South-Western College Publishing

14 D1 S1 W1 Q1 D2 W2 Q2 Real Wage and Employment 14 © ©1999 South-Western College Publishing

15 According to the Classical Economists, why might unemployment be persistent? People interfere with the competitive process © ©1999 South-Western College Publishing

16 How do people interfere with the competitive process? Unions Minimum wage laws © ©1999 South-Western College Publishing

17 According to the Classical Economists, what should the government do during periods of unemployment? NOTHING © ©1999 South-Western College Publishing

18 How do the Classical Economists explain inflation? © ©1999 South-Western College Publishing

19 19 © ©1999 South-Western College Publishing P = MV Q Prices Money Velocity GDP

20 Who controls the level of money and therefore the price level? The Federal Reserve © ©1999 South-Western College Publishing

21 How much should the Fed increase the money supply? Approximately equal to the long-run full employment rate of growth, about 3% © ©1999 South-Western College Publishing

22 What is Keynesian Economics? Government intervention when the economy is in a less than full employment equilibrium © ©1999 South-Western College Publishing

23 According to the Keynesians, why do we have unemployment? Unemployment is the result of insufficient aggregate demand © ©1999 South-Western College Publishing

24 What is the solution to Unemployment? Use government’s fiscal policies to increase aggregate demand © ©1999 South-Western College Publishing

25 Where does the money come from to increase aggregate demand? The government practices deficit spending © ©1999 South-Western College Publishing

What is a Contractionary Gap? The difference in real GDP between a less than full employment equilibrium and the real GDP at the full employment equilibrium © ©1999 South-Western College Publishing

Contractionary Gap Real GDP C+I+G+(X-M) less than full employment C+I+G+(X-M)’ Planned Spending full employment © ©1999 South-Western College Publishing

28 What is the Employment Act of 1946? Congress officially declares that it is the continuing policy and responsibility of the federal government to take an active role in the economy © ©1999 South-Western College Publishing

29 How do the Keynesians view inflation? They are not worried about inflation © ©1999 South-Western College Publishing

30 Highly simplified AS curve in Keynesian theory The backward L supply curve, no concern about inflation until full employment achieved

31 “Naive” AS Curve AS AD1 AD2 AD3 AD4 P GDP 31 AD5 Full Employment QfQf

32 For what were the Keynesians ill prepared ? The stagflation of the 1970’s, when we had high rates of both unemployment and inflation © ©1999 South-Western College Publishing

33 Modified AS Curve AS AD1 AD2 AD3 AD4 AD5 P GDP 33 AD6 Full Employment

34 What is neo-Keynesian Economics? The neo-Keynesians emphasized the possibility that an economy can be in equilibrium at less than full employment with inflation © ©1999 South-Western College Publishing

35 What discovery supported the view of less than full employment equilibrium and inflation? The Phillips Curve © ©1999 South-Western College Publishing

36 What is the Phillips Curve? A graph showing the inverse relationship between the economy’s rate of unemployment and the rate of inflation © ©1999 South-Western College Publishing

37 37 © ©1999 South-Western College Publishing Rate of Inflation Rate of Unemployment The Phillips Curve

Explaining the Phillips Curve -Rightward Shift in AD- Price level and output rise Employment increases Unemployment decreases Price level and unemployment move in opposite directions.

Explaining the Phillips Curve -Leftward Shift in AD- Price level and output fall Employment decreases Unemployment increases Price level and unemployment move in opposite directions.

Unemployment Inflation The Phillips Curve: U.S. Experience

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42 What happened to the Phillips curve in the 1970’s? It appeared to shift outward, due to the supply side inflation and stagflation of the 70’s

43 Explaining the outward shifts in the Phillips Curve Supply shocks of the 1970’s, leftward shifts in AS lead to higher inflation and unemployment both Thus a worsened trade-off between inflation and unemployment

44 What is Supply-side Inflation? Prices rise because of an increase in costs © ©1999 South-Western College Publishing

45 How did we break the back of Stagflation? In 1980, the Fed decreased the money supply and held it down until prices came down © ©1999 South-Western College Publishing

46 What was the result of this Fed action in 1980? A very severe recession © ©1999 South-Western College Publishing

47 What was the long-run gain from this policy? The back of inflation was broken making it possible to concentrate on stimulating employment © ©1999 South-Western College Publishing

48 How do the neo- Keynesians explain the 1970’s Phillips Curve Instead of one Phillips curve, there was a set of Phillips curves © ©1999 South-Western College Publishing

49 49 © ©1999 South-Western College Publishing Rate of Inflation Rate of Unemployment The 1970’s Phillips Curve

50 Another view of the Phillips curve is…Natural Rate Theory Recall the natural rate of unemployment, the sum of frictional and structural

51 According to natural rate theory, the unemployment rate tends to move, in the long run, back to its natural level

52 By this view, there is no permanent trade off between unemployment and inflation

53 What does the long-run Phillips curve look like according to natural rate theory? It is effectively vertical

54 What is the Rational Expectations School? Government’s policy of managing aggregate demand is undermined because of people’s anticipation of consequences © ©1999 South-Western College Publishing

55 Begin with different views of how people form expectations Adaptive expectations--base expectations of the future path of a variable on the past performance of the variable, with the most recent past having the greatest weight Rational expectations--people should be smarter than this, should use all information available to them in forming expectations

56 What is an example of the negative effect of anticipation? When workers anticipate an increase in aggregate demand, they will bargain for higher wages to protect them from inflation © ©1999 South-Western College Publishing

57 Conclusion of Rational Expectations Policies only affect the economy if they are a “surprise” If a policy is announced and people correctly anticipate the policy, then it has no effects. Still a controversial theory, not generally accepted in its entirety

58 What is Supply-side Economics? Through tax deductions, spending cuts, and deregulation, government creates incentives to increase aggregate supply © ©1999 South-Western College Publishing

59 S1 S2 P1 Right Shift in Supply P2 Q2 Q1 D 5959 © ©1999 South-Western College Publishing

60 What is the Laffer Curve? Increasing tax rates from zero increases tax revenues up to a point - beyond that point increases will shrink the economic pie because of disincentives © ©1999 South-Western College Publishing

The Laffer Curve Tax Rates (%) Tax Revenues (dollars) T* T* is the revenue maximizing tax rate

62 What is Crowding Out? A fall in private investment spending caused by an increase in government spending © ©1999 South-Western College Publishing

63 How can government borrowing cause Crowding Out? Interest rates can be driven up, leaving less money available for private investment © ©1999 South-Western College Publishing

64 Upon what do economists generally agree? Automatic stabilizers © ©1999 South-Western College Publishing

65 What are Automatic Stabilizers? Structures in the economy that tend to add to aggregate demand when the economy is in a recession, and subtract during inflation © ©1999 South-Western College Publishing

66 What are some examples of Automatic Stabilizers? Unemployment benefits The progressive income tax © ©1999 South-Western College Publishing

67 67 © ©1999 South-Western College Publishing h15/data/m/prime.txt

68 What are the basic Schools of Economic Thought?What are the basic Schools of Economic Thought? What is Classical Economics? What is Keynesian Economics? According to the Keynesians, why do we have unemployment?According to the Keynesians, why do we have unemployment? What is the Employment Act of 1946? What is neo-Keynesian Economics? What is the Phillips Curve?

69 What is Demand-side Inflation? What is Supply-side Inflation? What is the Rational Expectations School?What is the Rational Expectations School? What is Supply-side Economics? What is the Laffer Curve? What is Crowding Out? Upon what do economists agree? What are some examples of Automatic Stabilizers?What are some examples of Automatic Stabilizers?

70 ENDEND © ©1999 South-Western College Publishing