Chapter 18 Stabilization in an Integrated World Economy

Slide 18-2 Introduction When the Fed expressed concern about the threat of deflation, some observers interpreted this to mean that an expansionary monetary policy would be instituted and sustained. In what way is the expectation of a policy move an important economic variable?

Slide 18-3 Learning Objectives Explain why the actual unemployment rate might depart from the natural rate of unemployment Describe why economic theory implies that there may be an inverse relationship between the inflation rate and the unemployment rate, reflected by the Phillips curve

Slide 18-4 Learning Objectives Evaluate how expectations affect the relationship between the actual inflation rate and the unemployment rate Understand the rational expectations hypothesis and its implications for economic policymaking

Slide 18-5 Learning Objectives Identify the central features of the real business cycle challenge to active policymaking Distinguish among alternative modern approaches to strengthening the case for active policymaking

Slide 18-6 Chapter Outline Active Versus Passive Policymaking The Natural Rate of Unemployment Rational Expectations and the Policy Irrelevance Proposition Rational Expectations and the Policy Irrelevance Proposition

Slide 18-7 Real Business Cycles Modern Approaches to Rationalizing Active Policymaking Modern Approaches to Rationalizing Active Policymaking Active Versus Passive Policymaking Chapter Outline

Slide 18-8 Did You Know That... The magnitude of fluctuation in U.S. real GDP is lessening over time? There is no clear consensus on how fiscal and monetary policy have played a role in creating this stability?

Slide 18-9 Active Versus Passive Policymaking Active (Discretionary) Policymaking –All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy –Example Fiscal and monetary policy

Slide Active Versus Passive Policymaking Passive (Nondiscretionary) Policymaking –Policymaking that is carried out in response to a rule –Example Monetary rule Balancing the budget over the business cycle

Slide The Natural Rate of Unemployment Two components of the natural rate of unemployment –Frictional unemployment –Structural unemployment

Slide The Natural Rate of Unemployment Structural Unemployment –Unemployment resulting from: Union activity Government-imposed licensing arrangements Government-imposed wage laws Welfare and unemployment insurance A mismatch of worker training and skills with available jobs

Slide The Natural Rate of Unemployment Natural Rate of Unemployment –The rate of unemployment that is estimated to prevail in the long run –Every one in the economy has fully adjusted to any changes in the economy

Slide The Natural Rate of Unemployment Observations –The natural rate is the result of costly and imperfect information and rigidities –The natural rate is the long-run equilibrium rate of unemployment

Slide The U.S. Natural Rate of Unemployment Figure 18-1 Sources: Economic Report of the President; Economic Indicators, various issues.

Slide The Natural Rate of Unemployment What do you think? –How can we explain the increase in the natural rate of unemployment during the post-war years until the 1990s?

Slide The Natural Rate of Unemployment Departures from the natural rate of unemployment –Movements in the business cycle and cyclical unemployment

Slide LRAS Y1Y1 Impact of an Increase in Aggregate Demand on Output and Unemployment Real GDP per Year Price Level SRAS 1 AD 1 E1E1 P1P1 Figure 18-2

Slide Impact of an Increase in Aggregate Demand on Output and Unemployment Real GDP per Year Price Level AD 1 SRAS 2 SRAS 1 LRAS Y1Y1 AD 2 Monetary or fiscal policy shifts AD. The unemployment rate falls below the natural rate of unemployment Rising prices and resource prices shift SRAS 1 to SRAS 2 and the unemployment rate rises to the natural rate Figure 18-2 P1P1 E1E1 Y2Y2 P2P2 E2E2 P3P3 E3E3

Slide LRAS Y1Y1 Impact of a Decline in Aggregate Demand on Output and Unemployment Real GDP per Year Price Level AD 1 SRAS 1 P1P1 E1E1 Figure 18-3

Slide Impact of a Decline in Aggregate Demand on Output and Unemployment Real GDP per Year Price Level AD 1 SRAS 2 SRAS 1 LRAS Y1Y1 AD 2 SRAS 1 shifts to SRAS 2 at lower price level and the unemployment rate falls to the natural rate Monetary or fiscal policy shifts AD The unemployment rate rises above the natural rate of unemployment Figure 18-3 P1P1 E1E1 P2P2 Y2Y2 E2E2 P3P3 E3E3

Slide Example: Have Health Care Costs Changed the Natural Rate of Unemployment? Providing health insurance benefits for workers increases the costs an employer faces when adding another employee. This may account for a higher level of structural unemployment, especially because health care benefits represent an increasingly higher business expense.

Slide The Natural Rate of Unemployment The Phillips Curve –A curve showing the relationship between unemployment and changes in wages or prices –It was long thought to reflect a trade-off between unemployment and inflation

Slide The Natural Rate of Unemployment Observations –An unexpected increase in aggregate demand Causes the price level to rise and the unemployment rate to fall The greater the increase in AD the greater the rate of inflation and the lower the unemployment rate

Slide The Natural Rate of Unemployment Observations –An unexpected decrease in aggregate demand Causes the price level to fall and the unemployment rate to rise The greater the decrease in AD the greater the rate of deflation and the higher the unemployment rate

Slide The Phillips Curve Unemployment Rate Inflation Rate Figure 18-4

Slide The Phillips Curve Unemployment Rate Inflation Rate U* Higher inflation and lower unemployment Zero inflation and natural rate of unemployment, U* Deflation and higher unemployment B A C Figure 18-4

Slide The Phillips Curve Unemployment Rate Inflation Rate The Phillips curve implies a policy trade-off between inflation and unemployment Can policymakers fine-tune the economy? U* Figure 18-4

Slide The Natural Rate of Unemployment The Phillips curve: The trade-off? –Nonaccelerating Inflation Rate of Unemployment (NAIRU) The rate of unemployment below which the rate of inflation tends to rise and above which the rate of inflation tends to fall

Slide The Phillips Curve Unemployment Rate Inflation Rate Fed increases m S (one-time event to raise AD) PC 0 Increases in AD increase inflation and reduce unemployment The inflation and unemployment rate will return to A B U1U1 11 A U* Figure 18-5

Slide The Phillips Curve Unemployment Rate Inflation Rate A B U* U1U1 PC 0 To keep the economy at B the m S will have to continue to grow Economic participants will begin to assume the higher inflation rate is constant 11 Figure 18-5

Slide The Phillips Curve Unemployment Rate Inflation Rate As a result, the unemployment rate will increase to A and yield combination F 1 PC 0 PC 5 Figure 18-5 B U1U1 11 A U* F1F1 F2F2

Slide The Natural Rate of Unemployment The role of expected inflation –What are the long- and short-run macroeconomic implications of the shift from PC 0 to PC 5 ? –After the mid-1960s there was no apparent long-run or short-run trade-off.

Slide International Policy Example: Higher Inflation and Inflationary Expectations Research conducted by Federal Reserve Bank economists suggests that a slight increase in the annual inflation rate, sustained for three years, contributes to a higher expected inflation rate for as many as ten years into the future. These results were found to hold both in Japan and in Europe.

Slide The Phillips Curve: Theory Versus Data Figure 18-6 Sources: Economic Report of the President; Economic Indicators, various issues.

Slide Rational Expectations and the Policy Irrelevance Proposition Two key elements of rational expectations hypothesis –Individuals base their forecasts about the future values of economic variables on all available past and current information –These expectations incorporate individuals’ understanding about how the economy operates

Slide Rational Expectations and the Policy Irrelevance Proposition New Classical Model –A modern version of the classical model in which wages and prices are flexible –There is pure competition in all markets –The rational expectations hypothesis is assumed to be working

Slide Response to an Unanticipated Rise in Aggregate Demand Real GDP per Year Price Level AD 1 (M = M 1 ) SRAS 1 Y1Y1 LRAS AD 2 (M = M 2 ) Assume the m S increases unexpectedly to M 2 and AD increases to AD 2 Short-run equilibrium increases output to Y 2 with P 2 P1P1 A Y2Y2 B P2P2 Figure 18-7

Slide Response to an Unanticipated Rise in Aggregate Demand Y1Y1 Real GDP per Year Price Level AD 1 (M = M 1 ) SRAS 2 P1P1 A SRAS 1 P3P3 Y2Y2 B C P2P2 AD 2 (M = M 2 ) LRAS Assume the m S increases unexpectedly to M 2 and AD increases to AD 2 Short-run equilibrium increases output to Y 2 with P 2 Long-run equilibrium after adjustment yields Y 1 with P 3 Figure 18-7

Slide Rational Expectations and the Policy Irrelevance Proposition The response to anticipated policy –If the increase in the money supply was anticipated The higher price level would be anticipated Workers and suppliers would demand higher wages and prices immediately

Slide Effects of an Anticipated Rise in Aggregate Demand Real GDP per Year Price Level AD 1 (M = M 1 ) SRAS 1 (M e = M 1 ) Y1Y1 LRAS A P1P1 Figure 18-8

Slide Effects of an Anticipated Rise in Aggregate Demand Y1Y1 Real GDP per Year Price Level P1P1 A LRAS AD 1 (M = M 1 ) SRAS 1 (M e = M 1 ) AD 2 (M = M 2 ) SRAS 2 (M e = M 2 ) According to the rational expectations hypothesis the SRAS will shift simultaneously with the increase in AD Policy will have no impact on output Figure 18-8 P3P3 C B

Slide Rational Expectations and the Policy Irrelevance Proposition Policy Irrelevance Proposition –Under the assumption of rational expectations on the part of decision makers in the economy, anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP.

Slide Rational Expectations and the Policy Irrelevance Proposition Policy Irrelevance Proposition –Regardless of the nature of the anticipated policy, the unemployment rate will equal the natural rate, and real GDP will be determined by the economy’s long-run aggregate supply curve.

Slide Rational Expectations and the Policy Irrelevance Proposition What must people know? –The policy irrelevance proposition assumes only that people do not persistently make the same mistakes in forecasting the future.

Slide Effects of an Unanticipated Rise in Aggregate Demand Real GDP per Year Price Level AD 1 (M = M 1 ) SRAS 1 (M e = M 1 ) Y1Y1 P0P0 E0E0 Figure 18-9, Panel (a)

Slide Effects of an Anticipated Rise in Aggregate Demand Y1Y1 Real GDP per Year Price Level P0P0 AD 1 (M = M 1 ) SRAS 1 (M e = M 1 ) Policy will have no impact on output AD 2 (M = M 2 ) E0E0 According to rational expectations, an unanticipated change in AD can affect output in the short-run Figure 18-9, Panel (a) P1P1 Y2Y2 E1E1

Slide AD 1 (M = M 1 ) SRAS 1 (M e = M 1 ) Effects of an Unanticipated Rise in Aggregate Demand Real GDP per Year Price Level Y1Y1 LRAS AD 2 (M = M 2 ) E1E1 P1P1 P2P2 Y2Y2 E2E2 Figure 17-9, Panel (b)

Slide Effects of an Unanticipated Rise in Aggregate Demand Y1Y1 Real GDP per Year Price Level P1P1 P3P3 AD 1 (M = M 1 ) AD 2 (M = M 2 ) SRAS 2 (M e = M 2 ) SRAS 1 (M e = M 1 ) In the long run people will figure out the Fed’s actions and prices will increase and output will return to long-run equilibrium P2P2 Y2Y2 E1E1 E2E2 E3E3 Figure 17-9, Panel (b)

Slide Rational Expectations and the Policy Irrelevance Proposition The policy dilemma –Can only mistakes have “real” effects? –Fully anticipated changes in the money supply will lead to offsetting price changes, if rational expectations hold.

Slide Real Business Cycles Another Challenge to Policy Activism: Real Business Cycle An extension and modification of the theories of the new classical economists of the 1970s and 1980s, in which money is neutral and only real, supply-side factors matter in influencing labor employment and output

Slide AD SRAS 1 Effects of an Reduction in the Supply of Resources Real GDP per Year Price Level Y1Y1 LRAS 1 A reduction in the supply of a resource shifts the SRAS to the left The position of the LRAS depends upon resource endowments SRAS 2 E1E1 P1P1 E2E2 P2P2 Y2Y2 Figure 18-10

Slide Effects of an Reduction in the Supply of Resources Real GDP per Year Price Level P1P1 AD P2P2 Y2Y2 E1E1 E2E2 Y1Y1 LRAS 1 SRAS 1 A reduction in the supply of a resource shifts the SRAS to the left The position of the LRAS depends upon resource endowments SRAS 2 If the reduction in the resource is permanent, the LRAS will also shift Figure Y1Y1 LRAS 2 SRAS 3 P3P3 E3E3

Slide Real Business Cycle Theory Generalizing the theory –What impact would an oil shock have on aggregate demand? –Can we explain the Great Depression with the real business cycle theory? –The real business cycle approach cannot explain most of the apparent wage and price rigidity within the economy.

Slide Modern Approaches to Rationalizing Active Policymaking Small menu costs and sticky prices Efficiency wage theory The effect of aggregate demand changes on output and employment in the long run

Slide Example: Let’s Create Our Own Work As the U.S. economy began its recovery in 2002, many people who had been unemployed started their own businesses. If the economy is resilient and flexible, then people can find a means to generate an income, even if they are doing something a bit different from what they were doing before.

Slide Active vs. Passive Policymaking Most economists agree that active policymaking is unlikely to exert sizable long-run effects on any nation’s economy. Most also agree that aggregate supply shocks contribute to business cycles. There is a general consensus that monetary and fiscal policy measures are effective in the short run.

Slide Issues and Applications: What the Fed Says and What It Does When the Fed made an announcement in August 2003 that it would keep interest rates low for a considerable length of time, the intent was to generate a level of business and consumer confidence that would stimulate aggregate demand. By October, when the annual rate of economic growth was a surprisingly high 8 percent, the Fed faced a dilemma.

Slide Issues and Applications: What the Fed Says and What It Does If the Fed stuck to its promise, this would fuel inflationary expectations. If it allowed interest rates to rise, the unemployment rate would increase. After their next meeting, Fed officials announced that the decision as to whether to continue a pre-established policy would be determined by current circumstances, not by the passage of time.

Slide Summary Discussion of Learning Objectives Why the actual unemployment rate might depart from the national rate of unemployment –Unanticipated changes in aggregate demand Philips curve –A curve showing an inverse relationship between the rate of inflation and the rate of unemployment

Slide Summary Discussion of Learning Objectives How expectations affect the actual relationship between the inflation rate and the unemployment rate –The Phillips curve shifts Rational expectations –Policy irrelevance theorem –Only unanticipated policy actions affect short-run real GDP

Slide Summary Discussion of Learning Objectives Central features and predictions of real business cycle theory –Focus is on how shifts in aggregate supply can cause real GDP to vary over time Modern Approaches to Bolstering the Case for Active Policymaking –Emphasis on wage and price stickiness

End of Chapter 18 Stabilization in an Integrated World Economy