Chapter 28 CAN GOVERNMENT REALLY STABILIZE THE ECONOMY? Gottheil — Principles of Economics, 6e © 2010 Cengage Learning 1

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 2 The classical school of employment and inflation The Keynesian school of employment and inflation The neo-Keynesian school of employment and inflation

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 3 The rational expectations school of employment and inflation The supply-side school of employment and inflation

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 4 Phillips curve analysis Automatic stabilizers

The Nature of Economic Advice © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 5 Economists live in a world of limited information, and so their analysis leads to different and sometimes even highly conflicting conclusions and recommendations.

Why Does the Economy Generate Inflation and Unemployment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 6 Most economists agree that the most demanding macroeconomic issue is economic stability: Why do unemployment and inflation exist, and what should be done about them?

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 7 EXHIBIT 1U.S. RATES OF UNEMPLOYMENT AND INFLATION, 1970–2007 (percent) Source: Economic Report of the President, Washington, D.C., Inflationdata.com, HistoricalInflation.aspx?dsInflation_curre.

Exhibit 1: U.S. Rates of Unemployment and Inflation, 1970–2007 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 8 Exhibit 1 details the years of unemployment and inflation in the United States. What does it show in general? Moderate successes when compared to the 1930s—when unemployment soared to 25 percent of the labor.

Why Does the Economy Generate Inflation and Unemployment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 9 Name the five mainstream schools of economic thought? Classical Keynesian Neo-Keynesian Rational Expectations Supply-Side

Why Does the Economy Generate Inflation and Unemployment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 10 Stabilization policy The use of countercyclical monetary and fiscal policy by the government and the Fed to stabilize the economy.

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 11 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.

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 12 According to the classical school, unemployment is only a temporary phenomenon, caused by wage rates climbing above the equilibrium rate.

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 13 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 14 EXHIBIT 2CLASSICAL DETERMINATION OF UNEMPLOYMENT

Exhibit 2: Classical Determination of Unemployment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 15 1.What happens in Exhibit 2 if policy makers establish a $10 minimum wage? There will be an excess labor supply (unemployment) of 4,000 workers.

Exhibit 2: Classical Determination of Unemployment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 16 The equilibrium wage rate is $6. 2.What is the equilibrium wage rate in Exhibit 2, and what is the level of unemployment at the equilibrium wage rate?

Exhibit 2: Classical Determination of Unemployment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 17 2.What is the equilibrium wage rate in Exhibit 2, 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.

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 18 1.What is the quantity theory of money equation? P = MV/Q

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 19 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.

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 20 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.

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 21 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?

The Classical School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 22 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.

The Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 23 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.

The Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 24 Keynesian economics rejects the classical economists’ basic premise concerning competitive markets and flexible prices.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 25 EXHIBIT 3KEYNESIAN VIEW OF DEMAND AND PRICES IN THE SWIMSUIT MARKET

Exhibit 3: Keynesian View of Demand and Prices in the Swimsuit Market © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 26 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 27 EXHIBIT 4AAGGREGATE DEMAND, GDP, AND EMPLOYMENT

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 28 EXHIBIT 4BAGGREGATE DEMAND, GDP, AND EMPLOYMENT

Exhibit 4: Aggregate Demand, GDP, and Employment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 29 Note that the AD-AS equilibrium in Exhibit 4 occurs at less than full employment. If aggregate demand does not change, unemployment is chronic.

Exhibit 4: Aggregate Demand, GDP, and Employment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 30 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.

Exhibit 4: Aggregate Demand, GDP, and Employment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 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 ″.

Exhibit 4: Aggregate Demand, GDP, and Employment © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 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.

The Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 33 If equilibrium occurs at less than the full-employment output level, Keynesians argue that fiscal policy stimulus should be used to increase aggregate demand.

The Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 34 Keynesian countercyclical policy calls for deficit-spending and expansionary monetary policy during recessions, and surplus budgets and contrac- tionary monetary policy during times of prosperity.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 35 Traditional Keynesian policy was ill- prepared for the combination of high unemployment rates and high inflation rates (“stagflation”) in the 1970s and early 1980s.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 36 Phillips curve A graph showing the inverse relationship between the economy’s rate of unemployment and rate of inflation.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 37 EXHIBIT 5THE PHILLIPS CURVE

Exhibit 5: The Phillips Curve © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 38 Economist A. W. Phillips found an inverse relationship between inflation and unemployment after studying data for 1861–1957 in Britain.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 39 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 40 EXHIBIT 6THE NEO-KEYNESIAN AGGREGATE SUPPLY CURVE

Exhibit 6: The Neo-Keynesian Aggregate Supply Curve © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 41 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.

Exhibit 6: The Neo-Keynesian Aggregate Supply Curve © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 42 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 43 EXHIBIT 7THE PHILLIPS CURVE DURING THE 1960s

Exhibit 7: The Phillips Curve during the 1960s © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 44 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.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 45 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.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 46 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.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 47 Many economists attribute the stagflation of the 1970s and early 1980s to the OPEC oil price increases, which acted as adverse supply shocks.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 48 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 49 EXHIBIT 8RATES OF INFLATION AND UNEMPLOYMENT: 1970–1990

Exhibit 8: Rates of Inflation and Unemployment: 1970–1990 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 50 Were the data from 1970–1990 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 51 EXHIBIT 9SHIFTING PHILLIPS CURVES

Exhibit 9: Shifting Phillips Curves © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 52 How did neo-Keynesians manage to make the data from 1970–1990 consistent with the predicted shape of the Phillips curve? They argued that the 1970–1990 data are consistent with a Phillips curve that shifts over time.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 53 EXHIBIT 10SHIFTING PHILLIPS CURVES

Exhibit 10: Shifting Phillips Curves © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 54 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.

Exhibit 10: Shifting Phillips Curves © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 55 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.

The Neo-Keynesian School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 56 In the long run the rate of unemploy- ment 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.

The Rational Expectations School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 57 Rational expectations The school of thought that emphasizes the impossibility of government reducing the economy’s rate of unemployment by managing aggregate demand.

The Rational Expectations School © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 58 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 59 EXHIBIT 11RATIONAL EXPECTATIONS MODEL

Exhibit 11: Rational Expectations Model © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 60 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.

Exhibit 11: Rational Expectations Model © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 61 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.

Supply-Side Economics © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 62 Supply-side economics The school of thought that emphasizes the possibility of achieving full employment without inflation.

Supply-Side Economics © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 63 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 64 EXHIBIT 12THE LAFFER CURVE

Exhibit 12: The Laffer Curve © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 65 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.

Exhibit 12: The Laffer Curve © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 66 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.

Exhibit 12: The Laffer Curve © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 67 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.

Supply-Side Economics © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 68 To supply-siders, the myriad of government regulations affects almost every industry in the economy, reducing productivity and undermining industrial efficiency.

Supply-Side Economics © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 69 Crowding out A fall in private investment spending caused by an increase in government spending.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 70 EXHIBIT 13SUPPLY-SIDE EFFECTS ON UNEMPLOYMENT AND INFLATION

Exhibit 13: Supply-Side Effects on Unemployment and Inflation © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 71 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.

Exhibit 13: Supply-Side Effects on Unemployment and Inflation © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 72 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.

Is There a Macro Consensus? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 73 Real-world events since the 1970s have brought macroeconomists together. Rational-expectations, neo-Keynesian, and classical economists share the same view—even well-intentioned government interference in the economy is not only futile but counterproductive..

Automatic Stabilizers © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 74 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.

Automatic Stabilizers © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 75 Automatic stabilizers Unemployment insurance payments and benefits and the progressive income tax are two such automatic stabilizers.

Automatic Stabilizers © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 76 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.

Automatic Stabilizers © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 77 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.