C hapter 28 Can Government Really Stabilize the Economy? © 2002 South-Western

2 Economic Principles The Classical School of Employment and Inflation The Keynesian School of Employment and Inflation The Neo-Keynesian School of Employment and Inflation

3 Economic Principles The Rational Expectations School of Employment and Inflation The Supply-Side School of Employment and Inflation

4 Economic Principles Phillips Curve Analysis Automatic Stabilizers

5 The Nature of Economic Advice Economists live in a world of limited information, and so their analysis leads to different and sometimes even highly conflicting conclusions and recommendations.

6 The Classical School 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.

7 The Classical School According to the classical school, unemployment is only a temporary phenomenon, caused by wage rates climbing above the equilibrium rate.

8 The Classical School 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.

9 EXHIBIT 1CLASSICAL DETERMINATION OF UNEMPLOYMENT

10 Exhibit 1: Classical Determination of Unemployment 1. What happens in Exhibit 1 if policy makers establish a $10 minimum wage? There will be an excess labor supply (unemployment) of 4,000 workers.

11 Exhibit 1: Classical Determination of Unemployment 2. What is the equilibrium wage rate in Exhibit 1, and what is the level of unemployment at the equilibrium wage rate? The equilibrium wage rate is $6.

12 Exhibit 1: Classical Determination of Unemployment 2. What is the equilibrium wage rate in Exhibit 1, 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.

13 The Classical School Stabilization policy The use of countercyclical monetary and fiscal policy by the government and the Fed to stabilize the economy.

14 The Classical School 1. What is the quantity theory of money equation? P = MV/Q

15 The Classical School 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.

16 The Classical School 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.”

17 The Classical School 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? If the growth rate of “M” equals the “Q” growth rate, then the price level remains unchanged.

18 The Classical School 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.

19 The Keynesian School 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.

20 The Keynesian School Keynesian economics rejects the classical economists’ basic premise concerning competitive markets and flexible prices.

21 EXHIBIT 2KEYNESIAN VIEW OF DEMAND AND PRICES IN THE SWIMSUIT MARKET

22 Exhibit 2: Keynesian View of Demand and Prices in the Swimsuit Market 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.

23 EXHIBIT 3AAGGREGATE DEMAND, GDP, AND EMPLOYMENT

24 EXHIBIT 3BAGGREGATE DEMAND, GDP, AND EMPLOYMENT

25 Exhibit 3: Aggregate Demand, GDP, and Employment Note that the AD-AS equilibrium in Exhibit 3 occurs at less than full employment. If aggregate demand does not change, unemployment is chronic.

26 Exhibit 3: Aggregate Demand, GDP, and Employment 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.

27 Exhibit 3: Aggregate Demand, GDP, and Employment 2. 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’’.

28 Exhibit 3: Aggregate Demand, GDP, and Employment 2. 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.

29 The Keynesian School If equilibrium occurs at less than the full-employment output level, Keynesians argue that fiscal policy stimulus should be used to increase aggregate demand.

30 The Keynesian School Keynesian countercyclical policy calls for deficit-spending and expansionary monetary policy during recessions, and surplus budgets and contractionary monetary policy during times of prosperity.

31 The Neo-Keynesian School Traditional Keynesian policy was ill-prepared for the combination of high unemployment rates and high inflation rates (“stagflation”) in the 1970s and early 1980s.

32 The Neo-Keynesian School Phillips curve A graph showing the inverse relationship between the economy’s rate of unemployment and rate of inflation.

33 EXHIBIT 4THE PHILLIPS CURVE

34 Exhibit 4: The Phillips Curve Economist A.W. Phillips found an inverse relationship between inflation and unemployment after studying data for in Britain.

35 The Neo-Keynesian School 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.

36 EXHIBIT 5THE NEO-KEYNESIAN AGGREGATE SUPPLY CURVE

37 Exhibit 5: The Neo-Keynesian Aggregate Supply Curve 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.

38 Exhibit 5: The Neo-Keynesian Aggregate Supply Curve 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.

39 EXHIBIT 6THE PHILLIPS CURVE DURING THE 1960s

40 Exhibit 6: The Phillips Curve During the 1960s 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.

41 The Neo-Keynesian School 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.

42 The Neo-Keynesian School 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.

43 The Neo-Keynesian School Many economists attribute the stagflation of the 1970s and early 1980s to the OPEC oil price increases, which acted as adverse supply shocks.

44 The Neo-Keynesian School 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.

45 EXHIBIT 7RATES OF INFLATION AND UNEMPLOYMENT: 1970–90

46 Exhibit 7: Rates of Inflation and Unemployment: Were the data from 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.

47 EXHIBIT 8SHIFTING PHILLIPS CURVES

48 Exhibit 8: Shifting Phillips Curves How did neo-Keynesians manage to make the data from consistent with the predicted shape of the Phillips curve? They argued that the data are consistent with a Phillips curve that shifts over time.

49 EXHIBIT 9SHIFTING PHILLIPS CURVES

50 Exhibit 9: Shifting Phillips Curves 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.

51 Exhibit 9: Shifting Phillips Curves 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.

52 The Neo-Keynesian School In the long run the rate of unemployment 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.

53 The Rational Expectations School Rational expectations The school of thought that emphasizes the impossibility of government reducing the economy’s rate of unemployment by managing aggregate demand.

54 The Rational Expectations School 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.

55 EXHIBIT 10RATIONAL EXPECTATIONS MODEL

56 Exhibit 10: Rational Expectations Model 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.

57 Exhibit 10: Rational Expectations Model 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.

58 EXHIBIT 11U.S. RATES OF UNEMPLOYMENT AND INFLATION: 1992–99 Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000).

59 Supply-Side Economics Supply-side economics The school of thought that emphasizes the possibility of achieving full employment without inflation.

60 Supply-Side Economics 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.

61 EXHIBIT 12THE LAFFER CURVE

62 Exhibit 12: The Laffer Curve 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.

63 Exhibit 12: The Laffer Curve 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.

64 Exhibit 12: The Laffer Curve 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.

65 Supply-Side Economics To supply-siders, the myriad of government regulations affects almost every industry in the economy, reducing productivity and undermining industrial efficiency.

66 Supply-Side Economics Crowding out A fall in private investment spending caused by an increase in government spending.

67 EXHIBIT 13SUPPLY-SIDE EFFECTS ON UNEMPLOYMENT AND INFLATION

68 Exhibit 13: Supply-Side Effects on Unemployment and Inflation 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.

69 Exhibit 13: Supply-Side Effects on Unemployment and Inflation 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.

70 Is There A Consensus? Real-world events of the 1970s, 1980s, and 1990s have brought macroeconomists together.

71 Automatic Stabilizers 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.

72 Automatic Stabilizers Automatic stabilizers Unemployment insurance payments and benefits and the progressive income tax are two such automatic stabilizers.

73 Automatic Stabilizers 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.

74 Automatic Stabilizers 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.