1. A. Fiscal Policy

2. The Keynesian View of Fiscal Policy n Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in demand. n When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy -- it should either: n increase the government’s purchases of goods & services, and/or, n cut taxes.

3. G oods & S ervices (real GDP) P rice level LRAS AD 1 Y F P 1 Y 1 SRAS 1 Y F e1e1 P 3 n We begin in the short run at Y 1, below the economy’s potential capacity (Y F ). There are 2 routes to long-run full-employment equilibrium. n Policymakers could wait for both lower wages and resource prices to reduce costs, increase supply to SRAS 3 and restore equilibrium at Y F. P 2 Expansionary Fiscal Policy to Promote Full-Employment n Alternatively, expansionary fiscal policy could stimulate aggregate demand (shift AD 1 to AD 2 ) and guide the economy back to E 2, at Y F. SRAS 3 Expansionary fiscal policy stimulates demand and directs the economy to full-employment AD 2 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. E3E3 E2E2 Y F Y F

4. The Keynesian View of Fiscal Policy n When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive fiscal policy: n reduce government spending, and/or, n raise taxes. n Keynesians challenged the view that the government’s should always be balance its budget. n Rather than balancing the budget annually, Keynesians argued that counter-cyclical policy should be used to offset fluctuations in aggregate demand.

5. G oods & S ervices (real GDP) P rice level LRAS Y F P 1 Y 1 SRAS 1 AD 1 e1e1 P 2 n Strong demand such as AD 1 will temporarily lead to an output rate beyond the economy’s long-run potential (Y F ). n If maintained, the high level of demand will lead to the long-run equilibrium E 3 at a higher price level (as SRAS shifts back to SRAS 3 ). P 3 Restrictive Fiscal Policy to Combat Inflation n However, restrictive fiscal policy could restrain demand from expanding to AD 2 in the first place and guide the economy to a non-inflationary equilibrium (E 2 ). SRAS 3 Y F Restrictive fiscal policy restrains demand and helps control inflation. AD 2 E3E3 E2E2 Y F

6. Fiscal Policy and the Crowding-out Effect n The Crowding-out Effect: -- indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. n The implications of the crowding-out analysis are symmetrical. n Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending. n Crowding-out Effect in an open economy: -- Larger budget deficits and higher real interest rates also lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

7. Increase In Budget Deficit Higher Real Interest Rates Inflow of Financial Capital from Abroad Decline in Private Investment Appreciation of the Dollar Decline in Net Exports A Visual Presentation of the Crowding-Out Effect in an Open Economy n An increase in govt. borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. n This retards private investment and thereby Aggregate Demand. n As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. n In turn, the appreciation of the dollar causes net exports to fall. n Thus, as a result of increased budget deficits, higher interest rates trigger reductions in both private investment and net exports, which weaken the expansionary impact of a budget deficit. n In an open economy, higher interest rates attract capital from abroad.

8. The New Classical View of Fiscal Policy u debt financing merely substitutes higher future taxes for lower current taxes, and thus, u budget deficits affect the timing of taxes, but not their magnitude. n The New classical view stresses that: n New Classics argue that when debt is substituted for taxes u people will save the increased income so they will be able to pay the higher future taxes, thus, u the budget deficit does not stimulate aggregate demand.

9. The New Classical View of Fiscal Policy n Similarly, the real interest rate is unaffected by deficits since people will save more in order to pay the higher future taxes. n According to the new classical view, fiscal policy is completely impotent. It does not effect output, employment, or real interest rates.

10. G oods & S ervices (real GDP) P rice level P 1 Y 1 SRAS 1 AD 1 New Classical View -- Higher Expected Future Taxes Crowd-out Private Spending n New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes. AD 2 n If households did not anticipate the higher future taxes, aggregate demand would increase (from AD 1 to AD 2 ). n However, demand remains unchanged at AD 1 when households fully anticipate the future increase in taxes and, so, save for them.

11. L oanable F unds P rice level r 1 Q 1 D1D1 S1S1 e1e1 r 1 New Classical View -- Higher Expected Future Taxes Crowd-out Private Spending n According to the new classical view, people will save more in order to pay the higher future taxes implied by the increases in debt. This will increase the supply of loanable funds to S 2. D2D2 n This permits the government to borrow the funds to finance the deficit without pushing up the interest rate. S2S2 e2e2 n In order to finance the budget deficit, the govt borrows from the loanable funds market, increasing the demand (from D 1 to D 2 ). Q 2 Under this model, fiscal policy exerts no effect -- the interest rate, real GDP, and level of unemployment each remain unchanged.

12. Fiscal Policy: -- Problems with Proper Timing n Various time lags make proper timing of changes in discretionary fiscal policy difficult. n Discretionary fiscal policy is like a two-edged sword; it can both harm and help. u If timed correctly, it may reduce economic instability. u If timed incorrectly, however, it may increase economic instability.

13. G oods & S ervices (real GDP) P rice level LRAS AD 0 P 0 Y F SRAS Y F E0E0 n We begin long-run equilibrium (E 0 ) at the price level P 0 and output Y 0. At this output, only the natural rate of unemployment is present. n An investment slump and business pessimism result in an unanticipated decline in AD (to AD 1 ). Output falls and unemployment increases. P 1 Y 1 Why Proper Timing of Fiscal Policy is Difficult n After a time, policymakers institute expansionary fiscal policy seeking to shift AD back to AD 0, but by the time fiscal policy begins to exert its primary effect, private investment has recovered and decision makers have become increasingly optimistic about the future. AD 1 Consider that shifts in AD are difficult to forecast. e1e1

14. n Thus, just as AD begins shifting back to AD 0 by its own means, the effects of fiscal policy over-shift AD to AD 2. n The price level in the economy rises as the economy is now overheated. Why Proper Timing of Fiscal Policy is Difficult n Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS 2 (driving the price level up to P 3 ). G oods & S ervices (real GDP) P rice level LRAS AD 0 P 0 Y F P 2 P 1 Y 1 SRAS Y F AD 2 e2e2 e1e1 AD 1 Y 2 P 3 SRAS 2 e4e4 AD 0 E0E0

15. Fiscal Policy: -- Problems with Proper Timing n Automatic Stabilizers: -- without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. n Examples of Automatic Stabilizers : u Unemployment Compensation u Corporate Profit Tax u A Progressive Income Tax

16. Fiscal Policy as a Tool: -- A Modern Synthesis n The proper timing of discretionary fiscal policy is both difficult to achieve and of crucial importance. n Automatic stabilizers reduce the fluctuation of aggregate demand and help to direct the economy toward full-employment. n Fiscal policy is much less potent than the early Keynesian view implied.

17. Supply-side Effects of Fiscal Policy n From a supply-side viewpoint, the marginal tax rate is of crucial importance: n High marginal tax rates will tend to retard total output because they will: u A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed. u Discourage work effort and reduce the productive efficiency of labor, u Adversely affect the rate of capital formation and the efficiency of its use, and, u Encourage individuals to substitute less desired tax-deductible goods for more desired non-deductible goods.

18. Supply-side Effects of Fiscal Policy n Thus, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance. n Impact of supply-side effects u Are likely to take place over a lengthy time period. u There is some evidence that countries with high taxes grow more slowly—France and Germany versus United Kingdom. u While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high rate, say rates of 40 percent and above.

19. G oods & S ervices (real GDP) P rice level LRAS 1 P 0 Y F1 SRAS 1 AD 1 E1E1 P 0 n What are the supply-side effects of a reduction in marginal tax rates? n The lower marginal tax rates increase the incentive to earn and use resources efficiently. AD 1 shifts out to AD 2, and as the effects of the tax cut are long-run as well as short-run, both SRAS and LRAS shift out. Tax Rate Effects and Supply-Side Economics n If the lower tax rates are financed by budget deficits, aggregate demand may expand by a larger amount than aggregate supply, leading to an increase in the price level. Y F2 AD 2 SRAS 2 LRAS 2 With time, lower tax rates will promote more rapid growth (shifting LRAS and SRAS to the right to LRAS 2 and SRAS 2 ). E2E2

20. B. Money and the Banking System

21. What Is Money? n A Medium of Exchange -- An asset that is used to buy and sell goods & services. n A Store of Value -- An asset that will allow people to transfer purchasing power from one period to another. n A Unit of Account -- The units of measurement used by people to post prices and keep track of revenues and costs.

22. The Supply of Money n The components of the M1 money supply are: n The M2 money supply is a broader measure that includes: u Currency u Checking Deposits (including demand deposits and interest-earning checking deposits) u Traveler's checks u M1, u Savings, u Time deposits, and, u Money mutual funds.

23. The Business of Banking n The banking industry includes: n Banks accept deposits and use part of them to extend loans and make investments. n Banks are profit-seeking institutions. n Banks play a central role in the capital (loanable funds) market: u They help to bring together people who want to save for the future with those who want to borrow in order to undertake investment projects. n The banking system is a fractional reserve system: -- Banks maintain only a fraction of their assets in reserves to meet the requirements of depositors. u savings and loans, u credit unions, and, u commercial banks.

24. Bank New Cash Deposits: Actual Reserves New Required Reserves Potential Demand Deposits Created By Extending New Loans Initial deposit (Bank A) Second stage (Bank B) Third stage (Bank C) Fourth stage (Bank D) Fifth stage (Bank E) Sixth stage (Bank F) Seventh stage (Bank G) How Banks Create Money by Extending Loans n When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000. n Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (create additional checking deposits). $1,000.00$200.00 160.00 128.00 102.40 81.92 65.54 52.43 800.00 $800.00 640.00 512.00 409.60 327.68 262.14 209.71 Total$5,000.00$1,000.00$4,000.00 All others (other banks)1,048.58209.71838.87

25. How Banks Create Money by Extending Loans n The lower the percentage of the reserve requirement, the greater is the potential expansion in the money supply resulting from the creation of new reserves. n The actual deposit multiplier will be less than the potential because: u Some persons will hold currency rather than bank deposits. u Some banks may not use all their excess reserves to extend loans. n The fractional reserve requirement places a ceiling on potential money creation from new reserves.

26. The Three Tools the Fed Uses to Control the Money Supply n Reserve requirements : -- a % of a specified liability category (for example transaction accounts) that banking institutions are required to hold as reserves against that type of liability. u When the Fed lowers the required reserve ratio, it creates excess reserves and allows banks to extend additional loans, expanding the money supply. u Raising the reserve requirements has the opposite effect.

27. The Three Tools the Fed Uses to Control the Money Supply n Open Market Operations : -- the buying and selling of U.S. Government securities (national debt in the form of bonds) by the Fed. u This is the primary tool used by Fed. u When the Fed buys bonds the money supply will expand, because: u the bond buyers will acquire money, and, u bank reserves will increase, placing banks in a position to expand the money supply through the extension of additional loans. u When the Fed sells bonds the money supply will contract because: u bond buyers are giving up money in exchange for securities, and, u the reserves available to banks will decline, causing them to extend fewer loans.

28. The Three Tools the Fed Uses to Control the Money Supply n Discount Rate : -- the interest rate the Fed charges banking institutions for borrowed funds. u An increase in the discount rate is restrictive (decreases the money supply) because it discourages banks from borrowing from the Federal Reserve to extend new loans. u A reduction in the discount rate is expansionary (increases the money supply) because it makes borrowing from the Federal Reserve less costly.

29. Checking deposits ($642) Currency a ($434) $47 $434 M1 = $1,076 n The monetary base (currency plus bank reserves) provides the foundation for the money supply. n Currency in circulation contributes directly to the money supply... n Fed actions that alter the monetary base will affect the money supply: n By increasing reserve requirements, buying bonds, or increasing the discount rate, the Fed can reduce the money supply. n By decreasing reserve requirements, selling bonds, or decreasing the discount rate, the Fed can increase the money supply. Monetary Base and Money Supply monetary base = $481 (currency + bank reserves) while bank reserves provide the underpinnings for checking deposits. a Traveler’s checks are included in this category.

30. Ambiguities in the Meaning and Measurement of the Money Supply n Interest earning checking deposits n Widespread use of the U.S. dollar outside of the United States u Less costly to hold than currency and demand deposits. u Their introduction in the early 1980’s changed the nature of the M1 money supply. u More than one-half and perhaps as much as two-thirds of U.S. currency is held overseas. u This reduces the reliability of the M1 money supply measure.

31. Ambiguities in the Meaning and Measurement of the Money Supply n Sweeping of various interest-earning checking accounts into Money Market Deposit Accounts n Debit Cards and Electronic Money n The increasing availability of low-fee stock and bond mutual funds n Summary: u Recent financial innovations and other structural changes have blurred the meaning of money and reduced the reliability of the various money supply measures. u In the Computer-Age, continued change in this area is likely.

32. C. Monetary Policy

33. n The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earnings assets like bonds. M oney D emand M oney I nterest R ate Q uantity of M oney The Demand and Supply of Money:

34. Determined by the Fed M oney I nterest R ate Q uantity of M oney M oney S upply n The supply of money is vertical because it is determined by the Fed. The Demand and Supply of Money:

35. D S M oney S upply M oney I nterest R ate Q uantity of M oney M oney D emand i 3 i e i 2 Q s (Set by the Fed) Quantity of money E xcess S upply at i2i2 E xcess D emand at I3I3 At, people are willing to hold the money supply set by Fed i e The Demand and Supply of Money: n Equilibrium: -- The money interest rate will gravitate toward the rate where the quantity of money people want to hold (the demand) is just equal to the stock of money the Fed has supplied (the supply).

36. D1D1 M oney I nterest R ate Q uantity of M oney S1S1 D R eal I nterest R ate Q uantity of L oanable F unds S1S1 i 1 QsQs r 1 Q1Q1 n When the Fed shifts to a more expansionary monetary policy, it will generally buy additional bonds thereby expanding the money supply. Transmission of Monetary Policy i 2 QbQb S2S2 r 2 Q2Q2 S2S2 n This increase in the money supply (shifting S 1 to S 2 in the market for money) will supply the banking system with additional reserves. n Both the Fed’s bond purchases and the bank’s use of the additional reserves to extend new loans will increase the supply of loanable funds (shifting S 1 to S 2 in the loanable funds market)... and put downward pressure on the real rate of interest (reduction to r 2 ).

37. n As the real rate of interest falls, aggregate demand increases (to AD 2 ). Transmission of Monetary Policy n Since the effects of the monetary expansion were unanticipated, the expansion in AD leads to a short-run increase in current output (from Y 1 to Y 2 )... D R eal I nterest R ate Q uantity of L oanable F unds r 2 Q2Q2 S1S1 S2S2 P rice L evel G oods & S ervices (Real GDP) P 1 Y1Y1 Y2Y2 AS 1 AD 1 P 2 AD 2 and increase in prices (from P 1 to P 2 ) – inflation. n The path that monetary policy takes through the macroeconomic system is called the Transmission of Monetary Policy. n The impact of a shift in monetary policy is generally transmitted through interest rates, exchange rates, and asset prices.

38. A Shift to a More Expansionary Monetary Policy n During expansionary monetary policy the Fed may buy bonds, reduce the discount rate, or reduce the reserve requirements for deposits. n The Fed generally buys bonds, which: n increases bond prices, and, n creates additional bank reserves, while it, n places downward pressure on real interest rates. n As a result, an unanticipated shift to a more expansionary policy will stimulate aggregate demand and thereby increase both output and employment.

39. LRAS G oods & S ervices (real GDP) P rice level SRAS 1 P 1 Y 1 AD 1 e1e1 Y F P 2 Y F The Effects of Expansionary Monetary Policy n If the impact of an increase in aggregate demand accompanying expansionary monetary policy is felt when the economy is operating below capacity, the policy will help direct the economy back to a long-run full-employment output equilibrium (Y F ). AD 2 n In this case, the increase in output from Y 1 to Y F will be long term. E2E2

40. G oods & S ervices (real GDP) P rice level LRAS AD 1 P 1 Y F SRAS 1 Y F E1E1 The Effects of Expansionary Monetary Policy n In contrast, if the demand-stimulus effects are imposed on an economy already at full-employment (Y F ), they will lead to excess demand, higher product prices, and temporarily higher output (Y 2 ). n In the long-run, the strong demand will push up resource prices, shifting short run aggregate supply (from SRAS to SRAS 2 ). P 2 Y 2 P 3 n The price level rises to P 3 (from P 2 ) and output falls back to full-employment output once again (Y F from it temporary high,Y 2 ). AD 2 e2e2 SRAS 2 E2E2 Y F

41. = * * Monetary Policy in the Long Run n The Quantity Theory of Money: n If V and Y are constant, than an increase in M would lead to a proportional increase in P. M V P Y M oney V elocity P rice Y = Income

42. Monetary Policy in the Long Run n The Long-Run Implications of Modern Analysis: u In the long run, the primary impact will be on prices rather than on real output. u When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. u As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.

43. P rice L evel (ratio scale) T ime P eriods A nnual G rowth R ate of the M oney S upply 3.0 1 6.0 9.0 23 4 R eal GDP AD 1 LRAS Y F AS 1 e 1 P 100 (a) Growth rate of the money supply. (b) Impact in the goods and services market. n Here we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3 to 8 percent. The Long-run Effects of More Rapid Expansion in the Money Supply n Initially, prices are stable (P 100 ) when the money supply is expanding by 3% annually. n The acceleration in the growth rate of the money supply increases aggregate demand (shifting to AD 2 ). 3% growth AD 2 AS 2 n At first, real output may expand beyond the economy’s potential (Y F ), however low unemployment and strong demand create upward pressure on wages and other resource prices, shifting AS to AS 2. 8% growth

44. P rice L evel (ratio scale) P 100 T ime P eriods A nnual G rowth R ate of the M oney S upply 3.0 1 6.0 9.0 23 4 R eal GDP AD 1 LRAS Y F AS 1 e 1 (a) Growth rate of the money supply. (b) Impact in the goods and services market. n Output returns to its long-run potential (Y F ), and the price level increases to P 105 (e 2 ). n If more rapid monetary growth continues in subsequent periods, AD and AS will continue to shift upward, leading to still higher prices (e 3 and points beyond). P 105 P 110 8% growth 3% growth AD 2 3 AS 2 3 e 3 e 2 n The net result of this process is sustained inflation. The Long-run Effects of More Rapid Expansion in the Money Supply

45. r.04 D 1 (expected rate of inflation = 0 %) S 1 (expected rate of inflation = 0 %) L oanable F unds I nterest R ate Q i.09 Q A higher expected rate of inflation increases the money interest rate. n When prices are stable, supply and demand in the loanable funds market are in balance at a real and nominal interest rate of 4%. n If more rapid monetary expansion leads to a long-term 5% inflation rate, borrowers and lenders will build the higher inflation rate into their decision making. n As a result, the nominal interest rate ( i ) will rise to 9% -- the 4% real rate plus the 5% inflationary premium. D 2 (expected rate of inflation = 5 %) S 2 (expected rate of inflation = 5 %) The Long-run Effects of More Rapid Expansion in the Money Supply

46. Monetary Policy When Effects Are Anticipated n When the effects of policy are anticipated prior to their occurrence, the short ‑ run impact of an increase in the money supply is similar to its impact in the long run. n Nominal prices and interest rates rise, but real output remains unchanged.

47. G oods & S ervices (real GDP) P rice level SRAS 1 AD 1 P 1 Y 1 1 E 2 Y 1 P 2 SRAS 2 2 E The Short-run Effects of An Anticipated Monetary Expansion n When decision makers fully anticipate the effects of a monetary expansion, the expansion does not alter real output even in the short-run. n Suppliers, including resource suppliers, build the expected price rise into their decisions. The anticipated inflation leads to a rise in nominal costs (including wages) causing aggregate supply to decline (shifts to SRAS 2 ). n While nominal wages, prices, and interests rates rise, their real counter- parts are unchanged – and so, inflation without any change in output.

48. Interest Rates and Monetary Policy n While the Fed can strongly influence short-term interest rates, its impact on long-term rates is much more limited. n Interest rates can be a misleading indicator of monetary policy: u In the long run, expansionary monetary policy leads to inflation and high interest rates, rather than low interest rates. u Similarly, restrictive monetary policy, when pursued over a lengthy time period, leads to low inflation and low interest rates.

49. The Effects of Monetary Policy: -- A Summary n An unanticipated shift to a more expansionary (restrictive) monetary policy will temporarily stimulate (retard) output and employment. n The stabilizing effects of a change in monetary policy are dependent upon the state of the economy when the effects of the policy change are observed. n Persistent growth of the money supply at a rapid rate will cause inflation. n Money interest rates and the inflation rate will be directly related. n There will be only a loose year-to-year relationship between shifts in monetary policy and changes in output and prices.

50. D. Stabilization Policy, Output and Employment

51. Promoting Economic Stability -- Activist and Non-activist Views n Goals of Stabilization Policy: n Activists' Views of Stabilization Policy: u A stable growth of real GDP, u A relatively stable level of prices, u A high level of employment (low unemployment). u The self corrective mechanism works slowly if at all, u Policy-makers will be able to alter macro-policy, injecting stimulus to help pull the economy out of recession and implementing restraint to help control inflation, u According to the activist s view, policy-makers are more likely to keep the economy on track when they are free to apply stimulus or restraint based on forecasting devices and current economic indicators.

52. Promoting Economic Stability -- Activist and Non-activist Views n Non-activists' Views of Stabilization Policy: u The self-corrective mechanism of markets works pretty well, u Greater stability would result if stable, predictable policies based on predetermined rules were followed, u Non-activists argue that the problems of proper timing and political considerations undermine the effectiveness of discretionary macro policy as a stabilization tool.

53. Practical Problems With Discretionary Macro Policy n Lags and the Problem of Timing: n Politics and Timing of Policy Changes: u After a change in policy has been undertaken, there will be a time lag before it exerts a major impact. u This means policy makers need to forecast economic conditions several months in the future in order to institute policy changes effectively. u Policy changes may be driven by political considerations rather than stabilization.

54. How are Expectations Formed? -- Two Theories n Adaptive Expectations: -- individuals form their expectations about the future on the basis of data from the recent past. n Rational Expectations: -- Assumes that people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future.

55. 12345 12.0 8.0 4.0 0 12.0 8.0 4.0 0 T ime P eriod A ctual R ate of I nflation (percent) E xpected R ate of I nflation (percent) Corresponding expected rate of inflation in next period Actual rate of inflation Adaptive Expectations Hypothesis n According to the adaptive expectations hypothesis, what actually occurs during the most recent period (or set of periods) determines people’s future expectations. n Thus, the expected future rate of inflation lags behind the actual rate by one period as expectations are altered over time. A ctual R ate of I nflation (percent) E xpected R ate of I nflation (percent)

56. How Macro Policy Works – The Implications of Adaptive and Rational Expectations n With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment. n With rational expectations, expansionary policy will not generate a systematic change in output. n Both expectations theories indicate that sustained expansionary policies will lead to inflation without permanently increasing output and employment.

57. G oods & S ervices (real GDP) P rice level LRAS AD 1 P 1 Y F SRAS 1 Y F E1E1 n Under adaptive expectations, anticipation of inflation will lag behind its actual occurrence. n Thus, a shift to a more expansionary policy would increase aggregate demand (from AD 1 to AD 2 ) and lead to a temporary increase in GDP (from Y F to Y 2 ) accompanied by a modest increase in prices (from P 1 to P 2 ). P 2 Y 2 AD 2 e2e2 Expectations and the Short-run Effects of Demand Stimulus

58. G oods & S ervices (real GDP) P rice level LRAS AD 1 P 1 Y F SRAS 1 Y F E1E1 n In contrast, under rational expectations, decision makers will quickly anticipate the inflationary impact of a demand-stimulus policy. n Thus, while a shift to a more expansionary policy would increase aggregate demand (from AD 1 to AD 2 ), resource prices and production costs would rise just as rapidly (thereby shifting SRAS to SRAS 2 ). P 2 AD 2 SRAS 2 E2E2 Y F n The net effect of demand-stimulus in the rational expectations model is an increase in prices without altering real output -- even in the short run. Expectations and the Short-run Effects of Demand Stimulus

59. 34567 4 3 2 1 U nemployment R ate (%) I nflation R ate (% change in GDP price deflator) Phillips curve 66 68 57 55 56 67 65 60 62 63 54 64 61 59 58 n This exhibit is from the 1969 Economic Report of the President. Each dot represents the inflation and unemployment rate for that year. The report stated clearly that the chart “reveals a fairly close association of more rapid price increases with lower rates of unemployment.” Economists refer to this link as the Phillips Curve. n In the 1960s it was widely believed that policy makers could pursue expansionary macroeconomic policies and thereby permanently reduce the unemployment rate. n More recent experience has caused most economists to reject this view. The Phillips Curve – Before the Inflation of the 1970s

60. Early Views About the Phillips Curve n During the 1960s, most economists thought there was an inverse relationship between inflation and unemployment. u As the inflation rate rose from 3% in the late 1960s to double-digit levels during 1974-1975, the rate of unemployment rose from less than 4% to more than 8%. u As high rates of inflation continued in the latter half of the 1970s, so too did the high rates of unemployment. n This led to the belief that even though expansionary policies would lead to some inflation, they would also result in a long-lasting lower rate of unemployment. n Stability of the inflation-unemployment relationship proved to be an illusion.

61. Early Views About the Phillips Curve n The error of early Phillips Curve proponents: -- Failure to consider expectations u Integration of expectations into the Phillips curve analysis indicates that any trade-off between inflation and unemployment will be short-lived. u An unanticipated shift to a more expansionary policy may temporarily reduce the unemployment rate, but when decision makers come to anticipate the higher rate of inflation, unemployment will return to its natural rate. u Even high rates of inflation will fail to reduce unemployment once they are anticipated by decision makers.

62. (b) P hillips C urve F ramework 4 357 8 0 R ate of U nemployment P 100 LRAS Y F (a) G oods & S ervices M arket R eal GDP AD 1 SRAS 1 A P rice L evel R ate of I nflation 0 A AD 2 SRAS 2 Long-Run Phillips Curve (natural rate of unemployment ) PC 1 ( stable prices anticipated ) P 108 P 112 P 104 AD 3 SRAS 3 B Y 2 C BC PC 2 ( 4% inflation anticipated ) A n We begin at full-employment output – Y F (pt A in both frames). n With adaptive expectations, a shift to a more expansionary policy will increase prices, expand output beyond full-employment, and reduce the unemployment rate below its natural level (a move to pt B in both frames). n Decision makers, though, will eventually anticipate the rising prices and incorporate them into their decision making (shifting SRAS to SRAS 2, returning output to its full-employment level – Y F, and increasing unemployment back to the natural rate – a move to pt C in both frames). n If the inflationary policy continues, and decision makers anticipate it, the AD and SRAS curves will shift upward without an increase in output and employment … this leads to the vertical Long Run Phillips Curve. The AD/AS Model, Adaptive Expectations, and the Phillips Curve Y F

63. R ate of U nemployment (%) 4 357 8 Long-run Phillips curve (natural rate of unemployment) PC 2 R ate of I nflation (%) C 4% inflation anticipated 8% inflation anticipated D PC 3 E F n Point C illustrates the economy experiencing 4% inflation that was anticipated by decision makers, and because the inflation was anticipated the natural rate of unemployment is present. n With adaptive expectations, demand stimulus policies that result in a still higher rate of inflation (8% for example) would once again temporarily reduce the unemployment rate below its long-run, normal rate (moving from C to D along PC 2 ). n After a time, decision makers would come to anticipate the higher inflation rate, and the short-run Phillips curve would shift still further to the right to PC 3 (a movement from D to E). n Once the higher rate is anticipated, if macro planners try to decelerate the rate of inflation, unemployment will temporarily rise above its long-run natural rate (for example from E to F). Expectations and Shifts in the Phillips Curve

64. Expectations and the Modern View of the Phillips Curve n There is exists no permanent tradeoff between inflation and unemployment. u Demand stimulus will lead to inflation without permanently reducing unemployment below the natural rate. u Like LRAS, the Long-Run Phillips Curve is vertical at the natural rate of unemployment. u When inflation is greater than anticipated, unemployment falls below the natural rate. n When the inflation rate is steady — neither rising nor falling — the actual rate of unemployment will equal the economy’s natural rate of unemployment.

65. The Phillips Curve and Macro-policy n The early view that there was a trade-off between inflation and unemployment helped promote the more expansionary macro policy of the 1970s. u In turn, the increase in price level stability contributed to the lower unemployment rates of the 1990s. n Rejection of this view during the 1980s created an environment more conducive to price stability. n In the long-run, expansionary policy in pursuit of lower unemployment leads to higher rates of both inflation and unemployment.

66. The Phillips Curve and Macro-policy n There are two important lessons to be learned from the Phillips curve era: u Expansionary macro policy will not reduce the rate of unemployment, at least not for long. u Macro policy, particularly monetary policy, can achieve persistently low rates of inflation, which will help promote low rates of unemployment. n There is no inconsistency between low (and stable) rates of inflation and low rates of unemployment.