1. Copyright © 2005 Pearson Education Canada Inc.15-1 Chapter 15 Issues in Stabilization Policy

2. Copyright © 2005 Pearson Education Canada Inc.15-2 Learning Objectives 15.1Explain why the actual unemployment rate might depart from the natural rate of unemployment. 15.2Describe why there may be an inverse relationship between the inflation rate and the unemployment rate, reflected by the Phillips curve..

3. Copyright © 2005 Pearson Education Canada Inc.15-3 Learning Objectives 15.3Evaluate how expectations affect the relationship between the actual inflation rate and the unemployment rate. 15.4Describe the rational expectations hypothesis and the new classical model and their implications for economic policy making.

4. Copyright © 2005 Pearson Education Canada Inc.15-4 Learning Objectives 15.5Identify the central features of the real-business-cycle challenge to policy making. 15.6Identify the central features of supply-side economics to policy making.

5. Copyright © 2005 Pearson Education Canada Inc.15-5 Learning Objectives 15.7 Distinguish among alternative modern approaches to strengthening the case for active policy making.

6. Copyright © 2005 Pearson Education Canada Inc.15-6 The Natural Rate of Unemployment 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

7. Copyright © 2005 Pearson Education Canada Inc.15-7 The Natural Rate of Unemployment Passive (nondiscretionary) Policymaking  Policymaking that is carried out in response to a rule.  Example Monetary rule Balancing the budget over the business cycle

8. Copyright © 2005 Pearson Education Canada Inc.15-8 The Natural Rate of Unemployment Natural Rate of Unemployment  The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium.  All workers and employers have fully adjusted to any changes in the economy.

9. Copyright © 2005 Pearson Education Canada Inc.15-9 The Natural Rate of Unemployment Frictional Unemployment  Arises when people take the time to search for the best job opportunities.

10. Copyright © 2005 Pearson Education Canada Inc.15-10 The Natural Rate of Unemployment Structural Unemployment  Unemployment resulting from: Union activity Government-imposed licensing arrangements Government-imposed wage laws Welfare and Employment Insurance Changes in technology that make current workers’ skills obsolete

11. Copyright © 2005 Pearson Education Canada Inc.15-11 The Natural Rate of Unemployment Real GDP per Year Price Level AD 1 LRAS Y1Y1 P1P1 E1E1 SRAS 2 P3P3 E3E3 SRAS1 1 AD 2 P2P2 Y2Y2 Departures from the Natural Rate: Monetary or fiscal policy shifts AD. The unemployment rate falls temporarily below the natural rate of unemployment. E2E2

12. Copyright © 2005 Pearson Education Canada Inc.15-12 The Natural Rate of Unemployment Real GDP per Year Price Level Monetary or fiscal policy shifts AD. The unemployment rate temporarily rises above the natural rate of unemployment. P1P1 E1E1 LRAS Q1Q1 SRAS 1 AD 1 P2P2 Q2Q2 AD 2 E2E2 P3P3 E3E3 SRAS 2

13. Copyright © 2005 Pearson Education Canada Inc.15-13 The Phillips Curve The Phillips Curve: The Trade-Off?  A curve showing the apparent relationship between unemployment and changes in wages or prices.  It was long thought to reflect a trade-off between unemployment and inflation.

14. Copyright © 2005 Pearson Education Canada Inc.15-14 The Phillips Curve 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.

15. Copyright © 2005 Pearson Education Canada Inc.15-15 The Phillips Curve Unemployment Rate Inflation Rate U*U* A Zero inflation & natural rate of unemployment, U *. B Higher inflation & lower unemployment C Deflation & higher unemployment

16. Copyright © 2005 Pearson Education Canada Inc.15-16 The Importance of Expectations Unemployment Rate Inflation Rate U*U* PC 0 Government Policy increases M s (one-time event) to raise AD -Increase in AD increases inflation and reduces unemployment -The inflation and unemployment rate will return to A. A B U1U1

17. Copyright © 2005 Pearson Education Canada Inc.15-17 The Importance of Expectations Unemployment Rate Inflation Rate U*U* PC 0 A B U1U1 -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

18. Copyright © 2005 Pearson Education Canada Inc.15-18 The Importance of Expectations Unemployment Rate Inflation Rate U*U* PC 0 PC 5 F1F1 A B U1U1 F2F2 As a result, the unemployment rate will increase to A and yield combination F 1.

19. Copyright © 2005 Pearson Education Canada Inc.15-19 Rational Expectations and the New Classical Model Rational Expectations Hypothesis  A theory stating that people combine the effects of past policy changes on important economic variables with their own judgment about the future effects of current and future policy changes.

20. Copyright © 2005 Pearson Education Canada Inc.15-20 Rational Expectations and the New Classical Model New Classical Model  A modern version of the classical model in which wages and prices are flexible, there is pure competition in all markets, and the rational expectations hypothesis is assumed to be working.

21. Copyright © 2005 Pearson Education Canada Inc.15-21 SRAS 1 (M e = M 1 ) SRAS 2 (M e = M 2 ) AD 2 (M = M 2 ) B Rational Expectations and the New Classical Model Real GDP per Year Price Level AD 1 (M=M 1 ) LRAS Q1Q1 P1P1 A According to rational expectations hypothesis the SRAS will shift simultaneously with the increase in AD. P3P3 C Policy will have no impact on Output (The economy never gets to B)

22. Copyright © 2005 Pearson Education Canada Inc.15-22 Rational Expectations and the New Classical Model SRAS 1 (M e = M 0 ) AD 2 (M = M 1 ) Real GDP per Year Price Level AD 1 (M = M 0 ) P0P0 E0E0 Q1Q1 According to rational expectations, an unanticipated change in AD can affect output in the short run. P1P1 Q2Q2 E1E1

23. Copyright © 2005 Pearson Education Canada Inc.15-23 Rational Expectations and the New Classical Model SRAS 1 (M e = M 0 ) SRAS 2 (M e = M 1 ) AD 2 (M = M 1 ) Real GDP per Year Price Level AD 1 (M = M 0 ) LRAS Q1Q1 P2P2 E2E2 Q2Q2 In the long run, people will figure out the Bank of Canada’s actions -- prices will increase and output will return to long-run equilibrium. P3P3 E3E3 P1P1 E1E1

24. Copyright © 2005 Pearson Education Canada Inc.15-24 Real Business Cycle Theory  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 labour employment and output.

25. Copyright © 2005 Pearson Education Canada Inc.15-25 Real Business Cycle Theory Real GDP per Year Price Level AD SRAS 1 A reduction in the supply of a resource shifts the SRAS to the left. SRAS 2 SRAS 3 The position of the LRAS depends upon resource endowments. LRAS 1 Q1Q1 P1P1 E1E1 P2P2 Q2Q2 E2E2 LRAS 2 If the reduction in the resource is permanent, the LRAS will shift also. Q3Q3 P3P3 E3E3 Effects of a Reduction in the Supply of Resources

26. Copyright © 2005 Pearson Education Canada Inc.15-26 Supply-side Economics Supply-side Economics:  The notion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward.

27. Copyright © 2005 Pearson Education Canada Inc.15-27 Supply-side Economics Real GDP per Year Price Level AD SRAS 3 A increase in the supply of a resource shifts the SRAS to the right. SRAS 2 SRAS 1 If the increase in resources is permanent, the LRAS will also shift. LRAS 2 Q3Q3 P3P3 E3E3 P2P2 Q2Q2 E2E2 LRAS 1 The position of the LRAS depends upon resource endowments. Q1Q1 P1P1 E1E1

28. Copyright © 2005 Pearson Education Canada Inc.15-28 Supply-side Economics Tax Revenue Tax Rate (percentage) 0 100 The Laffer Curve

29. Copyright © 2005 Pearson Education Canada Inc.15-29 Alternative Models for Active Policy Making New Keynesian Economics  Economic models based on the idea that demand creates its own supply as a result of various possible government fiscal and monetary coordination failures.

30. Copyright © 2005 Pearson Education Canada Inc.15-30 Alternative Models for Active Policy Making Why are prices “sticky”? 1) Small-Menu Cost Theory Much of the economy is characterized by imperfect competition. It is costly for firms to change their prices in response to changes in demand (i.e., reprinting price lists, renegotiating contracts).

31. Copyright © 2005 Pearson Education Canada Inc.15-31 Alternative Models for Active Policy Making Why are prices “sticky”? 2) Efficiency Wage Theory Worker productivity actually depends on the wages that workers are paid.

32. Copyright © 2005 Pearson Education Canada Inc.15-32 Alternative Models for Active Policy Making New Growth Theorists  Argue that stabilization policy doesn’t have much benefit, since the “wiggles” in the business cycle are reflections of the discovery and innovation process.  Argue that governments should focus on economic growth instead of business fluctuations.