1. MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT
11/29/2018
MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition
Stabilization Policy
PowerPoint by Beth Ingram
University of Iowa
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

2. Key Concepts Credibility Rules versus Discretion Time Consistency
Phillips Curve
Credibility
Rules versus Discretion
Time Consistency

3. Decrease in Demand Keynesian view
Price Level
LRAS AD AS P0 P1 Y1 Y0
Real GDP

4. Decrease in Demand Keynesian view
Price Level
LRAS
Government responds by increasing demand AD AS
Increase G
Decrease T
Increase M P0 P1 Y1 Y0
Real GDP

5. Increase in Demand Keynesian view
Price Level
LRAS AD AS P1 P0 Y0 Y1
Real GDP

6. Increase in Demand Keynesian view
Price Level
LRAS
Government responds by decreasing demand AD AS
Decrease G
Increase T
Decrease M P0 Y0
Real GDP

7. Decrease in supply Keynesian stabilization response
Price Level
LRAS
Government responds by increasing demand AD AS
Big increase in price P0 Y0
Real GDP

8. Arguments against Stabilization Policy
Uncertainty
Policy Lags (informational lag, decsion lag and implementation lag)
Problems with Fiscal Policy
Ricardian Equivalence (if debt is issued people will anticpate tax in future. Thus raising tax and issuing debt has no impact)
Consumer Expectations
Crowding Out
Monetary Policy

9. Automatic Stabilizer
Taxation: During recession tax receipt decreases. Increasing disposable income
Unemployment Benefit or government spending in transfer payment increase as more people are unemployed
Thus automatic stabilizer increases government deficit increases (vicervera in boom)

10. Rate of Inflation Anticipated by Consumers
Phillips Curve
Inflation = Expected Inflation
+ A*(Natural Rate Unemployment – Actual Unemployment)
Rate of Inflation Anticipated by Consumers
Rate of Unemployment when all resources are fully employed at long-run level

11. What do we see in the data?
Inflation versus Unemployment
Wage Inflation versus Unemployment
Is the relationship exploitable in the short run?
Negative correlation between unemployment and inflation (bill phillip)

12. US Phillips Curve,

13. Inflation and unemployment, United States, 1983–2000

14. Inflation and unemployment, Japan, 1983–2000.

15. Inflation and unemployment, France, 1983–2000.

16. Why negative correlation
Wages cannot adjust as rapidly as price
During boom: Price is high wage is low and so more people get employed
During Contraction: Price falls but wage remain same and so less people employed
When wage and price gets adjusted unemployment returns to natural rate

17. Modified Phillip Curve
Inflation = Expected Inflation
+ A*(Natural Rate Unemployment – Actual Unemployment
+Supply Shock
Negative Correlation only occurs change in demand side.
If supply shock occurs entire curve will shift leading to stagflation (high
Unemployment and high inflation)
To reduce inflation by 1% the unemployment should be increase by 1/A %
Known as sacrifice ratio

18. Graphically… Inflation 10% 5% U < UN U > UN 0% Unemployment
Natural Rate

19. Graphically…
Inflation
10% 5% 0% 2%
Unemployment 5%
Natural Rate

20. Expectations catch up with reality
11/29/2018
Expectations catch up with reality
Inflation
10% 5%
Initially the inflation expectation is 3%. To reduce the unemployment government increased the aggregate demand. Now the umeployment falls but the inflation rises.
Three things can happen,
A. Real wage never rises unemployment will remain lower.
B. Inflation expectation will be low than actual
C. Owing to inflation wage increases anf the employment returns back to natural rate
Milton Firedman said that using phillip curve will only increase inflation as there are different Phillip curve at different level of inflation expectation 3%
Unemployment
Natural Rate

21. Time Inconsistency Scenario
Success of government action today will depend on private sectors belief about what government will do tomorrow
Talk is cheap

22. Prisoner’s Dilemma -1, -1 -9, 0 0, -9 -6, -6 Prisoner 2 Don’t Talk
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Prisoner’s Dilemma
Prisoner 2
Don’t Talk
Talk
-1, -1
-9, 0
0, -9
-6, -6
Don’t Talk
Prisoner 1
Talk
If neither talk, get convicted of minor crime. If both talk, get convicted of major crime.

23. Stabilization Policy -3,0 3, -3 -5, -3 0, 0 Citizens’ Expectations
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Stabilization Policy
Citizens’ Expectations
High Inflation
Low Inflation
-3,0
3, -3
-5, -3
0, 0
High Inf.
Policy
Maker
Low Inf.
If neither talk, get convicted of minor crime. If both talk, get convicted of major crime.
If expectations = reality, then unemployment = natural rate
If expectations < reality, then unemployment is low
If expectations > reality, then unemployment is high

24. Stabilization Policy -3,0 -3, -3 -5, -3 0, 0 Citizens’ Expectations
11/29/2018
Stabilization Policy
Citizens’ Expectations
High Inflation
Low Inflation
-3,0
-3, -3
-5, -3
0, 0
High Inf.
Policy
Maker
Low Inf.
If neither talk, get convicted of minor crime. If both talk, get convicted of major crime.
Zero payoff means private sector is indifferent if their exectation matches with real
Regardless of private sector’s expectation government will choose high inflation. So less optimal outcome is achieved

25. Rules versus Discretion
Can rules solve time consistency problem?
Can rules solve credibility problem?
Two examples of rules
European Union
UK Code for Fiscal Stability

26. European Union
A fiscal deficit of over 3% can only be run in exceptional circumstances:
Natural Disasters
Temporary overshooting (e.g. associated with a one-off payment)
Serious economic decline. (GDP decline of 0.75% or more with declines between 0.75% and 2% subject to the discretion of the Council of Ministers)
If circumstances not met, the offending country must
make a non-interest bearing deposit of 0.2% of GDP with a further 0.1% for every percentage point above the 3% mark in subsequent years.
If the deficit is still excessive after two years, the deposit becomes a fine.

27. UK Code for Fiscal Stability
Public Debt as a proportion of national income will be held at a stable and prudent level over the economic cycle.
The Golden Rule. Over the economic cycle, the government will borrow only to finance investment and not to fund current consumption.

28. Summary Stabilization Policy Difficulties with stabilization policy
Phillips curve and discretionary policy
Time inconsistency
Rules and Discretion
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.