1. M ACROECONOMICS C H A P T E R Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment 13

2. slide 1 Inflation inertia In this form, the Phillips curve implies that inflation has inertia:  In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.  Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.

3. slide 2 Graphing the Phillips curve In the short run, policymakers face a tradeoff between  and u. u  The short-run Phillips curve

4. slide 3 Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run. u  E.g., an increase in  e shifts the short-run P.C. upward.

5. slide 4 Rational expectations Ways of modeling the formation of expectations:  adaptive expectations: People base their expectations of future inflation on recently observed inflation.  rational expectations: People base their expectations on all available information, including information about current and prospective future policies.

6. slide 5 Painless disinflation?  Proponents of rational expectations believe that the sacrifice ratio may be very small:  Suppose u = u n and  =  e = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible.  If the announcement is credible, then  e will fall, perhaps by the full 4 points.  Then,  can fall without an increase in u.

7. slide 6 The natural rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3-8).

8. slide 7 An alternative hypothesis: Hysteresis  Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.  Negative shocks may increase u n, so economy may not fully recover.

9. slide 8 Hysteresis: Why negative shocks may increase the natural rate  The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends.  Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves. Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends.

10. Chapter Summary 1.Phillips curve  derived from the SRAS curve  states that inflation depends on  expected inflation  cyclical unemployment  supply shocks  presents policymakers with a short-run tradeoff between inflation and unemployment CHAPTER 13 Aggregate Supply slide 9

11. Chapter Summary 2.How people form expectations of inflation  adaptive expectations  based on recently observed inflation  implies “inertia”  rational expectations  based on all available information  implies that disinflation may be painless CHAPTER 13 Aggregate Supply slide 10

12. Chapter Summary 3.The natural rate hypothesis and hysteresis  the natural rate hypotheses  states that changes in aggregate demand can only affect output and employment in the short run  hysteresis  states that aggregate demand can have permanent effects on output and employment CHAPTER 13 Aggregate Supply slide 11

13. M ACROECONOMICS C H A P T E R Stabilization Policy 14

14. slide 13 In this chapter, you will learn… …about two policy debates: 1. Should policy be active or passive? 2. Should policy be by rule or discretion?

15. slide 14 Question 1: Should policy be active or passive?

16. slide 15 Growth rate of U.S. real GDP -4 -2 0 2 4 6 8 10 19701975198019851990199520002005 Average growth rate Percent change from 4 quarters earlier

17. slide 16 Arguments for active policy  Recessions cause economic hardship for millions of people.  The Employment Act of 1946: “It is the continuing policy and responsibility of the Federal Government to…promote full employment and production.”  The model of aggregate demand and supply (Chaps. 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy.

18. slide 17 Arguments against active policy Policies act with long & variable lags, including: inside lag: the time between the shock and the policy response.  takes time to recognize shock  takes time to implement policy, especially fiscal policy outside lag: the time it takes for policy to affect economy. If conditions change before policy’s impact is felt, the policy may destabilize the economy.

19. slide 18 Automatic stabilizers  definition: policies that stimulate or depress the economy when necessary without any deliberate policy change.  Designed to reduce the lags associated with stabilization policy.  Examples:  income tax  unemployment insurance  welfare

20. slide 19 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. Two ways economists generate forecasts:  Leading economic indicators data series that fluctuate in advance of the economy  Macroeconometric models Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies

21. slide 20 The LEI index and real GDP, 1960s source of LEI data: The Conference Board The Index of Leading Economic Indicators includes 10 data series (see p.258 ).

22. slide 21 The LEI index and real GDP, 1990s source of LEI data: The Conference Board

23. slide 22 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. The preceding slides show that the forecasts are often wrong. This is one reason why some economists oppose policy activism.

24. slide 23 The Lucas critique  Due to Robert Lucas who won Nobel Prize in 1995 for rational expectations.  Forecasting the effects of policy changes has often been done using models estimated with historical data.  Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables.

25. slide 24 An example of the Lucas critique  Prediction (based on past experience): An increase in the money growth rate will reduce unemployment.  The Lucas critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall.

26. slide 25 The Jury’s out… Looking at recent history does not clearly answer Question 1:  It’s hard to identify shocks in the data.  It’s hard to tell how things would have been different had actual policies not been used. Most economists agree, though, that the U.S. economy has become much more stable since the late 1980s…

27. slide 26 The stability of the modern economy Standard deviation 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1960196519701975198019851990199520002005 Volatility of GDP Volatility of Inflation

28. slide 27 Question 2: Should policy be conducted by rule or discretion?

29. slide 28 Rules and discretion: Basic concepts  Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through.  Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

30. slide 29 Arguments for rules 1. Distrust of policymakers and the political process  misinformed politicians  politicians’ interests sometimes not the same as the interests of society

31. slide 30 Arguments for rules 2. The time inconsistency of discretionary policy  def: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement.  Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.

32. slide 31 Examples of time inconsistency 1. To encourage investment, govt announces it will not tax income from capital. But once the factories are built, govt reneges in order to raise more tax revenue.

33. slide 32 Examples of time inconsistency 2. To reduce expected inflation, the central bank announces it will tighten monetary policy. But faced with high unemployment, the central bank may be tempted to cut interest rates.

34. slide 33 Monetary policy rules a.Constant money supply growth rate  Advocated by monetarists.  Stabilizes aggregate demand only if velocity is stable.

35. slide 34 Monetary policy rules b.Target growth rate of nominal GDP  Automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. a.Constant money supply growth rate

36. slide 35 Monetary policy rules c.Target the inflation rate  Automatically reduce money growth whenever inflation rises above the target rate.  Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. a.Constant money supply growth rate b.Target growth rate of nominal GDP

37. slide 36 Monetary policy rules d.The Taylor rule: Target the federal funds rate based on  inflation rate  gap between actual & full-employment GDP c.Target the inflation rate a.Constant money supply growth rate b.Target growth rate of nominal GDP

38. slide 37 The Taylor Rule i ff =  + 2 + 0.5 (  – 2) – 0.5 (GDP gap) where i ff = nominal federal funds rate target GDP gap = 100 x = percent by which real GDP is below its natural rate

39. slide 38 The Taylor Rule i ff =  + 2 + 0.5 (  – 2) – 0.5 (GDP gap)  If  = 2 and output is at its natural rate, then fed funds rate targeted at 4 percent.  For each one-point increase in , mon. policy is automatically tightened to raise fed funds rate by 1.5.  For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the fed funds rate by 0.5.

40. slide 39 The federal funds rate: Actual and suggested Percent 0 2 4 6 8 10 12 1987199019931996199920022005 Taylor’s Rule Actual

41. slide 40 Central bank independence  A policy rule announced by central bank will work only if the announcement is credible.  Credibility depends in part on degree of independence of central bank.

42. slide 41 Inflation and central bank independence average inflation index of central bank independence

43. slide 42 Chapter Summary 1. Advocates of active policy believe:  frequent shocks lead to unnecessary fluctuations in output and employment  fiscal and monetary policy can stabilize the economy 2. Advocates of passive policy believe:  the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly destabilizing  inept policy increases volatility in output, employment CHAPTER 14 Stabilization Policy slide 42

44. slide 43 Chapter Summary 3. Advocates of discretionary policy believe:  discretion gives more flexibility to policymakers in responding to the unexpected 4. Advocates of policy rules believe:  the political process cannot be trusted: Politicians make policy mistakes or use policy for their own interests  commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility CHAPTER 14 Stabilization Policy slide 43

45. M ACROECONOMICS C H A P T E R The Open Economy 5

46. slide 45 In an open economy,  spending need not equal output  saving need not equal investment

47. slide 46 Preliminaries EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM superscripts: d =spending on domestic goods f =spending on foreign goods

48. slide 47 The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) net exports domestic spending output

49. slide 48 Trade surpluses and deficits  trade surplus: output > spending and exports > imports Size of the trade surplus = NX  trade deficit: spending > output and imports > exports Size of the trade deficit = –NX NX = EX – IM = Y – (C + I + G )

50. slide 49 International capital flows  Net capital outflow =S – I = net outflow of “loanable funds” = net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets  When S > I, country is a net lender  When S < I, country is a net borrower

51. slide 50 The link between trade & cap. flows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflow Thus, a country with a trade deficit ( NX < 0) is a net borrower ( S < I ).

52. slide 51 National saving: The supply of loanable funds r S, I As in Chapter 3, national saving does not depend on the interest rate

53. slide 52 Assumptions re: Capital flows a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous a & b imply r = r* c implies r* is exogenous

54. slide 53 Investment: The demand for loanable funds Investment is still a downward-sloping function of the interest rate, r *r * but the exogenous world interest rate… …determines the country’s level of investment. I (r* ) r S, I I (r )I (r )

55. slide 54 If the economy were closed… r S, I I (r )I (r ) rcrc …the interest rate would adjust to equate investment and saving:

56. slide 55 But in a small open economy… r S, I I (r )I (r ) rcrc r* I 1I 1 the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflow and net exports NX