1. Chapter 36 Current Issues in Macro Theory and Policy McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives
Alternative perspectives on macroeconomic instability
Equation of exchange and monetarism
New classical economists and self-correction
Rules vs. discretion in conducting stabilization policy
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3. Causes of Macro Instability
Mainstream view
Held by most economists
Price stickiness
Unexpected demand shocks
Variable investment spending
Unexpected supply shocks
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4. Causes of Macro Instability
Monetarist view
Government interference is the problem
Equation of exchange MV = PQ
Stable velocity
Monetary causes of instability
Inappropriate monetary policy
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5. Causes of Macro Instability
Real-business-cycle view
Shifts in long-run aggregate supply
ASLR2
ASLR1
Price Level P1
AD1
AD2 Q2 Q1
Real Domestic Output
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6. Causes of Macro Instability
Coordination failures
Fourth modern view
Limited information
Expectations and self-fulfilling prophecy
Unemployment equilibrium
Inflation equilibrium
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7. Self-Correction New classical view Automatic correction will occur
Rational expectations theory
Monetarists
Automatic correction will occur
Speed of adjustment
Unanticipated price-level changes
Fully anticipated price-level changes
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8. Self-Correction New Classical View of Self-Correction Price Level
ASLR
AS2
AS1 P3 c
Price Level P2 b P1 a
AD2
AD1 Q1 Q2
Real Domestic Output
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9. Self-Correction New Classical View of Self-Correction Price Level
ASLR
AS1
AS3
Price Level f P1 a P4 d P5 e
AD1
AD3 Q4 Q3 Q1
Real Domestic Output
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10. Self-Correction Mainstream view Downward wage inflexibility
Efficiency wage theory
Greater work effort
Lower supervision costs
Reduced job turnover
Insider-outsider relationships
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11. Rules or Discretion? In support of policy rules
Reduce macro instability
Monetary rule
Shift AD to keep up with AS
Price stability achieved
Inflation targeting
Balanced budget
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12. Rationale for Monetary Rule
ASLR1
ASLR2
Price Level P1
AD2 P2
AD1 Q1 Q2
Real Domestic Output, GDP
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13. Rules or Discretion? In defense of discretionary stabilization policy
Discretionary monetary policy
Velocity is not stable
Discretionary fiscal policy
Useful during recession
Increased macro stability
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14. The Taylor Rule Rules: passive monetary policy
Discretion: active monetary policy
Hybrid policy rule to dictate Fed actions
Policy responds to changes in real GDP and inflation
Use the interest rate
Fed explains deviations from the rule
Increase Fed credibility and reduce uncertainty
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15. Key Terms monetarism equation of exchange velocity
real-business-cycle theory
coordination failures
rational expectations theory
new classical economics
Taylor rule
price-level surprises
efficiency wage
insider-outsider theory
monetary rule
inflation targeting
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International Trade
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