2. Chapter 17 Stabilization in an Integrated World Economy

3. Active vs. Passive Policymaking Active (discretionary) policymaking: a deliberate action in response to economic conditions, (i.e. fiscal & monetary policy) Passive (non-discretionary) policymaking: policies based on a rule (not a response), i.e. monetary rule Which is better?

4. Natural Rate of Unemployment Frictional unemployment: will always exist (even in LR equil.) b/c people take the time to search for the right job + Structural unemployment: will always exist b/c of rigidities such as: Occupation restrictions (licensing), union wages above equil., welfare, minimum wage laws, etc. *When LR equil. is reached, the current unemployment = natural rate of unemployment

5. When Unemployment is not the NRU: Cyclical unemployment means NRU will change in response to business fluctuations: (sometimes this is due to MP and/or FP) + cyclical unemployment is a result of a recession = more than natural rate - cyclical unemployment is a result of a boom = less than natural rate = less than natural rate

6. Expansionary Policy Effect on NRU When the MP is unexpected: The increased AD means unemployment will fall as production expands in the SR - when adjustments are made back to LR there is a higher PL, and we are back at the NRU

7. Contractionary Policy Effect on NRU When the MP is unexpected: AD decreases & unemployment rises as production is cut back in the SR - adjustment to LR will be at a lower price level (deflation), and at the NRU again.

8. Unexpected MP Summary: When the AD change is sudden / unexpected you end up with: Inflation & lower unemploymentor Deflation & higher unemployment The greater the increase/decrease in AD, the greater the effect on inflation/deflation and employment/unemployment.

9. Phillips Curve See graph 17-4 pg. 404 As inflation increases, unemployment decreases, (moves from A (NRU) to B (less than NRU) As inflation falls, unemployment increases, (moves from A (NRU) to C (more than NRU) –A trade-off exists between inflation & unemployment. If the trade-off really exists, our goal should be to find the nonaccelerating inflation rate of unemployment, (NAIRU): The rate of unemployment that corresponds to a stable rate of inflation

10. Importance of Expectations An unanticipated policy change to reduce unemployment (w/ a rise in inflation) may work temporarily, but the economy will adjust back for both unemp. and infl. If MS continues to grow (to keep unemp. low) inflation will be expected as workers know a higher nominal wage means nothing & they’ll stay unemployed Now unemployment is higher - so is inflation Friedman and Phelps suggest: –the inflation/unemployment trade-off may not be a reality, b/c of people’s expectations & reactions to them.

11. New Classical Model (their take on the economic response to MP) Rational expectations hypothesis: people forecast the future according their understanding of MP & FP, and act accordingly –Graph pg. 409 A shift occurs to AD2 when MS unexpectedly increases w/ a higher PL Unemployment is below NRU - workers demand higher wages, (b/c of higher PL) SRAS shifts upward to LR at point C w/ a higher PL, (GDP returns to Y1)

12. Expectations (according to rational expectations) If workers know about increased MS & its effects, their response will be to demand nominal wage increases now to keep pace w/ the PL If this is true, the new SRAS will move @ the same time as AD shifts (directly A to C, no point B) pg. 410 The only response to an increased MS is a rise in PL to P3 - (no fall in unemployment or rise in GDP, even temporarily)

13. Policy Irrelevance Proposition Anticipated MP does not determine levels of real variables, (i.e. unemp. & GDP) People don’t know exact monetary policy; they make educated predictions, and are usually somewhat correct. Sometimes, people are wrong and/or the Fed screws up, and the MP is unsystematic & therefore unanticipated. Unanticipated MP may lower unemployment & raise PL, (Panel a pg. 411) - people will still adjust in the LR though. The question is posed then, what good is MP if the economy finds itself in a recession???

14. Real Business Cycle Theory Supply of important inputs such as oil influence employment & real output rather than the money supply. Graph pg. 413 - reduced supply of input (such as oil) shifts SRAS left –If reduction is permanent this becomes the LR too. –Products of the input rise in price, firms cutback production & output falls. –Employment and real wages fall.

15. Finish reading the chapter on your own. THE END – NO MORE MACRO CHAPTERS!

16. But… you do get to take a cumulative semester final!