1. Stabilization Policy Lecture 22 Dr. Jennifer P. Wissink ©2015 Jennifer P. Wissink, all rights reserved. April 15, 2015

2. The NAIRU—The NonAccelerating Inflation Rate of Unemployment and U* unemployment rate actual inflation rate Long Run Phillips Curve (actual inflation = expected inflation) 5% = U*=U FE SR-PC with expected inflation = 2% 2% 4% 3% SR-PC with expected inflation = 4% 0% ↑G or ↑M s or...

3. u PP depicts the relationship between the change in the inflation rate and the unemployment rate. u Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). u To the left of the NAIRU the price level is accelerating (positive changes in the inflation rate). u To the right of the NAIRU the price level is decelerating (negative changes in the inflation rate). Your Text Book’s Version of (NAIRU) and the PP Curve

4. u A favorable shift of the PP curve is to the left because the PP curve crosses zero at a lower unemployment rate. Your Text Book’s Version of (NAIRU) and the PP Curve

5. Stabilization Policy & The Business Cycle u Recall: An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise. u Recall: A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall. u Recall: A positive trend line indicates long run growth. u MACRO QUESTIONS

6. Recall: Macroeconomic Data – Real Output Growth FIGURE 5.2 U.S. Aggregate Output (Real GDP), 1900–2009 The periods of the Great Depression and World Wars I and II show the largest fluctuations in aggregate output.

7. The U.S Economy Since 1970  FIGURE 5.4 Aggregate Output (Real GDP), 1970 I–2012 IV Aggregate output in the United States since 1970 has risen overall, but there have been five recessionary periods: 1974 I–1975 I, 1980 II–1982 IV, 1990 III–1991 I, 2001 I–2001 III, and 2008 I  2009 II.

8.  FIGURE 5.5 Unemployment Rate, 1970 I–2012 IV The U.S. unemployment rate since 1970 shows wide variations. The five recessionary reference periods show increases in the unemployment rate.

9.  FIGURE 5.6 Inflation Rate (Percentage Change in the GDP Deflator, Four-Quarter Average), 1970 I–2012 IV Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV. Inflation between 1983 and 1992 was moderate. Since 1992, it has been fairly low.

10.  FIGURE 15.1 The S&P 500 Stock Price Index, 1948 I–2012 IV An index based on the stock prices of 500 of the largest firms by market value. Two others: Dow Jones Industrial Average – an index based on the stock prices of 30 actively traded large companies. NASDAQ Composite – an index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market.

11.  FIGURE 15.2 Ratio of After-Tax Profits to GDP, 1948 I–2012 IV

12.  FIGURE 15.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2012 IV u S&P/CASE-SHILLER HOME PRICE INDICES u The S&P/Case-Shiller Home Price Indices are the leading measures of U.S. residential real estate prices, tracking changes in the value of residential real estate both nationally as well as in 20 metropolitan regions.

13. Stabilization Policy u Stabilization Policy: attempts to employ both monetary and fiscal policy to smooth out fluctuations in output and employment and to keep prices as stable as possible. –Business Cycle Policy –Counter-cyclical Policy –Will it work? What’s Important? »what depends on what –various sensitivities  efficacy of policy –lags –political realities

14. Consider Two Possible Time Paths for GDP or Y* u Path A is less stable—it varies more over time—than path B. u Other things being equal, society prefers path B to path A. u Can stabilization policy get us something more like path B? i>clicker question: Which path is less stable? A.Path A B.Path B

15. Time Lags Regarding Monetary & Fiscal Policy u The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump. u The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. –The implementation lag for monetary policy is generally much shorter than for fiscal policy. u The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. –E.g., The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

16. Stabilization Woe: “The Fool in the Shower” u Attempts to stabilize the economy can prove destabilizing because of time lags. u Milton Friedman likened these attempts to a “fool in the shower.” u The government is constantly stimulating or contracting the economy at the wrong time.

17. “The Fool in the Shower” u An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.

18. “The Fool in the Shower” u Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). u Income varies more widely than it would have if no policy had been implemented. u If the government is the fool, can the FED help control it?

19. The Typical Fed Response to the State of the Economy u The Fed is likely to lower the interest rate (via an increase the money supply) during times of low output and low inflation. –easy money u This shifts AD to the right. u When the economy is on the flat portion of the AS curve, an increase in the money supply will lead to –an increase in output with very little increase in the price level.

20. The Typical Fed Response to the State of the Economy u On the other hand… u The Fed is likely to increase the interest rate (via a decrease the money supply) during times of high output and high inflation. –tight money u This shifts AD to the left. u When the economy is on the relatively steep portion of the AS curve, contraction of the money supply will lead to –a decrease in the price level, with little decrease in output. u Famous/Funny quote by Harry S. Truman on what kind of economist he wants... –“Give me a one-handed economist! All my economists say, On the one hand,... and on the other.”

21. The Typical Fed Response to the State of the Economy u Stagflation is a more difficult problem for the Fed to help solve. –If the Fed lowers the interest rate, output will rise, but so will the inflation rate (which is already too high). –If the Fed increases the interest rate, the inflation rate will fall, but so will output (which is already too low). u Supply side policies are more important when it comes to dealing with stagflation. u GROWTH!

24. The Typical Fiscal Response to the State of the Economy u Basic Policy Tools: –G = government expenditures –T = taxes u Typically see expansionary policy (which shifts AD to right) when at low Y* and little inflation, and just the opposite with high Y* and troublesome inflation. Same concerns as with The Fed with stagflation. u Note: Some G and T “policy” is built into the system by existing laws. –The system has automatic stabilizers & automatic destabilizers built in.

25. REVIEW: The Budget, Budget Deficit and Debt u The federal budget is the budget of the federal government and… –It is a political document that dispenses favors to certain groups or regions and places burdens on others. –It is a reflection of goals the government wants to achieve. –It may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. u In any given time period, the difference between the federal government’s receipts (T) and its expenditures (G) is the federal surplus (+) or deficit (-). A FLOW CONCEPT. –If G exceeds T, then the government typically borrows from the public to finance the deficit. –It does so by selling Treasury bonds and bills. That is, it borrows. u The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time. A STOCK CONCEPT. u Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non-government-owned) portion of the federal debt.

26. FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2010 I Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

27. FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2010 1 The Federal Government Debt

28. Economic Stability & Fiscal Policy u Automatic stabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize Y* or GDP. –the tax code –the government safety net, social insurance u Automatic destabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize Y* or GDP. –deficit targeting policy

29. Fiscal Policy: Deficit Targeting u The Gramm-Rudman-Hollings Bill, passed by the U.S. Congress and signed by President Reagan in 1986, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. u In practice, these targets never came close to being achieved. u The deficits were: –-149,730million in 1987 –-155,178million in 1988 –-152,639million in 1989 –-221,036million in 1990