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MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT
Stabilization Policy
2nd edition
16-2
Key Concepts
Phillips Curve Credibility Rules versus Discretion Time Consistency
16-3
Decrease in Demand Keynesian view
Price Level
Real GDP
AD
AS
P0
Y0Y1
P1
LRAS
16-4
Decrease in Demand Keynesian view
Price Level
Real GDP
AD
AS
P0
Y0Y1
P1
LRAS Government responds by increasing demand
Increase GDecrease TIncrease M
16-5
Increase in Demand Keynesian view
Price Level
Real GDP
AD
AS
P0
Y0 Y1
P1
LRAS
16-6
Increase in Demand Keynesian view
Price Level
Real GDP
AD
AS
P0
Y0
LRAS Government responds by decreasing demand
Decrease GIncrease T
Decrease M
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Decrease in supply Keynesian stabilization response
Price Level
Real GDP
AD
AS
P0
Y0
LRAS Government responds by increasing demand
Big increase in
price
16-8
Arguments against Stabilization Policy
Uncertainty Demand or supply shocks?
Policy Lags => decrease stability Informational, decision, and implementation lags
Problems with Fiscal Policy Public investment and social goals may conflict with
stabilization goals Ricardian Equivalence Consumer Expectations Crowding Out Monetary Policy
Can only affect long-term rates through expectations of inflation and future interest rates
16-9
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( )e NA U U
16-10
2
3
4
5
6
7
8
0 2 4 6 8 10 Wage inflation.
Une
mpl
oym
ent.
US Phillips Curve, 1945 - 1970
16-11
Inflation and unemployment, United States, 1983–2000
16-12
Inflation and unemployment, Japan, 1983–2000.
16-13
Inflation and unemployment, France, 1983–2000.
16-14
Graphically…
Inflation
UnemploymentNatu
ral R
ate
10%
5%
0%
U > UNU < UN
( )e NA U U
0 ( )NA U U
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Graphically…
Inflation
UnemploymentNatu
ral R
ate
10%
5%
0%2%
5%
0 ( )NA U U
53
5% 0 (5% 2%)A
A
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Expectations catch up with reality
Inflation
UnemploymentNatu
ral R
ate
10%
5%
0%
5% 5% ( )N NA U U U U
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Phillips Curve
There is no usable long-run tradeoff between inflation and output
Expectations-augmented Philips may allow for short-run tradeoff
Complications to short-run tradeoff: supply shocks
Can lower inflation without increasing unemployment: lower inflation expectations
Importance of policymakers credibility Possible to lower inflation without costly unemployment
Phillips curve exist as a short-run tradeoff the government faces when it uses demand management it may not be visible empirically
S
Ne UUA )(
16-18
Time Inconsistency Scenario
Time Inconsistency: when the future arrives it may no longer be optimal to carry out plans “Gov’t will not negotiate with terrorist” “Monetary policy will not be inflationary”
Your child, Laura, has just graduated from high school, and is planning to attend State U in the fall. How should she spend her summer? Working to help pay for tuition (parents’ preference) Playing computer games (Laura’s preference)
You tell her the following If she works, you will help with tuition If she plays, she’s on her own in August
16-19
Time Inconsistency
Will you do what you say you’re going to do?
Play
Work
Laura
Pay for CollegePay for College
Don’t PayDon’t Pay
Pay for CollegePay for College
Don’t PayDon’t Pay
What you say…
16-20
Time Inconsistency
Will you do what you say you’re going to do?
Play
Work
Laura
Pay for CollegePay for College
Don’t PayDon’t Pay
Pay for CollegePay for College
Don’t PayDon’t Pay
What Laura thinks…
16-21
What is likely to happen?
?
16-22
Stabilization Policy
Government’s preferences Low inflation and low unemployment Stronger preference for low unemployment
16-23
Stabilization Policy
-3,0 3, -3
-5, -3 0, 0
Low Inflation
Low Inf.
High Inflation
High Inf.
Citizens’ Expectations
Policy Maker
•Private sector negotiates its wage, central bank responds
•If expectations = reality, then unemployment = natural rate
• If expectations < reality, then W/P low, unemployment is low
•If expectations > reality, then W/P high, unemployment is high
Government’s preferences•Low inflation and low unemployment•Stronger preference for low unemployment
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Rules versus Discretion
Why rules are preferred over discretion Information, decision, and implementation lags =>
stabilization policy destabilizes Uncertain impact on aggregate demand Time inconsistency
Can rules solve time consistency problem? Preference must be for low inflation
Can rules solve credibility problem? Two examples of rules
Monetary Policy: New Zealand Fiscal Policy: EU stability pact
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Rules
Friedman’s Rule Grow money supply at a certain, fixed percent
each year Remove instability from discretion
Reaction Function Rules Taylor Rule: policy response based on set rule
Predictability, but flexibility Nominal GDP targeting
Stabilize nominal spending Allow demand & supply shocks
16-26
Summary
Stabilization Policy Difficulties with stabilization policy Phillips curve and discretionary policy Time inconsistency Rules and Discretion
