Chapter 18 Stabilization in an Integrated World Economy

Chapter 18

Stabilization in an Integrated World Economy

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 18-2

Introduction

The period since 1984 is known as the “Great Moderation.”

The variability of U.S. real GDP has been more than 50% lower than was true from 1952 though 1983.

Can policymakers really contribute to greater macroeconomic stability?


Learning Objectives

• Explain why the actual unemployment rate might depart from the natural rate of unemployment

• Describe why economic theory implies that there may be an inverse relationship between the inflation rate and the unemployment rate, reflected by the Phillips curve

• Evaluate how expectations affect the actual relationship between the inflation rate and the unemployment rate


Learning Objectives (cont'd)

• Understand the rational expectations hypothesis and its implications for economic policymaking

• Identify the central features of the real- business-cycle challenge to active policymaking

• Distinguish among alternative modern approaches to strengthening the case for active policymaking


Chapter Outline

• Active Versus Passive Policymaking

• The Natural Rate of Unemployment

• Rational Expectations and the Policy Irrelevance Proposition

• Another Challenge to Policy Activism: Real Business Cycles

• Modern Approaches to Rationalizing Active Policymaking

• Summing Up: Economic Factors Favoring Active Versus Passive Policymaking


Did You Know That...

• Between 1900 and 1945, a recession typically lasted 19 months, and since 1945 the average duration has fallen to 9 months?

• The average expansion between 1900 and 1945 lasted about 31 months and the average duration since has been 50 months?


Active Versus Passive Policymaking

• Active (Discretionary) Policymaking

All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy

ExamplesMonetary and fiscal policy


Active VersusPassive Policymaking (cont'd)

• Passive (Nondiscretionary) Policymaking

Policymaking that is carried out in response to a rule

ExamplesMonetary rule

Balancing the budget over the business cycle


Policy Example: Will Bernanke Opt for Passivity via Inflation Targeting?

• The current Fed chair has long been a proponent of inflation-targeting.

• The Fed would passively adjust the money supply as appropriate.

• There would be a single objective: a target rate of inflation.


The Natural Rate of Unemployment

• Two components of the natural rate of unemployment

Frictional unemployment

Structural unemployment


The Natural Rate of Unemployment (cont'd)

• Structural unemployment results from

1. A mismatch of worker training and skills with requirements of employers

2. Government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work

3. Union activity that sets wages above the equilibrium level and also restricts the mobility of labor



• Natural Rate of Unemployment

The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium

When all workers and employers have fully adjusted to any changes in the economy


Example: The U.S. Natural Rate of Unemployment

• Question How has the natural rate of unemployment

changed over the years?

• Answer It rose from the 1950s until the late 1980s

and then gradually declined.


Sources: Economic Report of the President; Economic Indicators, various issues.

Figure 18-1 Estimated Natural Rate of Unemployment in the United States


Example: The U.S. Natural Rate of Unemployment (cont'd)

• For critical analysis

Of the factors that create structural unemployment, which ones do you think explained the gradual trend upward in the natural rate of unemployment from the late 1940s until the 1990s in the United States?



• Departures from the natural rate of unemployment

Deviations of the actual from the natural rate are called cyclical unemployment.

Deviations observed over the course of nationwide business fluctuations


Figure 18-2 Impact of an Increase in Aggregate Demand on Real GDP and Unemployment

Monetary or fiscal policy leads to increase in AD, and the unemployment rate falls below the natural rate

SRAS shifts, the price level is higher and the unemployment rate rises to the natural rate, real GDP returns to the LRAS level


Figure 18-3 Impact of a Decline in Aggregate Demand on Real GDP and Unemployment

Monetary or fiscal policy leads to decline in AD and the unemployment rate rises above the natural rate

SRAS shifts, the price level is lower, and the unemployment rate falls to the natural rate, the new equilibrium is reached



• The Phillips curve: a rationale for active policymaking?

1. The greater the unexpected increase in aggregate demand, the greater the amount of inflation that results in the short run, and the lower the unemployment rate.

2. The greater the unexpected decrease in aggregate demand, the greater the deflation that results in the short run, and the higher the unemployment rate.



• The Phillips Curve

A curve showing the relationship between unemployment and changes in wages or prices

It was long thought to reflect a trade-off between unemployment and inflation.


Figure 18-4 The Phillips Curve

Higher inflation and lower unemployment

Zero inflation and natural rate of unemployment, U*

Deflation and higher unemployment

The Phillips curve implies a policy trade-off between inflation and unemployment

Can policymakers fine-tune the economy?



• Nonaccelerating Inflation Rate of Unemployment (NAIRU)

The rate of unemployment below which the rate of inflation tends to rise and above which the rate of inflation tends to fall


Figure 18-5 A Shift in the Phillips Curve

•PC0 shows expectations at zero inflation

•PC5 reflects a higher expected inflation rate, such as 5%

•There is a change in the expected inflation rate

•The curve shifts to incorporate new expectations


International Policy Example: The Effects of Higher Inflation on Inflation Expectations

• Economists measured the effects of a short-lived increase in inflation on expectations regarding future inflation.

• Conclusion: higher actual inflation has a significant effect regarding long-term inflation expectations.


The Phillips Curve

• The U.S. experience with the Phillips curve

Economists Milton Friedman and E.S. Phelps published pioneering studies.

The apparent trade-off suggested by the Phillips curve could not be exploited by activist policymakers.


The Phillips Curve (cont'd)

• The U.S. experience with the Phillips curve

Attempts to reduce the unemployment rate by inflating the economy would be thwarted by higher inflation expectations.

Activist policymaking would be offset; the trade-off between unemployment and inflation would disappear.


Figure 18-6The Phillips Curve: Theory versus Data


Rational Expectations and the Policy Irrelevance Proposition

• Rational Expectations Hypothesis

1. Individuals base their forecasts (expectations) about the future values of economic variables on all available past and current information.

2. These expectations incorporate individuals’ understanding about how the economy operates, including the operation of monetary and fiscal policy.


Rational Expectations and the Policy Irrelevance Proposition (cont'd)

• New classical model

A modern version of the classical model in which wages and prices are flexible

There is pure competition in all markets.

The rational expectations hypothesis is assumed to be working.


Assume the mS increases unexpectedly to M2 and AD increases to AD2

Short-run equilibrium increases output to Y2 with P2

Figure 18-7 Response to an Unanticipated Rise in Aggregate Demand

Long-run equilibrium after adjustment yields Y1 with P3



• The response to anticipated policy

If the increase in the money supply was anticipatedThe higher price level would be anticipated

Workers and suppliers would demand higher wages and prices immediately



• Policy Irrelevance Proposition

The conclusion that policy actions have no real effects in the short run if the policy actions are anticipated and none in the long run even if the policy actions are unanticipated


Figure 18-8 Effects of an Anticipated Rise in Aggregate Demand

Policy will have no impact on output

According to the rational expectations hypothesis the SRAS will shift simultaneously with the increase in AD



• Under the assumption of rational expectations on the part of decision makers in the economy, anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP.



• Regardless of the nature of the anticipated policy, the unemployment rate will equal the natural rate, and real GDP will be determined solely by the economy’s long-run aggregate supply curve.



• Questions

What must people know?

What happens if they don’t know everything?

What are the implications?



• The policy dilemma

Policy irrelevance proposition seems to suggest only mistakes have real effects

Policymakers powerless to push real GDP and unemployment back to long-run levels when entering recessionary period


Figure 18-9 Effects of an Unanticipated Rise in Aggregate Demand, Panel (a)

Even with rational expectations, an unanticipated change in AD can affect real GDP in the short run


Figure 18-9 Effects of an Unanticipated Rise in Aggregate Demand, Panel (b)

In the long run people will figure out the Fed’s actions and prices will increase and output will return to long-run equilibrium

Policy will have no impact on output


Another Challenge to Policy Activism: Real Business Cycles

• The distinction between real and monetary shocks

Many economists argue real (as opposed to purely monetary) forces might help explain aggregate economic fluctuations.Real business cycles and aggregate supply

shocks produced economic stagnation with high inflation “stagflation.”


Figure 18-10 Effects of a Reduction in the Supply of Resources

If the reduction in the resource is permanent, the LRAS will also shift

A reduction in the supply of a resource shifts SRAS to the left

The position of LRAS depends on our resource endowments


Another Challenge to Policy Activism: Real Business Cycles (cont'd)

• Questions regarding real business cycle theory

What impact would an oil shock have on aggregate demand?

Can we explain the Great Depression with the real business cycle theory?

What about the apparent wage and price rigidity within the economy?


Modern Approaches to Rationalizing Active Policymaking

• Market clearing models of the economy may not fully explain business cycles.

• “Sticky” wages and prices remain important, some economists contend.

• New Keynesians have tried to refine the theory of aggregate supply.


Modern Approaches to Rationalizing Active Policymaking (cont'd)

• Small Menu Costs

Costs that deter firms from changing prices in response to demand changes

Examples—the costs of renegotiating contracts or printing new price lists


Example: U.S. Price Stickiness—In the Eye of the Beholder?

• Question Are prices sticky?

• Answer Although price stickiness occurs in

some industries, prices of many goods appear flexible.


Figure 18-11 Estimated Intervals Between Price Changes in Selected Industries



• New Keynesian Inflation Dynamics

In new Keynesian theory, the pattern of inflation exhibited by an economy with growing aggregate demand—initial sluggish adjustment of the price level in response to increased aggregate demand followed by higher inflation later


Figure 18-12 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (a)


Figure 18-12 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (b)



• An alternative to the Keynesian scenario uses the bounded rationality theory.

• People cannot process all the information that confronts them, so they approximate.

• Wages and prices are neither fully flexible or completely rigid as a result.


Table 18-1 Issues That Must Be Assessed in Determining the Desirability of Active versus Passive Policymaking


Issues and Applications: Can Active Policymaking Take Credit for the “Great Moderation”?

• Improved policymaking?

• A more resilient economy?

• A lucky break?


Figure 18-13 Quarterly Real GDP Growth Rates Since 1952


Summary Discussion of Learning Objectives

• Why the actual unemployment rate might depart from the natural rate of unemployment Unanticipated changes in

aggregate demand

• Philips curve A curve showing an inverse relationship

between the rate of inflation and the rate of unemployment


Summary Discussion of Learning Objectives (cont'd)

• How expectations affect the actual relationship between the inflation rate and the unemployment rate The Phillips curve shifts

• Rational expectations, market clearing, and policy ineffectiveness Policy irrelevance theorem

Only unanticipated policy actions affect short-run real GDP.


Summary Discussion of Learning Objectives (cont'd)

• The real-business-cycle challenge to active policymaking To the extent aggregate supply shocks contribute

to real business cycles, the case for active policymaking is weakened.

• Modern approaches to bolstering the case for active policymaking New Keynesian approach views wages and prices

as sufficiently inflexible. Discretionary policy actions can stabilize real GDP

in the short run.

End of Chapter 18

Stabilization in an Integrated World Economy

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Chapter 18 Stabilization in an Integrated World Economy