Debates on Macroeconomic Policy

By: Jeff, Billy, Chris T, Yuki, Chris H

* Day 1 Focus ** Day 1 Focus *

Demand-pull inflation, and the tradeoffs between inflation and unemployment as expressed by the Phillips Curve

Cost-push inflation and stagflation

Wage and price controls, and wage and price guidelines

Demand-pull inflation, and the tradeoffs between inflation and unemployment as expressed by the Phillips Curve

Cost-push inflation and stagflation

Wage and price controls, and wage and price guidelines

Demand-Pull Inflation

Demand-Pull Inflation

Caused by increase in aggregate demand inflation increases and unemployment decreases Increase in aggregate demand increases inflation

and output Increase in output lower unemployment and

higher wages Increase in wages further increases inflation Can be shown using a Phillips curve

Caused by increase in aggregate demand inflation increases and unemployment decreases Increase in aggregate demand increases inflation

and output Increase in output lower unemployment and

higher wages Increase in wages further increases inflation Can be shown using a Phillips curve

Demand-Pull InflationDemand-Pull Inflation

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The Phillips CurveThe Phillips Curve Keynesian economist A.W.H.

Phillips believed inverse relationship between inflation and unemployment was predictable

Created the curve called the Phillips curve

Government could use curve to predict how policy would affect the economy

Keynesian economist A.W.H. Phillips believed inverse relationship between inflation and unemployment was predictable

Created the curve called the Phillips curve

Government could use curve to predict how policy would affect the economy

The Phillips Curve

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Shifts in the Phillips Curve

Shifts in the Phillips Curve

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Cost-Push InflationCost-Push Inflation Caused by decreases in aggregate

supply, due to increase in input prices Cost of production increases higher

inflation and less output Less output higher unemployment Inflation and unemployment have direct

relationship, as both increase at same time, called stagflation (worst-case scenario)

Caused by decreases in aggregate supply, due to increase in input prices

Cost of production increases higher inflation and less output

Less output higher unemployment Inflation and unemployment have direct

relationship, as both increase at same time, called stagflation (worst-case scenario)

Cost-Push Inflation Cost-Push Inflation

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Wage and Price Policies

Wage and Price Policies

Attempted by government in 1970s and 1980s to solve stagflation

Consisted of wage and price controls, and wage and price guidelines

Attempted by government in 1970s and 1980s to solve stagflation

Consisted of wage and price controls, and wage and price guidelines

Wage and Price GuidelinesWage and Price Guidelines

Implemented from 1969-1975 Government encouraged voluntary caps on

wages and prices by labour unions and businesses

Businesses and labour unions were un-cooperative

Inflation was 5% when the commission was formed in 1969, and rose to 10% by 1975

Ineffective at battling inflation

Implemented from 1969-1975 Government encouraged voluntary caps on

wages and prices by labour unions and businesses

Businesses and labour unions were un-cooperative

Inflation was 5% when the commission was formed in 1969, and rose to 10% by 1975

Ineffective at battling inflation

Wage and Price ControlsWage and Price Controls

Implemented in 1975 Wages and salaries were only allowed to

increase by a maximum percentage each year (wages could increase by max of 8% in 1976, 6% in 1977, and 4% in 1978)

Businesses allowed price increases only to cover increase in costs, and restrictions put on profits

Inflation dropped during the next three years from 10% in 1975, to between 7.5-9% from 1976-1978, but rose above 10% by 1980, two years after wage and price controls were lifted

Implemented in 1975 Wages and salaries were only allowed to

increase by a maximum percentage each year (wages could increase by max of 8% in 1976, 6% in 1977, and 4% in 1978)

Businesses allowed price increases only to cover increase in costs, and restrictions put on profits

Inflation dropped during the next three years from 10% in 1975, to between 7.5-9% from 1976-1978, but rose above 10% by 1980, two years after wage and price controls were lifted

Debate Over Wage and Price PoliciesDebate Over Wage and Price Policies

Opposition to policies because they are ineffective, unfair, and inefficient

Ineffective because wage and price guidelines are voluntary are unsuccessful at decreasing inflation, and wage and price controls only work in short run but inflation rises again once the controls have been removed

Unfair because some sectors are easier to regulate than others and wage and price controls cannot be universally applied, so people in some sectors will have limited wage increases, and others will not.

Inefficient because wage and price controls are similar to price ceilings, so price cannot be used to gauge changes in supply and demand, and resources may be allocated to inefficient businesses rather than those who run more efficently

Opposition to policies because they are ineffective, unfair, and inefficient

Ineffective because wage and price guidelines are voluntary are unsuccessful at decreasing inflation, and wage and price controls only work in short run but inflation rises again once the controls have been removed

Unfair because some sectors are easier to regulate than others and wage and price controls cannot be universally applied, so people in some sectors will have limited wage increases, and others will not.

Inefficient because wage and price controls are similar to price ceilings, so price cannot be used to gauge changes in supply and demand, and resources may be allocated to inefficient businesses rather than those who run more efficently

Day One SummaryDay One Summary

Demand-Pull InflationThe Phillips CurveCost-Push InflationWage and Price Policies

Demand-Pull InflationThe Phillips CurveCost-Push InflationWage and Price Policies

Day 2 FocusDay 2 Focus

Monetarism: -central equations (velocity of money, equation

of exchange, quantity of money) -inflationary rates and monetary growth -monetarist policies -the monetary rule

Supply-Side Economics: -reduction in incentives -focus on aggregate supply -the Laffer curve -the influence of supply side economics

Monetarism: -central equations (velocity of money, equation

of exchange, quantity of money) -inflationary rates and monetary growth -monetarist policies -the monetary rule

Supply-Side Economics: -reduction in incentives -focus on aggregate supply -the Laffer curve -the influence of supply side economics

MonetarismMonetarism

An economic perspective that emphasizes the influence of money on the economy and the ability of private markets to accommodate fluctuations in economy

An economic perspective that emphasizes the influence of money on the economy and the ability of private markets to accommodate fluctuations in economy

Monetarists versus Keynesians

Monetarists versus Keynesians

Oppose fiscal policies preferred Keynesians, instead favour monetary policies

Monetarists agree that economy is susceptible to shocks, but misguided government intervention only worsens situation

Believe unwise use of monetary policy is mostly to blame for shocks in economy

Oppose fiscal policies preferred Keynesians, instead favour monetary policies

Monetarists agree that economy is susceptible to shocks, but misguided government intervention only worsens situation

Believe unwise use of monetary policy is mostly to blame for shocks in economy

The Velocity of Money (V)

The Velocity of Money (V)

Concept that is central to monetarism Velocity of money (V) = nominal GDP

money supply (M) Velocity of money (V): the average # of

times money is spent on final goods and services during a year

Nominal GDP: total dollar value of final goods and services produced in economy

Money supply (M) = M1 (publicly held currency and publicly held deposits, excluding cash reserves)EX1: If Canada’s nominal GDP is $800 billion, and M1 is $ 50 billion, what is the velocity?

Concept that is central to monetarism Velocity of money (V) = nominal GDP

money supply (M) Velocity of money (V): the average # of

times money is spent on final goods and services during a year

Nominal GDP: total dollar value of final goods and services produced in economy

Money supply (M) = M1 (publicly held currency and publicly held deposits, excluding cash reserves)EX1: If Canada’s nominal GDP is $800 billion, and M1 is $ 50 billion, what is the velocity?

The Equation of Exchange

The Equation of Exchange

Nominal GDP = V x M GDP expresses both price level (P)

and output (Q) Nominal GDP = P x Q

EX2: $800 billion = 2.0 x $400 billion

V x M = P x Q

Using EX1 and EX2:

$50 billion x 16 = 2.0 x $400 billion

Nominal GDP = V x M GDP expresses both price level (P)

and output (Q) Nominal GDP = P x Q

EX2: $800 billion = 2.0 x $400 billion

V x M = P x Q

Using EX1 and EX2:

$50 billion x 16 = 2.0 x $400 billion

The Quantity of MoneyThe Quantity of Money

The velocity of money changes over time due to long-run factors, almost constant in short run

Real output varies slightly from potential level in short run, wages are flexible so economy adjusts to changes in prices or unemployment (after a brief period of inflexible wages)

Velocity of money and real output are reasonably stable, so V* and Q* are set as constant values

M x V* = P x Q* Result is direct relationship between money

and prices

The velocity of money changes over time due to long-run factors, almost constant in short run

Real output varies slightly from potential level in short run, wages are flexible so economy adjusts to changes in prices or unemployment (after a brief period of inflexible wages)

Velocity of money and real output are reasonably stable, so V* and Q* are set as constant values

M x V* = P x Q* Result is direct relationship between money

and prices

Inflation Rates and Monetary Growth

Inflation Rates and Monetary Growth

Extension of quantity theory of money that shows relationship between inflation rates and growth in money supply

When both velocity and real output are constant, the percentage changes in money supply and in price level are equal

% in M = % in P Velocity of money and real output are

not perfectly constant, so inflation is not always identical to the rate of monetary growth, but they will be close

Extension of quantity theory of money that shows relationship between inflation rates and growth in money supply

When both velocity and real output are constant, the percentage changes in money supply and in price level are equal

% in M = % in P Velocity of money and real output are

not perfectly constant, so inflation is not always identical to the rate of monetary growth, but they will be close

Inflation Rates and Monetary Growth –

EXAMPLE

Inflation Rates and Monetary Growth –

EXAMPLEM x V* = P x Q*

$50 billion x 16 = 2.0 x $400 billion $55 billion x 16 = 2.2 x $400 billion

  % in M = ($55 billion - $50 billion) x 100

% $50 billion

= 10 %  % in P = (2.2 – 2.0) x 100%

2.0 = 10%

M x V* = P x Q* $50 billion x 16 = 2.0 x $400 billion $55 billion x 16 = 2.2 x $400 billion

  % in M = ($55 billion - $50 billion) x 100

% $50 billion

= 10 %  % in P = (2.2 – 2.0) x 100%

2.0 = 10%

Monetarist PoliciesMonetarist Policies

Money is the key factor in the economy, unlike Keynesians who believe it is only one of many factors

Fiscal policy has little influence due to “crowding out effect”

Even monetary policy cannot change output from its potential level

Only way to stabilize economy is minimizing harmful effects of inflation, when bank of Canada minimizes rate of growth of money supply

Money is the key factor in the economy, unlike Keynesians who believe it is only one of many factors

Fiscal policy has little influence due to “crowding out effect”

Even monetary policy cannot change output from its potential level

Only way to stabilize economy is minimizing harmful effects of inflation, when bank of Canada minimizes rate of growth of money supply

The Monetary RuleThe Monetary Rule

The monetary rule forces central banks to increase the money supply by a constant rate each year

Recommended at 3% based on real long-term growth in economy

The monetary rule forces central banks to increase the money supply by a constant rate each year

Recommended at 3% based on real long-term growth in economy

Supply-Side EconomicsSupply-Side Economics

Focuses on influence of production costs on prices and incomes

Influence on aggregate supply is most important result of government policy

Focuses on influence of production costs on prices and incomes

Influence on aggregate supply is most important result of government policy

Reduction in IncentivesReduction in Incentives

Recent government has impaired economic activity by reducing incentives to be productive

Personal Income and Business Taxes: When taxes increase, disposable income falls

Sales Taxes: Reduces amount of products that can be bough with a given disposable income

Transfers and Subsidies: welfare, Unemployment Insurance, and farm subsidies diminish incentives to generate private income

Regulation: Environmental, safety…regulations have all increased business costs and reduced incentives to invest

Recent government has impaired economic activity by reducing incentives to be productive

Personal Income and Business Taxes: When taxes increase, disposable income falls

Sales Taxes: Reduces amount of products that can be bough with a given disposable income

Transfers and Subsidies: welfare, Unemployment Insurance, and farm subsidies diminish incentives to generate private income

Regulation: Environmental, safety…regulations have all increased business costs and reduced incentives to invest

Focus on Aggregate SupplyFocus on Aggregate Supply

More taxes and government regulation decrease aggregate supply, and the AS curve shifts to the left

Same as cost-push inflation; increased costs push up prices a the same time that unemployment rises stagflation

Supply-siders call for tax cuts and deregulation to lower prices and unemployment

More taxes and government regulation decrease aggregate supply, and the AS curve shifts to the left

Same as cost-push inflation; increased costs push up prices a the same time that unemployment rises stagflation

Supply-siders call for tax cuts and deregulation to lower prices and unemployment

Effect of Government InterventionEffect of Government Intervention

The Laffer CurveThe Laffer Curve

Demonstrates an assumed relationship between tax rates and tax revenues

Tax rates and tax revenues have direct relationship at low tax rates, therefore tax increase at lower tax rates also increases tax revenues, and positive slope on graph

Tax rates and tax revenues have indirect relationship at high tax rates, therefore a tax increase at higher tax rates decreases tax revenues, and negative slope on graph

Tax increases at higher tax rates have dampening effect on economic activity

Demonstrates an assumed relationship between tax rates and tax revenues

Tax rates and tax revenues have direct relationship at low tax rates, therefore tax increase at lower tax rates also increases tax revenues, and positive slope on graph

Tax rates and tax revenues have indirect relationship at high tax rates, therefore a tax increase at higher tax rates decreases tax revenues, and negative slope on graph

Tax increases at higher tax rates have dampening effect on economic activity

The Laffer CurveThe Laffer Curve