M ACROECONOMICS C H A P T E R Aggregate Supply and the Short-run Tradeoff Between Inflation and...

MMACROECONOMICSACROECONOMICS

C H A P T E R

Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment

13

Inflation inertia

In this form, the Phillips curve implies that inflation has inertia:

In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.

Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.

1 ( )nu u

Graphing the Phillips curve

In the short run, policymakers face a tradeoff between and u.

In the short run, policymakers face a tradeoff between and u.

u

nu

1

The short-run Phillips curvee

Shifting the Phillips curve

People adjust their expectations over time, so the tradeoff only holds in the short run.

People adjust their expectations over time, so the tradeoff only holds in the short run.

u

nu

1e

2e

E.g., an increase in e shifts the short-run P.C. upward.

E.g., an increase in e shifts the short-run P.C. upward.

Rational expectations

Ways of modeling the formation of expectations:

adaptive expectations: People base their expectations of future inflation on recently observed inflation.

rational expectations:People base their expectations on all available information, including information about current and prospective future policies.

Painless disinflation?

Proponents of rational expectations believe that the sacrifice ratio may be very small:

Suppose u = u n and = e = 6%,

and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible.

If the announcement is credible, then e will fall, perhaps by the full 4 points.

Then, can fall without an increase in u.

The natural rate hypothesis

Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis:

Changes in aggregate demand affect output and employment only in the short run.

In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3-8).

An alternative hypothesis: Hysteresis

Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.

Negative shocks may increase un, so economy may not fully recover.

Hysteresis: Why negative shocks may increase the natural rate

The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends.

Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves.

Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends.

Chapter SummaryChapter Summary

1. Phillips curve derived from the SRAS curve states that inflation depends on

expected inflation cyclical unemployment supply shocks

presents policymakers with a short-run tradeoff between inflation and unemployment

CHAPTER 13 Aggregate Supply slide 10


2. How people form expectations of inflation adaptive expectations

based on recently observed inflation implies “inertia”

rational expectations based on all available information implies that disinflation may be painless



3. The natural rate hypothesis and hysteresis the natural rate hypotheses

states that changes in aggregate demand can only affect output and employment in the short run

hysteresis states that aggregate demand can have

permanent effects on output and employment



C H A P T E R

Stabilization Policy

14

In this chapter, you will learn…

…about two policy debates:

1. Should policy be active or passive?

2. Should policy be by rule or discretion?

Question 1:

Should policy be active or Should policy be active or passive?passive?

Should policy be active or Should policy be active or passive?passive?

Growth rate of U.S. real GDPGrowth rate of U.S. real GDP

-4

-2

0

2

4

6

8

10

1970 1975 1980 1985 1990 1995 2000 2005

Average growth

rate

Percent change from 4

quarters earlier

Arguments for active policy

Recessions cause economic hardship for millions of people.

The Employment Act of 1946: “It is the continuing policy and responsibility of the Federal Government to…promote full employment and production.”

The model of aggregate demand and supply (Chaps. 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy.

Arguments against active policy

Policies act with long & variable lags, including:

inside lag: the time between the shock and the policy response.

takes time to recognize shock takes time to implement policy,

especially fiscal policy

outside lag: the time it takes for policy to affect economy.

If conditions change before policy’s impact is felt, the policy may destabilize the economy.

If conditions change before policy’s impact is felt, the policy may destabilize the economy.

Automatic stabilizers

definition: policies that stimulate or depress the economy when necessary without any deliberate policy change.

Designed to reduce the lags associated with stabilization policy.

Examples: income tax unemployment insurance welfare

Forecasting the macroeconomy

Because policies act with lags, policymakers must predict future conditions.

Two ways economists generate forecasts:Leading economic indicators

data series that fluctuate in advance of the economy

Macroeconometric modelsLarge-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies

The LEI index and real GDP, 1960s

source of LEI data:The Conference Board

The Index of Leading Economic Indicators includes 10 data series

(see p.258 ).-10

-5

0

5

10

15

20

1960 1962 1964 1966 1968 1970

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators

Real GDP

The LEI index and real GDP, 1990s

source of LEI data:The Conference Board

-15

-10

-5

0

5

10

15

1990 1992 1994 1996 1998 2000 2002

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators

Real GDP

Forecasting the macroeconomy

Because policies act with lags, policymakers must predict future conditions.

The preceding slides show that the forecasts are often wrong.

This is one reason why some economists oppose policy activism.

The Lucas critique

Due to Robert Lucaswho won Nobel Prize in 1995 for rational expectations.

Forecasting the effects of policy changes has often been done using models estimated with historical data.

Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables.

An example of the Lucas critique

Prediction (based on past experience):An increase in the money growth rate will reduce unemployment.

The Lucas critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall.

The Jury’s out…

Looking at recent history does not clearly answer Question 1:

It’s hard to identify shocks in the data.

It’s hard to tell how things would have been different had actual policies not been used.

Most economists agree, though, that the U.S. economy has become much more stable since the late 1980s…

The stability of the modern economy

Sta

nd

ard

de

via

tio

n

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Volatility

of GDP

Volatility of Inflation

Question 2:

Should policy be conducted by Should policy be conducted by rule or discretion?rule or discretion?

Should policy be conducted by Should policy be conducted by rule or discretion?rule or discretion?

Rules and discretion: Basic concepts

Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through.

Policy conducted by discretion:As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

Arguments for rules

1. Distrust of policymakers and the political process misinformed politicians politicians’ interests sometimes not the same

as the interests of society

Arguments for rules

2. The time inconsistency of discretionary policy def: A scenario in which policymakers

have an incentive to renege on a previously announced policy once others have acted on that announcement.

Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.

Examples of time inconsistency

1. To encourage investment, govt announces it will not tax income from capital.

But once the factories are built, govt reneges in order to raise more tax revenue.

Examples of time inconsistency

2. To reduce expected inflation, the central bank announces it will tighten monetary policy.

But faced with high unemployment, the central bank may be tempted to cut interest rates.

Monetary policy rules

a. Constant money supply growth rate

Advocated by monetarists. Stabilizes aggregate demand only if velocity

is stable.


b. Target growth rate of nominal GDP Automatically increase money growth

whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target.



c. Target the inflation rate Automatically reduce money growth whenever

inflation rises above the target rate. Many countries’ central banks now practice

inflation targeting, but allow themselves a little discretion.


b. Target growth rate of nominal GDP


d. The Taylor rule: Target the federal funds rate based on inflation rate gap between actual & full-employment GDP

c. Target the inflation rate


b. Target growth rate of nominal GDP

The Taylor Rule

iff = + 2 + 0.5 ( – 2) – 0.5 (GDP gap)

where

iff = nominal federal funds rate target

GDP gap = 100 x

= percent by which real GDP is below its natural rate

Y Y

Y

The Taylor Rule

iff = + 2 + 0.5 ( – 2) – 0.5 (GDP gap)

If = 2 and output is at its natural rate, then fed funds rate targeted at 4 percent.

For each one-point increase in , mon. policy is automatically tightened to raise fed funds rate by 1.5.

For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the fed funds rate by 0.5.

The federal funds rate: Actual and suggested

Per

cen

t

0

2

4

6

8

10

12

1987 1990 1993 1996 1999 2002 2005

Taylor’s Rule

Actual

Central bank independence

A policy rule announced by central bank will work only if the announcement is credible.

Credibility depends in part on degree of independence of central bank.

Inflation and central bank independence

aver

age

infl

atio

n

index of central bank independence


1. Advocates of active policy believe: frequent shocks lead to unnecessary fluctuations in

output and employment fiscal and monetary policy can stabilize the

economy

2. Advocates of passive policy believe: the long & variable lags associated with monetary

and fiscal policy render them ineffective and possibly destabilizing

inept policy increases volatility in output, employment

CHAPTER 14 Stabilization Policy slide 43


3. Advocates of discretionary policy believe: discretion gives more flexibility to policymakers in

responding to the unexpected

4. Advocates of policy rules believe: the political process cannot be trusted: Politicians

make policy mistakes or use policy for their own interests

commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility

CHAPTER 14 Stabilization Policy slide 44


C H A P T E R

The Open Economy

5

In an open economy,

spending need not equal output

saving need not equal investment

Preliminaries

EX = exports = foreign spending on domestic goods

IM = imports = C f + I f + G f = spending on foreign goods

NX = net exports (a.k.a. the “trade balance”) = EX – IM

d fC C C d fI I I d fG G G

superscripts:d = spending on

domestic goodsf = spending on

foreign goods

The national income identity in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

net exports

domestic spending

output

Trade surpluses and deficits

trade surplus: output > spending and exports > imports Size of the trade surplus = NX

trade deficit: spending > output and imports > exports Size of the trade deficit = –NX

NX = EX – IM = Y – (C + I + G )

International capital flows

Net capital outflow

= S – I

= net outflow of “loanable funds”

= net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets

When S > I, country is a net lender

When S < I, country is a net borrower

The link between trade & cap. flows

NX = Y – (C + I + G )

implies

NX = (Y – C – G ) – I

= S – I

trade balance = net capital outflow

Thus, a country with a trade deficit (NX < 0)

is a net borrower (S < I ).

Thus, a country with a trade deficit (NX < 0)

is a net borrower (S < I ).

National saving: The supply of loanable funds

r

S, I

As in Chapter 3,national saving does not depend on the

interest rate

As in Chapter 3,national saving does not depend on the

interest rate

( )S Y C Y T G

S

Assumptions re: Capital flows

a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)

b. perfect capital mobility:no restrictions on international trade in assets

c. economy is small:cannot affect the world interest rate, denoted r*

a & b imply a & b imply rr = = r*r*

c implies c implies r*r* is exogenousis exogenous

a & b imply a & b imply rr = = r*r*

c implies c implies r*r* is exogenousis exogenous

Investment: The demand for loanable funds

Investment is still a downward-sloping function of the interest rate,

r *

but the exogenous world interest rate…

…determines the country’s level of investment.

I (r* )

r

S, I

I (r )

If the economy were closed…

r

S, I

I (r )

S

rc

cI

S

r

( )

…the interest rate would adjust to equate investment and saving:

…the interest rate would adjust to equate investment and saving:

But in a small open economy…

r

S, I

I (r )

S

rc

r*

I 1

the exogenous world interest rate determines investment…

the exogenous world interest rate determines investment…

…and the difference between saving and investment determines net capital outflow and net exports

…and the difference between saving and investment determines net capital outflow and net exports

NX

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