Transcript Dealing With Shocks

Reagan Style Tax Cut
• Cut personal taxes
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Idea is that this will improve incentives
People will work more
Shift the LRAS to the right
Increase Y* and reduce P
Note that SRAS shifts also as expectations adjust to the
new lower level
• But cutting taxes will shift the AD curve to right
– SR boom
– LR return to Y* with higher P
• Which happened?
– Both
– Demand effect larger
P
LRAS
AS(Pe)
D
AS(Pe)
A
C
B
Y0*
Y1*
AD0
Y
AD1
Comment
• So far we have show that policy (MP or FP)
seems to be ineffective in the LR
• Policy can have an impact only in the short
run
– i.e. only for as long as expectations fail to
adjust
• Policy Irrelevance: Robert Lucas
• But only holds when we start from Y*
• When Y<Y* policy can be relevant
Dealing With Shocks
• The AS-AD diagram shows how an
economy will automatically adjust to a
shock
• Start from LR eqm
– Y=Y*
– Pe=P
• Suppose there is a fall in AD
– Eqm moves from A to B
– Y<Y*
• This can only be a temporary eqm
• At B, P<Pe
– Real wages are higher than expected
• Prices fall, but by more than nominal wages
• See labour market diagram
– Workers are expensive
– Explains the decline in output
– Over time workers will
• Reduce price expectations
• Reduce wage demands
• SRAS shifts down
• Process continues until LR eqm is restored at C
– Real wage returns to original level
– Y=Y*
– Pe=P but at new lower level
LRAS
P
SRAS(Pe)
A
B
C
AD0
AD1
Y*
Y
• So the economy will automatically work itself out
of recession
• Mechanism depends on wage adjustment
– Mirror image of previous discussions
– Workers respond to lower prices by demanding lower
wages
– Reasonable?
• Yes real wages return to normal
• No long term decline in real wages
– Realistic?
• No! see data
• Nominal wages are rigid
• Have to wait for productivity
– Have lower wage increases than otherwise
• All this takes time
– 3+ years
• Alternative is for Government to expand AD
– Shift AD back
– Return to long run equilibrium A
• Rationale for stabilization policy
– After WTC, cut interest rates
– Enough? Or too much?
• Debate over which is best
– Policy: “long and variable lags”
– Automatic: “long run we are all dead”
– Calls for “flexibility” after EMU
Disinflation
• We can use the model to analyse the issue of
deflation
– i.e. how do we lower Prices without causing (much)
unemployment (lower output)
• We already know part of the answer
– LR there is no trade-off
• No LR increase in unemployment (or loss of output)
– SR there is a trade off
• Reducing inflation will mean higher U (lower Y)
– Expectations play a role
LRAS
P
AS(PAe)
AS(PBe)
A
B
C
D
AD0
AD1
Y*
Y
• Suppose we are at A
– Unemployment equals its natural rate
– The price level is too high (why?)
• Reduce AD (increase interest rates or taxes)
– Out put falls & Unemployment rises
– Move down the SRAS to B
– Actual price level falls
• B cannot be LR eqm (why?)
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Actual prices lower than expected
Real wages higher than expected
Expectations adjust down
New SRAS
• New SR eqm at C
– Still not a LR equilibrium
– prices will keep falling for as long as Y is kept
below the natural rate
– Expectations continue to adjust
• When the gov. is satisfied with the level of
prices,
– allow unemployment to return to the natural
rate
– prices stable
– New equilibrium at D
Sacrifice Ratio
• Disinflation achieved at a cost
– Y<Y* for several years
• Sacrifice ratio
– The increase in unemployment (above the
natural rate) needed to reduce inflation by one
percentage point in one year.
Example Volker disinflation
• Inflation fell by 6.7% over 4 years (198285)
• Unemployment was 9.5%, 9,5%, 7.4% and
7.1%
• Natural rate was 6%
• Sacrifice ratio 1.4
Painless Disinflation
• Previous example assumed expectations
adjust gradually
• In reality expectations could adjust a lot
quicker
• Think of extreme case
– Expectations adjust fully and immediately
– Full immediate fall in inflation without any
decrease in output
– Sacrifice ratio of zero
LRAS
P
AS(PAe)
AS(Pce)
A
B
C
AD0
AD1
Y*
Y
• The AS curve moves exactly the same time
as the AD curve
• What is required for this?
– Policy must be announced
– Policy must be credible
• Willing to cause pain
• Intermediate case is more realistic
– More credible policy maker faces a lower
sacrifice ratio
• Rationale for Independent central bank
Conclusions
1. Crucial role for expectations & for time frame.
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SR is for as long as expectations remain constant.
2. Policy conclusions of IS-LM-BP model hold only
in the short run and not in the long run.
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Policy is ineffective in long run if start from full
employment
3. The role for stabilization policy depends on
expectations adjustment process
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Policy can deliver faster adjustment than the
automatic adjustment mechanism
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What’s Missing?
1. Explicit consideration of unemployment
2. The role of expectations in aspects of AD
– Consumption, investment, Taxes and G
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