Transcript Ch 17

Chapter 17
Stabilization in
an Integrated
World Economy
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
The “5yr5yr rate” is a measure of the average annual
expected inflation rate 5 to 10 years in the future, as
derived from interest rates on government bonds.
Financial market participants interpret an increase in
this rate as a signal of higher inflation in the current
year.
In this chapter, you will learn that this interpretation is
consistent with predictions offered by a theory
proposed by economists known as “new Keynesians.”
Learning Objectives
• Explain why the actual unemployment rate
might depart from the natural rate of
unemployment
• Describe why 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
• 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, the Policy Irrelevance Proposition, and
Real Business Cycles
• Modern Approaches to Justifying Active Policymaking
• Is There a New Keynesian Phillips Curve?
• Summing Up: Economic Factors Favoring Active versus Passive
Policymaking
Did You Know That ...
• A number of economists have determined from data collected
from U.S. retail price scanners that prices of most items
remain unchanged for longer intervals during holiday periods
than at other times of the year?
• As you will learn in this chapter, a key modern economic
theory suggests that even relatively small costs of changing
prices can lead to widespread price stickiness.
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
– Examples are monetary and fiscal policy
Active Versus Passive Policymaking
(cont'd)
• Passive (Nondiscretionary) Policymaking
– Policymaking that is carried out in response to a
rule
– Not in response to an actual or potential change in
overall economic activity
– Examples include a monetary rule
The Natural Rate of Unemployment
• Two components of the natural rate of
unemployment
– Frictional unemployment
– Structural unemployment
The Natural Rate of Unemployment (cont’d)
• Frictional unemployment
– Arises because individuals take the time to search
for the best job opportunities
– Much of the unemployment is of this type, except
when there is a recession or depression
The Natural Rate of Unemployment
(cont'd)
• Structural unemployment results from
1. Government-imposed minimum wage laws, laws
restricting entry into occupations, and welfare
and unemployment insurance benefits that
reduce incentives to work
2. Union activity that sets wages above the
equilibrium level and also restricts the mobility of
labor
The Natural Rate of Unemployment
(cont'd)
• 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
• In 1982, the unemployment rate was about 10%.
• By the early 2000s, it was at this level once again.
• Figure 17-1 shows that the actual rate of unemployment has
varied over the decades.
• Why does the natural rate of unemployment differ from the
actual rate of unemployment?
Figure 17-1 Estimated Natural Rate of Unemployment
in the United States
The Natural Rate of Unemployment
(cont'd)
• 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 17-2 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 17-3 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 Natural Rate of Unemployment
(cont'd)
• 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 Natural Rate of Unemployment
(cont'd)
• 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 17-4 The Phillips Curve, Panel (a)
Figure 17-4 The Phillips Curve, Panel (b)
Higher inflation and
lower unemployment
The Phillips curve implies a
policy trade-off between
inflation and unemployment
Zero inflation and
natural rate of
unemployment, U*
Can policymakers fine-tune
the economy?
Deflation and higher
unemployment
The Natural Rate of Unemployment
(cont'd)
• 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
– The unemployment rate consistent with a steady
inflation rate can potentially change during the
course of cyclical adjustments
– Thus, the NAIRU typically varies by a relatively
greater and more frequent amount than the
natural rate of unemployment
Figure 17-5 A Shift in the Phillips Curve
• There is a change in the
expected inflation rate
• The curve shifts to incorporate
new expectations
• PC0 shows expectations
at zero inflation
• PC5 reflects a higher expected
inflation rate, such as 5%
Why Not … ignore media headlines about inflation?
• Instead of the headline inflation rate, policymakers prefer
looking at the core inflation rate, which is the rate of change
in average prices excluding food and energy prices.
• Nevertheless, economists also found that movements in the
headline inflation rate provide a better indication of how
much the price level will rise in the longer term than changes
in the core inflation rate.
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles
• 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, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• New classical approach
– 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
Figure 17-6 Responses to Anticipated and
Unanticipated Increases in Aggregate Demand
Short-run equilibrium
increases output to Y2
with P2
Long-run equilibrium
after adjustment yields
Y1 with P3
Assume the money
supply increases
unexpectedly to M2 and
AD increases to AD2
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• The response to anticipated policy
– If the increase in the money supply was
anticipated
• The higher price level would be anticipated
• Workers and suppliers would demand higher wages and
prices immediately
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• 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
– A key assumption: people don’t persistently make
the same mistakes in forecasting the future
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• 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
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• Questions
– What must people know?
– What happens if they don’t know everything?
– What are the implications?
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• 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
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• 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 represent another challenge
to policy activism
Rational Expectations, the Policy Irrelevance Proposition, and
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?
Figure 17-7 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
Rational Expectations, the Policy Irrelevance Proposition, and
Real Business Cycles (cont’d)
• Stagflation
– A situation characterized by lower real GDP, lower
employment, and a higher unemployment rate
during the same period that the rate of inflation
increases
– In Figure 17-7, real GDP declines at the same time
the price level rises
Modern Approaches to Justifying 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 Justifying 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: Small Menu Costs in the U.S. Market for Imported
Beer
• Economists at the Federal Reserve Bank of New York find that
the cost of changing prices of imported beers in the United
States is only about 0.1 percent of revenues for beer retailers,
and 0.4 percent for the beer manufacturers.
• So, these retailers change their prices of imported beer
slightly more often than manufacturers.
• Also, both retailers and manufacturers allow lengthy
intervals—one year or longer—to pass before adjusting those
prices.
Modern Approaches to Rationalizing Active
Policymaking (cont'd)
• 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 17-8 Short- and Long-Run Adjustments in the New Keynesian
Sticky-Price Theory,
Panel (a)
Figure 17-8 Short- and Long-Run Adjustments in the New Keynesian
Sticky-Price Theory,
Panel (b)
Policy Example: Moderating the Great Recession Is Harder
Than Anticipated
• In 2009, the federal government increased its spending
substantially.
• The Council of Economic Advisers suggested that every $1.00
of government expenditures would raise real GDP by $1.60.
• Later Robert Barro of Harvard University found that each $1 of
government expenditures replaced $1 of private spending
that otherwise would have occurred, leaving no net impact on
real GDP.
Is there a New Keynesian 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
Is there a New Keynesian 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 tradeoff between unemployment and inflation would
disappear
Figure 17-9 The Phillips Curve: Theory versus Data
Is there a New Keynesian Phillips Curve? (cont’d)
• New Keynesians say all that matters for is
whether such a relationship between inflation
and unemployment is exploitable in the near
term
• If so, policymakers can intervene as soon as
unemployment and real GDP vary from their
long-run levels, thusly dampening cyclical
fluctuations and making them short-lived
Is there a New Keynesian Phillips Curve? (cont’d)
• Two factors that affect inflation:
– Anticipated future inflation
– Average inflation-adjusted (real) per-unit costs
that firms incur in production
• Empirical evidence does indicate that these
two factors are associated with higher
observed rates of inflation
Is there a New Keynesian Phillips Curve? (cont’d)
• Are New Keynesians correct?
– Not all economists agree
– The new classical theory already indicates that when
prices are flexible, higher inflation expectations should
reduce short-run aggregate supply and contribute to
increased inflation
– All macroeconomic theories suggest that various
factors that push up firms’ production costs should
have the same effect on short-run aggregate supply
and inflation in a flexible-price economy
– How often do firms really adjust their prices?
Summing Up: Economic Factors Favoring Active versus Passive
Policymaking
• Most economists agree that active policymaking is unlikely to
exert sizable long-run effects on any nation’s economy
• Most agree that aggregate supply shocks contribute to
business cycles
• Some argue that monetary and fiscal policy actions can offset,
at least in the short run and possibly in the long-run the
effects that aggregate demand shocks would otherwise have
on real GDP and unemployment
Table 17-1 Issues That Must Be Assessed in Determining the
Desirability of Active versus Passive Policymaking
You Are There: Fed Discretion—Based on What the Fed Forecasts
or What It Observes?
• During the years leading to the financial meltdown in 2008,
the Fed’s forecasts of inflation were persistently lower than
actual inflation.
• Thus, it is likely that Fed policymaking would have been
more effective if the Fed had based its discretionary policies
on the inflation rates it actually observed instead of on
inflation forecasts.
Issues & Applications: Inflation Expectations and the “5yr5yr Rate”
• The theory of new Keynesian inflation dynamics predicts that
an increase in expectations of future inflation exerts upward
pressure on the current inflation rate.
• One measure of longer-term inflation expectations is the
“5yr5yr rate,” which is the difference between interest rates
on traditional securities and Treasury inflation-protected
securities (TIPS) maturing between 5 and 10 years from now.
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
– Theory predicts that there will be a Phillips curve
relationship only when expectations are
unchanged
– The Phillips curve shifts
Summary Discussion of Learning Objectives (cont'd)
• Rational expectations, policy ineffectiveness, and realbusiness-cycle theory
– Rational expectations hypothesis
– Only unanticipated policy actions affect short-run real GDP
– Policy irrelevance theorem
– Technological changes and labor market shocks can induce business
fluctuations, called real business cycles, which weaken the case for
active policymaking
Summary Discussion of Learning
Objectives (cont'd)
• Modern approaches to bolstering the case for active
policymaking
– New Keynesian approach suggests that firms facing costs of
adjusting their prices may be slow to change in the face of
variations in demand
– Prices and wages are sufficiently inflexible in the short run that
there is an exploitable relationship between inflation and real GDP
– Discretionary policy actions can stabilize real GDP in the short run