Transcript Chapter 28 Government and Stabilization

Principles of Economics
by Fred M Gottheil
PowerPoint Slides prepared by Ken Long
©1999 South-Western College Publishing
1
Chapter 28
Can Government
Really Stabilize the
Economy?
4/6/2016
©1999 South-Western College Publishing
2
What are the basic Schools
of Economic Thought?
• Classical • Supply-side
• Keynesian • neo-Keynesian
• Monetarism
• Rational Expectations
©1999 South-Western College Publishing
3
Classical theory
• Saw the economy as self-correcting
• Felt that a lack of aggregate demand
was unlikely
• If aggregate demand fell, adjustments
in prices, wages, and interest rates
would occur to return the economy to
full employment
4
What is the main conclusion of
Classical Economics?
Because the economy is
always tending toward a
full employment
equilibrium, there is no
need for government
intervention
5
What are the two
propositions of
Classical Economics?
1. All markets are
basically competitive
2. All prices are flexible
6
Another important
element of classical
theory….
• Say’s Law, Supply creates its own
demand
• Supplying output creates the
income needed to demand the
output
• Thus seen as unlikely for the
economy to suffer a “glut” of
7
unsold goods
What about savings in
classical theory?
Leads to the classical
theory of savings and
investment, belief that all
savings will get invested
in the economy
8
Classical theory of
savings and investment
• Savings--higher interest rates
encourage more savings
• Investment, lower interest rates
encourage business investment
9
Interest
Rates
Classical model of savings and
investment
Supply of
savings
i1
Investment
demand
S=I
Savings and
Investment
10
10
Interest
Rates
Classical model of savings and
investment
Supply of
savings, S1
S2
i1
Investment
demand
i2
Q1
Q2
Note that S=I at Q1 and Q2
Savings and
Investment
11
11
How do the Classical
Economists explain
unemployment?
Unemployment is a
temporary situation caused
by wage rates that are
above the equilibrium
level
©1999 South-Western College Publishing
12
What about the
long-run?
Wage rates will adjust,
bringing about full
employment in the
long-run
©1999 South-Western College Publishing
13
Real Wage and Employment
S1
W1
W2
D1
D2
Q2 Q1
14
©1999 South-Western College Publishing
14
According to the Classical
Economists, why might
unemployment be persistent?
People interfere with the
competitive process
©1999 South-Western College Publishing
15
How do people
interfere with the
competitive process?
• Unions
• Minimum wage laws
©1999 South-Western College Publishing
16
According to the Classical
Economists, what should
the government do during
periods of unemployment?
NOTHING
©1999 South-Western College Publishing
17
How do the Classical
Economists explain
inflation?
©1999 South-Western College Publishing
18
Money
Velocity
Prices
MV
P=
Q
GDP
©1999 South-Western College Publishing
1
19 9
Who controls the level
of money and therefore
the price level?
The Federal Reserve
©1999 South-Western College Publishing
20
How much should the
Fed increase the
money supply?
Approximately equal to the
long-run full employment
rate of growth, about 3%
©1999 South-Western College Publishing
21
What is
Keynesian Economics?
Government intervention
when the economy is in
a less than full
employment equilibrium
©1999 South-Western College Publishing
22
According to the
Keynesians, why do we
have unemployment?
Unemployment is the
result of insufficient
aggregate demand
©1999 South-Western College Publishing
23
What is the solution to
Unemployment?
Use government’s fiscal
policies to increase
aggregate demand
©1999 South-Western College Publishing
24
Where does the money
come from to increase
aggregate demand?
The government practices
deficit spending
©1999 South-Western College Publishing
25
What is a
Contractionary Gap?
The difference in real GDP
between a less than full
employment equilibrium
and the real GDP at the full
employment equilibrium
©1999 South-Western College Publishing
Planned Spending
Contractionary Gap
C+I+G+(X-M)’
C+I+G+(X-M)
less than full employment
full employment
Real GDP
©1999 South-Western College Publishing
What is the Employment
Act of 1946?
Congress officially declares
that it is the continuing
policy and responsibility
of the federal government
to take an active role in
the economy
©1999 South-Western College Publishing
28
How do the Keynesians
view inflation?
They are not worried
about inflation
©1999 South-Western College Publishing
29
Highly simplified AS
curve in Keynesian
theory
The backward L supply
curve, no concern about
inflation until full
employment achieved
30
“Naive” AS Curve
P
AS
Full Employment
AD5
AD4
AD1 AD2
AD3
Qf
GDP
31
31
For what were the
Keynesians ill prepared ?
The stagflation of the
1970’s, when we had high
rates of both
unemployment and
inflation
©1999 South-Western College Publishing
32
Modified AS Curve
P
AS
Full Employment
AD6
AD5
AD4
AD3
AD1 AD2
GDP
33
33
What is
neo-Keynesian Economics?
The neo-Keynesians
emphasized the possibility
that an economy can be in
equilibrium at less than full
employment with inflation
©1999 South-Western College Publishing
34
What discovery supported
the view of less than full
employment equilibrium
and inflation?
The Phillips Curve
©1999 South-Western College Publishing
35
What is the
Phillips Curve?
A graph showing the
inverse relationship
between the economy’s
rate of unemployment
and the rate of inflation
©1999 South-Western College Publishing
36
Rate of Inflation
The Phillips Curve
Rate of Unemployment
©1999 South-Western College Publishing
3
37 7
Explaining the Phillips Curve
-Rightward Shift in AD•Price level and output rise
•Employment increases
•Unemployment decreases
•Price level and unemployment
move in opposite directions.
Explaining the Phillips Curve
-Leftward Shift in AD•Price level and output fall
•Employment decreases
•Unemployment increases
•Price level and unemployment
move in opposite directions.
The Phillips Curve: U.S. Experience
2
Inflation
0
8
6
4
2
0
2
3
4
5
6
7
Unemployment
8
9
10
41
What happened to the
Phillips curve in the
1970’s?
It appeared to shift
outward, due to the
supply side inflation and
stagflation of the 70’s
42
Explaining the outward
shifts in the Phillips
Curve
Supply shocks of the 1970’s,
leftward shifts in AS lead to
higher inflation and
unemployment both
Thus a worsened trade-off between
inflation and unemployment
43
What is
Supply-side Inflation?
Prices rise because of
an increase in costs
©1999 South-Western College Publishing
44
How did we break the
back of Stagflation?
In 1980, the Fed decreased
the money supply and
held it down until prices
came down
©1999 South-Western College Publishing
45
What was the result of
this Fed action in 1980?
A very severe recession
©1999 South-Western College Publishing
46
What was the long-run
gain from this policy?
The back of inflation was
broken making it possible
to concentrate on
stimulating employment
©1999 South-Western College Publishing
47
How do the neoKeynesians explain the
1970’s Phillips Curve
Instead of one Phillips
curve, there was a set
of Phillips curves
©1999 South-Western College Publishing
48
Rate of Inflation
The 1970’s Phillips Curve
Rate of Unemployment
©1999 South-Western College Publishing
4
49 9
Another view of the
Phillips curve
is…Natural Rate Theory
Recall the natural rate of
unemployment, the sum
of frictional and
structural
50
According to natural
rate theory, the
unemployment rate
tends to move, in the
long run, back to its
natural level
51
By this view, there is no
permanent trade off
between unemployment
and inflation
52
What does the long-run
Phillips curve look like
according to natural rate
theory?
It is effectively vertical
53
What is the Rational
Expectations School?
Government’s policy of
managing aggregate demand
is undermined because of
people’s anticipation of
consequences
©1999 South-Western College Publishing
54
Begin with different views of how
people form expectations
Adaptive expectations--base
expectations of the future path of a
variable on the past performance of
the variable, with the most recent past
having the greatest weight
Rational expectations--people should be
smarter than this, should use all
information available to them in
forming expectations
55
What is an example of
the negative effect of
anticipation?
When workers anticipate an
increase in aggregate
demand, they will bargain
for higher wages to protect
them from inflation
©1999 South-Western College Publishing
56
Conclusion of Rational
Expectations
Policies only affect the economy if
they are a “surprise”
If a policy is announced and people
correctly anticipate the policy,
then it has no effects.
Still a controversial theory, not
generally accepted in its entirety 57
What is Supply-side
Economics?
Through tax deductions,
spending cuts, and
deregulation, government
creates incentives to
increase aggregate supply
©1999 South-Western College Publishing
58
Right Shift in Supply
S1
P1
P2
S2
D
Q1
Q2
©1999 South-Western College Publishing
559
9
What is the Laffer Curve?
Increasing tax rates from
zero increases tax revenues
up to a point - beyond that
point increases will shrink
the economic pie because
of disincentives
©1999 South-Western College Publishing
60
The Laffer Curve
Tax Rates (%)
100
T* is the revenue
maximizing tax rate
T*
0
Tax Revenues
(dollars)
What is Crowding Out?
A fall in private
investment spending
caused by an increase in
government spending
©1999 South-Western College Publishing
62
How can government
borrowing cause
Crowding Out?
Interest rates can be
driven up, leaving less
money available for
private investment
©1999 South-Western College Publishing
63
Upon what do economists
generally agree?
Automatic stabilizers
©1999 South-Western College Publishing
64
What are
Automatic Stabilizers?
Structures in the economy
that tend to add to
aggregate demand when
the economy is in a
recession, and subtract
during inflation
©1999 South-Western College Publishing
65
What are some examples
of Automatic Stabilizers?
Unemployment benefits
The progressive income tax
©1999 South-Western College Publishing
66
http://www.whitehouse.gov
http://stats.bls.gov/eag.table.html
http://www.bog.frb.fed.us/releases/
h15/data/m/prime.txt
http://thomas.loc.gov
http://www.bls.gov
http://www.westegg.com/inflation
©1999 South-Western College Publishing
6
67 7
• What are the basic Schools of
Economic Thought?
• What is Classical Economics?
• What is Keynesian Economics?
• According to the Keynesians, why do
we have unemployment?
• What is the Employment Act of 1946?
• What is neo-Keynesian Economics?
• What is the Phillips Curve?
68
• What is Demand-side Inflation?
• What is Supply-side Inflation?
• What is the Rational Expectations
School?
• What is Supply-side Economics?
• What is the Laffer Curve?
• What is Crowding Out?
• Upon what do economists agree?
• What are some examples of
Automatic Stabilizers?
69
END
©1999 South-Western College Publishing
70