Transcript Stabilization Policy, Output, and Employment

Chapter 15
Stabilization Policy,
Output, and Employment
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. Economic Fluctuations
—The Historical Record
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Economic Fluctuation
– The Historical Record



Historically, the United States has
experienced substantial swings in real
output.
Prior to the Second World War,
year-to-year changes in real GDP of 5
percent to 10 percent were experienced
on several occasions.
During the last five decades, the
fluctuations of real output have been
more moderate.
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Post-Second World War Decline in
Economic Instability



Prior to the conclusion of the WWII, the U.S. experienced double-digit
increases in real GDP (in 1918, 1922, 1935-1936, and 1941-1943).
In contrast, real output fell by 5% or greater in 1920-1921, 1930-1932,
1938, and 1946.
As illustrated here, fluctuations in real GDP have moderated during the
last four decades due, most economist agree, to more appropriate macro
policy (particularly monetary policy).
Annual %
Change
First World
War boom
(in real GDP)
Second World
War boom
16
14
12
10
8
6
4
2
0
–2
–4
–6
–8
–10
1920–1921
–12 Recession
–14
1910
1920
1937–1938
Recession
Great
Depression
1930
1940
1950
1960
1970
1980
1990
2000
Sources: Historical Statistics of the United States, p. 224; and Economic Report of the President (1999).
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2. Promoting
Economic Stability
– Activist and
Non-activist Views
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Promoting Economic Stability
-- Activist and Non-activist Views

Goals of Stabilization Policy:




A stable growth of real GDP,
A relatively stable level of prices,
A high level of employment (low unemployment).
Activists' Views of Stabilization Policy:



The self corrective mechanism works slowly if at all,
Policy-makers will be able to alter macro-policy,
injecting stimulus to help pull the economy out of
recession and implementing restraint to help control
inflation,
According to the activist s view, policy-makers are
more likely to keep the economy on track when they
are free to apply stimulus or restraint based on
forecasting devices and current economic indicators.
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Promoting Economic Stability
-- Activist and Non-activist Views

Non-activists' Views of Stabilization Policy:



The self-corrective mechanism of markets
works pretty well,
Greater stability would result if stable,
predictable policies based on predetermined
rules were followed,
Non-activists argue that the problems of proper
timing and political considerations undermine
the effectiveness of discretionary macro policy
as a stabilization tool.
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3. The Application
of Discretionary
Stabilization Policy
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Index of Leading Indicators

Index of Leading Indicators:




Is a composite statistic based on 10 key variables that generally
turn down prior to a recession and turn up before the beginning
of a business expansion.
The index can forecast the future and help policy makers, but it is
an imperfect forecasting device.
The index forecast the last 8 recessions (the arrows below show how
far ahead the index predicted recession) with variable advanced notice.
The index incorrectly forecasted recession on five occasions (*).
Composite Index of
Leading Indicators
18
(1987 = 100)
100
15
9
8
11
90
30
80
70
60
*
*
11
5
*
*
*
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996 1998
Source: Conference Board, Business Cycle Indicators.
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The Application of
Discretionary Stabilization Policy

Forecasting Models:


Highly complex statistical models used to
improve the accuracy of macro forecasts that
use past data from economic relationships to
forecast future outcomes and behaviors.
To date, the record of econometric forecasting
models has been mixed.
 They are accurate when conditions are
relatively stable but miss target when
things are otherwise.
 They also fail when major structural
changes occur which change the
relationships that their data is based upon.
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The Application of
Discretionary Stabilization Policy

Market Signals and Discretionary
Monetary Policy:
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
Some economists believe that information
supplied by certain economic markets can
also provide early warning of the need to
change policies.
Commodity prices, exchange rates, and other
market signals are best used as supplements,
rather than substitutes for, other economic
indicators and forecasting devices.
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4. Practical Problems
With Discretionary
Monetary Policy
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Practical Problems With
Discretionary Macro Policy

Lags and the Problem of Timing:



After a change in policy has been undertaken,
there will be a time lag before it exerts a
major impact.
This means policy makers need to forecast
economic conditions several months in the
future in order to institute policy changes
effectively.
Politics and Timing of Policy Changes:

Policy changes may be driven by political
considerations rather than stabilization.
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Time Lags and the Effects of
Discretionary Policy
Real GDP
Long-term
Growth Rate
E
Non-activists believe poor
timing of discretionary
policy will result in
destabilizing effects.
F
Path if macro policy
is timed improperly
D
A
B
C
Time




Beginning with pt A we illustrate the hypothetical business cycle.
If a forthcoming recession can be recognized quickly and more
expansionary policy instituted at pt B . . . expansionary policy may add
stimulus at pt C and help minimize the magnitude of the downturn.
Activists believe that discretionary policy may achieve this outcome.
However, if delays result in the adoption of the expansionary policy at C
and if it does not exert its major impact until pt D . . . the demand stimulus
will exacerbate the inflationary boom (as non-activists fear).
In turn, an anti-inflationary strategy instituted at pt E may exert its primary
impact at pt F . . . resulting in a deepening of the recession that follows.
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Questions for Thought:
1. What is the index of leading indicators?
Why is it useful to macro policy makers?
2. Why is proper timing of changes in
macroeconomic policy crucially important?
What are some of the practical problems that
limit the effectiveness of discretionary monetary
and fiscal policy as stabilization tools?
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5. How are
Expectations Formed?
-- Two Theories
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How are Expectations Formed?
-- Two Theories

Adaptive Expectations:
-- individuals form their expectations
about the future on the basis of data
from the recent past.

Rational Expectations:
-- Assumes that people use all pertinent
information, including data on the
conduct of current policy, in forming
their expectations about the future.
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Adaptive Expectations Hypothesis
Actual Rate
of Inflation
(percent)
12.0
Actual rate
of inflation
8.0
4.0
0
Expected Rate
of Inflation
Corresponding expected
rate of inflation in next period
(percent)
12.0
8.0
4.0
0
1


2
3
4
5
Time Period
According to the adaptive expectations hypothesis, what actually
occurs during the most recent period (or set of periods)
determines people’s future expectations.
Thus, the expected future rate of inflation lags behind the
actual rate by one period as expectations are altered over time.
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6. How Macro
Policy Works
-- The Implications of
Adaptive and Rational
Expectations
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How Macro Policy Works
– The Implications of Adaptive
and Rational Expectations
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With adaptive expectations, an unanticipated
shift to a more expansionary policy will
temporarily stimulate output and employment.
With rational expectations, expansionary
policy will not generate a systematic change
in output.
Both expectations theories indicate that
sustained expansionary policies will lead to
inflation without permanently increasing
output and employment.
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Expectations and the
Short-run Effects of Demand Stimulus
Price
level
LRAS
SRAS1
P2
P1
e2
E1
AD1
YF Y2


AD2
Goods & Services
(real GDP)
Under adaptive expectations, anticipation of inflation will lag
behind its actual occurrence.
Thus, a shift to a more expansionary policy would increase
aggregate demand (from AD1 to AD2) and lead to a temporary
increase in GDP (from YF to Y2) accompanied by a modest
increase in prices (from P1 to P2).
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Expectations and the
Short-run Effects of Demand Stimulus
Price
level
LRAS
P2
E2
P1
E1
SRAS2
SRAS1
AD1
YF



AD2
Goods & Services
(real GDP)
In contrast, under rational expectations, decision makers will
quickly anticipate the inflationary impact of a demand-stimulus policy.
Thus, while a shift to a more expansionary policy would increase
aggregate demand (from AD1 to AD2), resource prices and production
costs would rise just as rapidly (thereby shifting SRAS to SRAS2).
The net effect of demand-stimulus in the rational expectations model is
an increase in prices without altering real output -- even in the short run.
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7. The Emerging
Consensus View
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The Emerging
Consensus View



Monetary policy consistent with
approximate price stability is the key
ingredient of effective stabilization policy.
Sound policy avoids wide policy swings.
Responding to minor economic ups and
downs is a mistake.
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8. The Recent Stability
of the U.S. Economy
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The Recent Stability
of the U.S. Economy


The objectives of stabilization policy
have been less ambitious in recent years.
Rather than trying to control output and
employment, the focus has shifted to the
achievement of price stability.
Movement toward price stability has led
to a reduction in economic fluctuations.
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Reduction in the
Incidence of Recession
35
32.8
30
25
22.8
20
15
10
4.2
5
0
1910–1959
1960–1982
1983–1998
Sources: R.E. Lipsey and D. Preston, Source Book of Statistics Relating to Construction
(1966); & New York: National Bureau of Economic Research


The U.S. economy was in recession 32.8% of the time during the
1910-1959 period and 22.8% of the time between 1960-1982.
Since that time, the economy has become even more stable,
entering into recession only 4.2% of the time from 1983-1998.
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Questions for Thought:
1. State the adaptive-expectations hypothesis in
your own words. How does the theory of
rational expectations differ from that of adaptive
expectations?
2. Why do you think there has been less economic
instability during the last 16 years that any time
in American history?
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End
Chapter 15
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