Transcript McEachern Chapter 16 PPT

McEachern, Macroeconomics 11e, Ch. 16
16
Macro Policy Debate:
Active or Passive?
Prepared by: V. Andreea Chiritescu, Eastern Illinois University
Reviewed by: William A. McEachern, University of Connecticut
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
McEachern, Macroeconomics 11e, Ch. 16
• Does the economy work fairly well on its
own, or does it require active government
intervention?
• Does government intervention do more
harm than good?
• If people expect government to intervene
when the economy falters, does this
expectation affect people’s behavior?
• Does this expectation affect government
behavior?
• Is there a relationship between
unemployment and inflation in the short
run and in the long run?
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Active Policy vs. Passive Policy
• Active approach
– Economy is relatively unstable
– Government intervention is necessary
– Discretionary fiscal or monetary policy
• Passive approach
– Economy is relatively stable
– Natural market forces work
– Automatic stabilizers are all that’s needed
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.
McEachern, Macroeconomics 11e, Ch. 16
Closing a Recessionary Gap
• Passive approach
– Self-correcting forces of the economy
– Wages and prices are flexible enough
– High unemployment – decrease in wages
and production costs
– Increase SRAS
• Potential output
– Automatic stabilizers
– No discretionary policy
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
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McEachern, Macroeconomics 11e, Ch. 16
Closing a Recessionary Gap
• Active approach
– Prices and wages are not flexible
– Unemployment above natural rate
• Market forces may be too slow to respond
– Stimulate aggregate demand
• Fiscal policy
• Monetary policy
– Increase in price level
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
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McEachern, Macroeconomics 11e, Ch. 16
Exhibit 1
Closing a Recessionary Gap
(b) The active approach
Potential output
LRAS
SRAS110
SRAS100
110
Price
level
Price
level
(a) The passive approach
Potential output
LRAS
SRAS110
c
110
a
a
105
105
AD′
b
100
AD
AD
0
16.8 17.0
Real GDP
0
16.8 17.0
Real GDP
At point a in both panels, the economy is in short-run equilibrium, with unemployment exceeding its natural rate.
According to the passive approach, shown in panel (a), high unemployment eventually causes wages to fall,
reducing the cost of doing business. The decline in costs shifts the short-run aggregate supply curve rightward
from SRAS110 to SRAS100, moving the economy to its potential output at point b. In panel (b), the government
employs an active approach to shift the aggregate demand curve from AD to AD’. If the active policy works
perfectly, the economy moves to its potential output at point c.
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McEachern, Macroeconomics 11e, Ch. 16
Closing a Recessionary Gap
• Active response to the Great Recession
– Tried to revive a troubled economy
– President Barack Obama’s $831 billion
stimulus plan
• Approved by Congress in February 2009
• Aimed at counteracting the deep recession
triggered by the financial crisis
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McEachern, Macroeconomics 11e, Ch. 16
Closing a Recessionary Gap
• Active response to the Great Recession
– The most concentrated attempt to boost
aggregate demand ever
– Possible costs of using discretionary policy
to stimulate aggregate demand
• Inflation
• Increase the budget deficit, from $459 billion in
2008 to $1.4 trillion in 2009
– The deficit exceeded $1 trillion in each of the next
three years
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McEachern, Macroeconomics 11e, Ch. 16
Closing an Expansionary Gap
• Passive approach
– Self-correcting forces
• Negotiate higher wages
• Higher production costs
– Decrease SRAS
• Potential output
• Higher price level
– Automatic stabilizers
– No discretionary policy
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
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McEachern, Macroeconomics 11e, Ch. 16
Closing an Expansionary Gap
• Active approach
– Prices and wages are not flexible
– Decrease aggregate demand
• Fiscal policy
• Monetary policy
– Lower price level
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.
McEachern, Macroeconomics 11e, Ch. 16
Exhibit 2
Closing an Expansionary Gap
120
(b) The active approach
Potential output
LRAS
Price
level
Price
level
(a) The passive approach
Potential output
LRAS
SRAS120
SRAS110
SRAS110
e
115
110
c
d
115
d
AD″
110
AD″
c
AD′
0
17.0 17.2 Real GDP
0
17.0 17.2
Real GDP
At point d in both panels, the economy is in short-run equilibrium, producing $17.2 trillion, which exceeds the economy’s
potential output. Unemployment is below its natural rate.
In the passive approach reflected in panel (a), the government makes no change in policy, so natural market forces
eventually bring about a higher negotiated wage, increasing firm costs and shifting the short-run supply curve leftward to
SRAS120. The new equilibrium at point e results in a higher price level and lower output and employment.
An active policy reduces aggregate demand, shifting the equilibrium combination in panel (b) from point d to point c, thus
closing the expansionary gap without increasing the price level.
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McEachern, Macroeconomics 11e, Ch. 16
Closing an Expansionary Gap
• The correct discretionary policy
– Can relieve the inflationary pressure
associated with an expansionary gap
• Fed: cool down an overheated economy
– By increasing its target interest rate
• In 17 steps between mid-2004 and mid-2006
• Active monetary policy
– Soft-landing
• Gently slow the rate of growth before that
growth triggered unacceptably high inflation
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McEachern, Macroeconomics 11e, Ch. 16
Problems with Active Policy
• Timely adoption and implementation
– Identify potential output and natural rate of
unemployment
– Forecast AD and AS, passive approach
– Tools needed to achieve results quickly
– Predict effects of active policy
– Coordination
– Implementation
– Timing lags
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McEachern, Macroeconomics 11e, Ch. 16
The Problem of Lags
• Recognition lag
• Time needed to identify a macroeconomic
problem and assess its seriousness
• Decision-making lag
• Time needed to decide what to do once a
macroeconomic problem has been identified
• Implementation lag
• Time needed to introduce a change in
monetary or fiscal policy
• Longer for fiscal policy
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McEachern, Macroeconomics 11e, Ch. 16
The Problem of Lags
• Effectiveness lag
– Time needed for changes in monetary or
fiscal policy to affect the economy
• Lags obscure active policy
– The more variable the lags, the harder it is
to predict when a particular policy will take
hold and what the state of the economy will
be at that time
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McEachern, Macroeconomics 11e, Ch. 16
A Review of Policy Perspectives
• Active policy advocates
– See a high cost of not using discretionary
policy
– Despite the lags involved, they prefer action
• Discretionary fiscal policy
• Discretionary monetary policy
• Some combination of the two
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McEachern, Macroeconomics 11e, Ch. 16
A Review of Policy Perspectives
• Passive policy advocates
– Believe that uncertain lags and ignorance
about how the economy works undermine
active policy
– Rather than pursue a misguided activist
policy
• Sit back and rely on the economy’s natural
ability to correct itself just using automatic
stabilizers
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McEachern, Macroeconomics 11e, Ch. 16
Presidential Politics
• 1990, recession, sluggish recovery
– Monetary policy only
• 1992, $300 billion deficit
– G. H. W. Bush vs. Clinton election
• Clinton – active approach
– Clinton claimed Bush had not done enough
to revive the economy
– Clinton said Bush could not be trusted
• Because he broke the pledge of “no new taxes”
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McEachern, Macroeconomics 11e, Ch. 16
Presidential Politics
• Clinton – active approach
– Clinton argued that Bush and Ronald
Reagan were responsible for the sizable
federal deficits
– Clinton wanted to raise tax rates on the rich
and cut them for the middle class
– Clinton wanted to create jobs through
government spending programs that would
“invest in America”
– Advocated stronger role for government
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McEachern, Macroeconomics 11e, Ch. 16
Presidential Politics
• Bush – passive approach
– Noted the economy was growing again
• Hard sell with unemployment averaging 7.6%
during the six months leading up to the election
– Stronger role for the private sector
• Clinton won 1992 elections
• G.W. Bush took office in 2001
• Fiscal policy of tax cuts
• Aggressive monetary policy of federal funds
rate cuts
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McEachern, Macroeconomics 11e, Ch. 16
Presidential Politics
• 2008 election, McCain vs. Obama
– Joint statement, September 2008, both
support TARP
• McCain
– Favored extending all the Bush tax cuts
– Tax incentive to increase health coverage
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McEachern, Macroeconomics 11e, Ch. 16
Presidential Politics
• Obama proposed more active policies
– Extend the Bush tax cuts only for those
making less than $250,000 a year
– Proposed broad health insurance mandates
with more government regulations
– Proposed creating millions of new jobs by
investing in “green energy” programs
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McEachern, Macroeconomics 11e, Ch. 16
The Role of Expectations
• Rational expectations
– People form expectations based on all
available information
– Including the likely future actions of
government policy makers
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McEachern, Macroeconomics 11e, Ch. 16
The Role of Expectations
• Potential output, natural rate of
unemployment
– Fed policy pronouncements
• Sustain potential output
• Stable price level
– Fed actions: unexpected expansionary
policy
• Higher equilibrium output
• Higher price level
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McEachern, Macroeconomics 11e, Ch. 16
Exhibit 3
Price level
Short-Run Effects of an Unexpected Expansionary Policy
Potential output
LRAS
122
115
110
0
At point a, workers and firms
expect a price level of 110; supply
curve SRAS110 reflects that
expectation.
SRAS110
But an unexpected expansionary
c
policy shifts the aggregate demand
curve out to AD’. Output in the
b
short run (at point b) exceeds its
potential.
a
AD′ In the long run, costs increase,
shifting the SRAS leftward until the
economy produces its potential
AD
output at point c (the resulting
supply curve is not shown). The
short-run effect of an unexpected
17.0 17.2 Real GDP expansion is greater output, but the
(trillions of dollars) long-run effect is just a higher price
level, or inflation.
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McEachern, Macroeconomics 11e, Ch. 16
The Role of Expectations
• Time-inconsistency problem
– When policy makers have an incentive to
announce one policy
• To influence expectations
– But then pursue a different policy
• Once those expectations have been formed
and acted on
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McEachern, Macroeconomics 11e, Ch. 16
Anticipating Policy
• Potential output; High price level
– Fed policy pronouncements
• Sustain potential output and stable price level
– Firms – don’t trust Fed
• Expect higher price level
– Fed actions: expected expansionary policy
• Potential output
• Higher price level
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McEachern, Macroeconomics 11e, Ch. 16
Price level
Exhibit 4
Short-Run Effects: a More Expansionary Policy Than Announced
Potential output
LRAS
SRAS132
e
132
127
122
d
c
AD″
AD′
0
Real GDP
16.8 17.0
(trillions of dollars)
The Fed announces it plans to keep
prices stable at 122. Workers and
firms, however, expect monetary
policy to be expansionary. The shortrun aggregate supply curve, SRAS132,
reflects their expectations.
If the Fed follows the announced
stable-price policy, short-run output at
point d is less than the economy’s
potential output of $17.0 trillion. To
keep the economy at its potential, the
Fed must stimulate aggregate
demand as much as workers and
firms expect (shown by point e), but
this is inflationary.
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McEachern, Macroeconomics 11e, Ch. 16
Anticipating Policy
• If the economy is already producing its
potential
– A fully anticipated expansionary policy
• Has no effect on output or employment, not
even in the short run.
– Only unanticipated expansionary policy
• Can temporarily push output beyond its
potential
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McEachern, Macroeconomics 11e, Ch. 16
Policy Credibility
• Economy: potential output
– Unexpected expansionary policy
• Temporary increase output, employment
• Costs: inflation in the long term, loss of
credibility
• Hyperinflation
– Anti-inflation policy: cold turkey
• Announce and execute tough measures to
reduce high inflation
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Central Bank Independence and Price Stability
• Most independent central banks
– Germany, Switzerland
– Lowest inflation
• Least independent central bank
– Spain, New Zeeland, Australia, Italy
– Highest inflation (4 times higher)
• U.S. central bank
– Relatively independent
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Central Bank Independence and Price Stability
• U.S. inflation
• Double that of the most independent countries
• Half that of the least independent countries
• Trend worldwide
– Greater central bank independence
• European Central Bank
– Price stability
– Policy: not reducing the interest rate if
inflation exceeds 2%
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McEachern, Macroeconomics 11e, Ch. 16
Central Bank Independence and Price Stability
• Low inflation targets
– European Central Bank
– The Bank of England
– Swiss National Bank
– Many central banks
– U.S. Federal Reserve
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McEachern, Macroeconomics 11e, Ch. 16
Policy Rules Versus Discretion
• Active approach
– Economy is unstable
– Needs discretionary policy to cut cyclical
unemployment when it arises
• Passive approach
– Economy is stable enough
– Discretionary policy
• Unnecessary
• May worsen economic fluctuations
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.
McEachern, Macroeconomics 11e, Ch. 16
Policy Rules Versus Discretion
• Passive approach
– Fiscal policy: automatic stabilizers
• Unemployment insurance
• Progressive income tax, Transfer payments
– Monetary policy
• Allow the money supply to grow at a
predetermined rate
• Maintain interest rates at some predetermined
level
• Keep inflation below a certain rate
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly
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McEachern, Macroeconomics 11e, Ch. 16
Policy Rules Versus Discretion
• Limitations on discretion
– Complex interactions among economic
aggregates
– Lags
• Rules and rational expectations
– Fully anticipated monetary policy
• No effect on output
• Change price level
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McEachern, Macroeconomics 11e, Ch. 16