Transcript lag time turkey

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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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1
Active Policy vs. Passive Policy
• Active approach
– Economy - relatively unstable
• Fluctuations – from private sector
– Government intervention
– Discretionary fiscal or monetary policy
• Passive approach
– Economy – relatively stable
– Natural market forces
– Automatic stabilizers
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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
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3
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
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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
13.8 14.0
Real GDP
0
13.8 14.0
Real GDP
At point a - the economy is in short-run equilibrium, with unemployment > 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 SRAS curve rightward from SRAS 110 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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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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Closing an Expansionary Gap
• Active approach
– Prices and wages are not flexible
– Decrease aggregate demand
• Fiscal policy
• Monetary policy
– Lower price level
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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
14.0 14.2 Real GDP
0
14.0 14.2
Real GDP
At point d - the economy is in SR equilibrium, producing $14.2 trillion > the economy’s potential output.
Unemployment < 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 SRAS 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 AD, shifting the equilibrium in panel
(b) from point d to point c, thus closing the expansionary gap without increasing the price level.
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Problems with Active Policy
• Timely adoption and implementation
– Identify potential output
– Identify natural rate of unemployment
– Forecast AD and AS, passive approach
– Tools to achieve results quickly
– Forecast effects of active policy
– Coordination
– Implementation
– Timing lags
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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
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The Problem of Lags
• Implementation lag
– Time needed to introduce a change in
monetary or fiscal policy
– Longer for fiscal policy
• Effectiveness lag
– Time needed for changes in monetary or
fiscal policy to affect the economy
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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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The Role of Expectations
• Potential output; natural rate
– Fed policy pronouncements
• Sustain potential output
• Stable price level
– Fed actions: unexpected expansionary
policy
• Higher equilibrium output
• Higher price level
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Exhibit 3
Price level
Short-Run Effects of an Unexpected Expansionary Policy
Potential output
LRAS
c
122
SRAS110
b
115
a
110
AD’
AD
0
14.0
14.2 Real GDP
(trillions of dollars)
At point a, workers and firms
expect a price level of 110;
supply curve SRAS110 reflects
that expectation. But an
unexpected expansionary policy
shifts the aggregate demand
curve out to AD’. Output in the
short run (at point b) exceeds its
potential. In the long run, costs
increase, shifting SRAS leftward
until the economy produces its
potential output at point c (the
resulting supply curve is not
shown). The short-run effect of
an unexpected expansion is
greater output, but the long-run
effect is just a higher price level.
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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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Anticipating Policy
• Potential output; High price level
– Fed policy pronouncements
• Sustain potential output & 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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Exhibit 4
Price level
Short-Run Effects of a More Expansionary Policy Than Announced
Potential output
LRAS
SRAS132
e
132
127
122
d
c
AD’’
AD’
0
Real GDP
13.8 14.0
(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 short-run
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 $14.0 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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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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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Policy Credibility
• Economy: potential output
– Unexpected expansionary policy
• Temporary increase output, employment
• Costs
– Inflation in the long term
– Credibility loss
• Hyperinflation
– Anti-inflation policy: cold turkey
• Announce and execute tough measures
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Policy Rules vs. 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
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Policy Rules vs. 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
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Policy Rules vs. 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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22
The Phillips Curve
• Inverse relationship
– Unemployment rate
– Rate of change in nominal wages
(inflation)
• Phillips curve
– A curve showing possible combinations
of the inflation rate and the
unemployment rate
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Exhibit 5
Inflation rate
(percent change
in price level)
Hypothetical Phillips Curve
10
5
b
d
c
a
Phillips
curve
0
5
10
Unemployment rate
(percent)
The Phillips curve shows an inverse relation between unemployment and inflation.
Points a and b lie on the Phillips curve and represent alternative combinations of
inflation and unemployment that are attainable as long as the curve itself does not
shift. Points c and d are off the curve.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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The Short-Run Phillips Curve
• Short-run Phillips curve
– Based on an expected inflation rate
– A curve that reflects an inverse
relationship between the inflation rate
and the unemployment rate
– Labor contracts
• Given price level
• Given expected inflation
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The Short-Run Phillips Curve
• Inflation – as expected
– Unemployment = natural rate
• Inflation > expected
– Unemployment < natural rate
• Inflation < expected
– Unemployment < natural rate
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Exhibit 6
Aggregate Supply Curves & Phillips Curves in Short & Long Run
Potential output
LRAS
SRAS103
105
103
101
0
(b) Short-run and long-run Phillips curves
a
AD
13.9 14.0 14.1 Real GDP
Inflation rate (percent)
Price
level
(a) Short-run aggregate supply curve
5
a
3
1
0
4
5
6
Unemployment
rate (percent)
If people expect a price level of 103, which is 3 percent higher than the current level, and if
AD turns out to be the aggregate demand curve, then the actual price level is 103 and
output is at its potential. Point a in both panels represents this situation. Unemployment is
the natural rate, assumed to be 5 percent in panel (b).
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Exhibit 6
Aggregate Supply Curves & Phillips Curves in Short & Long Run
Potential output
LRAS
SRAS103
b
105
103
101
0
(b) Short-run and long-run Phillips curves
a
AD’
AD
13.9 14.0 14.1 Real GDP
Inflation rate (percent)
Price
level
(a) Short-run aggregate supply curve
b
5
a
3
1
0
4
5
6
Unemployment
rate (percent)
If aggregate demand turns out to be greater than expected (AD’ instead of AD), the
economy in the short run is at point b in panel (a), where the price level of 105 exceeds
expectations and output exceeds its potential. The resulting higher inflation and lower
unemployment are shown as point b in panel (b).
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Exhibit 6
Aggregate Supply Curves & Phillips Curves in Short & Long Run
(b) Short-run and long-run Phillips curves
Potential output
LRAS
SRAS103
b
105
AD’
a
103
c
101
AD
Inflation rate (percent)
Price
level
(a) Short-run aggregate supply curve
b
5
a
3
c
1
Short-run
Phillips curve
AD”
0
13.9 14.0 14.1 Real GDP
0
4
5
6
Unemployment
rate (percent)
If aggregate demand turns out to be less than expected (AD" instead of AD), short-run
equilibrium is at point c in panel (a), where the price level of 101 is lower than expected
and output falls short of potential. Lower inflation and higher unemployment are shown as
point c in panel (b). In panel (b), points a, b, and c trace a short-run Phillips curve.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Exhibit 6
Aggregate Supply Curves & Phillips Curves in Short & Long Run
Potential output
LRAS
SRAS103
d
b
105
AD’
a
103
c
101
(b) Short-run and long-run Phillips curves
AD
e
Long-run
Phillips curve
Inflation rate (percent)
Price
level
(a) Short-run aggregate supply curve
d
b
5
a
3
c
1
e
AD”
0
13.9 14.0 14.1 Real GDP
Short-run
Phillips curve
0
4
5
6
Unemployment
rate (percent)
In the long run, the actual price level equals the expected price level. Output is at the
potential level, $14.0 trillion, in panel (a). Unemployment is at the natural rate, 5 percent, in
panel (b). Points a, d, and e depict long-run points in each panel. In panel (a) these points
trace potential output, or long-run aggregate supply (LRAS). In panel (b), these points trace
a long-run Phillips curve.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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The Long-Run Phillips Curve
• Price level > expected
– Short run: Output > potential
– Long run: Output = potential
• Higher inflation; Higher unemployment
• Price level < expected
– Short run: Output < potential
– Long run: Output = potential
• Fall in inflation; Lower unemployment
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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The Long-Run Phillips Curve
• Long-run Phillips curve
– Vertical line
– Economy’s natural rate of unemployment
– Workers and employers
• Fully adjust to unexpected changes in AD
• Long-run, for flexible prices and wages
– Unemployment
• Independent of inflation
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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The Natural Rate Hypothesis
• Long-run
– Natural rate of unemployment
– Independent of AD stimulus
• Fiscal policy
• Monetary policy
• Optimal policy in long-run
– Results in low inflation
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Exhibit 7
Short-Run Phillips Curves Since 1960
Each curve
represents the U.S.
unemploymentinflation combination
for a given period,
with colored points
showing the years
associated with
each colored curve.
Shifts of the shortrun Phillips curve
reflect changes in
inflation
expectations.
Curves closer to the
origin reflect lower
expected inflation.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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