Ch 16 macro policy debate active or passive macro econ4

© 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.© 2015 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.

Chapter 16 ECON4 William A. McEachern

1

Macro Policy Debate:Active or Passive?


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

2


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

3



• 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

4

© 2015 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.

Exhibit 1

5


Pric

e le

vel

105

110

SRAS110

Potential outputLRAS

Real GDP0 14.013.8At 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 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.

(b) The active approach

AD

SRAS110

a


Real GDP 0 14.013.8

(a) The passive approach

AD

a

AD’

c

Pric

e le

vel

105

110

100

SRAS100

b


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

6



• Active approach– Prices and wages are not flexible– Decrease aggregate demand


– Lower price level

7


Exhibit 2

8


SRAS110


Real GDP0 14.0 14.2At 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.

(b) The active approach

AD”

SRAS110


(a) The passive approach

AD’

AD”c

Pric

e le

vel

115

120

110

SRAS120

d

c

e

Pric

e le

vel

115

110

Real GDP0 14.0 14.2

d


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

9


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

10


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

11


The Role of Expectations

• Rational expectations – People form expectations based on all

available information– Including the likely future actions of

government policy makers

12



• Potential output; natural rate– Fed policy pronouncements

• Sustain potential output• Stable price level

– Fed actions: unexpected expansionary policy• Higher equilibrium output• Higher price level

13


Exhibit 3

14

Short-Run Effects of an Unexpected Expansionary Policy

AD’

SRAS110

b


Real GDP (trillions of dollars)

0 14.0 14.2

AD

a

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.

c

Pric

e le

vel

115

110

122



• 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

15


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

16


Exhibit 4

17

Short-Run Effects of a More Expansionary Policy Than Announced

AD’’

SRAS132


Real GDP (trillions of dollars)

0 14.013.8

AD’

c

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.

e

Pric

e le

vel

127

122

132

d


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.

18


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

19


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

20



• 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

21



• Limitations on discretion– Complex interactions among economic

aggregates– Lags

• Rules and rational expectations– Fully anticipated monetary policy

• No effect on output• Change price level

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

23


Exhibit 5

24

Hypothetical Phillips Curve

c

d

a

b

Phillips curve

Unemployment rate (percent)5 100

5

10

Infla

tion

rate

(per

cent

cha

nge

in p

rice

leve

l)

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.


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

25


The Short-Run Phillips Curve

• Inflation – as expected– Unemployment = natural rate

• Inflation > expected– Unemployment < natural rate

• Inflation < expected– Unemployment < natural rate

26


Exhibit 6

27

Aggregate Supply Curves & Phillips Curves in Short & Long Run

AD


Pric

e le

vel

103

105

101

Real GDP0 14.0 14.113.9

SRAS103

a 3

5

Infla

tion

rate

(per

cent

)

1

Unemployment rate (percent)4 60 5

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).

a

(a) Short-run aggregate supply curve (b) Short-run and long-run Phillips curves


Exhibit 6

28


AD


Pric

e le

vel

103

105

101

Real GDP0 14.0 14.113.9

SRAS103

a AD’

b

3

5

Infla

tion

rate

(per

cent

)

1


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).

a

b



Exhibit 6

29


AD


Pric

e le

vel

103

105

101

Real GDP0 14.0 14.113.9

SRAS103

a AD’

b

AD”

c

3

5

Infla

tion

rate

(per

cent

)

1


Short-runPhillips curve

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.

a

c

b



Exhibit 6

30


AD


Pric

e le

vel

103

105

101

Real GDP0 14.0 14.113.9

SRAS103

a AD’

b

AD”

c

d

e

3

5

Infla

tion

rate

(per

cent

)

1


Short-runPhillips curve

d

e

Long-runPhillips curve

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.

a

c

b



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

31


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

32


The Natural Rate Hypothesis

• Long-run – Natural rate of unemployment– Independent of AD stimulus


• Optimal policy in long-run– Results in low inflation

33


Exhibit 7

34

Short-Run Phillips Curves Since 1960

Each curve represents the U.S. unemployment-inflation combination for a given period, with colored points showing the years associated with each colored curve. Shifts of the short-run Phillips curve reflect changes in inflation expectations. Curves closer to the origin reflect lower expected inflation.

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Ch 16 macro policy debate active or passive macro econ4

Economy & Finance