Stabilization in an Integrated World Economy

1. Chapter 17 Stabilization in an Integrated World Economy

2. Introduction The “5yr5yr rate” is a measure of the average annual expected inflation rate 5 to 10 years in the future, as derived from interest rates on government bonds. Financial market participants interpret an increase in this rate as a signal of higher inflation in the current year. In this chapter, you will learn that this interpretation is consistent with predictions offered by a theory proposed by economists known as “new Keynesians.”

3. Learning Objectives Explain why the actual unemployment rate might depart from the natural rate of unemployment Describe why there may be an inverse relationship between the inflation rate and the unemployment rate, reflected by the Phillips curve Evaluate how expectations affect the actual relationship between the inflation rate and the unemployment rate

4. Learning Objectives (cont'd) Understand the rational expectations hypothesis and its implications for economic policymaking Distinguish among alternative modern approaches to strengthening the case for active policymaking

5. Chapter Outline Active Versus Passive Policymaking The Natural Rate of Unemployment Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles Modern Approaches to Justifying Active Policymaking Is There a New Keynesian Phillips Curve? Summing Up: Economic Factors Favoring Active versus Passive Policymaking

6. Did You Know That ... A number of economists have determined from data collected from U.S. retail price scanners that prices of most items remain unchanged for longer intervals during holiday periods than at other times of the year? As you will learn in this chapter, a key modern economic theory suggests that even relatively small costs of changing prices can lead to widespread price stickiness.

7. Active Versus Passive Policymaking Active (Discretionary) Policymaking All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy Examples are monetary and fiscal policy

8. Active Versus Passive Policymaking (cont'd) Passive (Nondiscretionary) Policymaking Policymaking that is carried out in response to a rule Not in response to an actual or potential change in overall economic activity Examples include a monetary rule

9. The Natural Rate of Unemployment Two components of the natural rate of unemployment Frictional unemployment Structural unemployment

10. The Natural Rate of Unemployment (cont’d) Frictional unemployment Arises because individuals take the time to search for the best job opportunities Much of the unemployment is of this type, except when there is a recession or depression

11. The Natural Rate of Unemployment (cont'd) Structural unemployment results from Government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work Union activity that sets wages above the equilibrium level and also restricts the mobility of labor

12. The Natural Rate of Unemployment (cont'd) Natural Rate of Unemployment The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium When all workers and employers have fully adjusted to any changes in the economy

13. Example: The U.S. Natural Rate of Unemployment In 1982, the unemployment rate was about 10%. By the early 2000s, it was at this level once again. Figure 17-1 shows that the actual rate of unemployment has varied over the decades. Why does the natural rate of unemployment differ from the actual rate of unemployment?

14. Figure 17-1 Estimated Natural Rate of Unemployment in the United States

15. The Natural Rate of Unemployment (cont'd) Departures from the natural rate of unemployment Deviations of the actual from the natural rate are called cyclical unemployment. Deviations observed over the course of nationwide business fluctuations

16. Figure 17-2 Impact of an Increase in Aggregate Demand on Real GDP and Unemployment Monetary or fiscal policy leads to increase in AD, and the unemployment rate falls below the natural rate SRASshifts, the price level is higher and the unemployment rate rises to the natural rate, real GDP returns to the LRAS level

17. Figure 17-3 Impact of a Decline in Aggregate Demand on Real GDP and Unemployment Monetary or fiscal policy leads to decline in AD and the unemployment rate rises above the natural rate SRAS shifts, the price level is lower, and the unemployment rate falls to the natural rate, the new equilibrium is reached

18. The Natural Rate of Unemployment (cont'd) The Phillips curve: a rationale for active policymaking? The greater the unexpected increase in aggregate demand, the greater the amount of inflation that results in the short run, and the lower the unemployment rate The greater the unexpected decrease in aggregate demand, the greater the deflation that results in the short run, and the higher the unemployment rate

19. The Natural Rate of Unemployment (cont'd) The Phillips Curve A curve showing the relationship between unemployment and changes in wages or prices It was long thought to reflect a trade-off between unemployment and inflation

20. Figure 17-4 The Phillips Curve, Panel (a)

21. Figure 17-4 The Phillips Curve, Panel (b) Higher inflation and lower unemployment The Phillips curve implies a policy trade-off between inflation and unemployment Can policymakers fine-tune the economy? Zero inflation and natural rate of unemployment, U* Deflation and higher unemployment

22. The Natural Rate of Unemployment (cont'd) Nonaccelerating Inflation Rate of Unemployment (NAIRU) The rate of unemployment below which the rate of inflation tends to rise and above which the rate of inflation tends to fall The unemployment rate consistent with a steady inflation rate can potentially change during the course of cyclical adjustments Thus, the NAIRU typically varies by a relatively greater and more frequent amount than the natural rate of unemployment

23. Figure 17-5 A Shift in the Phillips Curve • There is a change in the expected inflation rate • The curve shifts to incorporate new expectations • PC0 shows expectations at zero inflation • PC5 reflects a higher expected inflation rate, such as 5%

24. Why Not … ignore media headlines about inflation? Instead of the headline inflation rate, policymakers prefer looking at the core inflation rate, which is the rate of change in average prices excluding food and energy prices. Nevertheless, economists also found that movements in the headline inflation rate provide a better indication of how much the price level will rise in the longer term than changes in the core inflation rate.

25. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles Rational Expectations Hypothesis Individuals base their forecasts (expectations) about the future values of economic variables on all available past and current information These expectations incorporate individuals’ understanding about how the economy operates, including the operation of monetary and fiscal policy

26. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) New classical approach A modern version of the classical model in which wages and prices are flexible There is pure competition in all markets The rational expectations hypothesis is assumed to be working

27. Figure 17-6 Responses to Anticipated and Unanticipated Increases in Aggregate Demand Short-run equilibrium increases output to Y2with P2 Long-run equilibrium after adjustment yields Y1 with P3 Assume the money supply increases unexpectedly to M2 and AD increases to AD2

28. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) The response to anticipated policy If the increase in the money supply was anticipated The higher price level would be anticipated Workers and suppliers would demand higher wages and prices immediately

29. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) Policy Irrelevance Proposition The conclusion that policy actions have no real effects in the short run if the policy actions are anticipated and none in the long run even if the policy actions are unanticipated A key assumption: people don’t persistently make the same mistakes in forecasting the future

30. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) Under the assumption of rational expectations on the part of decision makers in the economy: Anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP Regardless of the nature of the anticipated policy, the unemployment rate will equal the natural rate, and real GDP will be determined solely by the economy’s long-run aggregate supply curve

31. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) Questions What must people know? What happens if they don’t know everything? What are the implications?

32. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) The policy dilemma Policy irrelevance proposition seems to suggest only mistakes have real effects Policymakers powerless to push real GDP and unemployment back to long-run levels when entering recessionary period

33. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) The distinction between real and monetary shocks Many economists argue real (as opposed to purely monetary) forces might help explain aggregate economic fluctuations Real business cycles represent another challenge to policy activism

34. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) Questions regarding real business cycle theory: What impact would an oil shock have on aggregate demand? Can we explain the Great Depression with the real business cycle theory? What about the apparent wage and price rigidity within the economy?

35. Figure 17-7 Effects of a Reduction in the Supply of Resources If the reduction in the resource is permanent, the LRAS will also shift A reduction in the supply of a resource shifts SRAS to the left The position of LRAS depends on our resource endowments

36. Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d) Stagflation A situation characterized by lower real GDP, lower employment, and a higher unemployment rate during the same period that the rate of inflation increases In Figure 17-7, real GDP declines at the same time the price level rises

37. Modern Approaches to Justifying Active Policymaking Market clearing models of the economy may not fully explain business cycles “Sticky” wages and prices remain important, some economists contend New Keynesians have tried to refine the theory of aggregate supply

38. Modern Approaches to Justifying Active Policymaking (cont'd) Small Menu Costs Costs that deter firms from changing prices in response to demand changes Examples—the costs of renegotiating contracts or printing new price lists

39. Example: Small Menu Costs in the U.S. Market for Imported Beer Economists at the Federal Reserve Bank of New York find that the cost of changing prices of imported beers in the United States is only about 0.1 percent of revenues for beer retailers, and 0.4 percent for the beer manufacturers. So, these retailers change their prices of imported beer slightly more often than manufacturers. Also, both retailers and manufacturers allow lengthy intervals—one year or longer—to pass before adjusting those prices.

40. Modern Approaches to Rationalizing Active Policymaking (cont'd) New Keynesian Inflation Dynamics In new Keynesian theory, the pattern of inflation exhibited by an economy with growing aggregate demand—initial sluggish adjustment of the price level in response to increased aggregate demand followed by higher inflation later

41. Figure 17-8 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (a)

42. Figure 17-8 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (b)

43. Policy Example: Moderating the Great Recession Is Harder Than Anticipated In 2009, the federal government increased its spending substantially. The Council of Economic Advisers suggested that every $1.00 of government expenditures would raise real GDP by $1.60. Later Robert Barro of Harvard University found that each $1 of government expenditures replaced $1 of private spending that otherwise would have occurred, leaving no net impact on real GDP.

44. Is there a New Keynesian Phillips Curve? The U.S. experience with the Phillips curve Economists Milton Friedman and E.S. Phelps published pioneering studies The apparent trade-off suggested by the Phillips curve could not be exploited by activist policymakers

45. Is there a New Keynesian Phillips Curve? (cont'd) The U.S. experience with the Phillips curve Attempts to reduce the unemployment rate by inflating the economy would be thwarted by higher inflation expectations Activist policymaking would be offset; the trade-off between unemployment and inflation would disappear

46. Figure 17-9 The Phillips Curve: Theory versus Data

47. Is there a New Keynesian Phillips Curve? (cont’d) New Keynesians say all that matters for is whether such a relationship between inflation and unemployment is exploitable in the near term If so, policymakers can intervene as soon as unemployment and real GDP vary from their long-run levels, thusly dampening cyclical fluctuations and making them short-lived

48. Is there a New Keynesian Phillips Curve? (cont’d) Two factors that affect inflation: Anticipated future inflation Average inflation-adjusted (real) per-unit costs that firms incur in production Empirical evidence does indicate that these two factors are associated with higher observed rates of inflation

49. Is there a New Keynesian Phillips Curve? (cont’d) Are New Keynesians correct? Not all economists agree The new classical theory already indicates that when prices are flexible, higher inflation expectations should reduce short-run aggregate supply and contribute to increased inflation All macroeconomic theories suggest that various factors that push up firms’ production costs should have the same effect on short-run aggregate supply and inflation in a flexible-price economy How often do firms really adjust their prices?

50. Summing Up: Economic Factors Favoring Active versus Passive Policymaking Most economists agree that active policymaking is unlikely to exert sizable long-run effects on any nation’s economy Most agree that aggregate supply shocks contribute to business cycles Some argue that monetary and fiscal policy actions can offset, at least in the short run and possibly in the long-run the effects that aggregate demand shocks would otherwise have on real GDP and unemployment