Using Policy to Stabilize the Economy The Case for Active Stabilization Policy ƒ Since the Employment Act of 1946, economic ƒ Keynes: “animal spirits” cause waves of stabilization has been a goal of U.S. policy. pessimism and optimism among households and firms, leading to shifts in aggregate demand ƒ Economists debate how active a role the govt and fluctuations in output and employment. should take to stabilize the economy. ƒ Also, other factors cause fluctuations, e.g., • booms and recessions abroad • stock market booms and crashes ƒ If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers.

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The Case for Active Stabilization Policy Keynesians in the White House ƒ Proponents of active stabilization policy 1961: believe the govt should use policy John F Kennedy pushed for a to reduce these fluctuations: tax cut to stimulate agg demand. Several of his economic advisors • when GDP falls below its natural rate, were followers of Keynes. should use expansionary monetary or fiscal policy to prevent or reduce a recession

• when GDP rises above its natural rate, 2001: should use contractionary policy to prevent or George W Bush pushed for a reduce an inflationary boom tax cut that helped the economy recover from a recession that had just begun.

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The Case Against Active Stabilization Policy The Case Against Active Stabilization Policy ƒ Monetary policy affects economy with a long lag: ƒ Due to these long lags, • firms make investment plans in advance, critics of active policy argue that such policies so I takes time to respond to changes in r may destabilize the economy rather than help it: • most economists believe it takes at least By the time the policies affect agg demand, 6 months for mon policy to affect output and the economy’s condition may have changed. employment ƒ These critics contend that policymakers should ƒ Fiscal policy also works with a long lag: focus on long-run goals, like economic growth • Changes in G and T require Acts of Congress. and low inflation. • The legislative process can take months or years.

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1 Automatic Stabilizers Automatic Stabilizers: Examples ƒ Automatic stabilizers: ƒ The tax system changes in fiscal policy that stimulate • Taxes are tied to economic activity. agg demand when economy goes into recession, When economy goes into recession, without policymakers having to take any taxes fall automatically. deliberate action • This stimulates agg demand and reduces the magnitude of fluctuations.

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Automatic Stabilizers: Examples CONCLUSION ƒ Govt spending ƒ Policymakers need to consider all the effects of • In a recession, incomes fall and their actions. For example, unemployment rises. • When Congress cuts taxes, it needs to • More people apply for public assistance consider the short-run effects on agg demand (e.g., unemployment insurance, welfare). and employment, and the long-run effects • Govt outlays on these programs automatically on saving and growth. increase, which stimulates agg demand and • When the Fed reduces the rate of money reduces the magnitude of fluctuations. growth, it must take into account not only the long-run effects on inflation, but the short-run effects on output and employment.

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CHAPTER SUMMARY CHAPTER SUMMARY ƒ In the theory of liquidity preference, ƒ An increase in the money supply causes the the interest rate adjusts to balance interest rate to fall, which stimulates investment the demand for money with the supply of money. and shifts the aggregate demand curve rightward. ƒ The interest-rate effect helps explain why the ƒ Expansionary fiscal policy – a spending increase aggregate-demand curve slopes downward: or tax cut – shifts aggregate demand to the right. An increase in the price level raises money Contractionary fiscal policy shifts aggregate demand, which raises the interest rate, which demand to the left. reduces investment, which reduces the aggregate quantity of goods & services demanded.

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2 CHAPTER SUMMARY CHAPTER SUMMARY ƒ When the government alters spending or taxes, ƒ Economists disagree about how actively the resulting shift in aggregate demand can be policymakers should try to stabilize the economy. larger or smaller than the fiscal change: Some argue that the government should use The multiplier effect tends to amplify the effects of fiscal and monetary policy to combat destabilizing fiscal policy on aggregate demand. fluctuations in output and employment. The crowding-out effect tends to dampen the Others argue that policy will end up destabilizing effects of fiscal policy on aggregate demand. the economy, because policies work with long lags.

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In this chapter, look for the answers to The Short-Run Trade-off Between these questions: 35 Inflation and Unemployment ƒ How are inflation and unemployment related in the short run? In the long run? P R I N C I P L E S O F ƒ What factors alter this relationship? ECONOMICS ƒ What is the short-run cost of reducing inflation? FOURTH EDITION ƒ Why were U.S. inflation and unemployment both so low in the 1990s? N. GREGORY MANKIW

PowerPoint® Slides by Ron Cronovich

CHAPTER 35 THE SHORT-RUN TRADE-OFF 14 © 2007 Thomson South-Western, all rights reserved

Introduction The Phillips Curve ƒ In the long run, inflation & unemployment are ƒ Phillips curve: shows the short-run trade-off unrelated: between inflation and unemployment • The inflation rate depends mainly on growth in ƒ 1958: A.W. Phillips showed that the money supply. nominal wage growth was negatively • Unemployment (the “natural rate”) depends on correlated with unemployment in the U.K. the minimum wage, the market power of unions, efficiency wages, and the process of job search. ƒ 1960: Paul Samuelson & Robert Solow found a negative correlation between U.S. inflation ƒ In the short run, & unemployment, named it “the Phillips Curve.” society faces a trade-off between inflation and unemployment.

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3 Deriving the Phillips Curve Deriving the Phillips Curve ƒ Suppose P = 100 this year. A. Low agg demand, low inflation, high u-rate ƒ The following graphs show two possible P inflation outcomes for next year: SRAS A. Agg demand low, B B 5% small increase in P (i.e., low inflation), 105 A low output, high unemployment. A 103 AD 3% B. Agg demand high, 2 PC big increase in P (i.e., high inflation), AD1 high output, low unemployment. Y1 Y2 Y 4% 6% u-rate B. High agg demand, high inflation, low u-rate CHAPTER 35 THE SHORT-RUN TRADE-OFF 18 CHAPTER 35 THE SHORT-RUN TRADE-OFF 19

The Phillips Curve: A Policy Menu? Evidence for the Phillips Curve?

ƒ Since fiscal and mon policy affect agg demand, DuringDuring thethe 1960s,1960s, the PC appeared to offer policymakers a menu U.S.U.S. policymakerspolicymakers of choices: optedopted forfor reducingreducing • low unemployment with high inflation unemploymentunemployment • low inflation with high unemployment atat thethe expenseexpense ofof higherhigher inflationinflation • anything in between ƒ 1960s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable.

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The Vertical Long-Run Phillips Curve The Vertical Long-Run Phillips Curve In the long run, faster money growth only causes ƒ 1968: Milton Friedman and Edmund Phelps faster inflation. argued that the tradeoff was temporary. P inflation LRAS LRPC ƒ Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or high P “natural” rate, regardless of the inflation rate 2 infla- tion ƒ Based on the classical dichotomy and the P1 vertical LRAS curve. AD2 low infla- AD1 tion Y u-rate natural rate natural rate of of output unemployment CHAPTER 35 THE SHORT-RUN TRADE-OFF 22 CHAPTER 35 THE SHORT-RUN TRADE-OFF 23

4 Reconciling Theory and Evidence The Phillips Curve Equation

Natural ƒ Evidence (from ’60s): Unemp. Actual Expected = rate of – a – PC slopes downward. rate inflation inflation unemp. ƒ Theory (Friedman and Phelps’ work): PC is vertical in the long run. Short run Fed can reduce u-rate below the natural u-rate ƒ To bridge the gap between theory and evidence, by making inflation greater than expected. Friedman and Phelps introduced a new variable: expected inflation – a measure of how much Long run people expect the price level to change. Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low.

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How Expected Inflation Shifts the PC A C T I V E L E A R N I N G 1: Exercise Initially, expected & actual inflation = 3%, Natural rate of unemployment = 5% inflation unemployment = LRPC Expected inflation = 2% natural rate (6%). Coefficient a in PC equation = 0.5 Fed makes inflation A. Plot the long-run Phillips curve. 2% higher than expected, B C 5% B. Find the u-rate for each of these values of actual u-rate falls to 4%. A inflation: 0%, 6%. Sketch the short-run PC. In the long run, 3% expected inflation PC2 C. Suppose expected inflation rises to 4%. increases to 5%, PC1 Repeat part B. PC shifts upward, 4% 6% u-rate D. Instead, suppose the natural rate falls to 4%. unemployment returns to Draw the new long-run Phillips curve, its natural rate. then repeat part B. CHAPTER 35 THE SHORT-RUN TRADE-OFF 26 27

A C T I V E L E A R N I N G 1: LRPC The Breakdown of the Phillips Curve Answers D PCB LRPCA 7 EarlyEarly 1970s:1970s: An increase An increase unemploymentunemployment increased,increased, in expected 6 in expected despitedespite higherhigher inflation.inflation. inflation inflation 5 FriedmanFriedman && Phelps’Phelps’ shifts PC to shifts PC to explanation:explanation: thethe right.right. 4 PCD expectationsexpectations werewere 3 catchingcatching upup withwith

inflation rate PC AA fallfall inin thethe 2 C reality.reality. natural rate natural rate 1 shiftsshifts bothboth curvescurves 0 toto thethe left.left. 012345678 unemployment rate 28 CHAPTER 35 THE SHORT-RUN TRADE-OFF 29

5 Another PC Shifter: Supply Shocks How an Adverse Supply Shock Shifts the PC ƒ Supply shock: SRAS shifts left, prices rise, output & employment fall. an event that directly alters firms’ costs and P inflation prices, shifting the AS and PC curves SRAS2 ƒ Example: large increase in oil prices SRAS1 B B P2 A A P1 PC2

AD PC1

Y2 Y1 Y u-rate Inflation & u-rate both increase as the PC shifts upward. CHAPTER 35 THE SHORT-RUN TRADE-OFF 30 CHAPTER 35 THE SHORT-RUN TRADE-OFF 31

The 1970s Oil Price Shocks The 1970s Oil Price Shocks

Oil price per barrel The Fed chose to 1/1973 $ 3.56 accommodate the first shock in 1973 1/1974 10.11 with faster money growth. 1/1979 14.85 Result: 1/1980 32.50 Higher expected inflation, 1/1981 38.00 which further shifted PC. 1979: Oil prices surged again, SupplySupply shocksshocks && risingrising expectedexpected worsening the Fed’s tradeoff. inflationinflation worsenedworsened thethe PCPCtradeoff.tradeoff.

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The Cost of Reducing Inflation Disinflationary Monetary Policy ƒ Disinflation: a reduction in the inflation rate Contractionary monetary policy moves economy inflation ƒ To reduce inflation, from A to B. LRPC Fed must slow the rate of money growth, Over time, which reduces agg demand. expected inflation falls, A PC shifts downward. ƒ Short run: output falls and unemployment rises. B ƒ Long run: output & unemployment return to In the long run, C point C: their natural rates. PC1 the natural rate PC2 of unemployment, and lower inflation. u-rate natural rate of unemployment CHAPTER 35 THE SHORT-RUN TRADE-OFF 34 CHAPTER 35 THE SHORT-RUN TRADE-OFF 35

6 The Cost of Reducing Inflation Rational Expectations, Costless Disinflation? ƒ Disinflation requires enduring a period of high unemployment and low output. ƒ Rational expectations: a theory according to which people optimally use all the information ƒ Sacrifice ratio: the number of percentage points they have, including info about govt policies, of annual output lost in the process of reducing inflation by 1 percentage point when forecasting the future ƒ Typical estimate of the sacrifice ratio: 5 ƒ Early proponents: • Reducing inflation rate 1% requires a sacrifice Robert Lucas, Thomas Sargent, Robert Barro of 5% of a year’s output. ƒ Implied that disinflation could be much less ƒ This cost can be spread over time. Example: costly… To reduce inflation by 6%, can either • sacrifice 30% of GDP for one year • sacrifice 10% of GDP for three years CHAPTER 35 THE SHORT-RUN TRADE-OFF 36 CHAPTER 35 THE SHORT-RUN TRADE-OFF 37

Rational Expectations, Costless Disinflation? The Volcker Disinflation ƒ Suppose the Fed convinces everyone it is Fed Chairman Paul Volcker committed to reducing inflation. • appointed in late 1979 under high inflation & ƒ Then, expected inflation falls, unemployment the short-run PC shifts downward. • changed Fed policy to disinflation ƒ Result: 1981-1984: Disinflations can cause less unemployment • Fiscal policy was expansionary, than the traditional sacrifice ratio predicts. so Fed policy needed to be very contractionary to reduce inflation. • Success: Inflation fell from 10% to 4%, but at the cost of high unemployment…

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The Volcker Disinflation The Greenspan Era: 1987-2006

Disinflation turned out to be very costly: Disinflation turned out to be very costly: InflationInflation andand unemploymentunemployment werewere lowlow duringduring mostmost ofof AlanAlan Greenspan’sGreenspan’s yearsyears asas FedFed Chairman.Chairman.

u-rateu-rate nearnear 10%10% inin 1982-831982-83

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7 1990s: The End of the Phillips Curve? Favorable Supply Shocks in the ’90s ƒ During the 1990s, inflation fell to about 1%, ƒ Declining commodity prices unemployment fell to about 4%. (including oil) Many felt PC theory was no longer relevant. ƒ Labor-market changes ƒ Many economists believed the Phillips curve (reduced the natural rate of unemployment) was still relevant; it was merely shifting down: ƒ Technological advance • Expected inflation fell due to the policies of Volcker and Greenspan. (the information technology boom of 1995-2000) • Three favorable supply shocks occurred.

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CONCLUSION CHAPTER SUMMARY ƒ The theories in this chapter come from some of The Phillips curve describes the short-run tradeoff the greatest economists of the 20th century. ƒ between inflation and unemployment. ƒ They teach us that inflation and unemployment ƒ In the long run, there is no tradeoff: • are unrelated in the long run Inflation is determined by money growth, • are negatively related in the short run while unemployment equals its natural rate. are affected by expectations, which play an • ƒ Supply shocks and changes in expected inflation important role in the economy’s adjustment shift the short-run Phillips curve, making the from the short-run to the long run. tradeoff more or less favorable.

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CHAPTER SUMMARY ƒ The Fed can reduce inflation by contracting the money supply, which moves the economy along its short-run Phillips curve and raises unemployment. In the long run, though, expectations adjust and unemployment returns to its natural rate. ƒ Some economists argue that a credible commitment to reducing inflation can lower the costs of disinflation by inducing a rapid adjustment of expectations.

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