Using Policy to Stabilize the Economy The Case for Active Stabilization Policy Since the Employment Act of 1946, economic 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 Economists debate how active a role the govt and fluctuations in output and employment. should take to stabilize the economy. Also, other factors cause fluctuations, e.g., • booms and recessions abroad • stock market booms and crashes If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers. CHAPTER 35 THE SHORT-RUN TRADE-OFF 0 CHAPTER 35 THE SHORT-RUN TRADE-OFF 1 The Case for Active Stabilization Policy Keynesians in the White House 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 2 CHAPTER 35 THE SHORT-RUN TRADE-OFF 3 The Case Against Active Stabilization Policy The Case Against Active Stabilization Policy Monetary policy affects economy with a long lag: 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 These critics contend that policymakers should 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 4 CHAPTER 35 THE SHORT-RUN TRADE-OFF 5 1 Automatic Stabilizers Automatic Stabilizers: Examples Automatic stabilizers: 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 6 CHAPTER 35 THE SHORT-RUN TRADE-OFF 7 Automatic Stabilizers: Examples CONCLUSION Govt spending 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 8 CHAPTER 35 THE SHORT-RUN TRADE-OFF 9 CHAPTER SUMMARY CHAPTER SUMMARY In the theory of liquidity preference, 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. The interest-rate effect helps explain why the 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 10 CHAPTER 35 THE SHORT-RUN TRADE-OFF 11 2 CHAPTER SUMMARY CHAPTER SUMMARY When the government alters spending or taxes, 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 12 CHAPTER 35 THE SHORT-RUN TRADE-OFF 13 In this chapter, look for the answers to The Short-Run Trade-off Between these questions: 35 Inflation and Unemployment 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 What factors alter this relationship? ECONOMICS What is the short-run cost of reducing inflation? FOURTH EDITION 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 In the long run, inflation & unemployment are Phillips curve: shows the short-run trade-off unrelated: between inflation and unemployment • The inflation rate depends mainly on growth in 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. 1960: Paul Samuelson & Robert Solow found a negative correlation between U.S. inflation In the short run, & unemployment, named it “the Phillips Curve.” society faces a trade-off between inflation and unemployment. CHAPTER 35 THE SHORT-RUN TRADE-OFF 16 CHAPTER 35 THE SHORT-RUN TRADE-OFF 17 3 Deriving the Phillips Curve Deriving the Phillips Curve Suppose P = 100 this year. A. Low agg demand, low inflation, high u-rate 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? 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 1960s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable. CHAPTER 35 THE SHORT-RUN TRADE-OFF 20 CHAPTER 35 THE SHORT-RUN TRADE-OFF 21 The Vertical Long-Run Phillips Curve The Vertical Long-Run Phillips Curve In the long run, faster money growth only causes 1968: Milton Friedman and Edmund Phelps faster inflation. argued that the tradeoff was temporary. P inflation LRAS LRPC 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 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 Evidence (from ’60s): Unemp. Actual Expected = rate of – a – PC slopes downward. rate inflation inflation unemp. Theory (Friedman and Phelps’ work): PC is vertical in the long run. Short run Fed can reduce u-rate below the natural u-rate 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. CHAPTER 35 THE SHORT-RUN TRADE-OFF 24 CHAPTER 35 THE SHORT-RUN TRADE-OFF 25 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.