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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.
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.
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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.
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.
PowerPoint® Slides
by Ron Cronovich
CHAPTER 35 THE SHORT-RUN TRADE-OFF 14 © 2007 Thomson South-Western, all rights reserved
3
Deriving the Phillips Curve Deriving the Phillips Curve
Suppose P = 100 this year. A. Low agg demand, low inflation, high u-rate
The Phillips Curve: A Policy Menu? Evidence for the Phillips Curve?
Since fiscal and mon policy affect agg demand, During
During the the 1960s,
1960s,
the PC appeared to offer policymakers a menu U.S.
U.S. policymakers
policymakers
of choices: opted
opted forfor reducing
reducing
• low unemployment with high inflation unemployment
unemployment
• low inflation with high unemployment at
at the
the expense
expense of of
higher
higher inflation
inflation
• anything in between
1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.
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
P2 infla-
“natural” rate, regardless of the inflation rate
tion
Based on the classical dichotomy and the
vertical LRAS curve. P1 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
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Reconciling Theory and Evidence The Phillips Curve Equation
Evidence (from ’60s): Unemp.
Natural
PC slopes downward. = rate of – a Actual – Expected
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.
shifts
shifts PC
PC to
to explanation:
4
explanation:
the
the right.
right. PCD expectations
expectations were
were
3 catching
catching up
up with
with
PCC reality.
AA fall
fall in
in the
the 2 reality.
natural
natural raterate 1
shifts
shifts both
both
curves
curves 0
to
to the
the left.
left. 0 1 2 3 4 5 6 7 8
unemployment rate
28 CHAPTER 35 THE SHORT-RUN TRADE-OFF 29
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Another PC Shifter: Supply Shocks How an Adverse Supply Shock Shifts the PC
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
Example: large increase in oil prices SRAS1
B B
P2
P1 A A
PC2
AD PC1
Y2 Y1 Y u-rate
The 1970s Oil Price Shocks The 1970s Oil Price Shocks
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The Cost of Reducing Inflation Rational Expectations, Costless Disinflation?
Disinflation requires enduring a period of
high unemployment and low output. Rational expectations: a theory according to
which people optimally use all the information
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
u-rate
u-rate near
near
10%
10% in
in
1982-83
1982-83
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1990s: The End of the Phillips Curve? Favorable Supply Shocks in the ’90s
During the 1990s, inflation fell to about 1%, Declining commodity prices
unemployment fell to about 4%. (including oil)
Many felt PC theory was no longer relevant.
Labor-market changes
Many economists believed the Phillips curve (reduced the natural rate of unemployment)
was still relevant; it was merely shifting down:
• Expected inflation fell due to the policies of Technological advance
Volcker and Greenspan. (the information technology boom of 1995-2000)
• Three favorable supply shocks occurred.
CONCLUSION
CHAPTER SUMMARY
The theories in this chapter come from some of
the greatest economists of the 20th century.
The Phillips curve describes the short-run tradeoff
between inflation and unemployment.
They teach us that inflation and unemployment 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 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.
CHAPTER SUMMARY
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.
Some economists argue that a credible
commitment to reducing inflation can lower the
costs of disinflation by inducing a rapid adjustment
of expectations.