Macroeconomics IE_EBE1_MACEC

Prof. dr. Eric Bartelsman6 maart 2018

AS-AD and Stabilization Policy

• Building the Aggregate Supply Curve• Inflation and Unemployment: the role of

expectations• Arguments for and against stabilization policy• Budget deficits and government debt

How shocking!!!• shocks: exogenous changes in agg. supply or demand

• Shocks temporarily push the economy away from full employment.

• Example: exogenous decrease in velocity If the money supply is held constant, a decrease in Vmeans people will be using their money in fewer transactions, causing a decrease in demand for goods and services.

P SRAS

LRAS

AD2

The effects of a negative demand shock

Y

P

AD1

Y

P2

Y2

AD shifts left, depressing output and employment in the short run.

AB

C

Over time, prices fall and the economy moves down its demand curve toward full-employment.

Supply shocks• A supply shock alters production costs, affects the prices

that firms charge. (also called price shocks)• Examples of adverse supply shocks:– Bad weather reduces crop yields, pushing up

food prices. – Workers unionize, negotiate wage increases. – New environmental regulations require firms to

reduce emissions. Firms charge higher prices to help cover the costs of compliance.

• Favorable supply shocks lower costs and prices.

Three models of aggregate supply

1. The sticky-wage model2. The imperfect-information model3. The sticky-price modelAll three models imply:

( )eY Y P P= + -a

natural rate of output

a positive parameter

the expected price level

the actual price level

agg. output

The sticky-wage model• Assumes that firms and workers negotiate contracts and

fix the nominal wage before they know what the price level will turn out to be.

• The nominal wage they set is the product of a target real wage and the expected price level:

eW ω P= ´eW Pω

P PÞ = ´

Target real

wage

The sticky-wage model

If it turns out that

eW PωP P

= ´

eP P=

eP P>

eP P<

thenUnemployment and output are at their natural rates.Real wage is less than its target, so firms hire more workers and output rises above its natural rate.Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate.

The sticky-wage model• Implies that the real wage should be counter-cyclical, should move in the opposite direction as output during business cycles:– In booms, when P typically rises,

real wage should fall. – In recessions, when P typically falls,

real wage should rise. • This prediction does not come true in the real

world:

The cyclical behavior of the real wagePe

rcen

tage

chan

ge

in re

al w

age

Percentage change in real GDP

-5

-4

-3

-2

-1

0

1

2

3

4

5

-3 -2 -1 0 1 2 3 4 5 6 7 8

1974 1979

1991

1972

2004

2001

19981965

1984

1980

1982

1990

The imperfect-information model

Assumptions:– All wages and prices are perfectly flexible,

all markets clear.– Each supplier produces one good, consumes many

goods.– Each supplier knows the nominal price of the good

she produces, but does not know the overall price level.

The imperfect-information model• Supply of each good depends on its relative price: the

nominal price of the good divided by the overall price level.

• Supplier does not know price level at the time she makes her production decision, so uses the expected price level, P e.

• Suppose P rises but P e does not. – Supplier thinks her relative price has risen,

so she produces more. – With many producers thinking this way, Y will rise whenever P rises above P e.

The sticky-price model

• Reasons for sticky prices:– long-term contracts between firms and customers– menu costs– firms not wishing to annoy customers with

frequent price changes• Assumption:– Firms set their own prices

(e.g., as in monopolistic competition).

The sticky-price model

• In contrast to the sticky-wage model, the sticky-price model implies a pro-cyclical real wage:Suppose aggregate output/income falls. Then,– Firms see a fall in demand for their products. – Firms with sticky prices reduce production, and

hence reduce their demand for labor. – The leftward shift in labor demand causes

the real wage to fall.

Summary & implications

Suppose a positive ADshock moves output above its natural rate and P above the level people had expected.

Y

P LRAS

SRAS1

SRAS equation: eY Y P P= + -( )a

1 1eP P=

AD1

AD22eP =

2P3 3

eP P=

Over time, Pe rises, SRAS shifts up,and output returns to its natural rate.

1Y Y= 2Y3Y =

SRAS2

Inflation, Unemployment, and the Phillips Curve

The Phillips curve states that p depends on– expected inflation, pe.

– cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate

– supply shocks, n (Greek letter “nu”).

= - - +( )p p b ne nu u

where b > 0 is an exogenous constant.

The Phillips Curve and SRAS

• SRAS curve: Output is related to unexpected movements in the price level.

• Phillips curve: Unemployment is related to unexpected movements in the inflation rate.

SRAS: ( )eY Y P P= + -a

Phillips curve: e nu u= - - +( )p p b n

Adaptive expectations• Adaptive expectations: an approach that assumes

people form their expectations of future inflation based on recently observed inflation.

• A simple example: Expected inflation = last year’s actual inflation

1 ( )nu up p b n-= - - +

1ep p-=

§ Then, the P.C. becomes

Inflation inertia

In this form, the Phillips curve implies that inflation has inertia: – In the absence of supply shocks or cyclical

unemployment, inflation will continue indefinitely at its current rate.

– Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.

1 ( )nu up p b n-= - - +

Two causes of rising & falling inflation

• cost-push inflation: inflation resulting from supply shocksAdverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.

• demand-pull inflation: inflation resulting from demand shocksPositive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.

1 ( )nu up p b n-= - - +

Graphing the Phillips curveIn the short run, policymakers face a tradeoff between p and u.

u

p

nu

1b

The short-run Phillips curveep n+

( )e nu up p b n= - - +

Shifting the Phillips curvePeople adjust their expectations over time, so the tradeoff only holds in the short run.

u

p

nu

1ep n+

( )e nu up p b n= - - +

2ep n+

E.g., an increase in pe shifts the short-run P.C. upward.

Rational expectations

Ways of modeling the formation of expectations: – adaptive expectations:

People base their expectations of future inflation on recently observed inflation.

– rational expectations:People base their expectations on all available information, including information about current and prospective future policies.

The natural rate hypothesisOur analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis:

Changes in aggregate demand affect output and employment only in the short run.

In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3-8).

An alternative hypothesis: Hysteresis

• Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.

• Negative shocks may increase un, so economy may not fully recover.

Hysteresis: Why negative shocks may increase the natural rate

• The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends.

• Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves.Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends.

Chapter Summary1. Three models of aggregate supply in the short run:– sticky-wage model – imperfect-information model – sticky-price model

All three models imply that output rises above its natural rate when the price level rises above the expected price level.

slide 40

Chapter Summary2. Phillips curve– derived from the SRAS curve– states that inflation depends on

• expected inflation• cyclical unemployment • supply shocks

– presents policymakers with a short-run tradeoff between inflation and unemployment

slide 41

Chapter Summary3. How people form expectations of inflation– adaptive expectations• based on recently observed inflation• implies “inertia”

– rational expectations • based on all available information• implies that disinflation may be painless

slide 42

Chapter Summary4. The natural rate hypothesis and hysteresis– the natural rate hypotheses

• states that changes in aggregate demand can only affect output and employment in the short run

– hysteresis• states that aggregate demand can have permanent

effects on output and employment

slide 43

Stabilization Policy

• Should policy be rule-based or discretionary?• Discretionary or active policy:– Social costs of unemployment are high– AS-AD framework shows policy effects– Mandate of CB for ‘price stability’

• Rule-based or passive policy– Inside and outside lags– Fluctuations not necessarily welfare reducing

Keynes vs Real Business Cycle• IS-LM/AD-AS– Prices are sticky– Money is not neutral– Fiscal and Monetary Policy useful for stabilization

• RBC– Prices are flexible, markets are perfect– Money is neutral– Fluctuations occur as optimal response of firms and

households to shocks– Productivity shocks are main source of fluctuations

slide 45

New Keynesian Economics

• Many economists conclude, based on empirical evidence, that short-term fluctuations of Y and U around natural rate occur owing to wage and price stickiness.

• ‘New Keynesiaans’ research investigates micro-founded explanations for such stickiness. (see chptr 14, AS curve)

Automatic stabilizers• definition:

policies that stimulate or depress the economy when necessary without any deliberate policy change.

• Designed to reduce the lags associated with stabilization policy.

• Examples:– income tax– unemployment insurance– welfare

Forecasting the macroeconomyBecause policies act with lags, policymakers must predict future conditions.Two ways economists generate forecasts:–Leading economic indicators

data series that fluctuate in advance of the economy–Macroeconometric models

Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies

Mistakes forecasting the 1982 recessionUn

empl

oym

ent r

ate

Forecasting the macroeconomyBecause policies act with lags, policymakers must predict future conditions.

The preceding slides show that the forecasts are often wrong.

This is one reason why some economists oppose policy activism.

The Lucas critique• Due to Robert Lucas

who won Nobel Prize in 1995 for rational expectations.• Forecasting the effects of policy changes has often

been done using models estimated with historical data. • Lucas pointed out that such predictions would not be

valid if the policy change alters expectations in a way that changes the fundamental relationships between variables.

An example of the Lucas critique

• Prediction (based on past experience):An increase in the money growth rate will reduce unemployment.

• The Lucas critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall.

Rules and discretion: Basic concepts

• Policy conducted by rule:Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through.

• Policy conducted by discretion:As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

Arguments for rules

1. Distrust of policymakers and the political process– misinformed politicians– politicians� interests sometimes not the same as

the interests of society

Arguments for rules

2. The time inconsistency of discretionary policy– def: A scenario in which policymakers

have an incentive to renege on a previously announced policy once others have acted on that announcement.

– Destroys policymakers� credibility, thereby reducing effectiveness of their policies.

Examples of time inconsistency1. To encourage investment,

govt announces it will not tax income from capital. But once the factories are built, govt reneges in order to raise more tax revenue.

Examples of time inconsistency2. To reduce expected inflation,

the central bank announces it will tighten monetary policy. But faced with high unemployment, the central bank may be tempted to cut interest rates.

Examples of time inconsistency3. Aid is given to poor countries contingent on fiscal

reforms. The reforms do not occur, but aid is given anyway, because the donor countries do not want the poor countries� citizens to starve.

Monetary policy rules a. Constant money supply growth rate– Advocated by monetarists.– Stabilizes aggregate demand only if velocity is

stable.

Monetary policy rules

b. Target growth rate of nominal GDP– Automatically increase money growth whenever

nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target.

a. Constant money supply growth rate

Monetary policy rules

c. Target the inflation rate– Automatically reduce money growth whenever

inflation rises above the target rate.– Many countries� central banks now practice

inflation targeting, but allow themselves a little discretion.

a. Constant money supply growth rate

b. Target growth rate of nominal GDP

Monetary policy rules

d. The Taylor rule: Target the federal funds rate based on§ inflation rate§ gap between actual & full-employment GDP

c. Target the inflation rate

a. Constant money supply growth rate

b. Target growth rate of nominal GDP

The Taylor Rule

iff = p + 2 + 0.5(p – 2) – 0.5(GDP gap)whereiff = nominal federal funds rate target

GDP gap = 100 x

= percent by which real GDP is below its natural rate

Y YY-

The Taylor Rule

iff = p + 2 + 0.5(p – 2) – 0.5(GDP gap)

§ If p = 2 and output is at its natural rate, then fed funds rate targeted at 4 percent.

§ For each one-point increase in p, mon. policy is automatically tightened to raise fed funds rate by 1.5.

§ For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the fed funds rate by 0.5.

The federal funds rate: Actual and suggested

Percen

t

0

2

4

6

8

10

12

1987 1990 1993 1996 1999 2002 2005

Taylor�s Rule

Actual

Central bank independence

• A policy rule announced by central bank will work only if the announcement is credible.

• Credibility depends in part on degree of independence of central bank.

Inflation and central bank independence(1970s and 1980s)

aver

age

infla

tion

index of central bank independence

Chapter Summary1. Advocates of active policy believe:– frequent shocks lead to unnecessary fluctuations in

output and employment– fiscal and monetary policy can stabilize the economy

2. Advocates of passive policy believe:– the long & variable lags associated with monetary and

fiscal policy render them ineffective and possibly destabilizing

– inept policy increases volatility in output, employment

slide 73

Chapter Summary3. Advocates of discretionary policy believe:– discretion gives more flexibility to policymakers in

responding to the unexpected4. Advocates of policy rules believe:– the political process cannot be trusted: Politicians make

policy mistakes or use policy for their own interests– commitment to a fixed policy is necessary to avoid time

inconsistency and maintain credibility

slide 74