Introduction. Learning Objectives. Chapter 17. Stabilization in an Integrated World Economy

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1 Chapter 17 Stabilization in an Integrated World Economy Introduction For more than 50 years, many economists have used an inverse relationship involving the unemployment rate and real GDP as a guide to macroeconomic policymaking. Since 2009, however, the relationship appears to have broken down. If the inverse relationship does not return, the case for discretionary policymaking will be weakened. What you learn in this chapter will help you understand why this policy implication follows if the relationship between unemployment and real GDP no longer holds. Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

2 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved Did You Know That... Analysis of prices posted on Internet Web sites and processed by scanners at retail locations verifies that 9 is the most common ending number for prices as high as $11? In addition, prices ending in the number 9 changes less often than prices ending in other numbers. Some economists believe that this is evidence of price stickiness a generalized tendency for prices to adjust sluggishly over time. Copyright 2014 Pearson Education, Inc. All rights reserved

3 Did You Know That... (cont d) As you will learn in this chapter, one possible consequence of price stickiness is that macroeconomic policies may be less effective in stabilizing the economy. Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

4 The Natural Rate of Unemployment Two components of the natural rate of unemployment Frictional unemployment Structural unemployment Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved The Natural Rate of Unemployment (cont'd) Structural unemployment results from 1. Government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work 2. Union activity that sets wages above the equilibrium level and also restricts the mobility of labor Copyright 2014 Pearson Education, Inc. All rights reserved

5 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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? Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-1 Estimated Natural Rate of Unemployment in the United States Sources: Economic Report of the President; Economic Indicators, various issues; author s estimates. Copyright 2014 Pearson Education, Inc. All rights reserved

6 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 Copyright 2014 Pearson Education, Inc. All rights reserved What If... The government were to boost economic expansion by offering people more food stamps? Some U.S. government officials have claimed that surging utilization of the federal food stamp program has led to an increase in overall expenditures. Food stamp benefits, however, are a transfer program. This means that they transfer purchasing power between people without increasing the aggregate income flow. Consequently, higher food stamp benefits have virtually no impact on the overall level of economic activity. Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-2 Impact of an Increase in Aggregate Demand on Real GDP and Unemployment Copyright 2014 Pearson Education, Inc. All rights reserved

7 Figure 17-3 Impact of a Decline in Aggregate Demand on Real GDP and Unemployment Copyright 2014 Pearson Education, Inc. All rights reserved The Natural Rate of Unemployment (cont'd) The Phillips curve: a rationale for active policymaking? 1. 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 2. The greater the unexpected decrease in aggregate demand, the greater the deflation that results in the short run, and the higher the unemployment rate Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

8 Figure 17-4 The Phillips Curve, Panel (a) Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-4 The Phillips Curve, Panel (b) Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-5 A Shift in the Phillips Curve Copyright 2014 Pearson Education, Inc. All rights reserved

9 Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles Rational Expectations Hypothesis 1. Individuals base their forecasts (expectations) about the future values of economic variables on all available past and current information 2. These expectations incorporate individuals understanding about how the economy operates, including the operation of monetary and fiscal policy Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-6 Responses to Anticipated and Unanticipated Increases in Aggregate Demand Copyright 2014 Pearson Education, Inc. All rights reserved

10 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

11 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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? Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-7 Effects of a Reduction in the Supply of Resources Copyright 2014 Pearson Education, Inc. All rights reserved

12 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

13 Example: Just How Small Are Small Menu Costs? Economists have developed two ways of gauging small menu costs experienced by sellers: 1) Estimate the dollar cost of changing one item s price. This method yields estimates ranging from 50 cents to as high as several dollars. 2) Estimate these costs in relation to a firm s total revenues. This approach gives estimates ranging from 0.2 percent to 1 percent of total revenue. So, a firm facing a menu cost as high as 1 percent would not want to change prices unless the resulting increase in total revenue were expected to be at least 1 percent. Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved Figure 17-8 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (a) Copyright 2014 Pearson Education, Inc. All rights reserved

14 Figure 17-8 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (b) Copyright 2014 Pearson Education, Inc. All rights reserved Is There a New Keynesian Phillips Curve? A fundamental thrust of the new Keynesian theory is that activist policymaking can promote economic stability Copyright 2014 Pearson Education, Inc. All rights reserved Policy Example: How Fast Do U.S. Firms Change Their Prices? During the late 1990s and early 2000s, a number of studies by new Keynesian economists estimated that it took U.S. companies an average of two years to alter their selling prices. These findings suggested that considerable time was available for activist policymaking. Critics of these studies argued that they were biased by using the GDP deflator, which tends to exhibit smooth changes over time. Critics also argued that firms costs had not been measured appropriately. Copyright 2014 Pearson Education, Inc. All rights reserved

15 Policy Example: How Fast Do U.S. Firms Change Their Prices? (cont d) When these measurement adjustments are taken into account, the time it takes firms to change prices falls to four months, rather than two years. If this shorter time frame is correct, active policymaking must be employed very rapidly if it is to provide a stabilization benefit. Copyright 2014 Pearson Education, Inc. All rights reserved 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 tradeoff between unemployment and inflation would disappear Copyright 2014 Pearson Education, Inc. All rights reserved Is There a New Keynesian Phillips Curve? (cont d) 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 Copyright 2014 Pearson Education, Inc. All rights reserved

16 Figure 17-9 The Phillips Curve: Theory versus Data Sources: Economic Report of the President; Economic Indicators, various issues. Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

17 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 Copyright 2014 Pearson Education, Inc. All rights reserved Example: Are Households and Firms Rationally Inattentive? A fundamental drawback of most new Keynesian sticky-price theories is their prediction that decreases in inflation have expansionary effects on the economy. In reality, lower inflation rates typically lead to business cycle contractions. A theory of rational inattention attempts to explain this phenomenon by assuming that households and firms are limited in the amount of information they can process. Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

18 Table 17-1 Issues That Must Be Assessed in Determining the Desirability of Active versus Passive Policymaking Copyright 2014 Pearson Education, Inc. All rights reserved You Are There: Active Policies Can Raise Employment At a Substantial Cost Economic research suggests that the number of new jobs attributable to the American Recovery and Reinvestment Act (ARRA) varies across different forms of discretionary fiscal spending. Federal spending on infrastructure such as roads and bridges resulted in new jobs, whereas expenditures on education did not. Two economists evaluating the impact of ARRA find that it created about 2 million new jobs, at a cost to taxpayers of somewhere between $170,000 and $400,000 per position. Copyright 2014 Pearson Education, Inc. All rights reserved Issues & Applications: A Law for Guiding Active Policymaking Breaks Down Okun s law describes an inverse empirical relationship between the unemployment rate and actual real GDP. Proponents of active policy-making suggest that keeping the unemployment rate close to its longterm trend requires policies to cut the gap between actual real GDP and real potential GDP. The figure on the following page displays observed pairings between unemployment-rate deviations and output gaps for the United States. Copyright 2014 Pearson Education, Inc. All rights reserved

19 Figure An Altered Relationship between Unemployment Deviations from Trend and the Percentage Output Gap Sources: Bureau of Labor Statistics; Congressional Budget Office: author s estimates. Copyright 2014 Pearson Education, Inc. All rights reserved Issues & Applications: A Law for Guiding Active Policymaking Breaks Down (cont d) Proponents of active policymaking argue that the breakdown of Okun s law is temporary Those who support passive policymaking argue that the breakdown in Okun s law may persist They contend that unemployment benefits have reduced incentives to look for work, just as new government regulations have reduced labor demand by firms Copyright 2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives Why the actual unemployment rate might depart from the natural rate of unemployment Unanticipated changes in aggregate demand Philips curve A curve showing an inverse relationship between the rate of inflation and the rate of unemployment Copyright 2014 Pearson Education, Inc. All rights reserved

20 Summary Discussion of Learning Objectives (cont'd) How expectations affect the actual relationship between the inflation rate and the unemployment rate Theory predicts that there will be a Phillips curve relationship only when expectations are unchanged The Phillips curve shifts Copyright 2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives (cont'd) Rational expectations, policy ineffectiveness, and real-business-cycle theory Rational expectations hypothesis Only unanticipated policy actions affect short-run real GDP Policy irrelevance theorem Technological changes and labor market shocks can induce business fluctuations, called real business cycles, which weaken the case for active policymaking Copyright 2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives (cont'd) Modern approaches to bolstering the case for active policymaking New Keynesian approach suggests that firms facing costs of adjusting their prices may be slow to change in the face of variations in demand Prices and wages are sufficiently inflexible in the short run that there is an exploitable relationship between inflation and real GDP Discretionary policy actions can stabilize real GDP in the short run Copyright 2014 Pearson Education, Inc. All rights reserved