Download The Role of Government: Impact on Macroeconomy

Center for Policy Excellence: budget policy
Workshop eleven and twelve
The role of government: impact on macroeconomy
(Based on Macroeconomics – Mankiw)
Seminar notes for fellows
Prepared by Diana Cook
February 1999
CONTENTS
1.
Introduction.................................................................................... 1
2.
Production and growth ................................................................... 2
2.1 Productivity: its role and determinants ................................................. 2
2.2 Economic growth and public policy ...................................................... 3
2.3 Importance of long run growth ........................................................... 6
3.
Government and saving.................................................................. 7
3.1 Taxes and savings .............................................................................. 7
3.2 Taxes and investment......................................................................... 8
3.3 Government budget deficits ................................................................ 8
4.
Money and prices in the long run .................................................11
4.1 The causes of inflation ....................................................................... 11
4.2 Costs of inflation ............................................................................... 14
5.
Short run economic flucatations ..................................................18
5.1 Three key facts about economic fluctuations ....................................... 18
5.2 Explaining short run fluctuations ........................................................ 18
5.3 The aggregate demand curve ............................................................ 19
5.4 The aggregate supply curve ............................................................... 20
5.5 Two causes of recession .................................................................... 22
6.
Influence of monetary and fiscal policy on aggregate demand...26
6.1 How monetary policy influences aggregate demand ............................ 26
6.2 How fiscal policy influences aggregate demand ................................... 29
6.3 Using policy to stabilize the economy.................................................. 32
6.4 The economy in the long-run and the short-run .................................. 33
7.
The short-run tradeoff between inflation and unemployment ....35
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7.1 The Phillips curve .............................................................................. 35
7.2 Shifts in the Phillips curve: the role of expectations ............................. 36
7.3 Shifts in the Phillips curve: the role of supply shocks ........................... 38
7.4 The costs of reducing inflation ........................................................... 38
8.
Homework ....................................................................................41
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1. INTRODUCTION
In these course notes we look at the short term and long term determinants of growth and how
public policy can influence the economy.
We start by looking at the drivers of growth in the long run. This analysis illustrates that in the
long term public policy can only enhance growth by encouraging the efficient use of a country’s
labor and capital inputs. As an example, we look at the impact of some government polices on
incentives to save and invest. We also examine why inflation is harmful to a country’s long-term
growth prospects. These notes do not examine in detail the impact of taxes on the economy. This
will be covered in future course notes.
However, in the short term, changes in aggregate demand can impact on the economy’s growth
rate. What are the implications for policy makers? We examine this issue and then reconcile our
short and long term perspectives of the economy.
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2. PRODUCTION AND GROWTH
When you travel around the world, you see tremendous variation in the standard of living. What
explains these diverse experiences? What policies should countries adopt to promote more rapid
growth?
A country’s gross domestic product (GDP) measures both the total income in the economy and
the total expenditure on the economy’s output of goods and services. The level of real GDP is a
good gauge of economic prosperity, and the growth in real GDP is a good gauge of economic
progress. In this section we focus on the long run determinants of the level and growth of GDP.
2.1 Productivity: its role and determinants
Definition:
Productivity: the amount of goods and services produced from each hour of a worker’s time.
The variation in living standards across the world is explained by productivity. The term
productivity refers to the quantity of goods and services a worker can produce for each hour of
work.
Recall that a country’s GDP measures both the total income earned by everyone on the economy
and the total expenditure on the economy’s output of goods and services. These two things must
be equal: an economy’s income is the economy’s output. A nation can enjoy a high standard of
living only if it can produce a large quantity of goods and services.
2.1.1 Determinants of productivity
Definitions:
Physical capital: the stock of equipment and structures that are used to produce goods and services.
Human capital: the knowledge and skills that workers acquire through education, training and experience.
Natural resources: the inputs into the production of goods and services that are provided by nature, such as
lands, rivers and mineral deposits.
Technological knowledge: society’s understanding of the best ways to produce goods and services.
Productivity depends on:
Physical capital or the stock of equipment and structures that are used to produce goods
and services. Workers are more productive if they have tools with which to work. Note
that capital is an input into the production process that in the past was an output from the
production process.
Human capital or the knowledge and skills that workers acquire through education, training
and experience. Human capital is also a produced factor of production, as producing human
capital requires inputs.
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Natural resources or inputs into production that are provided by nature, such as lands,
rivers and mineral deposits. Natural resources take two forms: renewable and
nonrenewable. Although natural resources are important, they are not necessary for an
economy to be highly productive in producing goods and services.
Technological knowledge or society’s understanding of the best ways to produce goods and
services. Technological knowledge can be common knowledge – after one person uses it,
everyone becomes aware of it. Or it can be proprietary – only the company that discovers
it knows it. There is an important distinction between technological knowledge and human
capital. Technological knowledge refers to society’s understanding about how the world
works. Human capital refers to resources expanded transmitting this understanding to the
labor force.
2.2 Economic growth and public policy
What can government do to raise productivity and living standards?
2.2.1 Importance of savings and investment
Because capital is a produced factor of production, a society can change the amount of capital it
has. One way to raise future productivity is to invest more current resources in the production of
capital.
Society faces a trade-off between current and future consumption. Devoting more resources to
producing capital requires devoting fewer resources to current consumption. To invest more in
capital, society must consume less and save more of its current income.
Encouraging savings and investment is one way that a government can encourage growth and, in
the long run, raise the economy’s standard of living. In section 3 we look at the impact of some
government policies on savings and investment.
2.2.2 Diminishing returns and the catch up effect
Diminishing returns: The property whereby the benefit from an extra unit of input declines as the quantity of
the input increases.
Catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries
that start off rich.
Increasing the capital stock will lead to increases in productivity and economic growth. However,
capital is subject to diminishing returns. As the stock of capital rises, the extra output produced
from an additional unit of capital falls. In other words, when workers already have a large quantity
of capital to use in producing goods and services, giving them an additional unit of capital
increases their productivity only slightly. Because of diminishing returns, an increase in the
savings rate leads to higher growth only for a while. In the long run the higher savings rate leads to
a higher level of productivity and income, but not to higher growth in these variables.
The diminishing returns to capital have another important implication: other things being equal, it
is easier for a country to grow fast if it starts out relatively poor. This is sometimes called the
catch-up effect. In poor countries, workers lack even the most rudimentary tools and, as a result,
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have low productivity. Small amounts of capital investment can substantially raise their
productivity.
2.2.3 Investment from abroad
Savings by domestic residents are not the only way for a country to invest in new capital. The
other way is investment by foreigners.
Investment from abroad takes several forms:
Foreign direct investment is a capital investment that is owned and operated by a foreign
entity.
Foreign portfolio investment is an investment that is financed with foreign money but
operated by domestic residents.
When foreigners invest in a country, they do so because they expect to earn a return on their
investment. Therefore, investment from abroad affects GDP and GNP differently. GDP is the
income earned within a country by both residents and nonresidents, whereas GNP is the income
earned by residents of a country both at income and abroad. Foreign investment will raise GDP
more than GNP.
Investment from abroad is one way for a country to grow. Even though some of the benefits from
the investment flow back to the foreign owners, this investment does increase the economy’s
stock of capital, leading to higher productivity and higher wages. It is also a way to learn the stateof –the-art technologies developed and used in richer countries. Therefore, government can
support economic activity through policies that encourage investment from abroad. Often this
means removing restrictions that governments have imposed on foreign ownership of domestic
capital.
2.2.4 Education
Education – investment in human capital – is just as important as investment in physical capital for
a country’s long run economic success. Thus, one way the government can enhance the standard
of living is to provide good schools and to encourage the population to take advantage of them.
Some economists have argued that human capital is particularly important for economic growth
because it conveys positive externalities. An educated person, for instance, might generate new
ideas about how best to produce goods and services. If these ideas enter society’s pool of
knowledge, so everyone can use them, then the ideas are an external benefit of education. This
argument would justify the large subsidies to human capital investment that we observe in the
form of public education.
2.2.5 Property rights and political stability
An important prerequisite for the market system to work is an economy-wide respect for
property rights. Property rights refer to the ability of people to exercise authority over the
resources they own. For example, businesses will only invest if they are confident that they will
be able to benefit from the product of that investment.
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For this reason, courts play an important role of enforcing property rights in a market economy.
Through the criminal justice system, the courts discourage direct theft. Through the civil justice
system, courts ensure that buyers and sellers live up to their contracts.
In many countries the system of justice does not work well. Contracts are hard to enforce and
fraud often goes unpunished. Sometimes the government not only fails to enforce property rights
but actually infringes upon them. To do business in some countries, firms are expected to bribe
powerful officials. Such corruption impedes the coordinating power of markets. It also
discourages domestic saving and investment from abroad. Political instability, such as revolutions
and coups, are a particular threat to property rights.
This underlines the importance of an efficient court system, honest government officials and a
stable constitution to the country’s standard of living.
2.2.6 Free trade
Some of the world’s poorest countries have tried to achieve more rapid economic growth by
pursuing inward-orientated policies. Most economists today believe that poor countries are better
off pursuing outward orientated policies that integrate these countries into the world economy.
Trade is, in some ways, a type of technology. When a country exports wheat and imports steel,
the country benefits in much the same way as if it has invented a technology for turning wheat
into steel. A country that eliminates trade restrictions will, therefore, experience the same kind of
economic growth that would occur after a major technological advance.
2.2.7 Control of population growth
Countries with large populations have large labor forces and therefore tend to have greater GDP
than smaller countries. However, for policy makers concerned about living standards. GDP per
person is a better measure of economic well-being. It tells us about the quantity of goods and
services available for the typical person in the economy.
High population growth reduces GDP per person. When population growth is rapid, equipping
each worker with a large quantity of capital is more difficult. This leads to lower productivity and
lower GDP per worker.
Reducing the rate of population growth can be one way to raise the standard of living of
developing countries. Some countries do it directly via laws, others indirectly by increasing
awareness of birth control techniques. Policies that foster equal treatment of woman can also
reduce population growth. Woman with the opportunity to receive good education and desirable
employment tend to want fewer children than those with fewer opportunities outside the home.
2.2.8 Research and development
Although most technological advances come from private research by firms and individual
inventors, there is also a public interest in promoting these efforts. To a large extent, knowledge
is a public good. Once one person discovers an idea, it enters society’s pool of knowledge and
other people can freely use it. Therefore, government has a role in encouraging the research and
development of new technologies.
As well as directly playing a role in the creation and dissemination of technological knowledge,
government encourages research through the patent system. The patent gives the inventor a
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property right over his invention, turning his new idea from a public good into a private good.
This enhances the incentive for individuals and firms to engage in research.
2.3 Importance of long run growth
A country’s standard of living depends on its ability to produce goods and services. Policymakers
who want to encourage growth in standards of living must aim to increase their nation’s
productive ability by encouraging the rapid accumulation of the factors of production and
ensuring that these factors are employed as effectively as possible.
Discussion:
Most countries import substantial amounts of goods and services from other countries. Yet I have said that a
nation can only enjoy a high standard of living if it can produce a large quantity of goods and services itself.
Can you reconcile the two facts?
What is the opportunity cost of investing in capital? Do you think a country can “over-invest” in capital?
What is the opportunity cost of investing in human capital? Can a nation over invest in human capital?
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3. GOVERNMENT AND SAVING
In section 2.2.1 we discussed the importance of saving and investment for long run economic
growth. In this section we look at some of the ways that government policy can impact on
national savings and investment.
3.1 Taxes and savings
Tax laws may impact on the incentive to save. For example, many countries collect revenue by
taxing income, including income from interest and dividends. Some economists argue that taxing
the return on savings substantially reduces the payoff from current saving, and, as a result,
reduces the incentive for people to save.
One way to change the tax law to encourage greater saving is to replace income taxes with a
consumption tax. Under a consumption tax, income that is saved would not be taxed until that
saving is spent.
Other proposals have been to give tax exemptions to particular types of savings. What impact
would this type of savings incentive have? We can think about it in terms of the supply and
demand for loanable funds. As the tax change would alter the incentive for households to save at
any given interest rate, the supply curve for loanable funds would shift out. This results in a lower
interest rate, which encourages households and firms to borrow more to finance investment.
Thus, if a change in tax laws encouraged greater saving, the result would be lower interest rates
and greater investment.
Figure 1 An increase in the supply of loanable funds
Supply1
Interest rate
Supply2
I1
I2
Demand
Q1
Q2
Loanable funds
However, this analysis depends on tax changes actually leading to an increase in national saving.
Many economists are skeptical about whether they would have much effect on private saving.
Also, remember that government saving is part of national savings. A cut in taxes may reduce
government saving, offsetting any increase in private saving. Skeptics also often doubt the equity
of tax incentives. They argue that, in many cases, the benefits of the tax changes would accrue
primarily to the wealthy, who are least in need of tax relief.
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3.2 Taxes and investment
Imagine that the government decided to give a tax exemption to any firm building a new factory.
What would be the impact of a tax investment credit on saving and investment?
The tax credit would alter the incentive of firms to borrow and invest in new capital – it would
increase the demand for loanable funds. Therefore, it would shift the demand curve for loanable
funds to the right.
The result would be higher interest rates and greater savings.
Figure 2 An increase in the demand for loanable funds
Interest rate
Supply
I2
I1
Demand2
Demand1
Q1 Q2
Loanable funds
1
However, note that the tax credit increasesQinterest
rates. For those firms wishing to invest in
equipment or industries to which the tax credit does not apply, the cost of capital has increased.
Therefore, tax exemptions can change investment decisions away from the market outcome. If we
assume that the market is the most efficient allocator of resources, then tax exemptions for
particular types of investment may not be desirable. It may be better to design policies that
encourage investment by decreasing overall business tax rates.
3.3 Government budget deficits
Crowding out: A decrease in investment that results from government borrowing.
Discussion:
How does the budget deficit affect interest rates, investment and economic growth?
What are the impacts of budget deficits on private savings and investment?
Recall that national savings represent the supply of loananble funds. This is composed of private
and public saving. An increase in the budget deficit represents a decrease in public saving and,
thereby, in the supply of loanable funds. When the government borrows to finance its budget
deficit, it reduces the supply of loanable funds to finance investment by households and firms.
As a result, the interest rate increases. The higher interest rate reduces the demand of the private
sector for loanable funds. Fewer families buy new homes and fewer firms build new factories. The
fall in investment because of government borrowing is called crowding out.
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Therefore, when the government reduces national savings by running a budget deficit, interest
rates rise and investment falls. As investment is important for long-rune economic growth,
government budget deficits reduce the economy’s growth rate.
Figure 3 The effect of a government budget deficit
Supply2
Interest rate
Supply1
I2
I1
Demand
Q2
Q1
Loanable funds
Ricardian equivalence
Although most economists accept the view that government
budget deficits reduce national savings and crowd out
investment, a small group questions this conclusion. They
advance a theory called Ricardian equivalence.
According to the theory of Ricardian equivalence when
households see government running a budget deficit, they
understand that government will need to raise their taxes in
the future in order to pay off the debt that is now
accumulating. Therefore, they increase their saving to offset
the government dis-saving.
However, this theory does not seem to hold empirically. For
example, the big public deficits in the early 1980s in the US
were not accompanied by a rise in private savings. In fact,
US private saving actually fell.
But a rise in government debt does mean higher taxes in the
future. Why don’t households save in anticipation of those
taxes? Perhaps they are too short sighted to see this future
ramification of government policies. Or perhaps they expect
these tax increases to fall not on themselves but on future
generations of taxpayers.
Discussion:
These notes have suggested that investment can be increased both by reducing taxes on private saving and by
reducing the government deficit.
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A
Why is it difficult to implement both of these policies at the same time?
B
What would you need to know about private saving in order to judge which of these two policies would
be a more effective way to raise investment?
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4. MONEY AND PRICES IN THE LONG RUN
Inflation: the increase in the overall level of prices.
Hyperinflation: an extraordinarily high rate of inflation.
4.1 The causes of inflation
The economy’s overall price level can be viewed in two ways. We can view the price level as the
price of a basket of goods and services. When the price level rises, people have to pay more for
the goods and services they buy. Alternatively, we can view the price level as a measure of the
value of money. A rise in the price level means a lower value of money, because each hyrinvia
now buys a smaller quantity of goods and services.
4.1.1 Money supply, demand and equilibrium
What determines the value of money? Supply and demand.
The central bank, together with the banking system, determines the supply of money. Through
open-market operations the central bank can change the quantity of reserves available to banks
which, in turn, influences the quantity of money that banks can create.
There are many determinants of the demand for money. However, the most important variable is
the average level of prices in the economy. People hold money because it is the medium of
exchange. How much money people hold for this purpose depends on the prices of those goods
and services. The higher prices are, the more money people will chose to hold in their wallets or
checking accounts.
Figure 4 Supply and demand for money and price level
Money supply
Price level
Value of money
High
Low
Equilibrium value of
money
Equilibrium price level
Money
demand
Low
High
Quantity
fixed by the
central bank
Quantity of money
What ensures that the quantity of money the central bank supplies equals the quantity of money
people demand? It depends on the time horizon being considered. Later in these course notes, we
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will see that interest rates play a key role in the short term. However, in the long run, the overall
level of prices adjusts to the level at which the demand for money equals the supply.
If the price level is above the equilibrium level, people will want to hold more money than the
central bank has created, so the price level must fall to balance supply and demand.
This is shown in Figure 4. The horizontal axis shows the quantity of money. The left-hand vertical
axis shows the value of money and the right hand vertical axis shows the price level. Note that the
price level axis is inverted: when the value of money is high, the price level is low. The
equilibrium of money supply and demand determines the value of money and the price level.
4.1.2 Effects of a monetary injection
Quantity theory of money: a theory asserting that the quantity of money available determines the price level
and that the growth rate in the quantity of money available determines the inflation rate.
Money neutrality: the proposition that changes in the money supply do not effect real variables.
What happens if the central bank increases the money supply? Let’s assume that the central bank
injects money into the economy by buying some government bonds from the public in openmarket operations.
Figure 5 An increase in the money supply
MS1
MS2
Price level
Value of money
High
Low
V1
P1
V2
P2
Low
MD
M1
M2
High
Quantity of money
The money injection shifts the supply curve to the right. As a result, the value of money decreases
and the equilibrium price level increases. In other words, when an increase in the money supply
makes money more plentiful, the result is an increase in the price level that makes each dollar less
valuable.
How does this adjustment occur? The immediate effect of the monetary injection is to create an
excess supply of money. People now have more dollars in their wallets than they want. The
quantity of money supplied now exceeds the quantity demanded.
People get rid of this excess supply of money in various ways. They might buy goods and services
with their excess holdings of money. Or they might use this excess money to make loans to others
by buying bonds or by depositing the money in a bank savings account. These loans allow other
people to buy goods and services. In either case, the injection of money increases the demand for
goods and services.
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However, the economy’s ability to produce goods and services has not changed. So the greater
demand for goods and services causes the prices of goods and services to increase. The increase in
the price level, in turn, increases the quantity of money demanded. Eventually the economy
reaches a new equilibrium.
The explanation of how the price level is determined and why it might change over time is called
the quantity theory of money. According to the quantity theory, the quantity of money available
in the economy determines the value of money, and growth in the quantity of money is the
primary cause of inflation.
This theory is based on the assumption that money is neutral. That is, changes in the money
supply do not affect the economy’s ability to produce goods and services. The economy’s
production depends on productivity and factor supplies. An increase in the money supply will
change nominal GDP, through prices, but have no impact on real GDP. This is a valid description
of what happens in the long term. However, money can have important effects on real variables in
the short term. This is discussed in section 5.
4.1.3 Quantity equation
Velocity of money: the rate at which money changes hands.
Quantity equation: the equation M x V = P x Y, which relates the quantity of money, the velocity of money
and the dollar value of the economy’s output of goods and services.
The quantity theory of money can be expressed in the equation:
MxV=PxY
The equation states that the quantity of money (M) times the velocity of money (V) equals the
price of output (P) times the amount of output (Y). It is called the quantity of money because it
relates the quantity of money (M) to the nominal value of output (P x Y).
In summary the quantity theory argues:
1
The velocity of money is relatively stable over time.
2
Because velocity is stable, when the central bank changes the quantity of money (M), it
creates proportional changes in the nominal value of output (P x Y).
3
The economy’s output of goods and services (Y) is primarily determined by factor supplies
and the available technology. As money is neutral, it does not affect output.
4
With output (Y) determined by factor supplies and technology, when the money supply
changes (M), the parallel changes in the nominal value of output (P x Y) are reflected in the
price level (P).
5
Therefore, when the central bank increases the money supply rapidly, the result is a high
rate of inflation.
4.1.4 The inflation tax
Inflation tax: the revenue the government raises by creating money.
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If inflation is so easy to explain why do countries experience hyperinflation? That is, why do
central banks sometimes print so much money that its value is certain to fall rapidly over time?
The answer is that the governments in these countries use money creation as a way to pay for
their spending. Normally the government does this by levying taxes and borrowing by selling
government bonds. But the government can also pay for spending by simply printing the money it
needs.
In this sense, inflation acts like a tax. When the government prints money, the price level rises,
and the money in your wallet is less valuable. Thus, the inflation tax is like a tax on everyone who
holds money.
4.1.5 The Fisher effect
Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate.
The principle of money neutrality requires that an increase in the rate of money growth does not
affect any real variable. This implies that an increase in the money supply must not affect real
interest rates.
The real interest rate is the nominal rate adjusted for inflation. If you have a savings account the
real rate would tell you how fast the purchasing power of your savings account will rise over
time. The real interest rate is the nominal rate minus the inflation rate:
Real interest rate = Nominal interest rate – inflation rate.
We can rewrite this equation to show that the nominal interest rate is the sum of the real interest
rate and the inflation rate:
Nominal interest rate = Real interest rate + inflation rate.
Different economic forces determine each of the two terms on the right hand side of the equation.
The real interest rate is determined by the supply and demand for loanable funds. According to
the quantity theory of money, growth in the money supply determines the inflation rate.
For an increase in the money supply not to impact on the real interest rate, the nominal interest
rate must adjust one-for-one to changes in the inflation rate. Thus, when the central bank
increases the rate of money growth, the result is both a higher inflation rate and a higher nominal
interest rate. This is called the Fischer effect.
4.2 Costs of inflation
4.2.1 A fall in purchasing power? The inflation fallacy
Inflation does not in itself reduce people’s real purchasing power. When prices rise, buyers of
goods and services do pay more for what they buy. At the same time, however, sellers of goods
and services get more for what they sell. As most people earn incomes by selling their services,
such as their labor, inflation in income goes hand-in-hand with inflation in prices.
This is because real variables are determined by other real variables, such as physical capital,
human capital, natural resources and the available production technology. Nominal incomes are
determined by those factors and the overall price level.
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In Ukraine recent increases in inflation have been associated with decreases in purchasing power.
Real wages have been falling. However, this is not a direct consequence of inflation but a
consequence of a fall in labor productivity or in the ability of the economy to produce goods and
services that people want to buy. This means that real wages needed to fall. This was achieved
through inflation. In the absence of inflation, nominal wages would have had to fall or
unemployment would have increased even further. Inflation may have indirectly contributed to
this problem by imposing the economic costs discussed below.
4.2.2 Shoeleather costs
Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings.
Inflation is like a tax on the holders of money. The tax itself is not a cost to society: it is only a
transfer of resources from households to government. However, most taxes give people an
incentive to alter their behavior to avoid paying the tax. This distortion of incentives can cause
deadweight losses for society as a whole. Like other taxes, the inflation tax also creates
deadweight losses, as people waste scare resources trying to avoid it.
Because inflation erodes the real value of the money in your wallet, you can avoid the inflation tax
by holding less money. One way to do this is to go to the bank more often. By making more
frequent trips to the bank, you can keep more of your wealth in your interest-bearing savings
account and less in your wallet, where inflation erodes its value.
This is called the shoeleather cost of inflation. Of course it is not really the wear and tear of your
shoeleather from frequent trips to the bank, but the time and convenience you must sacrifice to
keep less money on hand because of inflation.
The shoeleather costs are trivial in the case of mild inflation. But the cost is magnified in countries
experiencing hyperinflation. In this situation people are forced to convert their currency into
another as a store of value.
4.2.3 Menu costs
Menu costs: the costs of changing prices.
Firms change prices infrequently because there are costs in changing prices. These are called menu
costs. They include the cost of printing new price lists and catalogues, the cost of sending these
new price lists and catalogues to dealers and customers, the cost of deciding on new prices, and
even the cost of dealing with customer annoyance over price changes.
Inflation increases menu costs. During hyperinflations, firms must change their prices daily, or
even more often, just to keep up with all the other prices in the economy.
4.2.4 Relative prices and the misallocation of resources
The relative price of a good is the price of that good relative to all other goods in the economy.
Inflation can mask changes in relative prices by making it difficult for producers and consumers to
identify whether a price change is inflation or a relative price increase. Also if, due to menu costs,
producers delay changing their price in the face of inflation, relative prices will change. This
relative price change would not reflect any change in the supply and demand for that good.
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Why does this matter? The reason is that market economies rely on relative prices to allocate
scarce resources. Consumers decide what to buy by comparing the quality and prices of various
goods and services. Through these decisions, they decide how the scarce factors of production
will be allocated among industries and firms. When inflation distorts relative prices, consumer
decisions are distorted, and markets are less able to allocate resources to their best use.
4.2.5 Inflation-induced tax distortions
Almost all taxes distort incentives, cause people to alter their behavior, and lead to a less efficient
allocation of the economy’s resources. Many taxes, however, become even more problematic in
the presence of inflation. The reason is that lawmakers often fail to take inflation into account
when writing the tax laws.
Some economists argue that inflation tends to raise the tax burden on income earned from
savings. One example is the tax treatment on capital gains. Capital gains are the profits you make
from selling an asset for more than its purchase price. However, capital gains taxes typically don’t
take into account inflation when assessing your tax liability. If there has been inflation between the
time you purchased and sold the asset, then your real gain, or increase in your purchasing power,
is less than your nominal gain. Inflation exaggerates the size of capital gains and inadvertentently
increases the tax burden on this type of income. The same problem arises from the taxation of
nominal interest income – part of the nominal interest rate merely compensates for inflation.
There are many other ways in which tax codes interact with inflation. As a result, higher inflation
tends to discourage people from saving. This could depress long run economic growth. However,
there is no consensus among economists about the size of this effect.
One solution to this problem is to index the tax system. That is, tax laws could be rewritten to
take into account the effects of inflation. However, indexation would also complicate the tax
code.
4.2.6 Confusion and inconvenience
Money, as the economy’s unit of account, is what we use to quote prices and record debts. It is
the yardstick with which we measure economic transactions. Inflation makes it more difficult to
use money as a unit of account.
It is difficult to judge the costs of confusion and inconvenience that arise from inflation. As
discussed above, the tax code incorrectly measures real incomes in the presence of inflation.
Similarly, accountants incorrectly measure firms’ profits when prices are rising over time. As
inflation causes money to have different values at different times, computing a firms profit is more
difficult in an economy with inflation. Therefore, to some extent, inflation makes investors less
able to sort out successful from unsuccessful firms, which in turn impedes financial markets in
their role of allocating the economy’s saving to alternative types of investment.
4.2.7 Arbitrary redistributions of wealth
Unexpected inflation redistributes wealth amongst the population in a way that has nothing to do
with merit or need. These redistributions occur because most of the loans in the economy are
specified in terms of money.
Let’s assume you take a loan for 10 years at a fixed interest rate. If there is high inflation it will
erode the value of your debt and it will be easier for you to repay it. However, deflation would
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increase the real value of your debt. If inflation were predictable, it can be taken into account
when the nominal interest rate is set. But when it is unpredictable it imposes a risk on the
borrower and lender.
We should also note that inflation is especially volatile and uncertain when the average rate of
inflation is high. This suggests that if a country pursues a high-inflation monetary policy, it will
have to bear not only the costs of high expected inflation but also the arbitrary redistribution of
wealth associated with unexpected inflation.
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5. SHORT RUN ECONOMIC FLUCATATIONS
Recession: a period of declining growth in real incomes and rising unemployment.
Depression: a severe recession.
Due to increases in the labor force, increases in the capital stock, and advances in technological
knowledge, economies can usually produce more and more over time.
However, sometimes economies grow at less than their normal rate. Firms are unable to sell all of
their goods and services so they cut back on production. Workers are laid off, unemployment
rises, and factories are left idle. With the economy producing fewer goods and services, real GDP
and other measures of income fall. Such a period of falling incomes and rising unemployment is
called a recession if it is relatively mild and a depression if it is more severe.
While our focus in the previous sections has been on the long term, we now turn our attention to
the short term. What causes short run fluctuations in economic activity? What can public policy
do about them?
5.1 Three key facts about economic fluctuations
Some important properties of economic fluctuations are:
Economic fluctuations are irregular and unpredictable.
Most macroeconomic quantities fluctuate together. As recessions are economy-wide
phenomena, they show up in many macroeconomic indicators. When GDP falls in a
recession, so does personal income, corporate profits, consumer spending, investment
spending and so on. However, variables do fluctuate by different amounts. For example,
investment tends to fluctuate more than GDP.
As output falls, unemployment rises. When firms produce a smaller quantity of goods and
services, they lay off workers, expanding the pool of unemployed.
5.2 Explaining short run fluctuations
In the previous sections, we argued that money is neutral. According to classical macroeconomic
theory, changes in the money supply affect nominal variables but not real variables. Most
economists believe that this classical theory describes the economy in the long run but not in the
short run.
Our model of economic fluctuations is based on two variables:
Economy’s output of goods and services as measured by real GDP.
Overall price level, as measured by the CPI or GDP deflator.
We analyze fluctuations in the economy as a whole with the model of aggregate demand and
aggregate supply. The aggregate demand curve shows the quantity of goods and services that
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households, firms and the government want to buy at any price level. The aggregate supply curve
shows the quantity of goods and services that firm produce and sell at any price.
Figure 6 Aggregate demand and supply
Aggregate supply
Price level
Equilibrium price level
Aggregate demand
Equilibrium output
Quantity of output
However, this model is quite different from the model of supply and demand in individual
markets. When we consider demand and supply in a particular market, the behavior of sellers and
buyers depends on the ability of resources to move from one market to another. This
microeconomic substitution is impossible when we are analyzing the economy as a whole. The
quantity in our model, real GDP, includes the quantities produced in all markets. To explain why
the aggregate demand curve is downward sloping and the aggregate supply curve upward sloping;
we need a macroeconomic theory.
5.3 The aggregate demand curve
5.3.1 Why the aggregate demand curve is downward sloping
What lies behind the negative relationship between the price level and the quantity of goods and
services demanded? There are three distinct but related reasons:
Pigou’s wealth effect. When prices fall, the money consumers are holding becomes more
valuable because it can be used to purchase more goods and services. Thus, a decrease in
the price level makes consumers feel more wealthy, which in turn encourages them to
spend more. The increase in consumer spending means a larger quantity of goods and
services are demanded.
Keyne’s interest rate effect. The lower the price level the less money households need to hold
to buy the goods and services they want. When the price level falls, therefore, households
try to reduce their holdings of money by lending some of it out. Thus, a lower price level
reduces the interest rate, encourages greater spending on investment goods and thereby
increases the quantity of goods and services demanded.
Mundell-Fleming’s exchange rate effect. When a fall in a country’s price level causes interest
rates to fall, the real exchange rate depreciates. The depreciation is caused by investors
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seeking higher returns abroad. This depreciation stimulates net exports and increases the
quantity of goods and services demanded.
Note: the aggregate demand curve is drawn for a given quantity of money.
5.3.2 Why the aggregate demand curve may shift
When factors other than prices change, the aggregate demand curve shifts. Events that would shift
the curve include:
Ukrainians become more concerned about saving for retirement so reduce their
consumption.
The computer industry introduces a new line of computers, and many firms decide to
invest in new computer systems.
The government decides it will reduce purchases of military equipment.
The central bank increases the money supply.
5.4 The aggregate supply curve
In the long run the aggregate supply curve is vertical, whereas in the short run the aggregate
supply curve is downward sloping.
5.4.1 Why the aggregate supply curve is vertical in the long run
In the long run an economy’s supply of goods and services depends on its supplies of capital and
labor and on the available production technology used to turn capital and labor into goods and
services. As the price level does not affect these long run determinants of GDP, the long-run
aggregate supply curve is vertical.
Note that supply curves for individual products are upward sloping: they depend on relative
prices or the price of those goods and services compared to other prices in the economy. When
the price of one good increases relative to others, resources are transferred to the production of
that good.
Figure 7 Long run aggregate supply curve
Price level
1 A change in the
price level…
Long run
aggregate
supply
P1
2. …does not affect the
quantity of goods and services
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P2
Natural rate of
output
Quantity of output
5.4.2 Why the long run aggregate supply curve may shift
The long run supply curve shows the natural rate of output. It shows what the economy produces
when unemployment is at its natural or normal rate. This is the rate of production towards which
the economy gravitates in the long run.
Any change in the economy that alters the natural rate of output shifts the long-run supply curve.
For example, if an increase in the economy’s capital stock increases the productivity of labor.
Many factors influence the long run growth, including policies towards savings, investment,
education, technology and so on. Whenever a change in one of these factors alters the ability of
the economy to produce goods and services, it shifts the long run supply curve.
The position of the long run aggregate supply curve also depends on the natural rate of
unemployment. For example, an increase in minimum wages would increase the natural rate of
unemployment and shift the aggregate supply curve to the left.
5.4.3 Why the aggregate supply curve is upward sloping in the short
run
The key difference between the short-run and the long-run is aggregate supply. In the short-run
the aggregate supply curve is upward sloping. That is, over a period of a year or two, an increase
in the overall level of prices in the economy tends to raise the quantity of goods and services
supplied and vice versa.
There are three alternative explanations for the upward slope of the supply curve in the short-run.
However, each theory share a common theme: a specific market imperfection causes the supply
side of the economy to behave differently in the short run than in the long-run. This happens
when the price level deviates from the price level that people expected. When the price level rises
above the expected level, output rises above its natural rate, and when the price level falls below
its expected level, output falls below its natural rate.
The three theories are:
The new classical misperceptions theory. According to this theory, changes in the overall price
level can temporarily mis-lead suppliers about what is happening in the markets in which
they sell their output. For example, suppliers may misperceive a lower price level as a
reduction in their relative price, and these misperceptions could induce suppliers to
respond to the lower price level by decreasing the quantity of goods and services supplied.
The Keynesian sticky wage theory. This theory is based on the idea that nominal wages are
“sticky” or slow to adjust. This may be due to long-term contracts or social norms in wage
setting. Imagine that a firm has agreed to pay its workers a nominal wage based on their
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expectations of the price level. If the price level turns out to be lower, the real wage will
rise above the level the firm intended to pay. This makes employment and production less
profitable, which induces firms to reduce the quantity of goods and services supplied.
The new Keynesian sticky price theory. As not all prices adjust instantly to changing conditions,
an unexpected fall in the price level leaves some firms with higher-than-desired prices. This
depresses sales and induces firms to reduce the quantity of goods and services they
produce.
Note that under each of these theories, the problem is only temporary. Eventually as people
adjust their expectations, misperceptions are corrected and nominal wages and prices adjust.
Thus, in the long-run the aggregate supply curve is vertical.
5.4.4 Why the short-run supply curve may shift
Many events that shift the long-run supply curve will also shift the short run supply curve.
However, the short-run supply curve is also affected by people’s expectation of the price level.
For example, when people expect the price level to be high, they will tend to set wages high.
High wages rise firms’ costs and, for any given actual price level, reduce the quantity of goods and
services the firm will supply. Thus, a higher expected price level decreases the quantity of goods
and services supplied. A lower expected price level increases the quantity of goods and services
supplied.
The influence of expectations on the position of the short-run supply curve reconciles the
economy’s behavior in the long run with the short run. In the short-run expectations are fixed.
But in the long-run expectations adjust, shifting the short-run supply curve. This ensures that the
economy eventually finds itself at the intersection of the aggregate demand curve and long run
supply curve.
5.5 Two causes of recession
Figure 8 shows an economy in long-run equilibrium. Equilibrium output is determined by the
intersection of the aggregate demand and long-run aggregate supply curve. The short-run
aggregate supply curve also passes through this point, indicating that perceptions, wages and
prices have fully adjusted to this long-run equilibrium.
Figure 8 Long run equilibrium
Long run aggregate
supply
Price level
Short-run aggregate
supply
Equilibrium price level
Aggregate demand
Natural rate of
Quantity of output
output
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5.5.1 Effects of a shift in aggregate demand
Suppose for some reason, perhaps a fall in the stockmarket, that pessimism overtakes the
economy and aggregate demand falls. Households cut back on their spending and businesses cut
back on investment.
Figure 9 A contraction in aggregate demand
Long run aggregate
supply
Short-run AS1
Price level
Short-run AS2
A
P1
B
P2
P3
C
AD2
Y2
Y1
AD1
Quantity of output
In the short run the economy moves along the initial short-run supply curve, going from point A
to point B. Output falls from Y1 to Y2 and the price level falls from P1 to P2. The falling levels of
output indicate that the economy is in recession. Firms would respond by lowering employment.
Thus, the pessimism that caused the shift in demand is to some extent self-fulfilling: it leads to
falling incomes and rising unemployment.
What could policy makers do? They could increase aggregate demand by increasing spending or
increasing the money supply. If policy makers can act with sufficient speed and precision, they
could return the economy to point A.
However, even without action by policy makers the recession will remedy itself. As expectations
about the price level fall, the short run aggregate supply curve shifts to the right. In the long run
the economy approaches point C where the new aggregate demand curve crosses the long-run
supply curve.
At point C output is back to its natural rate. Prices have fallen sufficiently to offset the shift in the
aggregate demand curve. Thus, in the long run the shift in the demand curve is reflected fully in
prices and not in output.
5.5.2 Effects of a shift in aggregate supply
Stagflation: a period of falling output and rising prices.
Imagine once again an economy in long-run equilibrium. Now suppose that suddenly some firms
experience an increase in their costs of production. This will shift the aggregate supply curve to
the right. Depending on the event, the long run supply curve may also shift but, to keep things
simple, we will assume it does not.
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Figure 10 An adverse shift in aggregate supply
Long run aggregate
supply
Price level
Short-run AS2
Short-run AS1
B
P2
P1
A
AD1
Y2 Y1
Quantity of output
The economy moves along the existing demand curve to point B. Output falls and prices rise.
This is stagflation: the economy experiences both stagnation (falling output) and inflation (rising
prices).
What should policy makers do with stagflation? There are no easy answers. One possibility is to
do nothing. Eventually the recession will remedy itself as wages and prices adjust to the higher
production costs. For example, a period of low output will put downward pressure on workers’
wages. Over time the aggregate supply curve will shift back to AS1, the price level falls and output
returns to its natural rate.
Alternatively, policy makers may want to offset some of the shift in the short-run aggregate
supply curve by boosting aggregate demand. This is shown in Figure 11. In this case, changes in
policy shift the aggregate demand curve just enough to prevent the shift in aggregate supply
affecting output. However, the price level increase to P3. Policy makers are said to accommodate
the shift in aggregate supply because they allow the price level to increase permanently.
Figure 11 Accommodating an adverse shift in aggregate supply
Long run aggregate
supply
Price level
P3
P2
P1
C
Short-run AS2
Short-run AS1
B
A
AD2
AD1
Y2 Y1
Quantity of output
Thus, policy makers can not use aggregate demand to offset both the price and output impacts of a
supply shock.
Discussion:
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1
What type of recession is Ukraine in?
2
Will the recession cure itself?
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6. INFLUENCE OF MONETARY AND FISCAL
POLICY ON AGGREGATE DEMAND
In this section we look in more detail how the government’s tools of monetary and fiscal policy
can influence aggregate demand and short-term economic fluctuations.
6.1 How monetary policy influences aggregate demand
The aggregate demand curve shows the quantity of goods and services demanded for any price
level. Remember that the aggregate demand curve slopes downwards for three reasons:
Pigou’s wealth effect. A lower price level raises the real value of households’ money holdings
and higher real wealth stimulates consumer spending.
Keyne’s interest rate effect. A lower price level lowers the interest rate as people try to lend
out their excess money holdings and the lower interest rate stimulates investment
spending.
Mundell-Fleming’s exchange rate effect. When a lower price level lowers the interest rate,
investors move some of their funds overseas and cause the domestic currency to depreciate
relative to the foreign currencies. This depreciation makes domestic goods cheaper
compared to foreign goods and, therefore, stimulates net exports.
These three effects occur simultaneously to increase the demand for goods and services when the
price level falls. However, they are not of equal importance. As money holdings are a small part
of household wealth, the Pigou wealth effect is the least important. The importance of the
Mundell-Flemming effect depends on the share of trade in a country’s GDP. In large economies
the most important reason for the downward slope of the aggregate demand curve is the Keyne’s
interest rate effect.
Therefore, to understand how policy influences aggregate demand, we examine Keyne’s interest
rate effect in more detail.
6.1.1 The theory of liquidity preference
Theory of liquidity preference: Keyne’s theory that the interest rate adjusts to bring money supply and money
demand into balance.
According to Keynes, interest rates adjust to balance the supply and demand for money. Let’s
look at the determinants of the supply and demand for money:
Money supply. The money supply is controlled by the central bank. Therefore, it does not
depend on other economic variables, including the interest rate. Therefore, the money
supply curve is vertical (see Figure 12).
Money demand. The liquidity of money explains the demand for it. People chose to hold
money instead of other assets that offer a higher rate of return because money can be used
to buy goods and services. Therefore, one of the most important determinants of money
demand is the interest rate. The interest rate is the opportunity cost of holding money. An
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increase in the interest rate raises the cost of holding money, compared to investing it in an
interest-bearing bond, and reduces the quantity of money demanded.
Figure 12 Equilibrium in the money market
Money supply
Interest rate
Equilibrium
interest rate
Money demand
Quantity fixed by
the central bank
Quantity of money
The interest rate adjusts to balance the supply and demand for money. If the interest rate is not at
the equilibrium level, people will try to adjust their portfolios of assets and, as a result, will drive
the interest rate towards equilibrium.
6.1.2 The downward slope of the aggregate demand curve
We now use the liquidity theory to explain the downward slope of the aggregate demand curve.
The price level is one determinant of the quantity of money demanded (see section 4.1.1). A
higher price level will increase the amount of money people want to hold and shift the demand
curve to the right. Yet the quantity of money supplied is unchanged, so the interest rate must rise
to discourage the extra demand.
This increase has ramifications not only for the money market but also for the quantity of goods
and services demanded. At a higher interest rate, the cost of borrowing and the return to saving
are greater. Therefore, the quantity of goods and services demanded fall.
Keynes’s interest rate effect can be summarized in three steps:
A higher price level reduces money demand.
Higher money demand leads to higher interest rates.
A higher interest rate reduces the quantity of goods and services demanded.
Figure 13 The money market and the slope of the aggregate demand curve
Money supply
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Interest rate
r2
3. ...which increases
the equilibrium
interest rate…
2. …increases the demand
for money…
r1
Money demand at price level P2, MD2
Money demand at price level P1, MD1
Quantity fixed by
the central bank
Quantity of money
Price level
P2
1. An increase
in the price
level…
P1
Aggregate demand
Y2
Y1
Quantity of output
4. …which in turn reduces the
quantity of goods and services
demanded.
The end result is a negative relationship between the price level and the quantity of goods and
services demanded.
6.1.3 Changes in the money supply
The liquidity theory also sheds light on how the central bank shifts aggregate demand when it
changes monetary policy. Suppose the central bank increases the money supply. And suppose that
the price level does not, in the short run, respond to this monetary injection. How does it affect
the equilibrium interest rate and aggregate demand curve?
Figure 14 A monetary injection
Interest rate
Money
supply,
MS1
MS2
1. When the central bank
increases the money supply…
r1
2. …the equilibrium
interest rate falls
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r2
Money demand at price level P
Quantity of money
Price level
P1
AD2
Aggregate demand, AD1
Y1
Y2
Quantity of output
3. …which increases the quantity of goods and services
demanded at a given price level
The increase in the money supply reduces the interest rate to induce people to hold the additional
money. The lower interest rate reduces the cost to borrowing and the return to saving, increasing
the quantity of goods and services demanded.
6.1.4 Interest rate targets
Sometimes central banks will target interest rates rather than the money supply. This would not
fundamentally change our analysis of monetary policy. Monetary policy can be described in terms
of the money supply or in terms of the interest rate. When the central bank sets an interest rate
target, it commits itself to adjusting the money supply in order to make the equilibrium in the
money market hit the target.
Thus a change in monetary policy that aims to expand aggregate demand can be described as
either increasing the money supply or raising the interest rate.
6.2 How fiscal policy influences aggregate demand
Government can also influence the economy thorough fiscal policy. Fiscal policy refers to the
government’s choices regarding the overall level of government purchases or taxes. In the long
run, fiscal policy can influence growth through its impact on savings and investment. In the short
run, however, the primary effect of fiscal policy is on the aggregate demand for goods and
services.
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6.2.1 Changes in government purchases
When government changes its own purchases of goods and services it shifts the demand curve
directly. However, the increase in aggregate demand will be different from the increase in
spending. There are two offsetting effects:
The multiplier effect suggests that the increase in aggregate demand could be larger than
the increase in spending.
The crowding out effect suggests that the shift in aggregate demand could be smaller than
the increase in spending.
6.2.2 The multiplier effect
Multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy
increases income and thereby increases consumer spending.
When the government increase its spending on goods and services that increase leads to higher
employment and profits in the firms from which the government purchases. As workers see
higher earnings and firm owners see higher profits, they rise their own spending on consumer
goods. Therefore, the government purchases raises the demand for the products of many other
firms in the economy. Because each dollar spent by the government can raise the aggregate
demand for goods and services by more than a dollar, government purchases are said to have a
multiplier effect on aggregate demand.
The multiplier
We can derive a formula for the size of the multiplier effect
that arises from consumer spending. An important number is
the marginal propensity to consume: the fraction of extra
income that a household consumes rather than saves.
Multiplier = 1/(1-MPC)
For example, if the MPC is 0.75, the government purchases
multiplier is 1/(1-0.75), which is 4. If the government
increases spending by $20 billion, it generates $80 billion
worth of demand for goods and services. However, note that
using multiplier analysis is very dangerous. It depends
crucially on the assumption about the marginal propensity of
consumption, which is very difficult to determine.
This multiplier effect continues even after the first round. Higher demand leads to higher
incomes, which leads to higher demand and so on. Once all these effects are added together, the
total impact on the quantity of goods and services demanded can be much larger than the initial
impact from higher government spending. The effect can also be strengthened by higher
investment in response to higher levels of demand.
6.2.3 The crowding-out effect
Crowding out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the
interest rate and thereby reduces investment spending.
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There is an effect that offsets the multiplier effect. While an increase in government purchases
stimulates the demand for goods and services, it also increases the demand for money. As incomes
rise from increased government spending, households plan to buy more goods and services and, as
a result, chose to hold more of their wealth in a liquid form.
Figure 15 The crowding-out effect
Money supply
Interest rate
r2
3. ...which increases
the equilibrium
interest rate…
2. …the increase in spending
increases money demand…
r1
MD2
Money demand, MD1
Quantity fixed by
the central bank
Price level
1. When an increase in
government purchases
increases aggregate
demand…
Quantity of money
4. …which in turn
partly offsets the
initial increase in
aggregate demand
AD2
AD3
Aggregate demand, AD1
Quantity of output
A higher interest rate tends to choke off the demand for goods and services. In particular, because
borrowing is more expensive, the demand for residential and business investment goods declines.
This is called the crowding-out effect.
The crowding out effect partially offsets the impact of government purchases on aggregate
demand. When the government increases its purchases by $20 billion, for example, the increase
in aggregate demand could be more or less than $20 billion, depending on whether the multiplier
effect or the crowding out effect is larger.
6.2.4 Changes in taxes
The other important instrument of fiscal policy is taxation. When the government cuts taxes, it
increases households’ take home pay. Households will save some of this additional income, but
they will also spend some of it. Therefore, the tax cut increases aggregate demand. Similarly, a
tax increase decreases aggregate demand.
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The multiplier and crowding-out effects also affect the size of the shift in aggregate demand
resulting from a tax change. In addition to these effects, there is another important determinant of
the size of the shift in aggregate demand that results from a tax change: households' perceptions
about whether the tax cut is temporary or permanent. In deciding how much of the extra income
to spend, households will ask themselves how long the extra income will last. Tax cuts that are
perceived as being temporary with only have a little impact on aggregate demand.
Fiscal policy and aggregate supply
Most economists believe that the short-run macroeconomic
effects of fiscal policy work primarily though aggregate
demand. Yet fiscal policy can also potentially influence the
quantity of goods and services supplied.
For example, when government cuts tax rates, workers get
to keep more of every hyrniva they earn and therefore have
a greater incentive to work and to produce goods and
services. As a result, the quantity of goods and services
supplied is greater at any price level. Some economists,
called supply-siders, have argued that the influence of tax
cuts on aggregate supply is very large. Some claim that a
cut in tax rates may actually increase tax revenue by
increasing worker effort (see attached article).
Changes in government purchases can also potentially affect
aggregate supply. For example, government spending on
economic infrastructure can boost the productivity of private
sector enterprises, leading to increases in aggregate supply.
However, this effect is probably more important in the long run than in the short-run.
6.3 Using policy to stabilize the economy
Should policymakers use fiscal and monetary policy to control aggregate demand and stabilize the
economy? If so, when? If not, why not?
6.3.1 The case for an active stabilization policy
At the least, government should avoid being the cause of economic fluctuations. Most economists
argue against large and sudden changes in monetary and fiscal policy. Moreover, when large
changes do occur, it is important that monetary and fiscal policy makers be aware and respond to
the other’s actions.
Some economists argue that the government should respond to changes in the private economy to
stabilize aggregate demand. These arguments are based on Keynes’ theory that aggregate demand
fluctuates largely because of irrational waves of pessimism and optimism. In principle,
government can adjust monetary and fiscal policy in response to these waves and thereby stabilize
aggregate demand. For example, when people are excessively pessimistic, the central bank can
expand the money supply and vice versa.
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6.3.2 The case against stabilization policy
Some economists argue that the government should avoid using monetary and fiscal policy to try
to stabilize the economy. They claim that these policy instruments should be set to achieve long
run goals, such as economic growth and low inflation, and that the economy should be left to deal
with short-term fluctuations on its own. Although monetary and fiscal policy may be able to
stabilize the economy in theory, these economists doubt whether it can in practice.
One problem is that these policies affect the economy with a substantial lag. Changes in monetary
policy are thought to take at least six months to have much effect on output and employment and
these effects can last for several years. Therefore, central banks often react too late to changing
economic fluctuations and, as a result, end up being a cause rather than a cure of economic
fluctuations. Lags in fiscal policy are largely attributable to the political process. By the time
policies are ready to implement, the economy may well have changed.
6.3.3 Automatic stabilizers
Automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a
recession without policymakers having to take any deliberate action.
Automatic stabilizers help policymakers avoid the problem of lags. Automatic stabilizers are
changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession
without policymakers having to take any deliberate action.
The most important automatic stabilizer is the tax system. When the economy goes into a
recession, the amount of taxes collected by the government falls automatically because almost all
taxes are tied to economic activity. The automatic tax cut stimulates aggregate demand and
reduces the magnitude of economic fluctuations.
Government spending also acts as a stabilizer. For example, spending on unemployment benefits
and other welfare support automatically increases in a recession. The automatic increase in
government spending stimulates aggregate demand at exactly the time when aggregate demand is
insufficient to maintain full employment.
The role of automatic stabilizers suggests that government shouldn’t always aim to balance its
budget. If the economy goes into a recession taxes fall and government spending rises. To balance
the budget, the government would have to look for ways to increase taxes or cut spending in a
recession – this could exacerbate the economic cycle. A strict budget balance rule would
eliminate the impact of automatic stabilizers. However, government should aim to balance the
budget over the economic cycle.
6.4 The economy in the long-run and the short-run
It may appear that we have two theories for how interest rates are determined. In section 3 we
said that the interest rate adjusts to balance the supply and demand of loanable funds. By contrast,
this chapter said that interest rates adjust to balance the supply and demand for money. Which of
these theories is right? The answer is both.
This reflects the difference between the long-run and the short-run behavior of the economy. In
the long run:
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1
Output is determined by the supplies of capital and labor and the available production
technology for turning capital and labor into output.
2
For any given level of output, the interest rate adjusts to balance the supply and demand for
loanable funds.
3
The price level adjusts to balance the supply and demand for money. Changes in the supply
of money lead to proportionate changes in the price level.
However, these propositions do not hold in the short-run. Many prices are slow to adjust to
changes in the money supply. As a result, the overall price level cannot, by itself, balance the
supply and demand for money in the short run. This price inflexibility forces the interest rate to
move in order to bring the monetary market into equilibrium. These changes in the interest rate,
in turn, affect the aggregate demand for goods and services. As aggregate demand fluctuates, the
economy’s output of goods and services moves away from the level determined by the factor
supplies and technology.
In the short run:
1
The price level is stuck at some level and, in the short run, is relatively unresponsive to
changing economic conditions.
2
For any given price level, the interest rate adjusts to balance the supply and demand for
money.
3
The level of output responds to changes in the aggregate demand for goods and services,
which is in part determined by the interest rate that balances the money market.
Discussion:
Suppose the central bank decides to expand the money supply.
A
What is the effect of this policy on the interest rate in the short term? Diagram.
B
What is the effect in the long run?
C
What characteristic of an economy makes the short run effect of monetary policy on the interest rate
different from the long-term effect?
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7. THE SHORT-RUN TRADEOFF BETWEEN
INFLATION AND UNEMPLOYMENT
Society faces a short run trade-off between inflation and unemployment. If monetary and fiscal
policymakers expand aggregate demand, they can lower unemployment in the short run, but only
at the cost of higher inflation. If they contract aggregate demand they can lower inflation but only
at the cost of temporarily higher unemployment.
7.1 The Phillips curve
Phillips curve: a curve that shows the short-run tradeoff between inflation and unemployment.
The short-run trade-off between inflation and unemployment is often called the Phillips curve.
The rationale for this correlation is that low unemployment is associated with high aggregate
demand and high aggregate demand puts upward pressure on wages and prices throughout the
economy. This suggests that while policy makers might prefer low unemployment and low
inflation this combination is impossible.
Figure 16 The Phillips curve
Inflation rate
(percent per year)
B
The Phillips curve illustrates a negative relationship
between the inflation rate and the unemployment
rate. At point A, inflation is low and employment
is high. At point B, inflation is high and
unemployment is low
A
Phillips curve
Unemployment rate (percent)
This fits in with our model of aggregate demand and supply. The Phillips curve simply shows the
combinations of inflation and unemployment that arise in the short term as shifts in the aggregate
demand curve move the economy along the short-run aggregate supply curve. The greater the
aggregate demand for goods and services, the greater the economy’s output and the higher the
overall price level. Higher output translates into higher employment and lower unemployment.
Therefore, by shifting the aggregate demand curve, monetary and fiscal policy can shift the
economy along the Phillips curve.
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7.2 Shifts in the Phillips curve: the role of expectations
7.2.1 The long run Phillips curve
In the long run most economists accept that the rate of inflation is not related to unemployment.
This means that monetary policy makers face a long-run Phillips curve that is vertical. If the
central bank increases the money supply slowly, the inflation rate is low and the economy finds
itself at point A in Figure 17. If the central bank increase the money supply quickly, the inflation
rate is high and the economy finds itself at point B. In either case the unemployment rate tends
towards its normal level called the natural rate of unemployment.
Figure 17 The long run Phillips Curve
Inflation rate
(percent per year)
High inflation
1. When the central
bank increases the
growth rate of the
money supply, the rate Low inflation
of inflation increases…
Long run Phillips curve
B
2. …but unemployment remains
at its natural rate in the long run
A
Natural rate of
unemployment
Unemployment rate (percent)
This is consistent with the idea of a vertical long run supply curve.
Note that the natural rate of unemployment is not necessarily the socially desirable rate of
unemployment. Nor is the natural rate of unemployment constant over time. The unemployment
rate is “natural” not because it is good but because it is beyond the influence of monetary policy.
However, while monetary policy can not influence the natural rate of unemployment, other types
of policies can. To reduce the natural rate of unemployment, policy makers should look to
policies that improve the functioning of the labor market. Labor market policies such as minimum
wage laws, collective-bargaining laws, unemployment insurance and job training affect the natural
rate of unemployment.
7.2.2 Expectations and the short-run Phillips curve
Policy makers can pursue expansionary monetary policy to achieve lower unemployment for a
while but eventually it returns to its natural rate.
The short run trade-off comes because of inflation expectations. Expected inflation measures how
much people expect the overall price level to change. The expected price level affects the
perceptions of relative prices that people form and the wages and prices they set. As a result,
expected inflation is one factor that sets the position of the short run supply curve. If expected
inflation is set in the short term, then monetary changes can lead to unexpected fluctuations in
output, prices, unemployment and inflation.
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However, perceptions, wages and prices will eventually adjust to the inflation rate so output will
return towards the natural rate.
This can be summarized in the equation:
Unemployment rate = Natural rate of unemployment –
a (Actual inflation – expected inflation)
In the short-run expected inflation is set. Higher actual inflation is associated with lower
unemployment. In the long run, however, people come to expect whatever inflation the central
bank produces. Thus, actual inflation equals expected inflation and unemployment is at its natural
rate.
Note that policy makers can not continue to exploit this short run trade-off. Let’s assume policy
makers use fiscal or monetary policy to expand aggregate demand. In the short run the economy
goes from point A to point B in Figure 18. Unemployment falls below its natural rate and inflation
rises above expected inflation.
Figure 18 Expected inflation and the short run Phillips curve
Inflation rate
(percent per year)
Long run Phillips curve
C
B
Short-run Phillips curve with high
expected inflation
A
Short-run Phillips curve with
low expected inflation
Natural rate of
unemployment
Unemployment rate (percent)
Over time, people get used to the higher inflation rate and they revise their expectations of
inflation. When expected inflation rises, the short run trade-off between inflation and
unemployment shifts upward. The economy ends up at point C with higher inflation than at point
A but with the same level of unemployment. So if policy makers use this trade-off they lose it.
People begin to expect the higher inflation and policy makers have to rack up inflation higher and
higher to get any short-term boost to output.
This is highlighted by the experience of the US in the late 1960s and 1970s. Beginning in the late
1960s the US government followed both fiscal and monetary policies that expanded aggregate
demand. As a result inflation stayed high – around 5% to 6% per year compared to 1% to 2% per
year in the early 1960s. However, unemployment did not stay low. As inflation remained high in
the early 1970s, people expectations caught up with reality and the unemployment rate reverted
to the 5% to 6% rate that had prevailed in the early 1960s.
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7.3 Shifts in the Phillips curve: the role of supply shocks
Shocks to aggregate supply will also shift the Phillips curve. One example, for the US and many
countries in the mid-1970s, was sharp increases in the price of oil as the Organization of
Petroleum Exporting Countries (OPEC) exerted its market power as a cartel in the oil market.
Ukraine faced a similar shock with the increase in energy prices with the break up of the Soviet
Union.
The increase in the price of oil raised the price of producing many goods and services so reduced
the quantity of goods and services provided at any given price level. The shift in aggregate supply
is associated with a similar shift in the short-run Phillips curve. As firms need fewer workers,
employment falls and unemployment rises. The inflation rate is also higher.
Confronted with an adverse shift in aggregate supply, policy makers face a difficult choice. If they
contract aggregate demand to fight inflation, they will raise unemployment further. If they
expand aggregate demand to fight unemployment, they will raise inflation further. In other
words, policy makers face a less favorable tradeoff between unemployment and inflation than they
did before the shift in aggregate supply.
An important question is whether the adverse shift in the Philips curve is permanent or
temporary. If people view the event as a temporary aberration, expected inflation does not
change and the Phillips curve will revert to its former position. But if people view the shock as
leading to a new era of higher inflation, then expected inflation rises and the Phillips curve
remains at it new, less desirable, position.
7.4 The costs of reducing inflation
When the central bank slows the rate of money growth, it contracts aggregate demand. The
economy moves from point A on the Phillips curve (see Figure 19) to point B, which has lower
inflation and higher unemployment. Over time, expected inflation falls and the short-run Phillips
curve shifts downwards. The economy moves from point B to C. Inflation is lower and
unemployment is back to its natural rate.
Thus, if an economy is to reduce inflation, it must endure a period of high unemployment and
low output. The size of this cost depends on the slope of the Phillips curve and how quickly
expectations of inflation adjust to the new monetary policy.
Figure 19 Deflationary monetary policy
Inflation rate
(percent per year)
Long run Phillips curve
A
B
Short-run Phillips curve with high
expected inflation
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C
C
Natural rate of
unemployment
Short-run Phillips curve with
low expected inflation
Unemployment rate (percent)
7.4.1 Rational expectations and the possibility of costless disinflation
Rational expectations: the theory according to which people use all the information they have, including
information about government policies, when forecasting the future.
Expected inflation is an important variable that explains why there is a trade-off between inflation
and unemployment in the short run but not in the long-run. How quickly the short-run trade-off
disappears depends on how quickly expectations adjust. The theory of rational expectations
argues that people take into account economic policies when forming their expectations of
inflation.
Therefore, if the government makes a credible commitment to reducing inflation, the output
costs of reducing inflation will be much lower. In this case, people would lower their expectations
of inflation much more quickly. The short-run Phillips curve would move downwards and the
economy would reach low inflation quickly without the cost of temporarily high unemployment
and low output. However, policy makers can not count on people immediately believing them
when they announce a policy of disinflation.
Discussion:
1
Show the effects of the following events on the short run and long run Phillips curve:
A
A rise in the natural rate of unemployment.
B
A decline in the price of imported oil.
C
A rise in government spending.
D
A decline in expected inflation.
2
A
Suppose the economy is in long-run equilibrium.
Draw the economy’s short-run and long run Phillips curves.
B
Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on the
Phillips curve. If the government undertakes expansionary monetary policy can it return the economy to its
original inflation and unemployment rate?
C
Now suppose the economy is back in long-run equilibrium and the price of imported oil rises. Show this
on Phillips curve. If the central bank undertakes expansionary monetary policy can it return the economy to its
original inflation and unemployment rate? If the bank undertakes contractionary monetary policy can it
return the economy to its original inflation and unemployment rate?
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3
Given the unpopularity of inflation, why don’t elected leaders always support efforts to reduce inflation?
Economists believe that countries can reduce the cost of disinflation by letting their central banks make
decisions about monetary policy without interference from politicians. Why?
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8. HOMEWORK
In these course notes we looked at the impact of government policy on the economy in the shortrun and the long-run. Using the tools from this analysis, think about the alternatives you have
identified in your solution analysis. See if you can use these tools to help explain the different
impact these policies may have on the economy in the short and long-run. We will discuss this in
the first half on the next workshop.
Also, expand your glossary to include:
Productivity.
Physical capital.
Human capital.
Natural resources.
Technological knowledge.
Diminishing returns.
Catch-up effect.
Ricardian equivalence.
Inflation.
Hyperinflation.
Quantity theory of money.
Money neutrality.
Velocity of money.
Quantity equation.
Inflation tax.
Fisher effect.
Shoeleather costs.
Recession.
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Depression.
Theory of liquidity preference.
Stagflation.
Multiplier effect
Crowding out effect.
Automatic stabilizers.
Phillips curve.
Rational expectations.
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