Download SRAS 2

Chapter 15
Issues in
Stabilization
Policy
Copyright © 2005 Pearson Education Canada Inc.
15-1
Learning Objectives
15.1 Explain why the actual
unemployment rate might depart from
the natural rate of unemployment.
15.2 Describe why there may be an
inverse relationship between the
inflation rate and the unemployment
rate, reflected by the Phillips curve.
.
Copyright © 2005 Pearson Education Canada Inc.
15-2
Learning Objectives
15.3 Evaluate how expectations affect the
relationship between the actual
inflation rate and the unemployment
rate.
15.4 Describe the rational expectations
hypothesis and the new classical
model and their implications for
economic policy making.
Copyright © 2005 Pearson Education Canada Inc.
15-3
Learning Objectives
15.5 Identify the central features of the
real-business-cycle challenge to policy
making.
15.6 Identify the central features of
supply-side economics to policy
making.
Copyright © 2005 Pearson Education Canada Inc.
15-4
Learning Objectives
15.7 Distinguish among alternative
modern approaches to strengthening
the case for active policy making.
Copyright © 2005 Pearson Education Canada Inc.
15-5
The Natural Rate
of Unemployment
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.
 Example
• Fiscal and monetary policy
Copyright © 2005 Pearson Education Canada Inc.
15-6
The Natural Rate
of Unemployment
Passive (nondiscretionary) Policymaking
 Policymaking that is carried out in response
to a rule.
 Example
• Monetary rule
• Balancing the budget over the business cycle
Copyright © 2005 Pearson Education Canada Inc.
15-7
The Natural Rate
of Unemployment
Natural Rate of Unemployment
 The rate of unemployment that is
estimated to prevail in long-run
macroeconomic equilibrium.
 All workers and employers have fully
adjusted to any changes in the economy.
Copyright © 2005 Pearson Education Canada Inc.
15-8
The Natural Rate
of Unemployment
Frictional Unemployment
 Arises when people take the time to
search for the best job opportunities.
Copyright © 2005 Pearson Education Canada Inc.
15-9
The Natural Rate
of Unemployment
Structural Unemployment
 Unemployment resulting from:
•
•
•
•
•
Union activity
Government-imposed licensing arrangements
Government-imposed wage laws
Welfare and Employment Insurance
Changes in technology that make current
workers’ skills obsolete
Copyright © 2005 Pearson Education Canada Inc.
15-10
The Natural Rate
of Unemployment
LRAS SRAS2
Price Level
SRAS11
P3
E3
E2
P2
P1
E1
Departures from the
Natural Rate:
Monetary or fiscal
policy shifts AD. The
unemployment rate falls
temporarily below the
natural rate
of unemployment.
AD2
AD1
Y1 Y2
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-11
The Natural Rate
of Unemployment
LRAS
Price Level
SRAS1
SRAS2
E1
P1
P2
E2
Monetary or fiscal
policy shifts AD.
The
unemployment
rate temporarily
rises
above the natural
rate of
unemployment.
E3
P3
AD1
AD2
Q2 Q1
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-12
The Phillips Curve
The Phillips Curve: The Trade-Off?
 A curve showing the apparent relationship
between unemployment and changes in
wages or prices.
 It was long thought to reflect a trade-off
between unemployment and inflation.
Copyright © 2005 Pearson Education Canada Inc.
15-13
The Phillips Curve
Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
 The rate of unemployment below which
the rate of inflation tends to rise and
above which the rate of inflation tends to
fall.
Copyright © 2005 Pearson Education Canada Inc.
15-14
The Phillips Curve
Inflation Rate
U*
Zero inflation &
natural rate of
unemployment, U*.
Higher inflation &
lower unemployment
B
Deflation & higher
unemployment
A
C
Unemployment Rate
Copyright © 2005 Pearson Education Canada Inc.
15-15
The Importance of
Expectations
PC0
U*
Inflation Rate
-Increase in AD increases
inflation and reduces
unemployment
-The inflation and
unemployment rate
will return to A.
1
Government Policy
increases Ms
(one-time event)
to raise AD
B
A
U1
Unemployment Rate
Copyright © 2005 Pearson Education Canada Inc.
15-16
The Importance of
Expectations
PC0
Inflation Rate
U*
1
-To keep the economy at B
the Ms will have to
continue to grow.
-Economic participants
will begin to assume
the higher inflation rate
is constant
B
A
U1
Unemployment Rate
Copyright © 2005 Pearson Education Canada Inc.
15-17
The Importance of
Expectations
PC0
U*
Inflation Rate
PC5
1
F2
F1
B
A
As a result, the
unemployment rate
will increase to A and
yield combination F1.
U1
Unemployment Rate
Copyright © 2005 Pearson Education Canada Inc.
15-18
Rational Expectations and the New
Classical Model
Rational Expectations Hypothesis
 A theory stating that people combine the
effects of past policy changes on
important economic variables with their
own judgment about the future effects of
current and future policy changes.
Copyright © 2005 Pearson Education Canada Inc.
15-19
Rational Expectations and the
New Classical Model
New Classical Model
 A modern version of the classical model in
which wages and prices are flexible, there
is pure competition in all markets, and the
rational expectations hypothesis is
assumed to be working.
Copyright © 2005 Pearson Education Canada Inc.
15-20
Rational Expectations and the
New Classical
Model
LRAS
SRAS2 (Me = M2 )
P
SRAS1 (Me = M1 )
C
Price Level
3
A
P1
Policy will have
no impact on
Output (The
economy never
gets to B)
According to rational
expectations hypothesis
the SRAS will shift
simultaneously with the
increase in AD.
B
AD2 (M = M2)
AD1 (M=M1)
Q1
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-21
Rational Expectations and the
New Classical Model
Price Level
SRAS1 (Me = M0)
P
According to rational
expectations, an
unanticipated change
in AD can affect
output in the short run.
E1
1
P0
E0
AD2 (M = M1)
AD1 (M = M0)
Q1 Q 2
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-22
Rational Expectations and the
New Classical
Model
LRAS
SRAS2 (Me = M1 )
P
E3
SRAS1 (Me = M0 )
Price Level
3
E2
P2
P1
In the long run, people will
figure out the Bank of Canada’s
actions -- prices will increase
and output will return to
long-run equilibrium.
E1
AD2 (M = M1)
AD1 (M = M0)
Q1 Q2
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-23
Real Business Cycle Theory
Real Business Cycle Theory
 An extension and modification of the
theories of the new classical economists
of the 1970s and 1980s, in which money
is neutral and only real, supply-side
factors matter in influencing labour
employment and output.
Copyright © 2005 Pearson Education Canada Inc.
15-24
Real Business Cycle Theory
LRAS2
Price Level
Effects of a
Reduction in
the Supply of
Resources
SRAS3
LRAS1
SRAS2
SRAS1
A reduction in
the supply of a
resource shifts
the SRAS to
the left.
E3
P3
E2
P2
P1
E1
If the reduction in
the resource is
permanent, the
LRAS will shift also.
The position of the
LRAS depends
upon resource
endowments.
AD
Q3
Q2
Q1
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-25
Supply-side Economics
Supply-side Economics:
 The notion that creating incentives for
individuals and firms to increase
productivity will cause the aggregate
supply curve to shift outward.
Copyright © 2005 Pearson Education Canada Inc.
15-26
Supply-side Economics
LRAS1
SRAS1
LRAS2
SRAS2
Price Level
SRAS3
A increase in
the supply of a
resource shifts
the SRAS to
the right.
E1
P1
E2
P2
P3
E3
The position of the
LRAS depends upon
resource
endowments.
If the increase in
resources is
permanent, the
LRAS will also shift.
AD
Q1
Q2
Q3
Real GDP per Year
Copyright © 2005 Pearson Education Canada Inc.
15-27
Supply-side Economics
The
Laffer
Curve
Tax Rate
(percentage)
100
0
Tax Revenue
Copyright © 2005 Pearson Education Canada Inc.
15-28
Alternative Models for
Active Policy Making
New Keynesian Economics
 Economic models based on the idea that
demand creates its own supply as a result
of various possible government fiscal and
monetary coordination failures.
Copyright © 2005 Pearson Education Canada Inc.
15-29
Alternative Models for
Active Policy Making
Why are prices “sticky”?
1) Small-Menu Cost Theory
• Much of the economy is characterized by
imperfect competition.
• It is costly for firms to change their prices in
response to changes in demand (i.e.,
reprinting price lists, renegotiating contracts).
Copyright © 2005 Pearson Education Canada Inc.
15-30
Alternative Models for
Active Policy Making
Why are prices “sticky”?
2) Efficiency Wage Theory
• Worker productivity actually depends on the
wages that workers are paid.
Copyright © 2005 Pearson Education Canada Inc.
15-31
Alternative Models for
Active Policy Making
New Growth Theorists
 Argue that stabilization policy doesn’t
have much benefit, since the “wiggles” in
the business cycle are reflections of the
discovery and innovation process.
 Argue that governments should focus on
economic growth instead of business
fluctuations.
Copyright © 2005 Pearson Education Canada Inc.
15-32