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Expectations and Macroeconomic
Stabilization Policies
Adaptive and Rational Expectations
Adaptive Expectations
• Adaptive Expectations
– Expectations depend on past experience only.
• Expectations are a weighted average of past
experiences.
• Expectations change slowly over time.
Rational Expectations
• Expectations that are based on all available
information past and present as well as on a basic
understanding of how the economy works.
• The theory of rational expectations states that
expectations will not differ from optimal forecasts
using all available information.
Rational Expectations
• Rational expectations mean that expectations
will be identical to optimal forecasts (the best
guess of the future) using all available
information, but…..
– It should be noted that even though a rational
expectation equals the optimal forecast using all
available information, a prediction based on it
may not always be perfectly accurate.
Non-rational Expectations
• There are two reasons why an expectation may
fail to be rational:
– People might be aware of all available
information but find it takes too much effort to
make their expectation the best guess possible.
– People might be unaware of some available
relevant information so their best guess of the
future will not be accurate.
Rational Expectations: Implications
• If there is a change in the way a variable moves,
there will be a change in the way expectations of
this variable are formed.
• Therefore, the forecast errors of expectations will
be random with a mean of zero, unrelated to those
made in previous periods, revealing no discernable
pattern, and have the lowest variance compared to
other forecasting methods.
The New Classical vs. New
Keynesian Debate
The Fooling Model
• Components
– Aggregate Supply
• Production function
– Determines the relationship between employed factors of
production and total output.
• Labor Market
– Determines employment of labor and the real wage.
– Aggregate Demand
The Fooling Model
• The distinctive features of this model are:
– All markets clear.
• The adjustment process of “market clearing” is the
essence of the model.
• The market is cleared when it is in equilibrium.
• Equilibrium is a state of rest where there are no forces
causing change or there are equal opposing forces.
– Business cycles can occur only if workers have
imperfect information about prices and as a
result inaccurately perceive price level changes.
Equilibrium
LAS
P
SAS0(Pe0)
At point E0, the model is in longrun and short-run equilibrium.
AD = SAS = LAS
E0
P0
0
YN
The equilibrium price level is
P0 and the full employment
equilibrium output is YN
AD0
Y
Employment
• Assumptions:
– Labor demand is determined by the real wage.
– When the actual price level changes, workers’
price expectations do not change.
– Labor supply is determined by the expected real
wage; that is, the nominal wage divided by the
price level expected by the workers.
The Fooling Model
LAS
W/P
Ls(W/Pe)
W1/P0
W0/P0
W1/P1
0
SAS0(Pe0)
P
D
E0
C
P1
C
L0 L1
Employment
P0
Ld(W/P)
L
E0
AD1
AD0
0
YN Y1
Real GDP
Y
AD-AS Model
• The initial equilibrium exists at E0.
– At E0, Y equals YN and P equals P0.
• The increase in aggregate demand shifts the
aggregate demand curve from AD0 to AD1.
– The price level rises from P0 to P1, causing the real
wage to fall from W1/P0 to W1/P1.
– Output increases from YN to Y1.
• The new equilibrium exists at C.
– At C, Y equals Y1 and P equals P1.
Employment
• The increase in aggregate demand raises the
actual price level and reduces the actual real
wage, encouraging firms to hire more workers.
– The workers do not realize that the real wage has
fallen. As a result, they work more.
• At L1, the real wage equals W1/P1 while the nominal
wage paid to the workers is W1/P0.
• The workers supply L1 labor, moving up the labor
supply curve to point D.
The Fooling Model
LAS
W/P
Ls(W/Pe)
W1/P0
W0/P0
W1/P1
0
SAS0(Pe0)
P
D
E0
C
P1
C
L0 L1
Employment
P0
Ld(W/P)
L
E0
AD1
AD0
0
YN Y1
Real GDP
Y
Fooling Model: Long Run Adjustment
SAS(Ls(W/P1))
P
SAS(Ls(W/P0))
When workers realize that the real
wage has fallen, they demand a higher
nominal wage.
P2
P1
P0
D
C
B
The increase in the nominal wage
causes the SAS to shift left.
A new equilibrium is established at D.
AD1
0
YN
Y1
AD0
Y
Fooling Model: Long Run Adjustment
SAS(Ls(W/P3))
P
SAS(Ls(W/P1))
SAS(Ls(W/P0))
P3
P2
P1
P0
At point D, the real wage has fallen
again, causing workers to demand
a higher nominal wage.
E3
D
C
As nominal wages increase, the SAS
shifts left.
E0
AD1
0
YN
Y1
AD0
Y
Fooling Model: Long Run Adjustment
SAS(Ls(W/P3))
P
SAS(Ls(W/P1))
SAS(Ls(W/P0))
P3
P2
P1
P0
Long-run equilibrium is restored at
point E3.
E3
D
C
At this point, the nominal wage has
risen such that W3/P3 = W0/P0.
E0
AD1
0
YN
Y1
AD0
Y
Long Run Aggregate Supply
• The long-run aggregate supply curve is a
vertical line drawn at the natural level of real
GDP.
– It shows that in the long-run expectations are
accurate.
– It shows that long run equilibrium in the labor
market can be achieved at many different price
levels but only a single level of output.
– Long-run equilibrium occurs when labor input is
the amount voluntarily supplied and demanded at
the equilibrium real wage.
Fooling Model: Summary
• Business cycles are explained in this model by
permitting the actual price level to differ from the
price level expected by the workers.
• However, when the workers learn they have been
fooled, their price expectations rise and they
demand a wage sufficient to regain the original
real wage.
• The SAS curve shifts up and to the left until
output has returned to YN.
• The model demonstrates that in the long run shifts
in aggregate demand have no long-run effect on
real GDP.
Rationale Behind the Fooling Model
• Friedman claims that firms have more accurate
information than workers because they need to
know only a small number of prices of
particular products and can monitor them
continuously.
• Workers, however, are interested in a wide
variety of prices and have insufficient time to
keep careful track of them.
Criticisms of the Fooling Model
• It is unlikely that workers would be fooled for
long because:
– Workers buy many goods and would notice
quickly when their prices rose.
– Expectational errors would be corrected quickly
because information about price level changes are
readily available from the government and the
media.
– If a periods of high real GDP were always
accompanied by an increase in the price level,
workers would learn to predict rising prices when
production was high and jobs were plentiful.
Friedman-Lucas Model
• Assumptions:
– Markets clear
– Information is imperfect
– Expectations are rational
• Expectations that are based on all available information
past and present as well as on a basic understanding of
how the economy works.
Friedman-Lucas Model
• The Model:
– Each firm in the economy produces in very
competitive markets.
• The firm has no pricing power.
– Each firm knows the price of what it produces, but
does not know about the prices of other products.
• This imperfect information leads to confusion about
changes in the overall price level and changes in relative
prices that affect the slope of the short-run supply curve.
Friedman-Lucas Model
• The Model:
– The amount of output a supplier chooses to produce
depends on relative prices.
• If the price of his output is high compared to other prices,
he is motivated to work hard and produce more.
• If the price of his output is low compared to other prices,
he prefers more leisure.
– When the supplier makes his decision about how
much to produce, he knows the price of his output
and forms his expectations about prices of the other
goods available using rational expectations.
Friedman-Lucas Model
• Let all prices rise.
– If past movements in the firm’s price have always
been accompanied by similar movements in the
prices of other firms, the owner will expect relative
prices to remain unchanged and will not produce
more.
– If the firm’s price has experienced unique price
movements compared to other firms, the owner
may conclude that relative prices have changed,
and may produce more or less.
Friedman-Lucas Model
• Produce More
– If the supplier determines that his price rose by
more than other prices, he produces more.
• Produce Less
– If the supplier determines that his price rose by
less than other prices, he produces less.
• The short-run aggregate supply curve can be
written as:
Y = YN + h(P - Pe)
Output and Price Expectations
• Y = YN + h(P - Pe)
– P > Pe,
• If P > Pe, the supplier works harder, Y rises.
– P < Pe
• If P < Pe, the supplier works less, Y falls.
– P = Pe
• If P = Pe, there is no change so Y = YN
Friedman-Lucas Model
P
LAS
P1
The Friedman-Lucas supply curve is
fixed in position by the price
expectations of workers.
SAS2(Pe1)
Real GDP can rise above YN in the
blue area only when the actual price
level rises above the expected price
level.
SAS1(Pe0)
P0
0
YN
Y
An increase in the expected price
level shifts the curve up from SAS1
to SAS 2.
Implications of the Model
• The major contribution of Lucas’s model is the
conclusion that the supply response will be
high for firms that have previously
experienced unique price movements and low
for firms that have experienced price
movements that mirror the aggregate economy.
Implications of the Model: Business
Cycle
• Lucas also concluded that the supply response
would be higher in countries like the USA
where inflation had been relatively stable,
making unique price movements in individual
prices easier to discern.
– This means that smaller changes in the price level
lead to larger changes in output and as a result a
bigger cyclical response.
• The SAS in the USA is more elastic or flatter than the
SAS in other countries.
Implications of the Model: Macro
Stabilization
• According to the rational expectations
hypothesis, monetary policy actions that
individuals and firms anticipate have no effect
on real variables such as output and
employment.
– This is known as the “policy ineffectiveness
proposition.”
• Only unanticipated policy actions that people
cannot predict in advance can influence real
GDP and employment.
Policy Ineffectiveness Proposition
• Let expectations of the price level, Pexp,
depend in part on their expectation of how the
government will change macroeconomic
policy.
• Also assume that people can anticipate
government policy with a great deal of
accuracy; ie. they know the policy rule.
Policy Ineffectiveness Proposition
• Expansionary monetary policy actions
cause an increase in aggregate demand.
• If people correctly forecast those policy
actions, then they fully anticipate the
change in the price level that the actions
will induce.
• As price expectations change, wage
demands change, causing an offsetting
change in aggregate supply.
Policy Ineffectiveness Proposition
AS2
P
AS1
Rational expectations cause
offsetting changes in AD and
AS.
P rises but Y remains constant.
P2
P1
0
AD2
AD1
Y1
Anticipated Policy Changes
Y
Unanticipated Policy Changes
• If people do not correctly forecast the
government’s policy actions, then they do not
correctly forecast the change in the price level
induced by the policy change.
• In this case, as the price level rises output
increases along the aggregate supply curve.
Unanticipated Policy Actions
• Expansionary monetary policy actions cause a
rightward shift in the aggregate demand curve.
• If people do not correctly forecast those policy
actions, then they do not correctly forecast the
change in the price level induced by the policy
change.
• As the price level rises, output increases along the
SRAS.
Unanticipated Policy Actions
AS1
P
Only unanticipated policy
changes result in a change
in output.
In this case, both the price
level and output rise.
P2
P1
0
AD2
Y1 Y2
AD1
Y
Unanticipated Policy Changes
Summary
• The new classical analysis suggests that:
– An unanticipated increase in the money supply
raises the price level and has no effect on real
output and employment
– Only unanticipated monetary surprises can affect
real variables in the short run.
Policy Ineffectiveness: Conclusions
• The development of rational expectations
ignited a major controversy among
economists because the model yielded an
implication of policy ineffectiveness that
directly challenged the mainstream view
that active fiscal and monetary policies are
needed to moderate the inherent instability
of a market economy.
Policy Ineffectiveness :
Conclusions
• The research on expectations that followed the
introduction of rational expectations increasingly
supported the rapid expectations adjustment
implied by rational expectations over the sluggish
adjustment of adaptive expectations.
• This suggested that price misperceptions would
disappear so quickly that there was no time for
countercyclical policies to be implemented.
• Later work, however, found evidence that suggested
that both unanticipated and anticipated monetary
policy affected output and employment.
Policy Ineffectiveness :
Conclusions
• Ultimately, a consensus was reached that the
key issue is not how price expectations are
formed, but whether changing expectations are
really the only important source of output
fluctuations.
• New approaches rely on underlying sources of
friction in the market clearing process to
explain business cycles.
Rational Expectations and the
Sacrifice Ratio
• The amount of output lost during disinflation
is known as the sacrifice ratio.
• The size of the sacrifice ratio depends in part
on how fast price expectations adjust.
– If they adjust slowly, the sacrifice ratio will be
large, but if they adjust quickly, the ratio will be
smaller.
Rational Expectations and the
Sacrifice Ratio
• The responsiveness of expectations depends on the
credibility and reputation of the monetary authority or
the Federal Reserve.
• The new classical approach argues that announced
changes in monetary policy will have no effect on
output and employment if the policy is credible.
• If the policy announcements lack credibility,
inflationary expectations will not fall sufficiently to
prevent the economy from experiencing outputemployment costs.
Real Business Cycle Model
• The real business cycle model explains
business cycles in output and employment as
being caused by real shocks.
– The origins of the business cycle lie in real shocks
rather than monetary shocks.
• This suggests that changes in the SAS curve and the
IS curve, but not the LM curve, explain cycles.
– Real business cycle theorists give the largest role
to production function shocks or supply shocks.
Real Business Cycle Shocks
• Supply shocks include the following:
–
–
–
–
–
New production techniques and/or new products
New management techniques
Changes in the quality of capital or labor
Changes in the availability of raw materials
Price changes in raw materials
• Demand shocks include the following:
– Changes in spending and saving decisions
– Changes in real government spending
• These shocks are assumed to be persistent, tending to
fade away smoothly after several years.
Real Business Cycle Features
• General Features:
– Agents try to maximize their utility or profits,
given prevailing resource constraints.
– Agents form expectations rationally and do not
suffer informational asymmetries. Agents may
have difficulty determining whether a shock is
temporary or permanent, but information
concerning the path of the general price level is
publicly available.
– Price flexibility ensures continuous market
clearing so that equilibrium always prevails.
Real Business Cycle Features
• General Features:
– Fluctuations in aggregate output and employment
are driven by large random changes in the
available production technology.
– Fluctuations in employment reflect voluntary
changes in the number of hours people want to
work.
– Monetary policy is irrelevant and has no influence
on real variables.
– There is no distinction between the short-run and
the long-run.
Real Business Cycle Model
• In real business cycle models, people are
assumed to supply more labor when the real
wage is high and less labor when the real wage
is low.
– This propensity to supply more labor during
periods of high real wages and less labor during
periods of low wages is called intertemporal
substitution.
Real Business Cycle Model
• As a result of intertemporal substitution, real
business cycle models explain unemployment
as the voluntary decision of workers to reduce
their labor supply in response to temporary
declines in their real wage.
• This means there is no need for government
policy intervention to reduce unemployment
associated with recession.
Y
Y
Y1=F(L)
1
Y1
Y2=F(L)
Y2
2
L 0
0
w/P
Y
P
AS2
LS
w1/P1
w1/P2
AS1
1
P2
2
2
1
P1
0
LD2
L2
L1
AD
LD1
L
0
Y2
Y1
Y
Real Business Cycle Model: Adverse
Shock
• Adverse shocks decrease productivity
– The production function shifts down.
– The labor demand curve shifts to the left.
• The decrease in demand for labor decreases the
real wage, causing a voluntary decrease in labor
supply along the labor supply curve.
• Aggregate supply decreases, causing an increase
in the price level given a fixed aggregate demand.
• At the new equilibrium the price level rises to P2,
and output falls to Y2.
Full Employment IS-LM Model
FE2 FE1 LM2
r
At E1, the economy is at full employment
at the interest rate r1 and output YN.
LM1
An adverse supply shock reduces full
employment output from YN to Y2, causing
the FE line to shift to the left and the
price level to rise.
r2
r1
Given a fixed nominal money supply, the
real money supply decreases, causing
the LM curve to shift to the left to LM2.
E2
E1
IS At the new equilibrium, output equal Y2
and the interest rate is r2.
0
Y2 YN
Y
Full employment exists at a lower level of Y
Adverse Supply Shock: Conclusions
• An adverse supply shock lowers the equilibrium
values of the real wage and employment.
• At the new equilibrium level of output, the supply
shock causes output to fall and interest rates to
rise.
• The supply shock raises the price level, causing a
temporary burst of inflation.
• Because interest rates are higher in the new
equilibrium, other things remaining the same,
saving increases, consumption decreases, and
investment decreases.
Real Business Cycles Facts
• Real business cycle theory (RBC) is consistent
with many of the basic business cycle facts.
– Under the assumption that the economy is
continuously buffeted by productivity shocks, the
RBC approach predicts recurrent fluctuations in
aggregate output, which actually occur.
– The RBC theory correctly predicts that
employment will move procyclically with output.
– The theory predicts that real wages will be higher
during booms than in recessions, which also
occurs.
Real Business Cycles Facts
– According to RBC theory, average labor
productivity is procyclical; that is, output per
worker is higher during booms than during
recessions.
• This fact is consistent with the RBC theorists’
assumption that booms are periods of beneficial
productivity shocks, which tend to raise productivity
while recessions are the result of adverse shocks which
lower productivity.
Real Business Cycles Facts
• With no productivity shocks and a stable production
function, the expansion of employment that occurs
during booms would tend to reduce average labor
productivity because of the principle of diminishing
marginal productivity of labor.
• Similarly, without productivity shocks, recessions would
be periods of relatively higher labor productivity, instead
of lower productivity as observed.
• RBC theorists argue that the procyclical nature of
average labor productivity provides strong evidence of
their approach.
Real Business Cycles Facts
• A business cycle fact that is not consistent with
the RBC theory is that inflation tends to slow
during or immediately after a recession.
• RBC theory predicts that an adverse productivity
shock will both cause a recession and inflation,
contrary to business cycle fact.
Real Business Cycle Criticisms
• It is hard to measure certain types of real shocks
(such as the annual rate of technological change in
computer software.)
• Since many real shocks are not readily observable,
one can explain any change in output as the result
of some unobserved real shock
• It is hard to believe that the unemployment that
occurred during the Great Depression and similar
downturns was voluntary.
Real Business Cycle Criticisms
• Labor supply of individual workers does not
appear to be sufficiently responsive to
intertemporal wage differences to explain the
bulk of variation in the use of labor over the
business cycle.
• If shocks are technological in nature, they are
likely to be both industry specific and to
average out in the aggregate economy.
Real Business Cycle Defense
• Some real shocks such as those due to natural
disasters are observable.
• Even if it is hard to measure the precise state of
technology, we know that there are shocks to
technology, even if we can’t measure precisely
their size and frequency.
• Although one could explain all macroeconomic
fluctuations by assuming enough shocks of the
right form, the question is whether one can
explain a good deal of the variation over time in
macro variables based on a limited and plausible
set of shocks.
Real Business Cycle Defense
• Much of he blame for the Great Depression
may be placed on the banking panics of the
early 1930s, the failure of large numbers of
banks, the collapse of credit, and the
subsequent closing of many business. These
events could be viewed as a type of aggregate
productivity shock leading to very low real
wages.
Real Business Cycle Defense
• The reason that workers don’t alter their hours of
work in response to changes in their real wages as
much as the simple real business cycle models
predict is that their employers find it more profitable
to require each worker to work full-time.
– Therefore, firms lay off workers in downturns rater than
permit those they don’t lay off to work less than full
time. These layoffs explain the unemployment
experienced in recessions.
• Industry specific shocks may be correlated and,
thereby, produce an aggregate shock.
Efficiency Wage Theory: Overview
• The efficiency wage theory explains slow adjustment
of wages relative to prices or by stressing the reasons
why firms would not want to cut the wage they pay
relative to the wage paid by other firms.
• According to this theory, a firm believes that the
productivity of its workers will increase if the firm
pays a higher wage.
– Higher wages lead to greater productivity, less shirking,
lower turnover as well as attracts higher quality workers
and improves morale.
Efficiency Wage Model
• Assumptions:
– Firms operate in a very competitive environment.
– Labor input is multiplied by an efficiency factor
that is a measure of effort and depends on the wage
rate paid relative to that paid by other firms.
• Raising the nominal wage raises labor costs, but also
reduces labor cost per unit of output by making
workers more efficient.
– Firms choose their wages to minimize the wage
bill and then choose employment to maximize
profit.
Wage Rate and Worker Efficiency
e
Effort
Curve
0
W*
W
W/e
0
W*
W
Worker efficiency increases faster than the relative wage up to point W* and more
slowly thereafter. As a result, labor cost per unit of efficiency (W/e) reaches a
minimum at W*.
Deriving the Short Run Aggregate
Supply Curve: Efficiency Wages
• Assumptions:
– Nominal wages are fixed by whatever
technological and institutional factors that
determine the efficiency function.
– Firms choose their wages to minimize the wage
bill and then choose employment to maximize
profit.
– Consequently, the firm’s reaction to any change in
demand for its product is to cut employment while
maintaining the nominal wage rate.
Y=F(L)
Y
Y
Y1
0
w/P
L 0
L1
Y1
Y
Y1*
Y
P
LS
U*
w1/P1*
P1
LD
0
L1*
LS
L 0
Deriving the Modern Aggregate
Supply Curve: Efficiency Wages
• We begin at the price level P1 where w1/P1*
is the efficiency wage.
• At w1/P1*, the level of unemployment is at
the natural rate of U*.
– L1 people are employed and LS minus L1* are
unemployed.
• Output equals Y1 at the price level P1.
Y=F(L)
Y
Y
Y2
Y1
0
w/P
L 0
L1 L2
Y
Y1 Y2
P
w1/P1*
SAS
LS
U*
P2
U
w1/P2
P1
LD
0
L1* L2
L 0
Y1* Y2
Y
Deriving the Modern Aggregate
Supply Curve: Efficiency Wages
• Let the price level increase to P2 .
• Since nominal wages do not change, the real
wage falls to w1/P2.
• Firms try to hire more workers while
households send fewer workers to the labor
market.
• Unemployment falls below U*.
• Output rises to Y2 at the price level P2.
Y=F(L)
Y
Y
Y2
Y1
Y3
0 L 3 L1 L2
w/P
w1/P3
w1/P1*
L 0
Y3
Y
Y1 Y2
P
U
SAS
LS
U*
P2
U
w1/P2
P1
P3
LD
0 L3 L1* L2
L 0
Y3
Y1* Y2
Y
Deriving the Modern Aggregate
Supply Curve: Efficiency Wages
• Let the price level decrease to P3 .
• Since nominal wages do not change, the
real wage rises to w1/P3.
• Firms reduce employment while households
send more workers to the labor market.
• Unemployment rises above U*.
• Output falls to Y3 at the price level P3.
The Modern Aggregate Supply
Curve: Efficiency Wages
• Summary:
– When nominal wages are sticky, a rise in the
price level results in higher levels of output,
and a fall in the price level results in lower
levels of output.
– When we plot the price level/output
combinations, we get an upward sloping
aggregate supply curve.
– Nominal wage is constant on any given
aggregate supply curve.
The Modern Aggregate Supply
Curve: Efficiency Wages
• Summary:
– When the real wage equals the efficiency
wage, unemployment is equal to its natural
rate, and the quantity of output produced is
called the “natural rate of output.”
Economic Policy
• Unlike the new classical model according to
new-Keynesian theory, the labor market may
not always be in equilibrium.
– When nominal wages are “sticky,” labor demand
can be less than labor supply.
– As a result, the economy can experience extended
periods when markets do not clear.
– Consequently, it is possible for macroeconomic
stabilization policies to change the level of output
in the short run.
Y
Y
Y=F(L)
0
w/P
L 0
Y
LAS
P
SAS
LS
w1/P1
U*
P1
AD1
LD
0
L1 L*
L 0
Y1 Y*
Y
The Efficiency Wage Model
• We begin at the price level P1 where w1/P1* is
the efficiency wage.
• At w1/P1*, the level of unemployment is at the
natural rate of U*.
– L1 people are employed and Ls minus L1 are
unemployed.
• Output equals Y1 at the price level P1.
Y
Y
Y=F(L)
0
w/P
L 0
LRAS
Y
LRAS
P
SRAS
LS
w1/P1*
w1/P2
P2
P1
2
1
AD2
AD1
LD
0
L1 L2 L*
L 0
Y1 Y2 Y*
Y
The Efficiency Wage Model:
Aggregate Demand Increase
• Let the money supply increase, causing the
aggregate demand curve to shift to the right.
• The price level rises to P2, and the real wage
falls to w1/P2.
• Labor demand rises to L2 while labor supply
responds with a lag.
• Unemployment falls below the natural rate.
• Output rises to Y2.
Y
Y
Y=F(L)
0
w/P
L 0
LRAS
Y
LRAS
P
SRAS
LS
w1/P2
w1/P1
P1
P2
1
2
AD1
AD2
LD
0
L2 L1 L*
L
0
Y2 Y1 Y*
Y
The Efficiency Wage Model:
Aggregate Demand Decrease
• Let the money supply contract, causing the
aggregate demand curve to shift to the left.
• The price level falls to P2, and the real wage
rises to w1/P2.
• Labor demand falls to L2while labor supply
rises.
• Unemployment rises above the natural rate.
• Output falls to Y2.
The Efficiency Wage Model: The NonNeutrality of Money
• A change in the money supply does not cause all
the variables to change in proportion because the
nominal wage is slow to adjust.
• Rather, the change in the money supply causes a
change in production and employment as well as
a change in prices.
• In this model, the economy adjusts through
changes in real variables as well as prices.
Implications
• The efficiency wage approach predicts the
widely observed phenomenon that workers line
up for high paying jobs but firms hire only a
few of them, maintaining the high wage in
order to be able to pick and choose rather that
reduce the wage rate in the face of abundant
supply of workers.
• The theory also predicts that less productive
workers, those whose labor cost per efficiency
unit is high, will suffer higher unemployment
rates than more productive groups.
Implications
• The model explains why we do not use work
sharing in the form of fewer hours per week in
periods of low demand. Such wage reductions
would raise labor cost by cutting the wage
income and hence the efficiency of the most
productive workers.
• Finally, the model explains why a firm may
find it profitable to keep wages above the level
that balances demand and supply, causing a
lower rate of job finding and higher
unemployment.
Supply Side Fiscal Policy
Supply Side Economics
• Supply side economics predicts that a
reduction in marginal income tax rates will
create an increase in the supply of output, that
is, in natural GDP.
Fiscal Policy: Supply Side
Transmission Mechanism
Inflation Falls
Unemployment Falls
After-tax Wage
Higher
Increase in
Labor Supply
Savings Rise
Interest Rates
Fall
After-tax ROR
Rises
Investment Rises
Aggregate Supply
Rises
Lower Personal
Tax Rates
Lower Business
Tax Rates
Productivity
Rises
Fiscal Policy: Supply Side
• Expansionary Fiscal Policy
– The federal government decreases taxes.
• People work more: People save more: Firms invest
more.
• Aggregate supply increases, unemployment falls,
inflation falls.
Tax Cuts: Labor Supply
• The decrease in marginal income tax rates
encourages people to work more.
– People are willing to work more because they now
keep more of their wages.
• More specifically, they get to keep more of the last
dollar earned.
– Therefore, the increased labor supply increases
output without putting upward pressure on wages.
Tax Cuts: Saving and Investment
• Business tax cuts increase business profits.
– Higher profits encourage investment in new
capital.
• Individual tax cuts stimulate household
savings.
– Increased savings contribute to lower interest rates
and increased investment in new capital.
• New capital increases productivity, thus,
lowering costs and inflationary pressures.
Supply-Side Fiscal Policy Problems
• Small Magnitude of the Supply-side Effects.
– Savings do not appear to respond to tax incentives.
• Demand Side Effects.
– People respond to tax cuts by spending more.
They may or may not respond by working more.
• Timing Problems
– The impact of increases in investment spending
occur much later as industrial capacity increases.
Supply-Side Fiscal Policy Problems
• Effect on Income Distribution
– Supply-side tax cuts favor the wealthy.
• Tax Cuts Increase the Budget Deficit
– But, so do demand-side tax cuts.
Criticisms of Supply Side Economics
• Most economists agree with the basic ideas
behind supply-side economics, but question
the magnitude of the changes that occur as a
result of marginal tax decreases.
• In particular, the response of labor supply to
the decreases in taxes was quite small.