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CHAPTER
13
Aggregate Supply and the
Short-run Tradeoff Between
Inflation and Unemployment
MACROECONOMICS
Inflation inertia
   1   (u  u n )  
In this form, the Phillips curve implies that
inflation has inertia:
 In the absence of supply shocks or cyclical
unemployment, inflation will continue
indefinitely at its current rate.
 Past inflation influences expectations of
current inflation, which in turn influences the
wages & prices that people set.
slide 1
Graphing the Phillips curve
In the short
run, policymakers
face a tradeoff
between  and u.

   e   (u  u n )  

1
The short-run
Phillips curve
e 
un
u
slide 2
Shifting the Phillips curve
People adjust
their
expectations
over time,
so the tradeoff
only holds in
the short run.

   e   (u  u n )  
 2e  
 1e  
E.g., an increase
in e shifts the
short-run P.C.
upward.
un
u
slide 3
Rational expectations
Ways of modeling the formation of expectations:
 adaptive expectations:
People base their expectations of future inflation
on recently observed inflation.
 rational expectations:
People base their expectations on all available
information, including information about current
and prospective future policies.
slide 4
Painless disinflation?
 Proponents of rational expectations believe
that the sacrifice ratio may be very small:
 Suppose u = u n and  = e = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
 If the announcement is credible,
then e will fall, perhaps by the full 4 points.
 Then,  can fall without an increase in u.
slide 5
The natural rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters,
is based on the natural rate hypothesis:
Changes in aggregate demand affect output
and employment only in the short run.
In the long run, the economy returns to
the levels of output, employment,
and unemployment described by
the classical model (Chaps. 3-8).
slide 6
An alternative hypothesis:
Hysteresis
 Hysteresis: the long-lasting influence of history
on variables such as the natural rate of
unemployment.
 Negative shocks may increase un,
so economy may not fully recover.
slide 7
Hysteresis: Why negative shocks
may increase the natural rate
 The skills of cyclically unemployed workers may
deteriorate while unemployed, and they may not
find a job when the recession ends.
 Cyclically unemployed workers may lose
their influence on wage-setting;
then, insiders (employed workers)
may bargain for higher wages for themselves.
Result: The cyclically unemployed “outsiders”
may become structurally unemployed when the
recession ends.
slide 8
Chapter Summary
1. Phillips curve
 derived from the SRAS curve
 states that inflation depends on
 expected inflation
 cyclical unemployment
 supply shocks
 presents policymakers with a short-run tradeoff
between inflation and unemployment
CHAPTER 13
Aggregate Supply
slide 9
Chapter Summary
2. How people form expectations of inflation
 adaptive expectations
 based on recently observed inflation
 implies “inertia”
 rational expectations
 based on all available information
 implies that disinflation may be painless
CHAPTER 13
Aggregate Supply
slide 10
Chapter Summary
3. The natural rate hypothesis and hysteresis
 the natural rate hypotheses
 states that changes in aggregate demand can
only affect output and employment in the short
run
 hysteresis
 states that aggregate demand can have
permanent effects on output and employment
CHAPTER 13
Aggregate Supply
slide 11
CHAPTER
14
Stabilization Policy
MACROECONOMICS
In this chapter, you will learn…
…about two policy debates:
1. Should policy be active or passive?
2. Should policy be by rule or discretion?
slide 13
Question 1:
Should policy be active or
passive?
slide 14
Growth rate of U.S. real GDP
Percent 10
change
from 4 8
quarters
earlier 6
Average 4
growth
rate 2
0
-2
-4
1970
1975
1980
1985
1990
1995
2000
2005
slide 15
Arguments for active policy
 Recessions cause economic hardship for millions
of people.
 The Employment Act of 1946:
“It is the continuing policy and responsibility of the
Federal Government to…promote full employment
and production.”
 The model of aggregate demand and supply
(Chaps. 9-13) shows how fiscal and monetary
policy can respond to shocks and stabilize the
economy.
slide 16
Arguments against active policy
Policies act with long & variable lags, including:
inside lag:
the time between the shock and the policy response.
 takes time to recognize shock
 takes time to implement policy,
especially fiscal policy
outside lag:
the time it takes for policy to affect economy.
If conditions change before policy’s impact is felt,
the policy may destabilize the economy.
slide 17
Automatic stabilizers
 definition:
policies that stimulate or depress the economy
when necessary without any deliberate policy
change.
 Designed to reduce the lags associated with
stabilization policy.
 Examples:
 income tax
 unemployment insurance
 welfare
slide 18
Forecasting the macroeconomy
Because policies act with lags, policymakers must
predict future conditions.
Two ways economists generate forecasts:
 Leading economic indicators
data series that fluctuate in advance of the
economy
 Macroeconometric models
Large-scale models with estimated parameters
that can be used to forecast the response of
endogenous variables to shocks and policies
slide 19
The LEI index and real GDP, 1960s
(see p.258 ).
annual percentage change
The Index of
Leading
Economic
Indicators
includes 10
data series
20
15
10
5
0
-5
-10
1960
source of LEI data:
The Conference Board
1962
1964
1966
1968
1970
Leading Economic Indicators
Real GDP
slide 20
The LEI index and real GDP, 1990s
annual percentage change
15
10
5
0
-5
-10
-15
1990
source of LEI data:
The Conference Board
1992
1994
1996
1998
2000
2002
Leading Economic Indicators
Real GDP
slide 21
Forecasting the macroeconomy
Because policies act with lags, policymakers must
predict future conditions.
The preceding slides show that the
forecasts are often wrong.
This is one reason why some
economists oppose policy activism.
slide 22
The Lucas critique
 Due to Robert Lucas
who won Nobel Prize in 1995 for rational
expectations.
 Forecasting the effects of policy changes has
often been done using models estimated with
historical data.
 Lucas pointed out that such predictions would not
be valid if the policy change alters expectations in
a way that changes the fundamental relationships
between variables.
slide 23
An example of the Lucas critique
 Prediction (based on past experience):
An increase in the money growth rate will reduce
unemployment.
 The Lucas critique points out that increasing the
money growth rate may raise expected inflation,
in which case unemployment would not
necessarily fall.
slide 24
The Jury’s out…
Looking at recent history does not clearly answer
Question 1:
 It’s hard to identify shocks in the data.
 It’s hard to tell how things would have been
different had actual policies not been used.
Most economists agree, though, that the
U.S. economy has become much more stable
since the late 1980s…
slide 25
Standard deviation
The stability of the modern economy
4.0
3.5
Volatility
of GDP
3.0
2.5
2.0
1.5
1.0
0.5
Volatility of
Inflation
0.0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
slide 26
Question 2:
Should policy be conducted by
rule or discretion?
slide 27
Rules and discretion:
Basic concepts
 Policy conducted by rule:
Policymakers announce in advance how
policy will respond in various situations,
and commit themselves to following through.
 Policy conducted by discretion:
As events occur and circumstances change,
policymakers use their judgment and apply
whatever policies seem appropriate at the time.
slide 28
Arguments for rules
1. Distrust of policymakers and the political
process
 misinformed politicians
 politicians’ interests sometimes not the same
as the interests of society
slide 29
Arguments for rules
2. The time inconsistency of discretionary
policy
 def: A scenario in which policymakers
have an incentive to renege on a
previously announced policy once others
have acted on that announcement.
 Destroys policymakers’ credibility, thereby
reducing effectiveness of their policies.
slide 30
Examples of time inconsistency
1. To encourage investment,
govt announces it will not tax income from capital.
But once the factories are built,
govt reneges in order to raise more tax revenue.
slide 31
Examples of time inconsistency
2. To reduce expected inflation,
the central bank announces it will tighten
monetary policy.
But faced with high unemployment,
the central bank may be tempted to cut interest
rates.
slide 32
Monetary policy rules
a. Constant money supply growth rate
 Advocated by monetarists.
 Stabilizes aggregate demand only if velocity
is stable.
slide 33
Monetary policy rules
a. Constant money supply growth rate
b. Target growth rate of nominal GDP
 Automatically increase money growth
whenever nominal GDP grows slower than
targeted; decrease money growth when
nominal GDP growth exceeds target.
slide 34
Monetary policy rules
a. Constant money supply growth rate
b. Target growth rate of nominal GDP
c. Target the inflation rate
 Automatically reduce money growth whenever
inflation rises above the target rate.
 Many countries’ central banks now practice
inflation targeting, but allow themselves a little
discretion.
slide 35
Monetary policy rules
a. Constant money supply growth rate
b. Target growth rate of nominal GDP
c. Target the inflation rate
d. The Taylor rule:
Target the federal funds rate based on
 inflation rate
 gap between actual & full-employment GDP
slide 36
The Taylor Rule
iff =  + 2 + 0.5 ( – 2) – 0.5 (GDP gap)
where
iff = nominal federal funds rate target
Y Y
GDP gap = 100 x
Y
= percent by which real GDP
is below its natural rate
slide 37
The Taylor Rule
iff =  + 2 + 0.5 ( – 2) – 0.5 (GDP gap)
 If  = 2 and output is at its natural rate,
then fed funds rate targeted at 4 percent.
 For each one-point increase in ,
mon. policy is automatically tightened
to raise fed funds rate by 1.5.
 For each one percentage point that GDP falls
below its natural rate, mon. policy automatically
eases to reduce the fed funds rate by 0.5.
slide 38
Percent
The federal funds rate:
Actual and suggested
12
Actual
10
8
6
4
Taylor’s Rule
2
0
1987
1990
1993
1996
1999
2002
2005
slide 39
Central bank independence
 A policy rule announced by central bank will
work only if the announcement is credible.
 Credibility depends in part on degree of
independence of central bank.
slide 40
average inflation
Inflation and central bank
independence
index of central bank independence
slide 41
Chapter Summary
1. Advocates of active policy believe:
 frequent shocks lead to unnecessary fluctuations in
output and employment
 fiscal and monetary policy can stabilize the
economy
2. Advocates of passive policy believe:
 the long & variable lags associated with monetary
and fiscal policy render them ineffective and
possibly destabilizing
 inept policy increases volatility in output,
employment
CHAPTER 14
Stabilization Policy
slide 42
Chapter Summary
3. Advocates of discretionary policy believe:
 discretion gives more flexibility to policymakers in
responding to the unexpected
4. Advocates of policy rules believe:
 the political process cannot be trusted: Politicians
make policy mistakes or use policy for their own
interests
 commitment to a fixed policy is necessary to avoid
time inconsistency and maintain credibility
CHAPTER 14
Stabilization Policy
slide 43
CHAPTER
5
The Open Economy
MACROECONOMICS
In an open economy,
 spending need not equal output
 saving need not equal investment
slide 45
Preliminaries
C C
d
d
C
I I I
f
f
G G d G f
superscripts:
d = spending on
domestic goods
f = spending on
foreign goods
EX = exports =
foreign spending on domestic goods
IM = imports = C f + I f + G f
= spending on foreign goods
NX = net exports (a.k.a. the “trade balance”)
= EX – IM
slide 46
The national income identity
in an open economy
Y = C + I + G + NX
or,
NX = Y – (C + I + G )
domestic
spending
net exports
output
slide 47
Trade surpluses and deficits
NX = EX – IM = Y – (C + I + G )
 trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
 trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX
slide 48
International capital flows
 Net capital outflow
=S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets
 When S > I, country is a net lender
 When S < I, country is a net borrower
slide 49
The link between trade & cap. flows
NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
=
S
–
I
trade balance = net capital outflow
Thus,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).
slide 50
National saving:
The supply of loanable funds
r
S  Y  C (Y  T )  G
As in Chapter 3,
national saving does
not depend on the
interest rate
S
S, I
slide 51
Assumptions re: Capital flows
a. domestic & foreign bonds are perfect substitutes
(same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*
a & b imply r = r*
c implies r* is exogenous
slide 52
Investment:
The demand for loanable funds
r
r*
Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world interest rate…
…determines the
country’s level of
investment.
I (r )
I (r* )
S, I
slide 53
If the economy were closed…
r
…the interest
rate would
adjust to
equate
investment
and saving:
S
rc
I (r )
I (rc )
S
S, I
slide 54
But in a small open economy…
the exogenous
world interest
rate determines
investment…
…and the
difference
between saving
and investment
determines net
capital outflow
and net exports
r
S
NX
r*
rc
I (r )
I1
S, I
slide 55