Download Inflation, Unemployment, and Stabilization Policies: Macroeconomic

AP Economics
Mr. Bordelon
INFLATION, UNEMPLOYMENT, AND
STABILIZATION POLICIES: MACROECONOMIC
THEORY
CLASSICAL THEORY

According to the classical model:
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Prices are flexible.
AS is vertical even in the short run.
An increase in MS leads, other things equal, to a
proportional rise in APL.
An increase in MS does not increase aggregate output (real
GDP).
Increases in MS lead to inflation.
And that’s all. Why?

Before 1930, most economists were aware that changes in MS
affect aggregate output as well as aggregate prices in the short run.
They were aware that the SRAS slopes upward. They regarded such
short-run effects as unimportant, stressing the long run instead.
CLASSICAL THEORY

Business Cycle
 There
was no consensus theory of how business
cycles worked.
 Many economists believed the economy would selfadjust to LRE. They assumed that any downturn in
the economy was only temporary.
 Active policy was not needed to alleviate a
recession.
KEYNESIAN THEORY
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Keynes presents his explanation of what was wrong with
the economy during the Great Depression in a book titled
The General Theory of Employment, Interest, and Money.
(Note: I’m not testing on this, but if for some reason the
title of the book shows up on the AP exam, think Keynes.)
Keynesian economics introduced two dramatic changes
to classical theory:
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Short-run shifts in AD do affect aggregate output and the
price level because there is an upward sloping AS curve.
These short-run shifts are important.
AD curve can shift because of several factors including
“animal spirits” (business confidence), and that these were
the main cause of business cycles.

Classical economists emphasized the role of changes in MS in
shifting AD, ignoring other factors.
KEYNESIAN THEORY
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Key point: Keynes’s work legitimized macroeconomic
policy activism—the use of monetary and fiscal policy to
smooth out the business cycle.
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In the 1930s, economists were divided on the issue of
government policy to affect the business cycle.
Today there is broad consensus that active monetary and/or
fiscal policy can play useful roles.
The debate today is the degree to which policies should be
taken.
AP Note: Very little economic history shows up on the
exam, but if it does, it’s almost always related to
Keynesian policy and the Great Depression.
CLASSICAL VS. KEYNESIAN MODELS
CHALLENGES TO KEYNESIAN THEORY
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Keynesian theory focused primarily on fiscal policy, but monetary policy
does make a comeback.
Milton Friedman and Anna Schwartz–A Monetary History of the United
States,1867–1960
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Showed that business cycles had historically been associated with fluctuations
in MS.
MS decreased sharply during the onset of the Great Depression.
Friedman and Schwartz argued that monetary policy should play a key role in
economic management.
The revival of interest in monetary policy was significant because it
suggested that the burden of managing the economy could be shifted away
from fiscal policy—meaning that economic management could largely be
taken out of the hands of politicians.
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What taxes, and for whom, should be cut?
What programs should receive more government spending?
A central bank, insulated from political pressures, should be able to conduct
monetary policy more effectively than fiscal policy.
CHALLENGES TO KEYNESIAN THEORY

Monetarism
Key point: GDP will grow steadily if MS grows steadily.
 Monetarist policy has the central bank target a
constant rate of growth of MS, and maintain that target
regardless of any fluctuations in the economy.
 By creating a kind of “monetary rule,” central bank
avoids political perils of fiscal policy and the effect of
large government spending crowding out investment
spending.
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CHALLENGES TO KEYNESIAN THEORY

Monetarism

How would this crowding-out happen?
 Government
spending increases.
 In the AD/AS model, AD shifts to the right.
 APL and real GDP increases.
 In the money market, higher prices cause an increase in MD.
 Interest rate begins to increase.
 Higher interest rates reduce private investment, which
decreases AD.
 Final effect of expansionary fiscal policy is weakened because
private investment is crowded out.
CROWDING OUT
CHALLENGES TO KEYNESIAN THEORY

Monetarism

The Quantity Theory of Money emerges to justify the slow
steady growth of the money supply.
MV = PY
 If we assume that V, the velocity of money, is constant then a slow
increase in M will increase PY or nominal GDP.
 In the 1980s, V becomes more erratic and the effectiveness of the
Monetarism policies slides.


AP Note: If this shows up on AP exam, you will not have to
calculate velocity of money. Monetarism is largely
discredited as a policy unto itself alone. A question may ask
something along the lines of “Which theory justifies the
monetarists’ believe in slow steady growth of the MS?”
CHALLENGES TO KEYNESIAN THEORY

Inflation and the Natural Rate of Unemployment

Remember that the natural rate of unemployment is
also NAIRU.
 Recall
that in order to avoid accelerating inflation over time,
the unemployment rate must be high enough so that actual
inflation equals the expected inflation rate.
 If unemployment rate is kept below NAIRU, inflation will start
to increase.
 Natural rate hypothesis. To avoid accelerating inflation over
time, the unemployment rate must be high enough that the
actual inflation rate equals the expected inflation rate.
 The natural rate hypothesis was validated with empirical
testing and the influence of monetarism declined.
CHALLENGES TO KEYNESIAN THEORY

Political Business Cycle
There is a statistical correlation between upcoming
political elections and expansionary fiscal policy.
 In months leading up to an election, government either
cuts taxes or announces new spending programs.
These policies put more money in the pockets of voters
and also tend to lower the unemployment rate.
 The eventual cost is inflation, but by then the election is
over and inflation can be addressed at a later date.
 This is even more justification for putting economic
policy in the hands of a central bank that is free of
political influence.
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RATIONAL EXPECTATIONS
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Rational expectations. Individuals and firms make decisions optimally,
using all available information.
This implies that the general public will be prepared for economic troubles.
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According to the natural rate hypothesis, a government attempt to trade off
higher inflation for lower unemployment would work in the short run but would
eventually fail because higher inflation would get built into expectations.
According to rational expectations, we should remove the word eventually. If it’s
clear that the government intends to trade off higher inflation for lower
unemployment, the public will understand this, and expected inflation will
immediately increase.
Contrast—New Keynesians. Price stickiness does exist in the economy and that
inflation is not always quick to rise, even if expectations are for higher prices.

AP Note: This is not on my test, and I doubt that this will be on the AP examination,
however, if it shows up, “price stickiness exists” is what to look for, and is a challenge to
rational expectations theory.
REAL BUSINESS CYCLE THEORY
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Real business cycle theory. Fluctuations in the rate of growth of total
factor productivity cause the business cycle.
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Real business cycle theorists attribute the source of business cycles to
shifts of AS, believing that AS is vertical (i.e., like in the classical model).
A recession occurs when a slowdown in productivity growth shifts AS to
the left.
A recovery occurs when a pickup in productivity growth shifts AS to the
right.
RBC theory serves as a counterbalance to relying too heavily on AD.
However, RBC theorists themselves acknowledge that their models
need a SRAS to fit economic data.


This would give AD a role in determining aggregate output.
Policy makers strongly believe that aggregate demand policy has an
important role to play in fighting recessions.
THEORY AND FISCAL AND MONETARY POLICY
IS EXPANSIONARY MONETARY POLICY HELPFUL
IN FIGHTING RECESSIONS?
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Classical economics really didn’t believe that monetary policy would
reverse a recession.
Keynesians thought it could have limited effectiveness.
Monetarists convinced economists that monetary policy is effective.
Modern. Nearly all macroeconomists now agree that monetary policy
can be used to shift AD and to reduce economic instability.
Classical view that changes in MS affect only aggregate prices, not
aggregate output, has few supporters today.
Keynesian view that changes in MS have little effect has few
supporters today.
Modern. Generally agreed that monetary policy is ineffective only in
the case of a liquidity trap.
IS EXPANSIONARY FISCAL POLICY
EFFECTIVE IN FIGHTING RECESSIONS?
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Classical macroeconomists were oppose fiscal expansion
more than monetary expansion.
Keynesian economists believe fiscal policy has a central role
in fighting recessions.
Monetarists argued that fiscal policy was ineffective as long
as MS was held constant.
Modern. Most macroeconomists agree that fiscal policy, like
monetary policy, can shift AD.
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Most macroeconomists also agree that government should not
seek to balance the budget regardless of the state of the
economy.
They believe that the budget acts as an automatic stabilizer helps
keep the economy on an even keel.
CAN MONETARY AND/OR FISCAL POLICY
REDUCE UNEMPLOYMENT IN THE LONG RUN?
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Classical macroeconomists didn’t believe the government
could do anything about unemployment.
Keynesian economists arguing that expansionary policies
could be used to achieve a permanently low unemployment
rate, perhaps at the cost of some inflation.
Monetarists believed that unemployment could not be kept
below the natural rate.
Modern. Almost all macroeconomists now accept the
natural rate hypothesis and agree on the limitations of
monetary and fiscal policy.

They believe that effective monetary and fiscal policy can limit the
size of fluctuations of the actual unemployment rate around the
natural rate, but can’t keep unemployment below the natural rate.
SHOULD FISCAL POLICY BE USED IN A
DISCRETIONARY WAY?
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Modern. Most macroeconomists believe that tax cuts and
spending increases are at least somewhat effective in
increasing AD.
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Many macroeconomists believe that discretionary fiscal policy is
usually counterproductive. The lags in adjusting fiscal policy
mean that, all too often, policies intended to fight a slump end up
intensifying a boom.
Macroeconomic consensus gives monetary policy the lead
role in economic stabilization.

Discretionary fiscal policy plays the leading role only in special
circumstances when monetary policy is ineffective, such as those
facing Japan during the 1990s when interest rates were at or
near the zero bound and the economy was in a liquidity trap.
SHOULD MONETARY POLICY BE USED IN A
DISCRETIONARY WAY?
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Classical macroeconomists didn’t think that monetary policy should
be used to fight recessions.
Keynesian economists didn’t oppose discretionary monetary policy,
but they were skeptical about its effectiveness.
Monetarists argued that discretionary monetary policy was doing
more harm than good.
Modern. Broad consensus among macroeconomists on these points:
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Monetary policy should play the main role in stabilization policy.
Central bank should be independent, insulated from political pressures,
in order to avoid a political business cycle.
Discretionary fiscal policy should be used sparingly, both because of
policy lags and because of the risks of a political business cycle.
DISCRETIONARY MONETARY POLICY

Central Bank Targets
 Some
central banks have announced specified
inflation targets. This provides more information to
the public about how the central bank would take
action if actual inflation got out of line with the
target.
 The Federal Reserve does not announce a target
rate of inflation, although some observers believe
that Fed actions are consistent with a target of
about 2%.
DISCRETIONARY MONETARY POLICY

Asset Prices

There is dispute as to whether the Fed should be proactively influencing the stock market, real estate market or
any other asset market.


Example. If the Fed thought the stock market was at an
unsustainably high level, should the Fed intervene and try to slow
down investors?
Some macroeconomists don’t want the Fed to intervene in
any market.

Example. If the stock market bubble bursts, the damage can be very
painful, so maybe the Fed should prevent that from happening.
Some macroeconomists, however, believe this leads to codependency of the markets on government bailouts.
DISCRETIONARY MONETARY POLICY

Asset Prices

There is dispute as to whether the Fed should be proactively influencing the stock market, real estate market or
any other asset market.


Example. If the Fed thought the stock market was at an
unsustainably high level, should the Fed intervene and try to slow
down investors?
Some macroeconomists don’t want the Fed to intervene in
any market.

Example. If the stock market bubble bursts, the damage can be very
painful, so maybe the Fed should prevent that from happening.
Some macroeconomists, however, believe this leads to codependency of the markets on government bailouts.