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Transcript
AP Economics Mr. Bordelon INFLATION, UNEMPLOYMENT, AND STABILIZATION POLICIES: MACROECONOMIC THEORY CLASSICAL THEORY According to the classical model: 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 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: 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 Key point: Keynes’s work legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle. 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 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 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. 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. 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. RATIONAL EXPECTATIONS Rational expectations. Individuals and firms make decisions optimally, using all available information. This implies that the general public will be prepared for economic troubles. 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 Real business cycle theory. Fluctuations in the rate of growth of total factor productivity cause the business cycle. 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? 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? 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. 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? 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? Modern. Most macroeconomists believe that tax cuts and spending increases are at least somewhat effective in increasing AD. 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? 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: 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.