Download MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

MACROECONOMICS
AND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition
Stabilization Policy
1
16-2
Key Concepts
 Phillips Curve
 Credibility
 Rules versus Discretion
 Time Consistency
16-3
Decrease in Demand
Keynesian view
LRAS
Price Level
AD
AS
P0
P1
Y1
Y0
Real GDP
16-4
Decrease in Demand
Keynesian view
LRAS
Price Level
AD
Government
responds by
increasing demand
AS
Increase G
Decrease T
Increase M
P0
P1
Y1
Y0
Real GDP
16-5
Increase in Demand
Keynesian view
LRAS
Price Level
AD
AS
P1
P0
Y0
Y1
Real GDP
16-6
Increase in Demand
Keynesian view
LRAS
Price Level
AD
Government responds
by decreasing
demand
AS
Decrease G
Increase T
Decrease M
P0
Y0
Real GDP
16-7
Decrease in supply
Keynesian stabilization response
LRAS
Price Level
AD
Government responds
by increasing demand
AS
Big
increase in
price
P0
Y0
Real GDP
16-8
Arguments against Stabilization Policy
 Uncertainty
 Demand or supply shocks?
 Policy Lags => decrease stability
 Informational, decision, and implementation lags
 Problems with Fiscal Policy
 Public investment and social goals may conflict with
stabilization goals
 Ricardian Equivalence
 Consumer Expectations
 Crowding Out
 Monetary Policy
 Can only affect long-term rates through expectations of
inflation and future interest rates
16-9
Phillips Curve
Inflation = Expected Inflation
+ A*(Natural Rate Unemployment – Actual Unemployment)
Rate of Inflation
Anticipated by
Consumers
    A(U  U )
e
N
Rate of
Unemployment
when all
resources are
fully employed at
long-run level
16-10
US Phillips Curve, 1945 - 1970
8
Unemployment.
7
6
5
4
3
2
0
2
4
6
Wage inflation.
8
10
16-11
Inflation and unemployment, United
States, 1983–2000
16-12
Inflation and unemployment, Japan,
1983–2000.
16-13
Inflation and unemployment, France,
1983–2000.
16-14
Graphically…   e  A(U N  U )
Inflation
  0  A(U  U )
N
10%
5%
U < UN
U > UN
0%
Natural Rate
Unemployment
16-15
Graphically…
  0  A(U  U )
Inflation
N
5%  0  A(5%  2%)
10%
5
A

 3
5%
5%
Natural Rate
2%
0%
Unemployment
16-16
Expectations catch up with
reality
Inflation
10%
5%  5%  A(U N  U )  U N  U
5%
0%
Natural Rate
Unemployment
16-17
Phillips Curve
 There is no usable long-run tradeoff between inflation
and output
 Expectations-augmented Philips may allow for shortrun tradeoff
 Complications to short-run tradeoff: supply shocks
    A(U  U )   S
e
N
 Can lower inflation without increasing unemployment:
lower inflation expectations
 Importance of policymakers credibility

Possible to lower inflation without costly unemployment
 Phillips curve exist as a short-run tradeoff the
government faces when it uses demand
management

it may not be visible empirically
16-18
Time Inconsistency Scenario
 Time Inconsistency: when the future arrives it may no
longer be optimal to carry out plans


“Gov’t will not negotiate with terrorist”
“Monetary policy will not be inflationary”
 Your child, Laura, has just graduated from high
school, and is planning to attend State U in the fall.
How should she spend her summer?


Working to help pay for tuition (parents’ preference)
Playing computer games (Laura’s preference)
 You tell her the following
 If she works, you will help with tuition
 If she plays, she’s on her own in August
16-19
Time Inconsistency
 Will you do what you say you’re going to do?
Pay for College
Don’t Pay
What you say…
Laura
Pay for College
Don’t Pay
16-20
Time Inconsistency
 Will you do what you say you’re going to do?
What Laura thinks…
Pay for College
Don’t Pay
Laura
Pay for College
Don’t Pay
16-21
What is likely to happen?
?
16-22
Stabilization Policy
 Government’s preferences


Low inflation and low unemployment
Stronger preference for low unemployment
16-23
Stabilization Policy
Government’s preferences
•Low inflation and low unemployment
•Stronger preference for low unemployment
Citizens’ Expectations
Policy
Maker
High Inf.
Low Inf.
High Inflation
Low Inflation
-3,0
3, -3
-5, -3
0, 0
•Private sector negotiates its wage, central bank responds
•If expectations = reality, then unemployment = natural rate
• If expectations < reality, then W/P low, unemployment is low
•If expectations > reality, then W/P high, unemployment is high
16-24
Rules versus Discretion
Why rules are preferred over discretion



Information, decision, and implementation lags =>
stabilization policy destabilizes
Uncertain impact on aggregate demand
Time inconsistency
 Can rules solve time consistency problem?
 Preference must be for low inflation
 Can rules solve credibility problem?
 Two examples of rules
 Monetary Policy: New Zealand
 Fiscal Policy: EU stability pact
16-25
Rules
 Friedman’s Rule
 Grow money supply at a certain, fixed percent
each year

Remove instability from discretion
 Reaction Function Rules
 Taylor Rule: policy response based on set rule

Predictability, but flexibility
 Nominal GDP targeting
 Stabilize nominal spending
 Allow demand & supply shocks
16-26
Summary
 Stabilization Policy
 Difficulties with stabilization policy
 Phillips curve and discretionary policy
 Time inconsistency
 Rules and Discretion