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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