Download 15.0 Policy: The Promise and the Problems

15.0 Policy: The Promise and the
Problems
15.1.1
Nice assumptions at the micro level gave us
Pareto optimality
1. No market failure- markets exist and
adjust smoothly and quickly
2.
No market power- a fair race, no
advantages exist
These nice assumptions mean
that the macroeconomy will quickly and
smoothly adjust to full employment
15.1.2
If AD is intersecting AS left of LAS,
Y* is less than YF
There is demand-deficient unemployment
In millions of micro labor markets, there is a
excess supply (or a deficient demand) for
workers
MICRO GENERIC
LABOR MARKET
MACRO PICTURE
LAS
P
AS
Wage
(W)
Excess
Supply
S
W1
We
D
AD
Y*
YF
Y
Number of
Workers
(N)
Figure 15.1.1 - Macro Demand-Deficient Unemployment and Its Underlying Micro Conditions
For many workers,
The current wage is above the equilibrium
wage
Macro unemployment is nothing more than
the aggregate consequence of millions of
excess supplies in micro markets
An adjustment process occurs
Workers offer to work for less until an
equilibrium is reached
Since wages are a factor price
and a change in factor prices moves AS
AS will shift downward
MICRO GENERIC
LABOR MARKET
W
MACRO PICTURE
P
LAS
S
W1
AS1
AS2
We
D
N
As Wages Across the Economy
Adjust Downwards to Clear
Micro Markets, The Aggregate
Effect is a Shift Down in AS
AD
Y*
YF
Figure 15.1.2 - Macro Demand-Deficient Unemployment, Underlying Micro Conditions,
and Adjustments Under Our Nice Micro Assumptions
Y
15.1.3
Suppose AD is very high,
like during a war
An excess demand for factors exists
MICRO GENERIC
LABOR MARKET
MACRO PICTURE
P
LAS
S
W
AS
W1
AD
Excess
Demand
YF Y*
Y
Figure 15.1.3 - Macro Inflationary Pressure And Its Underlying Micro Conditions
D
N
An adjustment process occurs
Employers offer higher wages in a tight labor
market
Process continues until an equilibrium is
reached
Since wages are a factor price
and a change in factor prices moves AS
AS will shift upward
P
W
LAS
S
AS2
AS1
We
W1
AD
D
N
As Wages Across the Economy
Adjust Upward to Clear Micro
Markets, The Aggregate Effect
is a Shift Up in AS
YF
Figure 15.1.4 - Macro Inflationary Pressure, Underlying Micro Conditions,
and Adjustments Under Our Nice Micro Assumptions
Y*
Y
15.1.4
If the nice assumptions are true,
the economy has amazing potential for selfadjustment
Adam Smith wrote about the “invisible hand”
in Wealth of Nations in 1776
The level of efficiency in the microeconomy
will determine how quickly the
macroeconomy can adjust
The quality of the invisible hand
is analogous to how realistic our nice
assumptions are
If the nice assumptions are realistic, then the
macroeconomy will always quickly adjust
back towards full employment
If they are not realistic, the economy can get
stuck in a bad situation like high
unemployment
Question becomes –
What should a government do?
15.1.5
Preamble to the U.S. Constitutionlists purposes of the U.S. government
such as promoting a common good for all
Sharp debate between
Non-interventionists – laissez-faire
They believe the system works pretty well,
and government just screws up the process
And interventionistsWho say thoughtful government policy is
needed to overcome shortcomings in the
system
Non-interventionists think
“thoughtful policy” is an oxymoron
Government intrusion is a threat to liberty
Interventionists think
That waiting for the invisible hand is a naive
belief with dreadful consequences
If we wait for the long-run adjustments to fix
things,
“In the long run we’re all dead”
People suffer in the meantime
15.2.1
Most economists agree that an ideal
would be full employment (at the natural rate)
and a stable price level
This represents the greatest wealth for the
nation,
but it doesn’t necessarily mean a just
distribution of wealth among individuals
In reality,
we seldom approach that situation of full
employment and stable price level
AS and AD shocks do often occur, and serious
macro consequences exist
We’ll look at some problems that have
occurred
Then we’ll look at the tools that the
government has at its disposal
15.2.2
Until the 1970’s, most economists believed all
shocks to the macroeconomy were
Caused by AD shifts
If AS is fixed,
Lower unemployment means more inflation
Higher unemployment means less inflation
This either/or relationship
was described in a paper in 1958 by A.W.
Phillips
He used historical data
The Phillips curve represented this trade-off
view
Inflation
High Inflation
Low Unemployment
The Trade-Off
Low Inflation
High Unemployment
Unemployment
Figure 15.2.1 - The Phillips Curve
The Phillips curve was
thought of as gospel
But events in the late 1960’s and 1970’s
caused economists to rethink the situation
Rising prices at full employment
Set off a wage-price spiral
Especially easy for workers to demand raises
in a tight labor market
P
LAS
AS5
P5
5
P4
4
P3
3
P2
2
P1
1
AS4
AS3
AS2
AS1
AD5
AD
AD4 3
AD
AD1 2
YF
Figure 15.2.2 - Wage-Price Spiral
Y*
Y
15.2.3
Expectations of inflation can remain even
with demand-deficient unemployment
Those who have jobs are still fighting to
maintain the value of their wages
Stagflation – a wage-price spiral with
demand-deficient unemployment
LAS
P
AS5
AS4
AS3
AS2
AS1
P5
5
P4
4
P3
3
P2
2
P1
1
AD5
AD
AD4 3
AD
AD1 2
Y* YF
Figure 15.2.3 - Stagflation
Y
1976 election
Carter defeated Ford by mentioning the
misery index - defined as unemployment rate
plus inflation rate
this was an unofficial measure of stagflation
17.6% - inf. 9.1 plus unemp. 8.5
1980 election
Reagan used the same measure to zap Carter 4
years later
still 17.1% - unemployment down to 5.8%,
but inf. 11.3%
Ford and Carter faced the worst
of both worldsHigh inflation and high unemployment
This flew in the face of Phillips curve tradeoff logic
Plus, each faced OPEC oil shocks which
moved AS up even further
15.2.4
The role of the government
Government policy can influence the
economy
G and T are directly determined by the
government
I, X, and M can be dramatically influenced by
the government
Should government intervene?
Smart people differ on this question
Some say always, some say never
The mainstream is a very wide body of
thought, and most mainstream economists
say “Maybe, it depends on the situation”
There are three dimensions of
macro policy
Monetary policy
Fiscal policy
Trade Policy
We will examine each
Keep in mind that in these
debates
Differences of opinion go back to a
fundamental philosophical difference of
belief
About the realism of the micro adjustment
process