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Chapter 18
Stabilization in
an Integrated
World Economy
Introduction
When the Fed expressed concern about
the threat of deflation, some observers
interpreted this to mean that an
expansionary monetary policy would be
instituted and sustained.
In what way is the expectation of a policy
move an important economic variable?
Slide 18-2
Learning Objectives
 Explain why the actual unemployment
rate might depart from the natural rate
of unemployment
 Describe why economic theory implies
that there may be an inverse
relationship between the inflation rate
and the unemployment rate, reflected
by the Phillips curve
Slide 18-3
Learning Objectives
 Evaluate how expectations affect the
relationship between the actual inflation
rate and the unemployment rate
 Understand the rational expectations
hypothesis and its implications for
economic policymaking
Slide 18-4
Learning Objectives
 Identify the central features of the real
business cycle challenge to active
policymaking
 Distinguish among alternative modern
approaches to strengthening the case
for active policymaking
Slide 18-5
Chapter Outline
 Active Versus Passive Policymaking
 The Natural Rate of Unemployment
 Rational Expectations and the Policy
Irrelevance Proposition
Slide 18-6
Chapter Outline
 Real Business Cycles
 Modern Approaches to Rationalizing
Active Policymaking
 Active Versus Passive Policymaking
Slide 18-7
Did You Know That...
 The magnitude of fluctuation in U.S.
real GDP is lessening over time?
 There is no clear consensus on how
fiscal and monetary policy have played
a role in creating this stability?
Slide 18-8
Active Versus
Passive Policymaking
 Active (Discretionary) Policymaking
– All actions on the part of monetary and
fiscal policymakers that are undertaken
in response to or in anticipation of some
change in the overall economy
– Example
• Fiscal and monetary policy
Slide 18-9
Active Versus
Passive Policymaking
 Passive (Nondiscretionary) Policymaking
– Policymaking that is carried out in response
to a rule
– Example
• Monetary rule
• Balancing the budget over the business cycle
Slide 18-10
The Natural Rate of Unemployment
 Two components of the natural rate of
unemployment
– Frictional unemployment
– Structural unemployment
Slide 18-11
The Natural Rate of Unemployment
 Structural Unemployment
– Unemployment resulting from:
•
•
•
•
•
Union activity
Government-imposed licensing arrangements
Government-imposed wage laws
Welfare and unemployment insurance
A mismatch of worker training and skills
with available jobs
Slide 18-12
The Natural Rate of Unemployment
 Natural Rate of Unemployment
– The rate of unemployment that is
estimated to prevail in the long run
– Every one in the economy has fully
adjusted to any changes in the economy
Slide 18-13
The Natural Rate of Unemployment
 Observations
– The natural rate is the result of costly and
imperfect information and rigidities
– The natural rate is the long-run
equilibrium rate of unemployment
Slide 18-14
The U.S. Natural
Rate of Unemployment
Figure 18-1
Sources: Economic Report of the President;
Economic Indicators, various issues.
Slide 18-15
The Natural Rate of Unemployment
 What do you think?
– How can we explain the increase in the
natural rate of unemployment during
the post-war years until the 1990s?
Slide 18-16
The Natural Rate of Unemployment
 Departures from the natural rate of
unemployment
– Movements in the business cycle and
cyclical unemployment
Slide 18-17
Impact of an Increase in Aggregate
Demand on Output and Unemployment
LRAS
Price Level
SRAS1
P1
E1
AD1
Figure 18-2
Y1
Real GDP per Year
Slide 18-18
Impact of an Increase in Aggregate
Demand on Output and Unemployment
LRAS
SRAS2
SRAS1
Price Level
P3
E3
E2
P2
P1
Rising prices and resource prices shift
SRAS1 to SRAS2 and the unemployment
rate rises to the natural rate
E1
AD2
Monetary or fiscal policy shifts AD.
The unemployment rate falls below
the natural rate of unemployment
AD1
Figure 18-2
Y1 Y2
Real GDP per Year
Slide 18-19
Impact of a Decline in Aggregate
Demand on Output and Unemployment
LRAS
Price Level
SRAS1
P1
E1
AD1
Figure 18-3
Y1
Real GDP per Year
Slide 18-20
Impact of a Decline in Aggregate
Demand on Output and Unemployment
LRAS
SRAS1
SRAS2
Price Level
SRAS1 shifts to SRAS2 at lower
price level and the unemployment
rate falls to the natural rate
P1
P2
P3
E1
• Monetary or fiscal policy shifts AD
• The unemployment rate rises
above the natural rate of
unemployment
E2
AD1
E3
AD2
Figure 18-3
Y2
Y1
Real GDP per Year
Slide 18-21
Example: Have Health Care Costs Changed
the Natural Rate of Unemployment?
 Providing health insurance benefits for
workers increases the costs an employer
faces when adding another employee.
 This may account for a higher level of
structural unemployment, especially
because health care benefits represent an
increasingly higher business expense.
Slide 18-22
The Natural Rate of Unemployment
 The Phillips Curve
– A curve showing the relationship between
unemployment and changes in wages
or prices
– It was long thought to reflect a trade-off
between unemployment and inflation
Slide 18-23
The Natural Rate of Unemployment
 Observations
– An unexpected increase in aggregate
demand
• Causes the price level to rise and the
unemployment rate to fall
• The greater the increase in AD the greater the
rate of inflation and the lower the
unemployment rate
Slide 18-24
The Natural Rate of Unemployment
 Observations
– An unexpected decrease in aggregate
demand
• Causes the price level to fall and the
unemployment rate to rise
• The greater the decrease in AD the greater the
rate of deflation and the higher the
unemployment rate
Slide 18-25
Inflation Rate
The Phillips Curve
Figure 18-4
Unemployment Rate
Slide 18-26
The Phillips Curve
Inflation Rate
U*
Zero inflation and
natural rate of
unemployment, U*
Figure 18-4
Higher inflation and
lower unemployment
B
Deflation and higher
unemployment
A
C
Unemployment Rate
Slide 18-27
The Phillips Curve
U*
Inflation Rate
The Phillips curve implies a
policy trade-off between
inflation and unemployment
Figure 18-4
Can policymakers fine-tune
the economy?
Unemployment Rate
Slide 18-28
The Natural Rate
of Unemployment
 The Phillips curve: The trade-off?
– Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
• The rate of unemployment below which the
rate of inflation tends to rise and above which
the rate of inflation tends to fall
Slide 18-29
The Phillips Curve
U*
Inflation Rate
PC0
P1
• Increases in AD increase inflation
and reduce unemployment
• The inflation and unemployment
rate will return to A
B
A
U1
Figure 18-5
Unemployment Rate
Fed increases mS
(one-time event to
raise AD)
Slide 18-30
The Phillips Curve
U*
Inflation Rate
PC0
• To keep the economy at B the mS
will have to continue to grow
• Economic participants will begin
to assume the higher inflation
rate is constant
P1
B
A
U1
Figure 18-5
Unemployment Rate
Slide 18-31
The Phillips Curve
U*
Inflation Rate
PC0
PC5
F2
P1
B
F1
As a result, the
unemployment rate will
increase to A and yield
combination F1
A
U1
Figure 18-5
Unemployment Rate
Slide 18-32
The Natural Rate of Unemployment
 The role of expected inflation
– What are the long- and short-run
macroeconomic implications of the
shift from PC0 to PC5?
– After the mid-1960s there was no
apparent long-run or short-run trade-off.
Slide 18-33
International Policy Example:
Higher Inflation and Inflationary
Expectations
 Research conducted by Federal Reserve
Bank economists suggests that a slight
increase in the annual inflation rate,
sustained for three years, contributes to a
higher expected inflation rate for as many as
ten years into the future.
 These results were found to hold both in
Japan and in Europe.
Slide 18-34
The Phillips Curve:
Theory Versus Data
Figure 18-6
Sources: Economic Report of the President; Economic Indicators, various issues.
Slide 18-35
Rational Expectations
and the Policy Irrelevance Proposition
 Two key elements of rational
expectations hypothesis
– Individuals base their forecasts about the future
values of economic variables on all available
past and current information
– These expectations incorporate individuals’
understanding about how the economy operates
Slide 18-36
Rational Expectations
and the Policy Irrelevance Proposition
 New Classical Model
– A modern version of the classical model in
which wages and prices are flexible
– There is pure competition in all markets
– The rational expectations hypothesis is
assumed to be working
Slide 18-37
Response to an Unanticipated Rise
in Aggregate Demand
LRAS
Price Level
SRAS1
P2
Short-run equilibrium
increases output to
Y2 with P2
B
A
P1
AD2 (M = M2)
Assume the mS increases
unexpectedly to M2 and
AD increases to AD2
AD1 (M = M1)
Y1
Figure 18-7
Y2
Real GDP per Year
Slide 18-38
Response to an Unanticipated Rise
in Aggregate Demand
LRAS
Price Level
Long-run equilibrium
after adjustment
yields Y1 with P3
SRAS2
SRAS1
P3
P2
C
P1
A
Short-run equilibrium
increases output to
Y2 with P2
B
AD2 (M = M2)
Assume the mS increases
unexpectedly to M2 and
AD increases to AD2
Figure 18-7
Y1 Y2
Real GDP per Year
AD1 (M = M1)
Slide 18-39
Rational Expectations
and the Policy Irrelevance Proposition
 The response to anticipated policy
– If the increase in the money supply
was anticipated
• The higher price level would be anticipated
• Workers and suppliers would demand higher
wages and prices immediately
Slide 18-40
Effects of an Anticipated Rise
in Aggregate Demand
LRAS
Price Level
SRAS1 (Me = M1)
P1
A
AD1 (M = M1)
Figure 18-8
Y1
Real GDP per Year
Slide 18-41
Effects of an Anticipated Rise
in Aggregate Demand
LRAS SRAS2 (Me = M2)
SRAS1 (Me = M1)
Price Level
P3
According to the rational
expectations hypothesis the
SRAS will shift simultaneously
with the increase in AD
B
P1
Policy will have no
impact on output
Figure 18-8
C
A
AD2 (M = M2)
AD1 (M = M1)
Y1
Real GDP per Year
Slide 18-42
Rational Expectations
and the Policy Irrelevance Proposition
 Policy Irrelevance Proposition
– Under the assumption of rational
expectations on the part of decision
makers in the economy, anticipated
monetary policy cannot alter either the
rate of unemployment or the level of real
GDP.
Slide 18-43
Rational Expectations
and the Policy Irrelevance Proposition
 Policy Irrelevance Proposition
– Regardless of the nature of the anticipated
policy, the unemployment rate will equal
the natural rate, and real GDP will be
determined by the economy’s long-run
aggregate supply curve.
Slide 18-44
Rational Expectations
and the Policy Irrelevance Proposition
 What must people know?
– The policy irrelevance proposition
assumes only that people do not
persistently make the same mistakes in
forecasting the future.
Slide 18-45
Effects of an Unanticipated Rise
in Aggregate Demand
Price Level
SRAS1 (Me = M1)
P0
E0
AD1 (M = M1)
Figure 18-9, Panel (a)
Y1
Real GDP per Year
Slide 18-46
Effects of an Anticipated Rise
in Aggregate Demand
Price Level
SRAS1 (Me = M1)
E1
P1
P0
According to rational
expectations, an
unanticipated change
in AD can affect output
in the short-run
E0
AD2 (M = M2)
Policy will have no
impact on output
AD1 (M = M1)
Figure 18-9, Panel (a)
Y1 Y2
Real GDP per Year
Slide 18-47
Effects of an Unanticipated Rise
in Aggregate Demand
LRAS
Price Level
SRAS1 (Me = M1)
E2
P2
P1
E1
AD2 (M = M2)
AD1 (M = M1)
Figure 17-9, Panel (b)
Y1 Y2
Real GDP per Year
Slide 18-48
Effects of an Unanticipated Rise
in Aggregate Demand
SRAS2 (Me = M2)
SRAS1 (Me = M1)
Price Level
P3
E2
P2
P1
In the long run people will figure
out the Fed’s actions and prices
will increase and output will
return to long-run equilibrium
E3
E1
AD2 (M = M2)
AD1 (M = M1)
Figure 17-9, Panel (b)
Y1 Y2
Real GDP per Year
Slide 18-49
Rational Expectations
and the Policy Irrelevance Proposition
 The policy dilemma
– Can only mistakes have “real” effects?
– Fully anticipated changes in the money
supply will lead to offsetting price
changes, if rational expectations hold.
Slide 18-50
Real Business Cycles
 Another Challenge to Policy Activism:
Real Business Cycle
An extension and modification of the
theories of the new classical economists of
the 1970s and 1980s, in which money is
neutral and only real, supply-side factors
matter in influencing labor employment and
output
Slide 18-51
Effects of an Reduction
in the Supply of Resources
LRAS1
A reduction in the
supply of a
resource shifts the
SRAS to the left
Price Level
SRAS2
P2
SRAS1
E2
E1
P1
The position of the
LRAS depends
upon resource
endowments
AD
Figure 18-10
Y2
Real GDP per Year
Y1
Slide 18-52
Effects of an Reduction
in the Supply of Resources
LRAS2
SRAS3
LRAS1
A reduction in the
supply of a
resource shifts the
SRAS to the left
SRAS2
Price Level
P3
P2
E3
SRAS1
E2
E1
P1
If the reduction in
the resource is
permanent, the
LRAS will also shift
Figure 18-10
The position of the
LRAS depends
upon resource
endowments
AD
Y1
Y2
Real GDP per Year
Y1
Slide 18-53
Real Business Cycle Theory
 Generalizing the theory
– What impact would an oil shock have on
aggregate demand?
– Can we explain the Great Depression with
the real business cycle theory?
– The real business cycle approach cannot
explain most of the apparent wage and
price rigidity within the economy.
Slide 18-54
Modern Approaches to
Rationalizing Active Policymaking
 Small menu costs and sticky prices
 Efficiency wage theory
 The effect of aggregate demand
changes on output and employment in
the long run
Slide 18-55
Example:
Let’s Create Our Own Work
 As the U.S. economy began its recovery in
2002, many people who had been
unemployed started their own businesses.
 If the economy is resilient and flexible, then
people can find a means to generate an
income, even if they are doing something a
bit different from what they were doing
before.
Slide 18-56
Active vs. Passive
Policymaking
 Most economists agree that active
policymaking is unlikely to exert sizable
long-run effects on any nation’s economy.
 Most also agree that aggregate supply
shocks contribute to business cycles.
 There is a general consensus that monetary
and fiscal policy measures are effective in
the short run.
Slide 18-57
Issues and Applications:
What the Fed Says and What It Does
 When the Fed made an announcement in
August 2003 that it would keep interest rates
low for a considerable length of time, the
intent was to generate a level of business
and consumer confidence that would
stimulate aggregate demand.
 By October, when the annual rate of
economic growth was a surprisingly high 8
percent, the Fed faced a dilemma.
Slide 18-58
Issues and Applications:
What the Fed Says and What It Does
 If the Fed stuck to its promise, this would
fuel inflationary expectations.
 If it allowed interest rates to rise, the
unemployment rate would increase.
 After their next meeting, Fed officials
announced that the decision as to whether
to continue a pre-established policy would
be determined by current circumstances, not
by the passage of time.
Slide 18-59
Summary Discussion
of Learning Objectives
 Why the actual unemployment rate might
depart from the national rate of
unemployment
– Unanticipated changes in aggregate demand
 Philips curve
– A curve showing an inverse relationship between
the rate of inflation and the rate of unemployment
Slide 18-60
Summary Discussion
of Learning Objectives
 How expectations affect the actual
relationship between the inflation rate
and the unemployment rate
– The Phillips curve shifts
 Rational expectations
– Policy irrelevance theorem
– Only unanticipated policy actions affect
short-run real GDP
Slide 18-61
Summary Discussion
of Learning Objectives
 Central features and predictions of real
business cycle theory
– Focus is on how shifts in aggregate
supply can cause real GDP to vary over
time
 Modern Approaches to Bolstering the
Case for Active Policymaking
– Emphasis on wage and price stickiness
Slide 18-62
End of
Chapter 18
Stabilization in
an Integrated
World Economy