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A Lecture Presentation
to accompany
Exploring Economics
3 Edition
by Robert L. Sexton
rd
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Printed in the United States of America
ISBN 0-324-26086-5
Copyright © 2002 by Thomson Learning, Inc.
Chapter 25
Issues in Macroeconomic
Theory and Policy
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve

Periods of high unemployment still
occur despite legislation committing
the federal government to the goal of
full employment and the development
of macroeconomic theory purporting
to show that full employment can be
achieved by manipulating aggregate
demand.
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Unemployment and Inflation


Similarly, price stability, which had
been achieved for long periods before
the 1930s, has not been consistently
observed since that time.
In every year in the lifetimes of most
students enrolled in this course, the
general level of prices has risen.
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

We usually think of inflation as an
evil.
But some economists believe that
inflation could actually help eliminate
unemployment in the short run.
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


If output prices rise but money wages do
not go up as quickly or as much, real
wages fall.
At the lower real wage, unemployment is
less because the lower wage makes it
profitable to hire more, now cheaper,
employees than before.
Hence, with increased inflation, one might
expect lower unemployment in the short
run.
Copyright © 2002 by Thomson Learning, Inc.
The Phillips Curve


An inverse relationship between the rate of
unemployment and the changing level of
prices has been observed in many periods
and places in history.
Credit for identifying this relationship
generally goes to British economist A.H.
Phillips.

In the late 1950s he published a paper setting
forth what has since been called the Phillips
curve.
Copyright © 2002 by Thomson Learning, Inc.

Phillips, and many others since, have
suggested that



at higher rates of inflation, the rate of
unemployment is lower,
while during periods of relatively or falling
stable prices, there is substantial
unemployment.
The cost of lower unemployment appears
to be greater inflation, and the cost of
greater price stability appears to be higher
unemployment.
Copyright © 2002 by Thomson Learning, Inc.


The actual inflation-unemployment
relationship for the United States for
the 1960s is shown in the next slide.
U.S. Phillips curve

The curved line is the smooth line that
best “fits” the data points.
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Copyright © 2002 by Thomson Learning, Inc.
The Slope of the Phillips Curve


It shows an inverse relationship
between the rate of unemployment
and the rate of inflation.
The Phillips curve is steeper at higher
rates of inflation and lower levels of
unemployment.
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

This suggests that once the economy
has relatively low unemployment rates,
further reductions in the unemployment
rate can occur only by accepting larger
increases in the inflation rate.
Once unemployment is low, it takes
larger and larger doses of inflation to
eliminate a given quantity of
unemployment.
Copyright © 2002 by Thomson Learning, Inc.

Presumably, at lower unemployment
rates, an increased part of the economy is
already operating at or near full capacity,
and further fiscal or monetary stimulus
primarily triggers


inflationary pressures in sectors already at
capacity,
while eliminating decreasing amounts of
unemployment in those sectors where some
excess capacity and unemployment still exist.
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The Phillips Curve and Aggregate
Supply and Demand

The relationship between AS and AD
analysis and the Phillips curve


Increased annual inflation lowering
unemployment is a move up along the Phillips
curve.
We can see the same relationship in AD/AS
model, as a result of an AD shift.


Increasing AD, moving up along an upward-sloping,
short-run AS curve, increases the price level and real
output.
To increase real output, firms employ more
workers, so employment increases and
unemployment falls.
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Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

In the 1960s it became widely
accepted that policy makers merely
had to decide on the combination of
unemployment and inflation they
wanted from the Phillips curve and
then simply pursue the appropriate
economic policies.
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The Phillips Curve—The 1960s


A reduction in the rate of unemployment
came at a cost (more inflation) as did a
reduction in the amount of inflation
(more unemployment).
Nonetheless, policy makers believed
they could influence economic activity
in a manner in which some goal could
be met, though with a trade-off in terms
of other macroeconomic goals.
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
At first the empirical evidence on
prices and unemployment fit the
Phillips curve approach so beautifully
that it is not surprising that it was
embraced so rapidly and completely.
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
Economists like Milton Friedman and
Edmund Phelps, who questioned the
long-term validity of the Phillips
curve, were largely ignored in the
1960s.
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

These economists believed there
might be a short-term trade-off
between unemployment and inflation,
but not a permanent trade-off.
According to Friedman, the short-run
trade-off comes from unanticipated
inflation.
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Is The Phillips Curve Stable?


In the 1970s (and 1980s and 1990s),
economists recognized that
macroeconomic decision making was
not as simple as picking a point on
the Phillips curve.
The data from the 1970s showed the
Phillips curve started to break down.
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
From 1974 through 1996, every data
point was to the right of the 1960s
Phillips curve, meaning a worsening
trade-off between inflation and
unemployment.
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

The 1970s experienced more of both
inflation and unemployment than
existed in the 1960s.
However, in the 1980s, the Fed
followed a very tight monetary policy
to combat high inflation rates.
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

People altered their expectations of
inflation downward.
In the mid-1990s, when lower
inflation was achieved and expected,
the Phillips curve shifted inward,
back to the level of the 1960s.
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Copyright © 2002 by Thomson Learning, Inc.
The Short-Run Phillips Curve Versus
The Long-Run Phillips Curve

The natural rate hypothesis states
that the economy will self-correct to
the natural rate of unemployment.
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


The long-run Phillips curve shows the
relationship between the inflation rate
and the unemployment rate when the
actual and expected inflation rates
are the same.
The long-run Phillips curve is vertical
at the natural rate of unemployment.
This is equivalent to the vertical longrun AS curve.
Copyright © 2002 by Thomson Learning, Inc.


Along the long-run Phillips curve we
see that the natural rate of
unemployment can occur at any rate
of inflation.
That is, regardless of fiscal and
monetary stimulus, output and
employment will be at their natural
rate in the long run.
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
Starting from the natural rate of
unemployment, suppose that the growth
rate of the money supply increases.


If it is unanticipated, it will stimulate aggregate
demand.
In the short-run, the increase in aggregate
demand will increase output and decrease
unemployment below the natural rate as the
economy moves up along the short-run Phillips
curve, increasing the actual inflation rate.
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

However, over time, people adjust to
the new inflation rate and the short-run
Phillips curve shifts to the right.
If the higher inflation rate continues,
the adjustment of expectations will
move the economy to where the
expected and actual inflation rates are
equal at the natural level of output and
the natural rate of unemployment.
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

This reveals that there is no trade-off
between the inflation rate and the
unemployment rate in the long run.
The policy implication is that the use of
fiscal or monetary policy to alter real
output from the natural level of real
output or unemployment from the
natural rate of unemployment is
ineffective in the long run.
Copyright © 2002 by Thomson Learning, Inc.

Say there was a decrease in the rate
of growth in the money supply.


If unanticipated, it would reduce
aggregate demand.
In the short-run, the decrease in
aggregate demand moves the economy
down along the short-run Phillips curve,
where the actual inflation rate has
decreased and the unemployment rate
has risen above the natural rate.
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


The decrease in aggregate demand has led
to lower production and to a fall in
employment.
When people recognize that prices are not
rising as rapidly as before, they adjust their
expectations to reflect that fact, and the
short-run Phillips curve shifts downward.
The inflation rate is now lower and
unemployment and output have returned to
their natural rates.
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

In this scenario, the economy’s road to
lower inflation rates has come at the
expense of higher unemployment in the
short run, until people’s expectations
adapt to the new lower inflation rate in
the long run.
These expectations are called adaptive
expectations—individuals believe that
the best indicator of the future is recent
information on inflation and
unemployment.
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Copyright © 2002 by Thomson Learning, Inc.
Supply Shocks




Changes in the expected inflation rate can
shift the short-run Phillips curve.
So can supply shocks.
An adverse supply shock, such as higher
energy prices, causes a leftward shift in the
SRAS curve, with a higher price level and
lower RGDP stagflation.
But the higher inflation rate and higher
unemployment rate that result shift the
short-run Phillips curve to the right.
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
A favorable supply shock, causes a
rightward shift in the SRAS curve with
a lower price level and higher RGDP.


example: lower energy prices
But the lower inflation rate and lower
unemployment rate that result shift
the short-run Phillips curve to the left.
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


The impact of adverse or favorable
shocks depend on expectations.
If people expect the changes to be
permanent, then the shifted Phillips
curve will stay in the new position until
something else happens.
If the shock is expected to be
temporary, the Phillips curve will soon
shift back to its original position.
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

If economic fluctuations are expected to
be permanent and are caused primarily
by supply-side shifts, then there may be
a positive relationship between the
inflation rate and the unemployment
rate—a shifting Phillips curve.
Higher rates of inflation will be coupled
with higher rates of unemployment and
lower rates of inflation will be coupled
with lower rates of unemployment.
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Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Is it possible that people can
anticipate the plans of policy makers
and alter their behavior quickly, to
neutralize the intended impact of
government action?

For example, if workers see that the
government is allowing the money
supply to expand rapidly, they may
quickly demand higher money wages in
order to offset the anticipated inflation.
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Can Human Behavior Counteract
Government Policy?


In the extreme form, if people could
instantly recognize and respond to
government policy changes, it might be
impossible to alter real output or
unemployment levels through policy
actions unless they can surprise
consumers and businesses.
An increasing number of economists
believe that there is at least some truth
to this point of view.
Copyright © 2002 by Thomson Learning, Inc.

At a minimum, most economists
accept the notion that real output and
the unemployment rate cannot be
altered with the ease that was earlier
believed; some believe that the
unemployment rate can seldom be
influenced by fiscal and monetary
policies.
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The Rational Expectations Theory

The relatively new extension of
economic theory that leads to this
rather pessimistic conclusion
regarding macroeconomic policy’s
ability to achieve our economic goals
is called the theory of rational
expectations.
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

The notion that expectations or
anticipations of future events are relevant
to economic theory is not new; for decades
economists have incorporated expectations
into models analyzing many forms of
economic behavior.
Only in the recent past, however, has a
theory evolved that tries to incorporate
expectations as a central factor in the
analysis of the entire economy.
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
Rational expectation economists
believe that wages and prices are
flexible, and that workers and
consumers incorporate the likely
consequences of government policy
changes quickly into their
expectations.
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
In addition, rational expectation
economists believe that the economy is
inherently stable after macroeconomic
shocks, and that tinkering with fiscal
and monetary policy cannot have the
desired effect unless consumers and
workers are caught off-guard (and
catching them off-guard gets harder
the more you try to do it).
Copyright © 2002 by Thomson Learning, Inc.
Rational Expectations and the Consequences
of Government Macroeconomic Policies


Rational expectations theory suggests that
government economic policies designed to
alter aggregate demand to meet
macroeconomic goals are of very limited
effectiveness.
When policy targets become public, it is
argued, people will alter their own behavior
from what it would otherwise have been,
and, in so doing, they largely negate the
intended impact of policy changes.
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
If government policy seems tilted
towards permitting more inflation in
order to try to reduce unemployment,
people start spending their money
faster than before, become more
adamant in their wage and other
input price demands, and so on.
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
In the process of quickly altering their
behavior to reflect the likely
consequences of policy changes, they
make it more difficult (costly) for
government authorities to meet their
macroeconomic objectives.
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

Rather than fooling people into changing
real wages, and therefore unemployment,
with inflation “surprises,” changes in
inflation are quickly reflected into
expectations with little or no effect on
unemployment or real output even in the
short run.
As a consequence, policies intended to
reduce unemployment through stimulating
aggregate demand will often fail to have
the intended effect.
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
Fiscal and monetary policy, according
to this view, will work only if the
people are caught off-guard or fooled
by policies so that they do not modify
their behavior in a way that reduces
policy effectiveness.
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Anticipation of an Expansionary
Monetary Policy


In the case of an expansionary
monetary policy, AD will shift to the
right.
As a result of anticipating the
predictable inflationary
consequences of that expansionary
policy, the price level will
immediately adjust to a new higher
price level.
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
Consumers, producers, workers, and
lenders who have anticipated the
effects of the expansionary policy
simply built the higher inflation rates
into their product prices, wages, and
interest rates because they realize
that expansionary monetary policy
can cause inflation if the economy is
working close to capacity.
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
Consequently, in an effort to protect
themselves from the higher
anticipated inflation, workers ask for
higher wages, suppliers increase
input prices, and producers raise their
product prices.
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

Because wages, prices, and interest
rates are assumed to be flexible, the
adjustments take place immediately.
This increase in input costs for wages,
interest, and raw materials causes the
aggregate supply curve to also shift
up or leftward.
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
So the desired policy effect of greater
real output and reduced
unemployment from a shift in the
aggregate demand curve is offset by
an upward or leftward shift in the
aggregate supply curve caused by an
increase in input costs.
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Copyright © 2002 by Thomson Learning, Inc.
RGDP
Unanticipated Expansionary Policy



An unanticipated increase in AD as a
result of an expansionary monetary policy
stimulates output and employment in the
short run.
The output is beyond the full employment
level, and so is not sustainable in the long
run.
The price level ends up higher than
workers and other input owners expected.
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
However, when they eventually
realize that the price level has
changed, they will require higher
input prices, shifting SRAS left to a
new long-run equilibrium at full
employment and a higher price level.
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
In the short run, the policy expands
output and employment, but only
increases the price level inflation in
the long run.
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

A correctly anticipated increase in AD
from expansionary monetary or fiscal
policy will not change real output or
unemployment even in the short run.
The only effect is an immediate
change in the price level.
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
The only way that monetary or fiscal
policy can change output in the
rational expectations model is with a
surprise—an unanticipated change.
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Copyright © 2002 by Thomson Learning, Inc.
When an Anticipated Expansionary Policy
Change is Less Than the Actual Policy Change


In the rational expectations model, when
people expect a larger increase in AD than
actually results from a policy change (say,
from a smaller increase in the money
supply than expected), it leads to a higher
price level and a lower level of RGDP—a
recession.
A policy designed to increase output may
actually reduce output if prices and wages
are flexible and the expansionary effect is
less than people anticipated.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Critics of Rational Expectations
Theory
 Rational expectations theory does
have its critics.

Critics want to know if consumers and
producers are completely informed about
the impact that say, an increase in
money supply will have on the economy.

In general, not all citizens will be completely
informed, but key players like corporations,
financial institutions, and labor organizations
may well be informed about the impact of
these policy changes.
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
Are wages and other input prices
really that flexible?
 Even
if decision makers could anticipate
the eventual effect of policy changes on
prices, prices may still be slow to adapt
(e.g., what if you had just signed a
three-year labor or supply contract when
the new policy is implemented?).
Copyright © 2002 by Thomson Learning, Inc.


Many economists reject the extreme
rational expectations model of
complete wage and price flexibility.
Most still believe there is a short-run
trade-off between inflation and
unemployment.
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

The reason is that some input prices
are slow to adjust to changes in the
price level.
In the long run, the expected inflation
rate adjusts to changes in the actual
inflation rate at the natural rate of
unemployment.
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25.4 Wage and Price Controls
and Indexing


If monetary and fiscal policy are
ineffective or counterproductive, what
policies are left to control inflation?
It is possible that the federal
government could set up a
comprehensive program over wages
and prices—often called incomes
policy.
Copyright © 2002 by Thomson Learning, Inc.
Purpose of Wage and Price Controls

We have imposed such controls three
times in modern American history:



during World War II
during the Korean War
in 1971 near the end of the Vietnam War
Copyright © 2002 by Thomson Learning, Inc.

Wage and price controls involve either



a complete freeze on wages and prices
at pre-control levels or
some rigid limits as to the increases in
wages and prices that will be permitted.
One or more government agencies are
created to monitor the program.
Copyright © 2002 by Thomson Learning, Inc.
Implementing Price Controls
Without Government Regulation

Sometimes voluntary guidelines or
guideposts are established to avoid forcing
companies and unions to limit their price
and wage levels.



This approach avoids the expense and political
acrimony associated with establishing a control
bureaucracy.
Sometimes the “jawboning” gets pretty intense.
Such guidelines can come close to being
mandatory controls.
Copyright © 2002 by Thomson Learning, Inc.
Justifications for Wage and
Price Controls

There are two justifications given for wage
and price controls.


By limiting price increases by law, the
government directly reduces the rate of
inflation legally allowed.
Especially with respect to wage controls, it is
argued that wage and price controls lower the
inflationary expectations of workers and their
unions, reducing the “inflation psychology”
that contributes to cost-push inflation.
Copyright © 2002 by Thomson Learning, Inc.
If Wage and Price Controls Have These
Advantages, Why Are They Not Used More Often?

Wage and price controls have several
major disadvantages, which are very
likely to be viewed as greater than
the advantages, except possibly
during wartime situations when
aggregate demand is growing very
rapidly.
Copyright © 2002 by Thomson Learning, Inc.



There is the problem of enforcing the
controls.
Black markets (illegal sales) often
develop.
These problems are often very hard
to solve.
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

Another, even more fundamental
problem with wage and price controls
is that they lead to shortages of
goods, services, and workers.
Inflationary pressures are not
eradicated but rather disguised,
manifesting themselves not in price
increases but in the lack of desired
goods or human resources.
Copyright © 2002 by Thomson Learning, Inc.

Severe and prolonged controls can
lead to a very serious misallocation
of resources, as a result.
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Price Controls Lead to a
Misallocation of Resources


Straightforward supply and demand
analysis indicates the misallocation
of resources due to wage and price
controls.
At the legal price ceiling, the quantity
demanded exceeds the quantity
supplied and shortages arise.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Examples of Problems With
Price Controls

Problems with price controls are
illustrated by the 1973 Arab oil
boycott, when the federal government
imposed price ceilings on gasoline
that prevented gas prices from rising
as they normally would have in
response to reduced supply.
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

At the ceiling price, quantity demanded
exceeded quantity supplied; gas stations
ran out of gas, were often closed, or
placed a limit on the amount of gas they
would sell.
When drivers were able to buy gas, they
often not only filled their tanks but also
several containers they carried along to
reduce the risk of being unable to buy
gas when they needed it.
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
In the former Soviet Union, where
price-control-related shortages were
commonplace, citizens typically
carried briefcases or even suitcases
and large quantities of cash, in case
they were able to purchase a
normally unavailable good.
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
Rather than just buy the product for
themselves, they would buy several
items for their friends and relatives as
well, to keep them from having to
stand in line for hours, often in vain,
trying to buy it.
Copyright © 2002 by Thomson Learning, Inc.
Examples of Problems Created
by Wage Controls

In the case of prolonged wage controls,
shortages of personnel can occur.



Wages serve as market signals.
Rising wages in an occupation increases an
occupation's attractiveness, leading to new
entrants of workers.
If the government decrees that salaries in that
field could not rise enough, the increase in the
quantity of new workers supplied will not occur
and a shortage will arise.
Copyright © 2002 by Thomson Learning, Inc.


Whether the gains from wage and
price controls in the form of reduced
inflation outweigh the costs in the
form of shortages and inefficient
resource allocation is debatable.
This is a normative issue where
honest, informed people can differ
in their perceptions of costs and
benefits.
Copyright © 2002 by Thomson Learning, Inc.

An example was the debate over the
removal of price controls on natural gas.


One side argued that controls should be
removed to end shortages and enhance
long-term supply.
The other side argued that removing controls
would lead to inflated prices for gas and
inflated profits for gas producers, while
causing hardships to lower income users of
gas.
Copyright © 2002 by Thomson Learning, Inc.
Keeping Prices Down Without
the Use of Price Controls


The attempt to control prices
politically can take another form.
The presence of monopolistic
elements in an industry can lead to
higher prices for that industry’s
products than would be the case for
a more competitive industry.
Copyright © 2002 by Thomson Learning, Inc.


By stimulating price competition among
private firms, the government may be
able to help in reducing inflationary
pressures.
However, there has been relatively little
actual use of antitrust laws to try to
reduce inflation pressures. Moreover,
monopoly power can also be artificially
created by government regulations.
Copyright © 2002 by Thomson Learning, Inc.
Could Indexing Reduce the
Costs of Inflation?


Another approach to some of the
problems posed by inflation is
indexing.
Inflation poses substantial equity
and distributional problems only
when it is unanticipated or
unexpected.
Copyright © 2002 by Thomson Learning, Inc.

One means of protecting parties
against unanticipated price increases
is to write contracts that
automatically change prices of goods
or services whenever the overall price
level changes, effectively rewriting
agreements in terms of dollars of
constant purchasing power.
Copyright © 2002 by Thomson Learning, Inc.

By making as many contracts as
possible payable in dollars of constant
purchasing power, those involved can
protect themselves against
unanticipated changes in inflation.
Copyright © 2002 by Thomson Learning, Inc.
Why Isn’t Indexing More
Extensively Used?


Indexing seems to eliminate most of
the wealth transfers associated with
unexpected inflation. Why then is it
not more commonly used?
One main argument against indexing
is that it could worsen inflation.
Copyright © 2002 by Thomson Learning, Inc.

As prices go up, wages and certain
other contractual obligations would
also automatically increase.


e.g., rents
This immediate and comprehensive
reaction to price increases will lead
to greater inflationary pressures.
Copyright © 2002 by Thomson Learning, Inc.
Other Problems Associated
With Indexing
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If inflation gets bad enough, it may
become almost impossible
administratively to maintain the
indexing scheme.
There are other inefficiencies, as well.
Copyright © 2002 by Thomson Learning, Inc.
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During the German hyperinflation of the
early 1920s, prices at one point rose so
rapidly that workers demanded to be paid
twice a day, at noon and at the end of
work.
During their lunch hour, workers would
rush money home to their wives, who
would then run out and buy real goods
before price increases further eroded
purchasing power.
Copyright © 2002 by Thomson Learning, Inc.
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Indexing also reduces the ability for
relative price changes to allocate
resources where they are more
valuable.
Copyright © 2002 by Thomson Learning, Inc.
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Not everything can be indexed, so
indexing would cause wealth
redistribution plus the cost of
negotiating cost of living (COLA)
clauses.
Excessive inflation leads to great
inefficiency, as well as a loss of
confidence in the issuer of money,
namely the government.
Copyright © 2002 by Thomson Learning, Inc.