Download Chapter 28 Government and Stabilization

Principles of Economics
by Fred M Gottheil
PowerPoint Slides prepared by Ken Long
©1999 South-Western College Publishing
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Chapter 28
Can Government
Really Stabilize the
Economy?
5/23/2017
©1999 South-Western College Publishing
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What are the basic Schools
of Economic Thought?
• Classical • Supply-side
• Keynesian • neo-Keynesian
• Monetarism
• Rational Expectations
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Classical theory
• Saw the economy as self-correcting
• Felt that a lack of aggregate demand
was unlikely
• If aggregate demand fell, adjustments
in prices, wages, and interest rates
would occur to return the economy to
full employment
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What is the main conclusion of
Classical Economics?
Because the economy is
always tending toward a
full employment
equilibrium, there is no
need for government
intervention
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What are the two
propositions of
Classical Economics?
1. All markets are
basically competitive
2. All prices are flexible
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Another important
element of classical
theory….
• Say’s Law, Supply creates its own
demand
• Supplying output creates the
income needed to demand the
output
• Thus seen as unlikely for the
economy to suffer a “glut” of
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unsold goods
What about savings in
classical theory?
Leads to the classical
theory of savings and
investment, belief that all
savings will get invested
in the economy
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Classical theory of
savings and investment
• Savings--higher interest rates
encourage more savings
• Investment, lower interest rates
encourage business investment
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Interest
Rates
Classical model of savings and
investment
Supply of
savings
i1
Investment
demand
S=I
Savings and
Investment
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Interest
Rates
Classical model of savings and
investment
Supply of
savings, S1
S2
i1
Investment
demand
i2
Q1
Q2
Note that S=I at Q1 and Q2
Savings and
Investment
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How do the Classical
Economists explain
unemployment?
Unemployment is a
temporary situation caused
by wage rates that are
above the equilibrium
level
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What about the
long-run?
Wage rates will adjust,
bringing about full
employment in the
long-run
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Real Wage and Employment
S1
W1
W2
D1
D2
Q2 Q1
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According to the Classical
Economists, why might
unemployment be persistent?
People interfere with the
competitive process
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How do people
interfere with the
competitive process?
• Unions
• Minimum wage laws
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According to the Classical
Economists, what should
the government do during
periods of unemployment?
NOTHING
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How do the Classical
Economists explain
inflation?
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Money
Velocity
Prices
MV
P=
Q
GDP
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Who controls the level
of money and therefore
the price level?
The Federal Reserve
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How much should the
Fed increase the
money supply?
Approximately equal to the
long-run full employment
rate of growth, about 3%
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What is
Keynesian Economics?
Government intervention
when the economy is in
a less than full
employment equilibrium
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According to the
Keynesians, why do we
have unemployment?
Unemployment is the
result of insufficient
aggregate demand
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What is the solution to
Unemployment?
Use government’s fiscal
policies to increase
aggregate demand
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Where does the money
come from to increase
aggregate demand?
The government practices
deficit spending
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What is a
Contractionary Gap?
The difference in real GDP
between a less than full
employment equilibrium
and the real GDP at the full
employment equilibrium
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Planned Spending
Contractionary Gap
C+I+G+(X-M)’
C+I+G+(X-M)
less than full employment
full employment
Real GDP
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What is the Employment
Act of 1946?
Congress officially declares
that it is the continuing
policy and responsibility
of the federal government
to take an active role in
the economy
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How do the Keynesians
view inflation?
They are not worried
about inflation
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Highly simplified AS
curve in Keynesian
theory
The backward L supply
curve, no concern about
inflation until full
employment achieved
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“Naive” AS Curve
P
AS
Full Employment
AD5
AD4
AD1 AD2
AD3
Qf
GDP
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For what were the
Keynesians ill prepared ?
The stagflation of the
1970’s, when we had high
rates of both
unemployment and
inflation
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Modified AS Curve
P
AS
Full Employment
AD6
AD5
AD4
AD3
AD1 AD2
GDP
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What is
neo-Keynesian Economics?
The neo-Keynesians
emphasized the possibility
that an economy can be in
equilibrium at less than full
employment with inflation
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What discovery supported
the view of less than full
employment equilibrium
and inflation?
The Phillips Curve
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What is the
Phillips Curve?
A graph showing the
inverse relationship
between the economy’s
rate of unemployment
and the rate of inflation
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Rate of Inflation
The Phillips Curve
Rate of Unemployment
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Explaining the Phillips Curve
-Rightward Shift in AD•Price level and output rise
•Employment increases
•Unemployment decreases
•Price level and unemployment
move in opposite directions.
Explaining the Phillips Curve
-Leftward Shift in AD•Price level and output fall
•Employment decreases
•Unemployment increases
•Price level and unemployment
move in opposite directions.
The Phillips Curve: U.S. Experience
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Inflation
0
8
6
4
2
0
2
3
4
5
6
7
Unemployment
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What happened to the
Phillips curve in the
1970’s?
It appeared to shift
outward, due to the
supply side inflation and
stagflation of the 70’s
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Explaining the outward
shifts in the Phillips
Curve
Supply shocks of the 1970’s,
leftward shifts in AS lead to
higher inflation and
unemployment both
Thus a worsened trade-off between
inflation and unemployment
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What is
Supply-side Inflation?
Prices rise because of
an increase in costs
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How did we break the
back of Stagflation?
In 1980, the Fed decreased
the money supply and
held it down until prices
came down
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What was the result of
this Fed action in 1980?
A very severe recession
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What was the long-run
gain from this policy?
The back of inflation was
broken making it possible
to concentrate on
stimulating employment
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How do the neoKeynesians explain the
1970’s Phillips Curve
Instead of one Phillips
curve, there was a set
of Phillips curves
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Rate of Inflation
The 1970’s Phillips Curve
Rate of Unemployment
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Another view of the
Phillips curve
is…Natural Rate Theory
Recall the natural rate of
unemployment, the sum
of frictional and
structural
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According to natural
rate theory, the
unemployment rate
tends to move, in the
long run, back to its
natural level
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By this view, there is no
permanent trade off
between unemployment
and inflation
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What does the long-run
Phillips curve look like
according to natural rate
theory?
It is effectively vertical
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What is the Rational
Expectations School?
Government’s policy of
managing aggregate demand
is undermined because of
people’s anticipation of
consequences
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Begin with different views of how
people form expectations
Adaptive expectations--base
expectations of the future path of a
variable on the past performance of
the variable, with the most recent past
having the greatest weight
Rational expectations--people should be
smarter than this, should use all
information available to them in
forming expectations
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What is an example of
the negative effect of
anticipation?
When workers anticipate an
increase in aggregate
demand, they will bargain
for higher wages to protect
them from inflation
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Conclusion of Rational
Expectations
Policies only affect the economy if
they are a “surprise”
If a policy is announced and people
correctly anticipate the policy,
then it has no effects.
Still a controversial theory, not
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What is Supply-side
Economics?
Through tax deductions,
spending cuts, and
deregulation, government
creates incentives to
increase aggregate supply
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Right Shift in Supply
S1
P1
P2
S2
D
Q1
Q2
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What is the Laffer Curve?
Increasing tax rates from
zero increases tax revenues
up to a point - beyond that
point increases will shrink
the economic pie because
of disincentives
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The Laffer Curve
Tax Rates (%)
100
T* is the revenue
maximizing tax rate
T*
0
Tax Revenues
(dollars)
What is Crowding Out?
A fall in private
investment spending
caused by an increase in
government spending
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How can government
borrowing cause
Crowding Out?
Interest rates can be
driven up, leaving less
money available for
private investment
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Upon what do economists
generally agree?
Automatic stabilizers
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What are
Automatic Stabilizers?
Structures in the economy
that tend to add to
aggregate demand when
the economy is in a
recession, and subtract
during inflation
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What are some examples
of Automatic Stabilizers?
Unemployment benefits
The progressive income tax
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http://www.whitehouse.gov
http://stats.bls.gov/eag.table.html
http://www.bog.frb.fed.us/releases/
h15/data/m/prime.txt
http://thomas.loc.gov
http://www.bls.gov
http://www.westegg.com/inflation
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• What are the basic Schools of
Economic Thought?
• What is Classical Economics?
• What is Keynesian Economics?
• According to the Keynesians, why do
we have unemployment?
• What is the Employment Act of 1946?
• What is neo-Keynesian Economics?
• What is the Phillips Curve?
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• What is Demand-side Inflation?
• What is Supply-side Inflation?
• What is the Rational Expectations
School?
• What is Supply-side Economics?
• What is the Laffer Curve?
• What is Crowding Out?
• Upon what do economists agree?
• What are some examples of
Automatic Stabilizers?
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