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Chapter 15 Stabilization Policy, Output, and Employment Slides to Accompany “Economics: Public and Private Choice 9th ed.” James Gwartney, Richard Stroup, and Russell Sobel Next page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Economic Fluctuations —The Historical Record Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Economic Fluctuation – The Historical Record Historically, the United States has experienced substantial swings in real output. Prior to the Second World War, year-to-year changes in real GDP of 5 percent to 10 percent were experienced on several occasions. During the last five decades, the fluctuations of real output have been more moderate. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Post-Second World War Decline in Economic Instability Prior to the conclusion of the WWII, the U.S. experienced double-digit increases in real GDP (in 1918, 1922, 1935-1936, and 1941-1943). In contrast, real output fell by 5% or greater in 1920-1921, 1930-1932, 1938, and 1946. As illustrated here, fluctuations in real GDP have moderated during the last four decades due, most economist agree, to more appropriate macro policy (particularly monetary policy). Annual % Change First World War boom (in real GDP) Second World War boom 16 14 12 10 8 6 4 2 0 –2 –4 –6 –8 –10 1920–1921 –12 Recession –14 1910 1920 1937–1938 Recession Great Depression 1930 1940 1950 1960 1970 1980 1990 2000 Sources: Historical Statistics of the United States, p. 224; and Economic Report of the President (1999). Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. Promoting Economic Stability – Activist and Non-activist Views Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Promoting Economic Stability -- Activist and Non-activist Views Goals of Stabilization Policy: A stable growth of real GDP, A relatively stable level of prices, A high level of employment (low unemployment). Activists' Views of Stabilization Policy: The self corrective mechanism works slowly if at all, Policy-makers will be able to alter macro-policy, injecting stimulus to help pull the economy out of recession and implementing restraint to help control inflation, According to the activist s view, policy-makers are more likely to keep the economy on track when they are free to apply stimulus or restraint based on forecasting devices and current economic indicators. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Promoting Economic Stability -- Activist and Non-activist Views Non-activists' Views of Stabilization Policy: The self-corrective mechanism of markets works pretty well, Greater stability would result if stable, predictable policies based on predetermined rules were followed, Non-activists argue that the problems of proper timing and political considerations undermine the effectiveness of discretionary macro policy as a stabilization tool. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. The Application of Discretionary Stabilization Policy Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Index of Leading Indicators Index of Leading Indicators: Is a composite statistic based on 10 key variables that generally turn down prior to a recession and turn up before the beginning of a business expansion. The index can forecast the future and help policy makers, but it is an imperfect forecasting device. The index forecast the last 8 recessions (the arrows below show how far ahead the index predicted recession) with variable advanced notice. The index incorrectly forecasted recession on five occasions (*). Composite Index of Leading Indicators 18 (1987 = 100) 100 15 9 8 11 90 30 80 70 60 * * 11 5 * * * 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 1998 Source: Conference Board, Business Cycle Indicators. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Application of Discretionary Stabilization Policy Forecasting Models: Highly complex statistical models used to improve the accuracy of macro forecasts that use past data from economic relationships to forecast future outcomes and behaviors. To date, the record of econometric forecasting models has been mixed. They are accurate when conditions are relatively stable but miss target when things are otherwise. They also fail when major structural changes occur which change the relationships that their data is based upon. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Application of Discretionary Stabilization Policy Market Signals and Discretionary Monetary Policy: Some economists believe that information supplied by certain economic markets can also provide early warning of the need to change policies. Commodity prices, exchange rates, and other market signals are best used as supplements, rather than substitutes for, other economic indicators and forecasting devices. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. Practical Problems With Discretionary Monetary Policy Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Practical Problems With Discretionary Macro Policy Lags and the Problem of Timing: After a change in policy has been undertaken, there will be a time lag before it exerts a major impact. This means policy makers need to forecast economic conditions several months in the future in order to institute policy changes effectively. Politics and Timing of Policy Changes: Policy changes may be driven by political considerations rather than stabilization. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Time Lags and the Effects of Discretionary Policy Real GDP Long-term Growth Rate E Non-activists believe poor timing of discretionary policy will result in destabilizing effects. F Path if macro policy is timed improperly D A B C Time Beginning with pt A we illustrate the hypothetical business cycle. If a forthcoming recession can be recognized quickly and more expansionary policy instituted at pt B . . . expansionary policy may add stimulus at pt C and help minimize the magnitude of the downturn. Activists believe that discretionary policy may achieve this outcome. However, if delays result in the adoption of the expansionary policy at C and if it does not exert its major impact until pt D . . . the demand stimulus will exacerbate the inflationary boom (as non-activists fear). In turn, an anti-inflationary strategy instituted at pt E may exert its primary impact at pt F . . . resulting in a deepening of the recession that follows. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Questions for Thought: 1. What is the index of leading indicators? Why is it useful to macro policy makers? 2. Why is proper timing of changes in macroeconomic policy crucially important? What are some of the practical problems that limit the effectiveness of discretionary monetary and fiscal policy as stabilization tools? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. How are Expectations Formed? -- Two Theories Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How are Expectations Formed? -- Two Theories Adaptive Expectations: -- individuals form their expectations about the future on the basis of data from the recent past. Rational Expectations: -- Assumes that people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Adaptive Expectations Hypothesis Actual Rate of Inflation (percent) 12.0 Actual rate of inflation 8.0 4.0 0 Expected Rate of Inflation Corresponding expected rate of inflation in next period (percent) 12.0 8.0 4.0 0 1 2 3 4 5 Time Period According to the adaptive expectations hypothesis, what actually occurs during the most recent period (or set of periods) determines people’s future expectations. Thus, the expected future rate of inflation lags behind the actual rate by one period as expectations are altered over time. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6. How Macro Policy Works -- The Implications of Adaptive and Rational Expectations Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How Macro Policy Works – The Implications of Adaptive and Rational Expectations With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment. With rational expectations, expansionary policy will not generate a systematic change in output. Both expectations theories indicate that sustained expansionary policies will lead to inflation without permanently increasing output and employment. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Expectations and the Short-run Effects of Demand Stimulus Price level LRAS SRAS1 P2 P1 e2 E1 AD1 YF Y2 AD2 Goods & Services (real GDP) Under adaptive expectations, anticipation of inflation will lag behind its actual occurrence. Thus, a shift to a more expansionary policy would increase aggregate demand (from AD1 to AD2) and lead to a temporary increase in GDP (from YF to Y2) accompanied by a modest increase in prices (from P1 to P2). Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Expectations and the Short-run Effects of Demand Stimulus Price level LRAS P2 E2 P1 E1 SRAS2 SRAS1 AD1 YF AD2 Goods & Services (real GDP) In contrast, under rational expectations, decision makers will quickly anticipate the inflationary impact of a demand-stimulus policy. Thus, while a shift to a more expansionary policy would increase aggregate demand (from AD1 to AD2), resource prices and production costs would rise just as rapidly (thereby shifting SRAS to SRAS2). The net effect of demand-stimulus in the rational expectations model is an increase in prices without altering real output -- even in the short run. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7. The Emerging Consensus View Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Emerging Consensus View Monetary policy consistent with approximate price stability is the key ingredient of effective stabilization policy. Sound policy avoids wide policy swings. Responding to minor economic ups and downs is a mistake. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 8. The Recent Stability of the U.S. Economy Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Recent Stability of the U.S. Economy The objectives of stabilization policy have been less ambitious in recent years. Rather than trying to control output and employment, the focus has shifted to the achievement of price stability. Movement toward price stability has led to a reduction in economic fluctuations. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Reduction in the Incidence of Recession 35 32.8 30 25 22.8 20 15 10 4.2 5 0 1910–1959 1960–1982 1983–1998 Sources: R.E. Lipsey and D. Preston, Source Book of Statistics Relating to Construction (1966); & New York: National Bureau of Economic Research The U.S. economy was in recession 32.8% of the time during the 1910-1959 period and 22.8% of the time between 1960-1982. Since that time, the economy has become even more stable, entering into recession only 4.2% of the time from 1983-1998. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Questions for Thought: 1. State the adaptive-expectations hypothesis in your own words. How does the theory of rational expectations differ from that of adaptive expectations? 2. Why do you think there has been less economic instability during the last 16 years that any time in American history? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 15 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.