Download ECON 521 Special Topics in Economic Policy

ECON 521
Special Topics in Economic Policy
CHAPTER TWO
Economic Policy
First: Overview
• This chapter -- looks at Economic Policy,
overt intervention taken to improve a
economy currently operating with problems.
• Economic Policy -- “medicine” given to cure
a “sick” economy.
• Emphasizes Fluctuations Strategy,
Get Y* closer to a given YN.
• Steps follow- Diagnosing the Economy, Policy
Strategy, Choosing Policy Type, Policy
Objective
Diagnosing the Economy –
A Quick Review
Y < YN -- sluggish economy
Y > YN -- economy with
accelerating inflation
Y = YN -- economy with constant
inflation rate (desired)
Strategies for (Fluctuations)
Economic Policy
• Expansionary Policy -- Policy designed to
address a sluggish economy (Y* < YN).
• Contractionary Policy -- Policy designed to
address an overstimulated, or accelerated
inflation economy (Y* > YN).
Types of Economic Policy
• Monetary Policy -- The Federal Reserve
changing the supply of financial capital to
promote investment (and possibly durable
goods consumption).
• Fiscal Policy – The Federal Government
changing the government budget position (G-T).
• Trade Policy -- Trying to managing the economy
through changing exports (X) and imports (M).
• Exchange Rate Policy -- Trying to managing the
exchange rate for influencing the local economy.
The Intent & Method of Economic
Policy
• Intent -- to move Y* closer to YN.
• Expansionary Policy (policy for Y* < YN),
seeks to increase spending on goods and
services, shifting the AD curve rightward.
• Contractionary Policy (policy for Y* > YN),
seeks to decrease spending on goods and
services, shifting the AD curve leftward.
Second: Challenges to Using
Economic Policy
(1) Can the economy cure itself instead?
(2) Avoiding excessive expansion and the
wage-price spiral.
(3) Reacting to adverse supply shocks.
Challenge (1):
Can The Economy Cure Itself?
• Short-Run Perspective (equilibrium in
AD-AS model): Y* does not necessarily
equal YN due to market failure in the
labor market. Therefore, the economy
needs policy (interventionist position).
• Long-Run Perspective (equilibrium in
AD-LAS model): Y* = YN . Therefore, it
can cure itself and there is no need for
policy (non-interventionist position).
The Long-Run:
A Graphical Description
• Let’s return to the Labor Market -- the
demand and supply for labor employment.
• In this case, let’s consider the Aggregate
Labor Market, or the total demand and
supply for labor.
• Labor Market Equilibrium (N*) -- where labor
demand equals labor supply across the
economy.
• At N*, there is no demand-deficient
unemployment. So at N*, Y* = YN and u = uN.
The Economy Curing Itself in the
The Long-Run
• Example 1 -- sluggishness
(Y < YN),
and correspondingly, demand-deficient
unemployment.
• Problem -- wage rate (W) is too high.
• Solution -- allow W to decrease, until N = N*.
When that occurs, simultaneously Y* = YN.
• Example 2 -- accelerating inflation (Y > YN),
and correspondingly, having u < uN.
• Problem -- wage rate (W) is too low.
• Solution -- allow W to increase, until N = N*.
When that occurs, simultaneously Y* = YN.
The Economy in the The ShortRun (Market Failure)
• Example 1 -- sluggishness (Y* < YN), and
correspondingly, demand-deficient unemployment.
• Problem -- W is too high.
• Key -- W does not decrease due to market failure
(e.g. labor contracts).
• Therefore, Y* stays less than YN. Problem persists
without policy.
• Example 2 – overstimulated, accelerating
inflation economy (Y* > YN).
• Problem -- W is too low.
• Key -- W does not increase due to market
failure (e.g. labor contracts).
•
• Therefore, Y* stays greater than YN.
Problem persists without overt policy.
Challenge (2):
Avoiding the Wage-Price Spiral
• Excessive demand policy -- shifts the
AD curve rightward too far , Y* > YN,
accelerates inflation, increases inflation
expectations.
• Labor seeks above-normal increases in
nominal wage rates to protect
themselves, AS curve shifts leftward.
• As a result, Y* returns to previous level,
call for further expansionary policy.
• Process keeps repeating itself.
Avoiding the Wage-Price Spiral
• Use expansionary policy with caution.
Be careful of overshooting where Y*
exceeds YN, don’t arouse inflation
fears.
• Be watchful for nominal wage rate
increases when deciding to use policy.
Avoid expansionary policy if nominal
wage increases are larger than normal.
Challenge (3):
Reacting to Adverse Supply Shocks
• Most dramatic US Experiences -- 1973
and 1978.
• Adverse supply shock -- large increase
in the price of energy (PE), shifts AS
curve leftward.
• As a result, Y* decreases and P*
increases.
• Both represent problems in the
economy.
Reacting to Adverse Supply Shocks Lessons Learned:
• Don’t react -- standard policy will not
help the situation.
• Calls for alternative strategy, such as
energy policy.
• Or wait it out – inherent instability of
cartels.