Download Can Government Really Stabilize the Economy?

Chapter 28
Can Government Really
Stabilize the Economy?
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Economic Principles
The classical school of
employment and inflation
The Keynesian school of
employment and inflation
The neo-Keynesian school of
employment and inflation
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Economic Principles
The rational expectations
school of employment and
inflation
The supply-side school of
employment and inflation
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Economic Principles
Phillips curve analysis
Automatic stabilizers
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The Nature of Economic Advice
Economists live in a world of
limited information, and so their
analysis leads to different and
sometimes even highly conflicting
conclusions and
recommendations.
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The Classical School
Classical economics
• The school of thought that emphasizes the
natural tendency for an economy to move
toward equilibrium at full employment
without inflation. It argues against
government intervention.
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The Classical School
According to the classical school,
unemployment is only a
temporary phenomenon, caused
by wage rates climbing above the
equilibrium rate.
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The Classical School
Persistently high unemployment,
according to the classical school,
occurs because labor unions and
policy makers interfere with the
competitive process, preventing
wages from reaching equilibrium.
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EXHIBIT 1
CLASSICAL DETERMINATION OF
UNEMPLOYMENT
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Exhibit 1: Classical Determination
of Unemployment
1. What happens in Exhibit 1 if
policy makers establish a $10
minimum wage?
• There will be an excess labor supply
(unemployment) of 4,000 workers.
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Exhibit 1: Classical Determination
of Unemployment
2. What is the equilibrium wage
rate in Exhibit 1, and what is the
level of unemployment at the
equilibrium wage rate?
• The equilibrium wage rate is $6.
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Exhibit 1: Classical Determination
of Unemployment
2. What is the equilibrium wage
rate in Exhibit 1, and what is the
level of unemployment at the
equilibrium wage rate?
• At the equilibrium wage rate of $6 the
quantity of labor demanded equals the
quantity of labor supplied.
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The Classical School
Stabilization policy
• The use of countercyclical monetary and
fiscal policy by the government and the
Fed to stabilize the economy.
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The Classical School
1. What is the quantity theory of
money equation?
• P = MV/Q
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The Classical School
1. What is the quantity theory of
money equation?
• P = MV/Q
• P is the price level, M is the money
supply, V is money velocity, and Q is the
quantity of goods and services produced.
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The Classical School
2. What is the relationship between
the money supply M and the price
level P in the quantity theory of
money equation?
• If resources are fully employed and if
money velocity V is constant, then the
price level P depends on the quantity of
money M.
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The Classical School
3. How does the classical school use the
quantity theory of money equation to
find the money supply growth rate that
is consistent with zero inflation?
• If the growth rate of M equals the Q
growth rate, then the price level remains
unchanged.
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The Classical School
3. How does the classical school use the
quantity theory of money equation to
find the money supply growth rate that
is consistent with zero inflation?
• In this view, inflation occurs when the
annual rate of growth in the money supply
exceeds the annual rate of growth of fullemployment real GDP.
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The Keynesian School
Keynesian economics
• The school of thought that emphasizes the
possibility that an economy can be in
equilibrium at less than full employment
(or with inflation). It argues that with
government intervention, equilibrium at
full employment without inflation can be
achieved by managing aggregate demand.
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The Keynesian School
Keynesian economics rejects the
classical economists’ basic
premise concerning competitive
markets and flexible prices.
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EXHIBIT 2
KEYNESIAN VIEW OF DEMAND AND PRICES
IN THE SWIMSUIT MARKET
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Exhibit 2: Keynesian View of Demand
and Prices in the Swimsuit Market
How does the price of swimsuits
change as demand decreases from
D to D′?
• Price remains at $30 since the swimsuit
supply curve is horizontal.
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EXHIBIT 3A AGGREGATE DEMAND, GDP, AND
EMPLOYMENT
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EXHIBIT 3B AGGREGATE DEMAND, GDP, AND
EMPLOYMENT
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Exhibit 3: Aggregate Demand,
GDP, and Employment
• Note that the AD-AS
equilibrium in Exhibit 3 occurs at
less than full employment.
• If aggregate demand does not
change, unemployment is
chronic.
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Exhibit 3: Aggregate Demand,
GDP, and Employment
1. Why is the Keynesian
aggregate supply curve a
horizontal line up to the fullemployment level of real GDP?
• It reflects the Keynesian view that the
price level does not rise as long as there is
any unemployment.
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Exhibit 3: Aggregate Demand,
GDP, and Employment
2. If aggregate demand increases
from AD′ to AD″ in panel a, what
must occur in panel b?
• The aggregate expenditure curve must
shift upwards from AE′ to AE″.
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Exhibit 3: Aggregate Demand,
GDP, and Employment
2. If aggregate demand increases
from AD′ to AD″ in panel a, what
must occur in panel b?
• The aggregate expenditure curve must
shift upwards from AE′ to AE″.
• The vertical distance between AE′ and
AE″ is the resulting inflationary gap.
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The Keynesian School
If equilibrium occurs at less than
the full-employment output level,
Keynesians argue that fiscal
policy stimulus should be used to
increase aggregate demand.
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The Keynesian School
Keynesian countercyclical policy
calls for deficit-spending and
expansionary monetary policy
during recessions, and surplus
budgets and contractionary
monetary policy during times of
prosperity.
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The Neo-Keynesian School
Traditional Keynesian policy was
ill-prepared for the combination of
high unemployment rates and high
inflation rates (“stagflation”) in the
1970s and early 1980s.
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The Neo-Keynesian School
Phillips curve
• A graph showing the inverse relationship
between the economy’s rate of
unemployment and rate of inflation.
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EXHIBIT 4
THE PHILLIPS CURVE
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Exhibit 4: The Phillips Curve
Economist A.W. Phillips found an
inverse relationship between
inflation and unemployment after
studying data for 1861-1957 in
Britain.
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The Neo-Keynesian School
Neo-Keynesian economics
• The school of thought that emphasizes
the possibility that an economy can be in
equilibrium at less than full employment
with inflation. It argues that by managing
aggregate demand, government can
achieve the most acceptable combination
of unemployment and inflation.
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EXHIBIT 5
THE NEO-KEYNESIAN AGGREGATE
SUPPLY CURVE
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Exhibit 5: The Neo-Keynesian
Aggregate Supply Curve
How does the Phillips curve relate
to the neo-Keynesian aggregate
supply curve?
• Development of the Phillips curve caused
neo-Keynesians to modify the formerly flat
portion of the aggregate supply curve at
output levels below full employment.
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Exhibit 5: The Neo-Keynesian
Aggregate Supply Curve
How does the Phillips curve relate to
the neo-Keynesian aggregate supply
curve?
• The Phillips curve reflects a new
intermediate, upward-sloping segment of
the Keynesian aggregate supply curve up
to the full-employment output level.
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EXHIBIT 6
THE PHILLIPS CURVE DURING THE 1960s
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Exhibit 6: The Phillips Curve
During the 1960s
Were the data from the 1960s
consistent with the predicted shape
of the Phillips curve?
• Yes. Data from the 1960s reveal the
inverse relationship between inflation and
unemployment rates.
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The Neo-Keynesian School
According to the neo-Keynesians,
why does a fall in the rate of
unemployment cause the rate of
inflation to rise?
• During periods of rapid economic growth
when unemployment rates are low, firms
are more likely to accept workers’
demands for higher wages.
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The Neo-Keynesian School
According to the neo-Keynesians,
why does a fall in the rate of
unemployment cause the rate of
inflation to rise?
• That occurs because firms can more
easily pass along higher costs to
consumers in the form of higher prices
during times of economic prosperity.
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The Neo-Keynesian School
Many economists attribute the
stagflation of the 1970s and early
1980s to the OPEC oil price
increases, which acted as adverse
supply shocks.
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The Neo-Keynesian School
The Humphrey-Hawkins Act of
1978 initially identified a 4
percent rate of unemployment
and a 3 percent rate of inflation
as acceptable and reasonable
policy targets.
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EXHIBIT 7 RATES OF INFLATION AND UNEMPLOYMENT:
1970–90
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Exhibit 7: Rates of Inflation and
Unemployment: 1970-90
Were the data from 1970-90
consistent with the predicted shape
of the Phillips curve?
• No. The scatter of points seem to bear no
resemblance to the well-defined Phillips
curve of the 1960s, as shown in Exhibit 6.
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EXHIBIT 8 SHIFTING PHILLIPS CURVES
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Exhibit 8: Shifting Phillips Curves
How did neo-Keynesians manage
to make the data from 1970-90
consistent with the predicted
shape of the Phillips curve?
• They argued that the 1970-90 data are
consistent with a Phillips curve that shifts
over time.
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EXHIBIT 9 SHIFTING PHILLIPS CURVES
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Exhibit 9: Shifting Phillips Curves
According to neo-Keynesian
theory, why do Phillips curves
shift over time?
• Expansionary policy that reduces
unemployment and raises inflation (along a
given Phillips curve) also raises costs and
lowers profit, causing firms to cut
production and employment.
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Exhibit 9: Shifting Phillips Curves
According to neo-Keynesian
theory, why do Phillips curves shift
over time?
• Therefore the unemployment rate
increases at the new, higher rate of
inflation, putting the economy on a new,
higher Phillips curve.
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The Neo-Keynesian School
In the long run the rate of
unemployment remains unchanged
in spite of government stabilization
policy, but the dynamics of the
economic activity that the
government sets in motion generates
accelerating rate of inflation.
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The Rational Expectations School
Rational expectations
• The school of thought that emphasizes
the impossibility of government reducing
the economy’s rate of unemployment by
managing aggregate demand.
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The Rational Expectations School
Rational expectations economists
believe that workers are not only
rational but also smart enough to
learn from experience how best to
overcome the effects of the
government’s fiscal policy.
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EXHIBIT 10 RATIONAL EXPECTATIONS MODEL
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Exhibit 10: Rational
Expectations Model
According to rational expectations
theory, why does the Phillips curve
fail to hold?
• Workers correctly anticipate a higher
rate of inflation from expansionary policy
and demand higher wages.
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Exhibit 10: Rational
Expectations Model
According to rational expectations
theory, why does the Phillips curve
fail to hold?
• These wage demands erase any shortterm profit that firms would have made. As
a result, the unemployment rate remains
unchanged, but the rate of inflation
increases.
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EXHIBIT 11
U.S. RATES OF UNEMPLOYMENT AND
INFLATION: 1992–99
Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000).
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Supply-Side Economics
Supply-side economics
• The school of thought that emphasizes the
possibility of achieving full employment
without inflation.
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Supply-Side Economics
Supply-side economics
• It argues that through tax reductions,
spending cuts, and deregulation, government
creates the proper incentives for the private
sector to increase aggregate supply.
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EXHIBIT 12 THE LAFFER CURVE
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Exhibit 12: The Laffer Curve
According to the Laffer curve, what
happens to total tax revenue if
relatively high tax rates are reduced?
• Reductions in high tax rates increase
after-tax profit, which induces suppliers to
increase aggregate supply, and workers to
work longer.
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Exhibit 12: The Laffer Curve
According to the Laffer curve, what
happens to total tax revenue if
relatively high tax rates are reduced?
• The increase in real GDP is
proportionately larger than the decline
in the tax rate.
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Exhibit 12: The Laffer Curve
According to the Laffer curve, what
happens to total tax revenue if
relatively high tax rates are reduced?
• Consequently, total tax revenues increase
when relatively high tax rates are reduced,
because the high tax rates stifle incentive.
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Supply-Side Economics
To supply-siders, the myriad of
government regulations affects
almost every industry in the
economy, reducing productivity
and undermining industrial
efficiency.
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Supply-Side Economics
Crowding out
• A fall in private investment spending
caused by an increase in government
spending.
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EXHIBIT 13 SUPPLY-SIDE EFFECTS ON UNEMPLOYMENT
AND INFLATION
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Exhibit 13: Supply-Side Effects
on Unemployment and Inflation
According to supply-side
economists, what causes aggregate
supply to increase in Exhibit 13?
• If government reduces its spending, more
investment capital would be made
available at lower rates of interest to
private sector suppliers.
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Exhibit 13: Supply-Side Effects
on Unemployment and Inflation
According to supply-side
economists, what causes aggregate
supply to increase in Exhibit 13?
• Combined with lower tax rates and less
government regulation, lower government
spending shifts the AS curve outward,
reducing prices and increasing output.
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Is There a Consensus?
Real-world events of the 1970s,
1980s, and 1990s have brought
macroeconomists together.
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Automatic Stabilizers
Automatic stabilizers
• Structures in the economy that tend to
add to aggregate demand when the
economy is in recession, and subtract from
aggregate demand when the economy is
inflationary.
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Automatic Stabilizers
Automatic stabilizers
• Unemployment insurance payments and
benefits and the progressive income tax are
two such automatic stabilizers.
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Automatic Stabilizers
How does our personal income tax
structure work to automatically
stabilize the macroeconomy?
• Because the personal income tax is
progressive, as incomes grow, tax revenues
grow even faster, which reduces disposable
income and thus consumption spending.
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Automatic Stabilizers
How does our personal income tax
structure work to automatically
stabilize the macroeconomy?
• During a recession incomes fall, and
income tax revenues fall even faster, which
reduces the decline in disposable income
and thus in consumption spending.
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