Chapter 18 Stabilization in an Integrated World Economy

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Introduction During the Great Recession of the late 2000s, the U.S. unemployment rate jumped to about 10 percent, and the EMU unemployment rate rose above 12 percent Many economists concluded that policymakers could not induce decreases in unemployment rates without generating significantly higher inflation Why did these economists reach this conclusion? Reading this chapter will help you answer this question

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Learning Objectives • Explain why the actual unemployment rate might depart from the natural rate of unemployment • Describe why there may be an inverse relationship between the inflation rate and the unemployment rate, reflected by the Phillips curve • Evaluate how expectations affect the actual relationship between the inflation rate and the unemployment rate 18-3 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Learning Objectives (cont'd) • Understand the rational expectations hypothesis and its implications for economic policymaking • Distinguish among alternative modern approaches to strengthening the case for active policymaking

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Chapter Outline • Active Versus Passive Policymaking • The Natural Rate of Unemployment • Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles • Modern Approaches to Justifying Active Policymaking • Is There a New Keynesian Phillips Curve? • Summing Up: Economic Factors Favoring Active versus Passive Policymaking

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Did You Know That... • Prior to the onset of the Great Recession of the late 2000s, the average length of the recessions since the beginning of the twentieth century was about 15 months? • In recent decades, the average recession has shortened, while the average business expansion has lengthened • Some observers believe that the shorter recessions and longer expansions have resulted from improved monetary and fiscal policymaking 18-6 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Active Versus Passive Policymaking • Active (Discretionary) Policymaking – All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy – Examples • Monetary and fiscal policy

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Active Versus Passive Policymaking (cont'd) • Passive (Nondiscretionary) Policymaking – Policymaking that is carried out in response to a rule – Examples • Monetary rule • Balancing the budget over the business cycle

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The Natural Rate of Unemployment • Two components of the natural rate of unemployment – Frictional unemployment – Structural unemployment

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The Natural Rate of Unemployment (cont’d) • Frictional unemployment – Arises because individuals take the time to search for the best job opportunities – Much of the unemployment is of this type, except when there is a recession or depression

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The Natural Rate of Unemployment (cont'd) • Structural unemployment results from 1. Government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work 2. Union activity that sets wages above the equilibrium level and also restricts the mobility of labor

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The Natural Rate of Unemployment (cont'd) • Natural Rate of Unemployment – The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium – When all workers and employers have fully adjusted to any changes in the economy

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Example: The U.S. Natural Rate of Unemployment • In 1950, the unemployment rate was about 5% • By the late 2000s, it was at this level once again • Figure 18-1 shows that the actual rate of unemployment has varied wildly over the decades • Why does the natural rate of unemployment differ from the actual rate of unemployment? 18-13 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Figure 18-1 Estimated Natural Rate of Unemployment in the United States

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The Natural Rate of Unemployment (cont'd) • Departures from the natural rate of unemployment – Deviations of the actual from the natural rate are called cyclical unemployment. – Deviations observed over the course of nationwide business fluctuations

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Figure 18-2 Impact of an Increase in Aggregate Demand on Real GDP and Unemployment Monetary or fiscal policy leads to increase in AD, and the unemployment rate falls below the natural rate

SRAS shifts, the price level is higher and the unemployment rate rises to the natural rate, real GDP returns to the LRAS level

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Figure 18-3 Impact of a Decline in Aggregate Demand on Real GDP and Unemployment

Monetary or fiscal policy leads to decline in AD and the unemployment rate rises above the natural rate

SRAS shifts, the price level is lower, and the unemployment rate falls to the natural rate, the new equilibrium is reached

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The Natural Rate of Unemployment (cont'd) • The Phillips curve: a rationale for active policymaking? 1. The greater the unexpected increase in aggregate demand, the greater the amount of inflation that results in the short run, and the lower the unemployment rate 2. The greater the unexpected decrease in aggregate demand, the greater the deflation that results in the short run, and the higher the unemployment rate 18-18 Copyright © 2011 Pearson Education, Inc. All rights reserved.

The Natural Rate of Unemployment (cont'd) • The Phillips Curve – A curve showing the relationship between unemployment and changes in wages or prices – It was long thought to reflect a trade-off between unemployment and inflation

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Figure 18-4 The Phillips Curve

The Phillips curve implies a policy trade-off between inflation and unemployment Can policymakers fine-tune the economy?

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The Natural Rate of Unemployment (cont'd) • Nonaccelerating Inflation Rate of Unemployment (NAIRU) – The rate of unemployment below which the rate of inflation tends to rise and above which the rate of inflation tends to fall – The unemployment rate consistent with a steady inflation rate can potentially change during the course of cyclical adjustments – Thus, the NAIRU typically varies by a relatively greater and more frequent amount than the natural rate of unemployment

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Figure 18-5 A Shift in the Phillips Curve

• There is a change in the expected inflation rate • The curve shifts to incorporate new expectations

• PC0 shows expectations at zero inflation • PC5 reflects a higher expected inflation rate, such as 5%

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Policy Example: Will a Higher Minimum Wage Boost the Natural Unemployment Rate and the NAIRU? • The NAIRU depends on the same structural factors that influence the natural rate of unemployment, such as minimum wage laws that set wage floors above equilibrium wage levels in some labor markets • During the 2000s, some cities established their own minimum wage rules, called “living wage laws” • The U.S. Congress raised the U.S. minimum wage in a series of steps from $5.15 per hour in 2006 to $7.25 per hour in 2009 • Such laws resulted in a surplus of labor, or unemployment, in the affected labor markets

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles

• Rational Expectations Hypothesis 1. Individuals base their forecasts (expectations) about the future values of economic variables on all available past and current information 2. These expectations incorporate individuals’ understanding about how the economy operates, including the operation of monetary and fiscal policy

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• New classical approach – A modern version of the classical model in which wages and prices are flexible – There is pure competition in all markets – The rational expectations hypothesis is assumed to be working

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Figure 18-6 Responses to Anticipated and Unanticipated Increases in Aggregate Demand •Short-run equilibrium increases output to Y2 with P2 •Long-run equilibrium after adjustment yields Y1 with P3 •Assume the money supply increases unexpectedly to M2 and AD increases to AD2 18-26 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• The response to anticipated policy – If the increase in the money supply was anticipated • The higher price level would be anticipated • Workers and suppliers would demand higher wages and prices immediately

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• Policy Irrelevance Proposition – The conclusion that policy actions have no real effects in the short run if the policy actions are anticipated and none in the long run even if the policy actions are unanticipated

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• Under the assumption of rational expectations on the part of decision makers in the economy, anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• Regardless of the nature of the anticipated policy, the unemployment rate will equal the natural rate, and real GDP will be determined solely by the economy’s long-run aggregate supply curve

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• Questions – What must people know? – What happens if they don’t know everything? – What are the implications?

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• The policy dilemma – Policy irrelevance proposition seems to suggest only mistakes have real effects – Policymakers powerless to push real GDP and unemployment back to long-run levels when entering recessionary period

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Figure 18-7 Effects of an Unanticipated Rise in Aggregate Demand, Panel (a)

•Even with rational expectations, an unanticipated change in AD can affect real GDP in the short run

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Figure 18-7 Effects of an Unanticipated Rise in Aggregate Demand, Panel (b)

Policy will have no impact on output

•In the long run people will figure out the Fed’s actions and prices will increase and output will return to longrun equilibrium 18-34 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• The distinction between real and monetary shocks – Many economists argue real (as opposed to purely monetary) forces might help explain aggregate economic fluctuations • Real business cycles and aggregate supply shocks produced economic stagnation with high inflation “stagflation”

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Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• Questions regarding real business cycle theory – What impact would an oil shock have on aggregate demand? – Can we explain the Great Depression with the real business cycle theory? – What about the apparent wage and price rigidity within the economy?

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Figure 18-8 Effects of a Reduction in the Supply of Resources •If the reduction in the resource is permanent, the LRAS will also shift •A reduction in the supply of a resource shifts SRAS to the left •The position of LRAS depends on our resource endowments 18-37 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)

• Stagflation – A situation characterized by lower real GDP, lower employment, and a higher unemployment rate during the same period that the rate of inflation increases

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Example: Does the United States Face a Stagflation Threat? • Between 2006 and 2009, the U.S. inflation rate increased from 2.5 percent to nearly 5 percent before dropping suddenly to below 1 percent • During the same interval, the U.S. unemployment rate increased from 4.6 percent to about 10 percent • Does the United States face a renewed threat of persistent stagflation?

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Example: Does the United States Face a Stagflation Threat? (cont’d) • Concern about stagflation are related to slow growth in the nation’s long-run aggregate supply as a result of: – The U.S. Congress has slated an increase in marginal tax rates – The government has significantly raised regulatory burdens on U.S. industries and is contemplating further increases

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Modern Approaches to Justifying Active Policymaking • Market clearing models of the economy may not fully explain business cycles • “Sticky” wages and prices remain important, some economists contend • New Keynesians have tried to refine the theory of aggregate supply

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Modern Approaches to Justifying Active Policymaking (cont'd)

• Small Menu Costs – Costs that deter firms from changing prices in response to demand changes – Examples—the costs of renegotiating contracts or printing new price lists

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Modern Approaches to Rationalizing Active Policymaking (cont'd) • New Keynesian Inflation Dynamics – In new Keynesian theory, the pattern of inflation exhibited by an economy with growing aggregate demand—initial sluggish adjustment of the price level in response to increased aggregate demand followed by higher inflation later

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Figure 18-9 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (a)

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Figure 18-9 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (b)

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Is there a New Keynesian Phillips Curve? • The U.S. experience with the Phillips curve – Economists Milton Friedman and E.S. Phelps published pioneering studies – The apparent trade-off suggested by the Phillips curve could not be exploited by activist policymakers

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Is there a New Keynesian Phillips Curve? (cont'd) • The U.S. experience with the Phillips curve – Attempts to reduce the unemployment rate by inflating the economy would be thwarted by higher inflation expectations – Activist policymaking would be offset; the tradeoff between unemployment and inflation would disappear

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Figure 18-10 The Phillips Curve: Theory versus Data

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Is there a New Keynesian Phillips Curve? (cont’d)

• New Keynesians say all that matters for is whether such a relationship between inflation and unemployment is exploitable in the near term • If so, policymakers can intervene as soon as unemployment and real GDP vary from their long-run levels, thusly dampening cyclical fluctuations and making them short-lived 18-49 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Is there a New Keynesian Phillips Curve? (cont’d) • Two factors that affect inflation: – Anticipated future inflation – Average inflation-adjusted (real) per-unit costs that firms incur in production

• Empirical evidence does indicate that these two factors are associated with higher observed rates of inflation

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Is there a New Keynesian Phillips Curve? (cont’d) • Are New Keynesians correct? – Not all economists agree – The new classical theory already indicates that when prices are flexible, higher inflation expectations should reduce short-run aggregate supply and contribute to increased inflation – All macroeconomic theories suggest that various factors that push up firms’ production costs should have the same effect on short-run aggregate supply and inflation in a flexible-price economy – How often do firms really adjust their prices? 18-51 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Example: Measurement Issues Complicate Assessing the Speed of U.S. Price Adjustment • New Keynesian sticky-price theories focus on how often firms change prices • Economists Carl Gwin and David VanHoose have found that: – Looking at the Producer Price Index instead of the GDP deflator cuts the estimated average price-adjustment interval of U.S. firms by almost 50% to about 9 months – Taking into account variation in real labor costs over time cuts the estimated average price-adjustment interval further to just over 5 months

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Summing Up: Economic Factors Favoring Active versus Passive Policymaking

• Most economists agree that active policymaking is unlikely to exert sizable long-run effects on any nation’s economy • Most agree that aggregate supply shocks contribute to business cycles • Some argue that monetary and fiscal policy actions can offset, at least in the short run and possibly in the long-run the effects that aggregate demand shocks would otherwise have on real GDP and unemployment 18-53 Copyright © 2011 Pearson Education, Inc. All rights reserved.

Table 18-1 Issues That Must Be Assessed in Determining the Desirability of Active versus Passive Policymaking

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Issues and Applications: Are Actual Unemployment Rates or NAIRUs Rising Faster in the United States and Europe?

• Figure 18-11 shows that in both the United States and EMU nations, the actual unemployment rate rose significantly during the Great Recession that began in December 2007, while the NAIRU was also increasing • Why are the U.S. and EMU NAIRUs increasing?

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Figure 18-11 Actual Unemployment Rates and Estimated Nonaccelerating Inflation Rates of Unemployment in the United States and the EMU

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Issues and Applications: Are Actual Unemployment Rates or NAIRUs Rising Faster in the United States and Europe? (cont’d)

• One explanation for the rising NAIRUs focuses on cyclical factors: – Part of a nation’s capital stock fell into disuse while some people who lost their jobs must enter into a period of retraining before returning to the workforce

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Issues and Applications: Are Actual Unemployment Rates or NAIRUs Rising Faster in the United States and Europe? (cont’d)

• Another explanation for the rising NAIRUs focuses on structural factors: – Heavy regulations on product and labor markets in European nations and new regulations in the U.S. depressed long-run aggregate supply and then employment

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Summary Discussion of Learning Objectives • Why the actual unemployment rate might depart from the natural rate of unemployment – Unanticipated changes in aggregate demand

• Philips curve – A curve showing an inverse relationship between the rate of inflation and the rate of unemployment

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Summary Discussion of Learning Objectives (cont'd) • How expectations affect the actual relationship between the inflation rate and the unemployment rate – Theory predicts that there will be a Phillips curve relationship only when expectations are unchanged – The Phillips curve shifts

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Summary Discussion of Learning Objectives (cont'd) • Rational expectations, policy ineffectiveness, and real-business-cycle theory – Rational expectations hypothesis – Only unanticipated policy actions affect short-run real GDP – Policy irrelevance theorem – Technological changes and labor market shocks can induce business fluctuations, called real business cycles, which weaken the case for active policymaking

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Summary Discussion of Learning Objectives (cont'd) • Modern approaches to bolstering the case for active policymaking – New Keynesian approach suggests that firms facing costs of adjusting their prices may be slow to change in the face of variations in demand – Prices and wages are sufficiently inflexible in the short run that there is an exploitable relationship between inflation and real GDP – Discretionary policy actions can stabilize real GDP in the short run

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