Macroeconomics I E_EBE1_MACEC. Prof. dr. Eric Bartelsman March 11, 2019

Macroeconomics I

E_EBE1_MACEC

Prof. dr. Eric Bartelsman

March 11, 2019

AS-AD and Stabilization Policy

•

_{Building the Aggregate Supply Curve}

•

_{Inflation and Unemployment: the role of}

expectations

•

Arguments for and against stabilization policy

•

_{Budget deficits and government debt}

How shocking!!!

• shocks: exogenous changes in agg. supply or demand • Shocks temporarily push the economy away from full

employment.

• Example: exogenous decrease in velocity

If the money supply is held constant, a decrease in V means people will be using their money in fewer

transactions, causing a decrease in demand for goods and services.

P SRAS

LRAS

AD₂

The effects of a negative demand shock

Y P AD₁ Y P₂ Y₂ AD shifts left, depressing output and employment in the short run.

A B

C Over time, prices

fall and the

economy moves down its demand curve toward

Supply shocks

• _{A supply shock alters production costs, affects the prices}

that firms charge. (also called price shocks)

• Examples of adverse supply shocks:

– _{Bad weather reduces crop yields, pushing up}

food prices.

– Workers unionize, negotiate wage increases.

– New environmental regulations require firms to

reduce emissions. Firms charge higher prices to help cover the costs of compliance.

Three models of aggregate supply

1. The sticky-wage model

2. The imperfect-information model 3. The sticky-price model

All three models imply:

(

e

)

Y

=

Y

+

a

P P

-natural rate of output a positive parameter the expected price level the actual price level agg. output

The sticky-wage model

• Assumes that firms and workers negotiate contracts and

fix the nominal wage before they know what the price level will turn out to be.

• The nominal wage they set is the product of a target real

wage and the expected price level:

e

W

=

ω P

´

e

W

_ω

P

P

P

Þ

=

´

Target real wage

The imperfect-information model

Assumptions:

–

All wages and prices are perfectly flexible,

all markets clear.

–

Each supplier produces one good, consumes many

goods.

–

Each supplier knows the nominal price of the good

she produces, but does not know the overall price

level.

The sticky-price model

•

_{Reasons for sticky prices:}

–

long-term contracts between firms and customers

–

menu costs

–

firms not wishing to annoy customers with

frequent price changes

•

Assumption:

–

Firms set their own prices

Summary & implications

Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation. Y P _LRAS Y SRAS ( e) Y Y= +a P P -e P P= e P P> e P P<

Summary & implications

Suppose a positive AD shock moves output above its natural rate and

P above the level

people had expected.

Y P _LRAS SRAS₁ SRAS equation: _{Y Y= +a (P P-} e₎ 1 1 e P = P AD₁ AD₂ 2 e P = 2 P 3 3 e P = P Over time, Pe rises,

SRAS shifts up,

and output returns to its natural rate.

1

Y =Y Y2 3

Y =

Inflation, Unemployment,

and the Phillips Curve

The

Phillips curve

states that

p

depends on

–

expected inflation,

p

e.

–

cyclical unemployment

: the deviation of the actual

rate of unemployment from the natural rate

–

supply shocks,

n

(Greek letter “nu”).

=

-

(

-

)

+

p

p

e

b

_{u u}

n

n

The Phillips Curve and SRAS

•

_{SRAS curve:}

Output is related to

unexpected movements in the price level.

•

_{Phillips curve:}

Unemployment is related to

unexpected movements in the inflation rate.

SRAS:

Y

=

Y

+

a

(

P P

-

e

)

Adaptive expectations

• Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.

• A simple example:

Expected inflation = last year’s actual inflation

1

(

)

n

u u

p

=

p

_-

-

b

-

+

n

1 e

p

=

p

Inflation inertia

In this form, the Phillips curve implies that inflation has inertia:

–

In the absence of supply shocks or cyclical

unemployment, inflation will continue

indefinitely at its current rate.

–

Past inflation influences expectations of current

inflation, which in turn influences the wages &

prices that people set.

1

(

)

n

u u

Two causes of rising & falling inflation

• cost-push inflation:

inflation resulting from supply shocks

Adverse supply shocks typically raise production costs and induce firms to raise prices,

“pushing” inflation up.

• demand-pull inflation:

inflation resulting from demand shocks

Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.

1

(

)

n

u u

Graphing the Phillips curve

In the short run, policymakers face a tradeoff between p and u. u p n u 1 b The short-run Phillips curve e p +n ( ) e _{u u}n p p= - b - + n

Shifting the Phillips curve

People adjust their expectations over time, so the tradeoff only holds in the short run. u p n u 1e p +n ( ) e _{u u}n p p= - b - + n 2e p +n E.g., an increase in pe _{shifts the} short-run P.C. upward.

The sacrifice ratio

•

_{To reduce inflation, policymakers can}

contract agg. demand, causing

unemployment to rise above the natural rate.

•

_The

_{sacrifice ratio}

_measures

the percentage of a year’s real GDP

that must be foregone to reduce inflation

by 1 percentage point.

Rational expectations

Ways of modeling the formation of

expectations:

–

adaptive expectations

:

People base their expectations of future inflation on

recently observed inflation.

–

rational expectations

:

People base their expectations on all available

information, including information about current

and prospective future policies.

Painless disinflation?

•

Proponents of rational expectations believe

that the sacrifice ratio may be very small:

•

_{Suppose u = u}

n

_{and p = p}

e

_{= 6%,}

and suppose the Fed announces that it will

do whatever is necessary to reduce inflation

from 6 to 2 percent as soon as possible.

•

_{If the announcement is credible,}

then p

e

_{will fall, perhaps by the full 4 points.}

The natural rate hypothesis

Our analysis of the costs of disinflation, and of

economic fluctuations in the preceding chapters, is based on the natural rate hypothesis:

Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to

the levels of output, employment, and unemployment described by

An alternative hypothesis: Hysteresis

•

_Hysteresis

_{: the long-lasting influence of}

history on variables such as the natural rate of

unemployment.

•

_{Negative shocks may increase u}

n

_,

Hysteresis: Why negative shocks may

increase the natural rate

• The skills of cyclically unemployed workers may

deteriorate while unemployed, and they may not find a job when the recession ends.

• _{Cyclically unemployed workers may lose} their influence on wage-setting;

then, insiders (employed workers)

may bargain for higher wages for themselves. Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends.

Chapter Summary

1. Three models of aggregate supply in the short run:

– sticky-wage model

– imperfect-information model

– sticky-price model

All three models imply that output rises above its natural rate when the price level rises above the expected price level.

Chapter Summary

2. Phillips curve

– derived from the SRAS curve

– states that inflation depends on

• expected inflation

• cyclical unemployment • supply shocks

– presents policymakers with a short-run tradeoff

between inflation and unemployment

Chapter Summary

3. How people form expectations of inflation

– adaptive expectations

• based on recently observed inflation • implies “inertia”

– rational expectations

• based on all available information

• implies that disinflation may be painless

Chapter Summary

4. The natural rate hypothesis and hysteresis

– the natural rate hypotheses

• states that changes in aggregate demand can only affect

output and employment in the short run

– hysteresis

• states that aggregate demand can have permanent

effects on output and employment

Stabilization Policy

•

_{Should policy be rule-based or discretionary?}

•

_{Discretionary or active policy:}

–

Social costs of unemployment are high

–

AS-AD framework shows policy effects

–

Mandate of CB for ‘price stability’

•

_{Rule-based or passive policy}

–

Inside and outside lags

Keynes vs Real Business Cycle

•

_IS-LM/AD-AS

– Prices are sticky

– _{Money is not neutral}

– Fiscal and Monetary Policy useful for stabilization

•

_RBC

– _{Prices are flexible, markets are perfect}

– Money is neutral

– Fluctuations occur as optimal response of firms and

households to shocks

– Productivity shocks are main source of fluctuations

New Keynesian Economics

•

_{Many economists conclude, based on}

empirical evidence, that short-term

fluctuations of Y and U around natural rate

occur owing to wage and price stickiness.

•

‘New Keynesiaans’ research investigates

micro-founded explanations for such

stickiness. (see chptr 14, AS curve)

Automatic stabilizers

• _definition:

policies that stimulate or depress the economy when necessary without any deliberate policy change.

• Designed to reduce the lags associated with stabilization policy.

• Examples:

–

income tax

–

unemployment insurance

–

welfare

Forecasting the macroeconomy

Because policies act with lags, policymakers must predict future conditions.

Two ways economists generate forecasts:

–

Leading economic indicators

data series that fluctuate in advance of the

economy

–

Macroeconometric models

Large-scale models with estimated parameters

that can be used to forecast the response of

endogenous variables to shocks and policies

Mistakes forecasting the 1982 recession

U ne mp lo yme nt ra te

Forecasting the macroeconomy

Because policies act with lags, policymakers must predict future conditions.

The preceding slides show that the

forecasts are often wrong.

This is one reason why some

The Lucas critique

• Due to Robert Lucas

who won Nobel Prize in 1995 for rational expectations. • Forecasting the effects of policy changes has often

been done using models estimated with historical data. • Lucas pointed out that such predictions would not be

valid if the policy change alters expectations in a way that changes the fundamental relationships between variables.

An example of the Lucas critique

•

_{Prediction (based on past experience):}

An increase in the money growth rate will

reduce unemployment.

•

_{The Lucas critique points out that increasing}

the money growth rate may raise expected

inflation, in which case unemployment would

not necessarily fall.

Rules and discretion:

Basic concepts

•

_{Policy conducted by rule:}

Policymakers announce in advance how

policy will respond in various situations,

and commit themselves to following through.

•

_{Policy conducted by discretion:}

As events occur and circumstances change,

policymakers use their judgment and apply

whatever policies seem appropriate at the

time.

Arguments for rules

1.

Distrust of policymakers and the political

process

–

misinformed politicians

–

politicians interests sometimes not the same as

the interests of society

Arguments for rules

2.

The time inconsistency of discretionary

policy

–

def: A scenario in which policymakers

have an incentive to renege on a

previously announced policy once others have

acted on that announcement.

–

Destroys policymakers credibility, thereby

reducing effectiveness of their policies.

Examples of time inconsistency

1. To encourage investment,

govt announces it will not tax income from capital. But once the factories are built,

Examples of time inconsistency

2. To reduce expected inflation,

the central bank announces it will tighten monetary policy.

But faced with high unemployment,

Examples of time inconsistency

3. Aid is given to poor countries contingent on fiscal

reforms.

The reforms do not occur, but aid is given anyway, because the donor countries do not want the poor countries citizens to starve.

Monetary policy rules

a. Constant money supply growth rate

–

Advocated by monetarists.

–

Stabilizes aggregate demand only if velocity is

stable.

Monetary policy rules

b. Target growth rate of nominal GDP

–

Automatically increase money growth whenever

nominal GDP grows slower than targeted;

decrease money growth when nominal GDP

growth exceeds target.

Monetary policy rules

c. Target the inflation rate

–

Automatically reduce money growth whenever

inflation rises above the target rate.

–

Many countries central banks now practice

inflation targeting, but allow themselves a little

discretion.

a. Constant money supply growth rate b. Target growth rate of nominal GDP

Monetary policy rules

d. The Taylor rule:

Target the federal funds rate based on

§ inflation rate

§ gap between actual & full-employment GDP c. Target the inflation rate

a. Constant money supply growth rate b. Target growth rate of nominal GDP

The Taylor Rule

i

_ff

=

p

+ 2 + 0.5(

p

– 2) – 0.5(GDP gap)

where

i

_ff

= nominal federal funds rate target

GDP gap = 100 x

= percent by which real GDP

is below its natural rate

Y Y

Y

-The Taylor Rule

i

_ff

=

p

+ 2 + 0.5(

p

– 2) – 0.5(GDP gap)

§

If p = 2 and output is at its natural rate, then fed funds rate targeted at 4 percent.

§

For each one-point increase in p,

mon. policy is automatically tightened to raise fed funds rate by 1.5.

§

For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the fed funds rate by 0.5.

The federal funds rate:

Actual and suggested

Pe rc en t 0 2 4 6 8 10 12 1987 1990 1993 1996 1999 2002 2005 Taylor s Rule Actual

Central bank independence

•

_{A policy rule announced by central bank will}

work only if the announcement is credible.

•

_{Credibility depends in part on degree of}

Inflation and central bank independence

(1970s and 1980s)

av er ag e in fla tio n

Chapter Summary

1. Advocates of active policy believe:

– frequent shocks lead to unnecessary fluctuations in output and employment

– fiscal and monetary policy can stabilize the economy

2. Advocates of passive policy believe:

– the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly

destabilizing

– inept policy increases volatility in output, employment

Chapter Summary

3. Advocates of discretionary policy believe:

– discretion gives more flexibility to policymakers in responding to the unexpected

4. Advocates of policy rules believe:

– the political process cannot be trusted: Politicians make policy mistakes or use policy for their own interests

– commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility