©2012 the mcgraw-hill companies, all rights reserved 1 chapter 24: macroeconomic policy
TRANSCRIPT
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Learning Objectives
1.Analyze the effects of anti-inflationary monetary policy
2.Discuss the policy options available to the central bank in response to an aggregate demand shock
3.Discuss the policy options available to the central bank in response to an aggregate supply shock
4.Explain the roles of core rate of inflation, anchored inflationary expectation, and central bank credibility in keeping inflation low
5.Describe how fiscal policy can affect both AD and AS
6.Address the question: why is macroeconomic policy as much an art as a science?
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Using Monetary Policy To Reduce High Inflation: The Short Run
Monetary policy can be used to reduce short-run and long-run inflation
Start at potential output, Y1, and 1 Increase the interest rate
at each level of inflation Shifts AD left to AD2
Recessionary gap and short-run equilibrium at Y2, 2
Cyclical unemploymentoccurs
LRAS
Y 1
AD1
Output (Y)
Infla
tion
()
AS1
1
AD2
Y2
2
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Using Monetary Policy To Reduce High Inflation: The Long Run
Start at short-run equilibrium with a recessionary gap at Y2, and 2
Actual inflation, 2, is below expected inflation of 1
Expected inflation decreases
Lower expected inflation shifts AS to AS2
Economy moves down AD2
New equilibrium at Y1, 3
Short-term pain gets long-term gain
LRAS
Y 1
AD1
Output (Y)
Infla
tion
()
AS1
AD2
1
Y2
2
3
AS2
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Responding to Shocks in Spending
Aggregate demand shifts from either an increase in government spending or other exogenous changes Suppose changes are permanent To maintain expected rate of inflation,
central bank tightens monetary policy Suppose military spending increases
sharply Aggregate demand increases, opening an
expansionary gap Inflation exceeds expectations central bank must decide whether to
maintain monetary policy or fight inflation
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Accommodating Monetary Policy
Accommodating monetary policy allows the effects of a shock to occur When exogenous spending
goes up, the central bank does not change monetary policy
AD shift to AD2 and the economy moves to an expansionary gap at Y2, 2 The central bank holds it MPR and AS shifts to AS2 Economy settles at Y1, 3
LRAS
Output (Y)
1
AD1
Y 1
Infla
tion
()
AS1
3
AD2
Y2
2
AS2
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Maintains Low Inflation After A Change in Spending
The central bank can choose to enforce its inflation target, 1
central bank tightens monetary policy, shifting MPR left
AD shift to AD2 and the economy moves to an expansionary gap at Y2, 2
central bank tightens monetary policy Interest rates increase
more than if the central bank had accommodated the change AD shifts back to AD1
Economy returns to Y1, 1
LRAS
Output (Y)
1
AD1
Y 1
Infla
tion
()
AS1
AD2
Y2
2
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Defending Target Inflation Rate
When aggregate demand increases, the central bank shifts its MPR Each inflation rate is now associated
with a higher interest rate Increase in spending reduces spending
and increases interest rates in the long run
To fight inflation, the central bank raises its interest rates to the new, long-run level
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Responding to Shocks In Aggregate Supply
The economy begins in long-run equilibrium at Y1, 1
Adverse supply shock shifts aggregate supply to AS2 central bank follows its monetary policy rule and
raises interest rates Recessionary gap at Y2
with higher inflation, 2
The central bank must choose Close the recessionary gap Restore target inflation rate
LRAS
Output (Y)
1
AD1
Y 1
Infla
tion
()
AS1
Y2
2
AS2
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Accommodating an Aggregate Supply Shock
Suppose the central bank moves to close the recessionary gap Eases monetary policy, lowering interest
rates at 2 Resets target inflation rate to 3
Lower interest rates stimulate consumption and investment spending
AD shifts to AD2
Long-run equilibrium is nowat Y1 and 3
Aggregate supply shock leadsto higher long-run inflation
LRAS
Output (Y)
1
AD1
Y 1
Infla
tion
()
AS13
Y2
2
AD2
AS2
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Responding to An Aggregate Supply Shock
Suppose the central bank decides to maintain inflation at 1 Inflation is 2, above expected inflation of 1 The central bank raises interest rates Along AS2, expected
inflation is 3 When the central bank fails to respond with looser
monetary policy, expected inflation decreases
AS2 shifts back to AS1 Original long-run equilibrium
is restored
LRAS
Output (Y)
1
AD1
Y 1
Infla
tion
()
AS1
Y2
2
AS2
3
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Anchored Inflation
Anchored inflationary expectations means people's expectations of future inflation do not change even if inflation rises temporarily Inflation anchoring dampens response to an
aggregate supply shock Businesses and consumers believe the
central bank will reestablish its target inflation rate
Shortens the time required to close the recessionary gap from the shock
Encourages central bank to maintain its original inflation target
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An Alternative View Explaining Stability
Structural changes in the economy may have made it more adept at absorbing changes Changes in technology Business practices Better management of inventories Deregulation Shift toward services and away from
manufacturing Increased openness to trade Freer international capital flows
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Oil Price Increases of 2003-2005
Crude oil price was $3 in 1972 $12 at the end of 1974 $35 in 1981
Oil shocks were followed by stagflation Prices fell gradually after 1981, reaching $23
in 2002 Some exceptions to this trend Oil prices increased dramatically beginning in
2002 By late 2004, oil was more than $40 and
reached $65 in August 2005 BUT… oil price shocks of 2003 – 2005 did not
create stagflation
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Oil Price Increases of 2003-2005
One explanation for avoiding stagflation is the changes in the real price of oil While the nominal price was $65 in August
2005, the real price (adjusted for inflation) was below the 1981 price
The 1981 nominal price of $35, adjusted to 2005 prices, would have been $460 in Egypt and $99 in Morocco
Another contributing factor was the legacy of previous oil shocks The 1973 oil shock caused factories that
were energy inefficient to close Factories were ready for higher priced
energy
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Oil Price Increases of 2003-2005
Most economies are less reliant on energy than previously Shift to services from manufacturing Energy efficient homes, appliances, and
vehiclesThe central bank's history of defeating
inflation and sustaining a low target rate of inflation helped avoid stagflation Inflation is more firmly anchored than in
the earlier oil shocks
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Core Rate of Inflation
Core inflation excludes energy and food Shows the effects of a supply shock
separate from the change in the price of the good causing the shock
Food and energy are the most volatile elements of the CPI and most likely to cause a supply shock
Core inflation lets the central bank prevent the inflation from a supply shock from becoming permanent
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Core Rate of Inflation
Central banks in the Middle East and North Africa do not focus on the core rate of inflation.
1. Most of these central banks already face a daunting task in regularly reporting accurate CPI figures.
2. Food and energy represent a large proportion of the CPI basket (e.g., 67 percent in Morocco) and excluding them would not be meaningful.
3. Most of these countries have consistently faced high inflation and have yet to consider setting inflation targets.
A small number of countries, including Tunisia, Morocco, and Egypt, have started reporting their core rate of inflation.
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Inflationary Expectations And Credibility
Credibility of monetary policy is the degree to which the public believes the central bank will defend its target inflation rate The more credible policy is, the more
inflation is anchoredFactors that affect credibility
Degree of central bank's independence The announcements of explicit inflation
targets Established reputation for fighting inflation
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Central Bank’s Independence
Central banks insulated from short-term issues are better able to stabilize the economy
Indicators of independence are Length of appointments to the central bank Whether the central bank's actions are
subject to frequent interference Whether the central bank has obligation to
finance the national deficit The degree to which the central bank's
budget is controlled by the legislative or executive branch
Countries with independent central banks have lower inflation
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Central Bank's Independence
The central bank is a relatively independent central bank Monetary policy is generally in the
central bank's hands The central bank is not obligated to
finance the national debt The central bank is self-funding, largely
through its holdings of different securities
When the central bank has a budget surplus, it returns it to the government
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Announcing Inflation Target
Proponents argue announced target adds to credibility of monetary policy and strengthens anchoring Reduce uncertainty in the financial markets
Some countries use announced targets or a narrow range for inflation These central banks provide additional
economic data to support their target Targets must be consistently met
Announced targets have been successful in industrialized and developing countries Highly successful in Brazil, Chile, Mexico, and
Peru Not very successful in Turkey due to frequent
target revisions
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Zero Inflation Undesirable Target
Zero inflation has several undesirable consequences Imperfect control over inflation mean
periods of deflation are possible Central bank may use negative real
interest rates at times Can only be achieved if nominal rates are less
than inflation, so nominal rates would be negative
Measured inflation overstates actual inflation
A true inflation of zero means measured inflation of about 1%
A small amount of inflation makes labor markets work better
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US Inflation 2002 - 2003
Inflation in September, 2002 was 1.5% -- and falling Federal funds rate was 1.75% Further declines would make monetary policy
difficult to implement if there were an adverse supply shock
Consumption and planned investment respond to real interest rates In September 2002, the real interest rate was
0.25% Additional stimulus might require negative real
interest rates Hard to achieve when inflation is low
Federal funds rate fell to 1.0% by June 2003
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US Inflation 2002 - 2003
Fed has options even at 0% inflation Long-term interest rates are higher than
the federal funds rate If the Fed needed additional stimulus, it could
buy long-term US Treasury securities• Increased demand for bonds increases the price
and lowers the interest rate
Fed is not allowed to buy stocks, but some other central banks are allowed
Fed could commit to a low federal funds rate, stimulating investment spending
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Central Bank Reputation
A central bank's success at stabilizing the economy depends on whether its acts align with its reputation Inflation hawk is committed to achieving
and maintaining low inflation, Accepts some short-run cost in reduced output
and employment Inflation dove is not strongly committed to
achieving and maintaining low inflation Inflation hawks are more successful in
maintaining stable output and employment, even in the short run Stronger anchoring of inflation expectations
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Fiscal Policy Effects
Tax rates reduction increase aggregate spending through the consumption function Shifts aggregate demand to
the right Supply-side effects shift long-
run aggregate supplyWhether inflation increases,
decreases, or stays constantdepends on the relative sizes
of the shifts in AD and LRAS
LRAS1
Output (Y)
1
AD1
Y 1
Infla
tion
()
AD2
LRAS2
Y 2
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Tariq, Single Self-Employed Person's Taxes
Tax and transfer policies also affect potential output by affecting the supply of labor Lower tax rates on earnings may increase
potential output by inducing people to work more hours
A reduction in Tariq’s tax rate from 40 percent to 30 percent increases his after-tax wage from $6 to $7 per hour
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Marginal Tax Rates
Cost – Benefit Principle says individual make labor supply decisions based on the added costs and added benefits of an action Marginal tax rate is the tax rate on an
additional dollar Average tax rate is total taxes divided
by total pre-tax incomeMany taxes are not based on income
Property tax, gasoline tax, sales tax
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Taxes in the MENA
Egypt Total taxes collected in Egypt were about 15.4 percent
of GDP and many of these taxes, such as property taxes, do not depend on income.
The highest marginal tax rate was 20 percent in 2008. Morocco
Total taxes collected in Morocco were about 27.4 percent of GDP in 2008.
The highest marginal tax rate was 42 percent in 2008 (lowered to 38 percent in 2009).
UAE, Qatar, and Saudi Arabia There are no taxes on personal income. These governments rely primarily on oil and natural
gas revenues and to a lesser degree on taxes on profits.
Taxes on profits are estimated at around 14 percent, 11 percent, and 15 percent in the UAE, Qatar, and Saudi Arabia, respectively.
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The Potential Effects of Tax Rate Reductions on Aggregate Demand and
Aggregate Supply
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Americans Work More than Europeans
CountryRelative Hours
Worked (US = 100)Marginal Tax
Rate
Japan 104 37%
US 100 40
UK 88 44
Canada 88 52
Germany 75 59
France 68 59
Italy 64 64
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Americans Work More than Europeans
US average work week is longer US takes fewer vacations and holidays Retire later Less unemployment
Marginal interest rates matter When European marginal rates were
lower, they worked moreOther factors matter
More unionization in Europe Government regulations regarding hours
per week More generous social security systems
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Policymaking: Art or Science?
Economy is complex Actors learn, adapt, and change
Macroeconomic policy works best with Accurate knowledge of current economic
conditions Knowledge of the future path of the
economy without policy Precise value of potential output Good control of fiscal and monetary
policies Knowledge of how and when the economy
will respond to policy changes
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Barriers to Perfect Policies
Policy makers act with an approximate understanding of the economy
Policy is subject to lags The inside lag is the delay between the
time a policy change is needed and the time it is implemented
Shorter for monetary policy than for fiscal policy
The outside lag is the delay between policy implementation and the major effects of the policy occur
Longer for monetary policy than for fiscal policy