chapter 28 can government really stabilize the economy? gottheil — principles of economics, 7e ©...

Chapter 28Chapter 28

CAN GOVERNMENT CAN GOVERNMENT REALLY STABILIZE THE REALLY STABILIZE THE ECONOMY?ECONOMY?

Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1

Economic PrinciplesEconomic Principles

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e2

The classical school of employment and inflation

The Keynesian school of employment and inflation

The neo-Keynesian school of employment and inflation



The rational expectations school of employment and inflation

The supply-side school of employment and inflation



Phillips curve analysis

Automatic stabilizers

The Nature of Economic AdviceThe 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.

Why Does the Economy Why Does the Economy Generate Inflation and Generate Inflation and

UnemploymentUnemployment


Most economists agree that the most demanding macroeconomic issue is economic stability: Why do unemployment and inflation exist, and what should be done about them?


EXHIBIT 1 U.S. RATES OF UNEMPLOYMENT ANDINFLATION, 1970–2007 (percent)

Source: Economic Report of the President, Washington, D.C., 2006. Inflationdata.com, http://inflatiodata.com/inflation/Inflation_Rate/HistoricalInflation.aspx?dsInflation_curre.

Exhibit 1: U.S. Rates of Exhibit 1: U.S. Rates of Unemployment and Inflation, Unemployment and Inflation,

1970–20071970–2007


Exhibit 1 details the years of unemployment and inflation in the United States. What does it show in general?• Moderate successes when compared to the

1930s—when unemployment soared to 25 percent of the labor.




Name the five mainstream schools of economic thought?• Classical• Keynesian

• Neo-Keynesian• Rational

• Expectations • Supply-Side




Stabilization policy• The use of countercyclical monetary and fiscal

policy by the government and the Fed to stabilize the economy.

The Classical SchoolThe 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.



According to the classical school, unemployment is only a temporary phenomenon, caused by wage rates climbing above the equilibrium rate.



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.


EXHIBIT 2 CLASSICAL DETERMINATION OF UNEMPLOYMENT

Exhibit 2: Classical Determination of Exhibit 2: Classical Determination of UnemploymentUnemployment


1. What happens in Exhibit 2 if policy makers establish a $10 minimum wage?

• There will be an excess labor supply (unemployment) of 4,000 workers.



• The equilibrium wage rate is $6.

2. What is the equilibrium wage rate in Exhibit 2, and what is the level of unemployment at the equilibrium wage rate?



2. What is the equilibrium wage rate in Exhibit 2, 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.



1. What is the quantity theory of money equation?

• P = MV/Q



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.



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.



• If the growth rate of M equals the Q growth rate, then the price level remains unchanged.

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?



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 full-employment real GDP.

The Keynesian SchoolThe 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.



Keynesian economics rejects the classical economists’ basic premise concerning competitive markets and flexible prices.


EXHIBIT 3 KEYNESIAN VIEW OF DEMAND AND PRICES IN THE SWIMSUIT MARKET

Exhibit 3: Keynesian View of Demand Exhibit 3: Keynesian View of Demand and Prices in the Swimsuit Marketand 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.


EXHIBIT 4A AGGREGATE DEMAND, GDP, AND EMPLOYMENT


EXHIBIT 4B AGGREGATE DEMAND, GDP, AND EMPLOYMENT

Exhibit 4: Aggregate Demand, Exhibit 4: Aggregate Demand, GDP, and EmploymentGDP, and Employment


• Note that the AD-AS equilibrium in Exhibit 4 occurs at less than full employment.

• If aggregate demand does not change, unemployment is chronic.



1. Why is the Keynesian aggregate supply curve a horizontal line up to the full-employment level of real GDP?

• It reflects the Keynesian view that the price level does not rise as long as there is any unemployment.



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″.



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.



If equilibrium occurs at less than the full-employment output level, Keynesians argue that fiscal policy stimulus should be used to increase aggregate demand.



Keynesian countercyclical policy calls for deficit-spending and expansionary monetary policy during recessions, and surplus budgets and contrac-tionary monetary policy during times of prosperity.

The Neo-Keynesian SchoolThe 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.



Phillips curve

• A graph showing the inverse relationship between the economy’s rate of unemployment and rate of inflation.


EXHIBIT 5 THE PHILLIPS CURVE

Exhibit 5: The Phillips CurveExhibit 5: The Phillips Curve


Economist A. W. Phillips found an inverse relationship between inflation and unemployment after studying data for 1861–1957 in Britain.



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.


EXHIBIT 6 THE NEO-KEYNESIAN AGGREGATE SUPPLY CURVE

Exhibit 6: The Neo-Keynesian Exhibit 6: The Neo-Keynesian Aggregate Supply CurveAggregate 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.

Exhibit 6: The Neo-Keynesian Exhibit 6: The Neo-Keynesian Aggregate Supply CurveAggregate 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.


EXHIBIT 7 THE PHILLIPS CURVE DURING THE 1960s

Exhibit 7: The Phillips Curve Exhibit 7: The Phillips Curve during the 1960sduring 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.



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.



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.



Many economists attribute the stagflation of the 1970s and early 1980s to the OPEC oil price increases, which acted as adverse supply shocks.



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.


EXHIBIT 8 RATES OF INFLATION AND UNEMPLOYMENT: 1970–1990

Exhibit 8: Rates of Inflation and Exhibit 8: Rates of Inflation and Unemployment: 1970–1990Unemployment: 1970–1990


Were the data from 1970–1990 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.


EXHIBIT 9 SHIFTING PHILLIPS CURVES

Exhibit 9: Shifting Phillips CurvesExhibit 9: Shifting Phillips Curves


How did neo-Keynesians manage to make the data from 1970–1990 consistent with the predicted shape of the Phillips curve?• They argued that the 1970–1990 data are

consistent with a Phillips curve that shifts over time.


EXHIBIT 10 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.



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.



In the long run the rate of unemploy-ment 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.

The Rational Expectations SchoolThe 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.

The Rational Expectations SchoolThe 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.


EXHIBIT 11 RATIONAL EXPECTATIONS MODEL

Exhibit 11: Rational Exhibit 11: Rational Expectations ModelExpectations 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.

Exhibit 11: Rational Exhibit 11: Rational Expectations ModelExpectations Model


According to rational expectations theory, why does the Phillips curve fail to hold?• These wage demands erase any short-term

profit that firms would have made. As a result, the unemployment rate remains unchanged, but the rate of inflation increases.

Supply-Side EconomicsSupply-Side Economics


Supply-side economics

• The school of thought that emphasizes the possibility of achieving full employment without inflation.



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.


EXHIBIT 12 THE LAFFER CURVE

Exhibit 12: The Laffer CurveExhibit 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.



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.



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.



To supply-siders, the myriad of government regulations affects almost every industry in the economy, reducing productivity and undermining industrial efficiency.



Crowding out

• A fall in private investment spending caused by an increase in government spending.


EXHIBIT 13 SUPPLY-SIDE EFFECTS ON UNEMPLOYMENT AND INFLATION

Exhibit 13: Supply-Side Effects Exhibit 13: Supply-Side Effects on Unemployment and Inflationon 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.

Exhibit 13: Supply-Side Effects Exhibit 13: Supply-Side Effects on Unemployment and Inflationon 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.

Is There a Macro Consensus?Is There a Macro Consensus?


Real-world events since the 1970s have brought macroeconomists together. Rational-expectations, neo-Keynesian, and classical economists share the same view—even well-intentioned government interference in the economy is not only futile but counterproductive.

.

Automatic StabilizersAutomatic 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.




• Unemployment insurance payments and benefits and the progressive income tax are two such 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.



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.

chapter 28 can government really stabilize the economy? gottheil — principles of economics, 7e ©...

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