Chapter # 13 ECN 101.60 Microeconomics
You are on the economic advisory council for the country of Dystopia. The current economic situation is as follows: Unemployment = 9% on an upward trend Government deficit = $700 billion for 3 consecutive quarters Inflation = 2% Real GDP growth for past year = -3% GDP = $9,000 billion FE = $12,000 billion Describe one appropriate fiscal policy for the current year. What parts of government or institutions are involved in making decisions about this policy?
"If government spending increases, taxes decrease, consumers or investors become more confident, or net exports increase, demand for goods in the economy rises" (chp. 13 p. 294). The tax department of the economy will affect an economy growth. To increase consumption, we need to keep low interest rates and low taxation, so the consumer would feel more purchase power. And for Investors we also need to keep lower interest rate so they can barrow more money for new projects to produce more. We can increase taxes for business (direct and indirect), so that the government has higher revenue for better investment. "Investor and consumer confidence and expectations also have important effects on output and inflation" (chp. 13 p. 298) The fiscal policy decisions are taken by Congress and administration.
Figure 13.18 A New Classical View of Economic Fluctuations
"New Classical" economists suggest that an expansionary move by the Fed, shifting the AD curve to the right, will be accompanied by an increase in inflationary expectations, shifting the AS curve up. The net effect, at E1 , is an increase in inflation with no change in equilibrium output.
A2. The Neoclassical Synthesis and New Keynesian Macroeconomics
(It is a bit confusing that the terms "neoclassical" and "new classical" sound so similar, but they represent two different approaches). In this way of looking at the world, Keynesian theory, which allows for output to vary from its full-employment level, is considered a reasonably good description of how things work in the short and medium run. However, this view holds that, for the reasons set out in the classical model, the economy will tend to return to full employment in the long run
For example, in a severe recession the Fed might decide that the economy requires additional stimulus. If the Fed instituted significant expansionary monetary policies, driving interest rates down
(as it did, for example, starting in 2007), this would, in theory, have the effect of boosting investment and shifting the AD curve to the right. Alternatively, if the Fed decided that its policies on inflation have been too lax, it could tighten monetary policy sharply (this happened, for example, in 1982 in response to severe continuing inflation). This would have the effect of shifting the AD curve to the left. To summarize: • The AD curve indicates levels of equilibrium GDP at different possible rates of inflation. • The AD curve can be shifted by changes in levels of autonomous consumer spending, autonomous investment, fiscal policy, net exports, or by major changes in monetary policy
Consider an economy in equilibrium as depicted in Chapter 13, section 3 of your text. How would the following events change the equilibrium? 1. Raw material prices rise for all firms. AS (increase / decrease / stay the same) AD (increase / decrease / stay the same) Inflation rate (increase / decrease / stay the same) Output (increase / decrease / stay the same)
1. Raw material prices rise for all firms. AS (INCREASE / decrease / stay the same) AD (increase /DECREASE / stay the same) Inflation rate (INCREASE / decrease / stay the same) Output (increase / DECREASE / stay the same)
wage and price controls:
1971 - To curb inflation, President Nixon froze prices, wages, and revenues for 90 days. The government, knowing that such pressures could lead to sharply rising inflation (as shown in the wage-price spiral region of Figure 13.3), kept inflation from getting out of hand by instituting wage and price controls—direct regulations telling firms what they could and could not do in the way of price or wage increases.
Box 13.2 Soft Jobs Data Poses Dilemma for Fed
A disappointing jobs report in September 2013 raised questions about whether the Federal Reserve should continue with its stimulus program, or "taper" its efforts. While the economy continued to add jobs, the rate of growth was slow, and the proportion of Americans either working or looking for work fell to its lowest level since 1978. There were a few bright spots in the report, including a slight increase in the number of hours worked and a 5-cent gain in hourly wages for private sector workers. Over the previous year, average hourly earnings have risen by 52 cents, or 2.2 percent, before adjusting for inflation of about 1.6 percent.
Figure 13.12 The Effect of the Oil Price Shock of the 1970s
A drastic increase in the price of a key resource reduces the economy's total capacity and shifts the AS curve up and to the left. Both inflation and unemployment get worse at equilibrium point E1 .
The strong performance of the macroeconomy in the 1990s inspired economic optimism
A number of commentators wondered whether we were entering a "new economy" in which business cycles would become a thing of the past. Events after 2000 proved otherwise. In 2001-2 the stock
Figure 13.13 The Effects of The Fed's "Tight Money" Policies in the 1980s
A very restrictive monetary policy drives the AD curve sharply to the left, pushing unemployment to very high levels. But a resulting decrease in inflationary expectations shown in aggregate supply curve AS1 lowers inflation and allows the economy to recover to equilibrium point E2 .
3. A new technology is developed which increases worker productivity for all firms. AS (increase / decrease / stay the same) AD (increase / decrease / stay the same) Inflation rate (increase / decrease / stay the same) Output (increase / decrease / stay the same)
AS (increase / decrease / STAY THE SAME AD (INCREASE / decrease / stay the same) Inflation rate (INCREASE / decrease / stay the same) Output (INCREASE / decrease / stay the same)
4. The government increases taxes to slow the economy. AS (increase / decrease / stay the same) AD (increase / decrease / stay the same) Inflation rate (increase / decrease / stay the same) Output (increase / decrease / stay the same)
AS (increase / decrease / STAY THE SAME) AD (increase / DECREASE/ stay the same) Inflation rate (increase / DECREASE / stay the same) Output (INCREASE / decrease / stay the same)
Figure 13.15 Inflation trends 1960-present (Annual Percent Inflation)
After peaking in 1980, inflation fell throughout the 1980s and 1990s, and has remained low. Following the Great Recession it fell briefly to zero, raising concerns about possible deflation. By 2011 it had returned to about 2%, historically a relatively low level.
Figure 13.7 Expansionary Fiscal Policy in Response to a Recession
An expansion of government spending, as well as a program of tax cuts, shifts the AD curve to the right. This reduces unemployment, but since the economy is in the flat portion of the AS curve at equilibrium E1 , it has little effect on inflation.
Figure 13.5 A Beneficial Supply Shock: Expansion of Output Capacity
An expansion of output capacity could be a result of new technology or improved labor productivity
Box 13.1 What Happened to Inflation?
As of mid-2013, inflation in the United States remained sluggish. Prices rose at the slowest pace in at least half a century, up just 1.1 percent over the previous year as of May 2013, according to the Bureau of Economic Analysis. "Inflation has been quiet, and perhaps more important from a central bank perspective, inflationary expectations remain subdued" (Norris, 2013).
How about the effect of this expansionary program on inflation?
As the AS/AD model would lead us to expect, inflation did not rise because the economy did not move beyond the flat portion of the AS curve. Some economists and political commentators warned that such a high level of government spending and deficits would certainly cause serious inflation—but as of late 2013, four years after the initiation of the stimulus program, inflation remained low (See Box 13.1).
Figure 13.3 The Aggregate Supply curve
As the economy approaches its maximum capacity, inflation levels tend to rise as excessive demand for workers, goods and services, and production inputs pushes up wages and prices.
What, according to the classical model, is the effect of aggregate demand management policies?
As we can see in Figure 13.17, expansionary fiscal or monetary policy can have no effect on the output level. Classical economists believe that increased government spending just "crowds out" private spending (as discussed in Chapter 10), in particular spending on investment. Because the economy is already at its full-employment level of Y*, more spending by government just means less spending by consumers and business
2. Capacity and the Aggregate Supply Curve
As we have noted in earlier chapters, increases in AD can push output up toward the full employment level. But what happens when output reaches—or maybe even exceeds—the full-employment level? In a graph such as Figure 13.2, for example, there is nothing in the model that seems to prevent expansionary policies from just shifting the AD curve, and output, up and up and up
1.3 Shifts of the AD Curve: Monetary Policy
As we have noted, the Federal Reserve usually responds to higher inflation by increasing interest rates, and this is reflected in the slope of the AD curve. This kind of policy response, which aims to keep inflation near a target level, is a rather passive sort of monetary policy. A more active form of Fed intervention occurs when the Fed's leaders decide to change policy more fundamentally—either by changing their inflation target or by shifting their focus to fighting unemployment
The high rates of inflation experienced in the late 1970s were very damaging to the economy
As we noted in Chapter 11, high rates of inflation can wipe out the value of people's savings and make it very difficult for households and business to plan, save, and invest. Because unemployment was also high, as shown in Figure 13.12, it was difficult to see how consumers and businesses could ever recover confidence while inflation seemed out of control.
The rationale for this vertical AS curve is as follows
At the full-employment level, people are making their optimizing choices about how much to work, consume, and so on. If for some reason the economy were to produce at less than the full-employment level, the unemployed workers would bid down wages and full employment would be restored. If the economy were to produce at more than its full-employment level, wages would be bid up, and employment would drop back to its full-employment level. Such processes are assumed to work so quickly and smoothly that the economy will return to full employment fairly quickly
The AS curve in Figure 13.3 was drawn for a particular level of expected inflation in the short run
Before people have caught on to the fact that the inflation rate might be changing, their expectations of inflation will continue to reflect their recent experience. The rate of inflation at which the AS curve becomes horizontal is the expected inflation rate. In this model, an economy in recession, or on the horizontal part of the AS curve, will tend in the short run to roll along at pretty much the same inflation rate as it has experienced in the past
Figure 13.16 The Effects of Technological Innovation and Increased Efficiency
Beneficial supply shocks such as improved technology move the AS curve and the economy's maximum capacity to the right, also tending to raise employment and output while lowering inflation levels, as seen in the shifts from E0 to E1 to E2 .
Competing Theories
Conservative Models (original strand is "conserved") Dispersive (original strand is completely broken up) The AS/AD model has given us insight into some of the major macroeconomic fluctuations of the past several decades. But there remains much room for controversy. Was it necessary to enact expansionary fiscal policy in order to get the economy out of the 2007-8 recession? Was it a good idea for the Federal Reserve to lower interest rates to near zero in 2007-13 to try to promote recovery? Economists differ greatly in their views on these issues, and their theoretical backgrounds tend to inform their answers to these and other more contemporary questions. Here we review the ways in which classical and Keynesian economics address these questions. Additional theories—some of which take positions between these two poles—are reviewed in the Appendix to this chapter.
3. Putting the AS/AD Model to Work
Economists invented the AS/AD model to illustrate three points about the macroeconomy: 1. Fiscal and monetary policies affect output and inflation: • Expansionary fiscal and monetary policies tend to push the economy toward higher output. If the economy is approaching its maximum capacity, they will also cause inflation to rise. • Contractionary fiscal and monetary policies tend to push the economy toward lower output. Inflation is unlikely to fall quickly, but a persistent recession will tend to lower inflation over the long term. 2. Supply shocks may also have significant effects: • Adverse supply shocks lower output and raise inflation. • Beneficial supply shocks raise output and lower inflation. 3. Investor and consumer confidence and expectations also have important effects on output and inflation. Bearing these principles in mind, we will see how this model helps to explain some major macroeconomic events.
rational expectations theory:
Economists of the rational expectations school (which originated during the 1970s and 1980s) proposed a theory as to why monetary policy only affects the inflation rate and not output. The basic idea is that people have perfect foresight (i.e., they are perfectly rational), so their decisions already factor in the effects of predictable Fed policy, rendering it ineffective. This model can be explained by using the AS/AD model with a classical-type vertical AS (as shown in Figure 13.17). This vertical AS is interpreted to be the real supply curve for the economy, while in the short term the ordinary, curved AS reflects people's inflationary expectations.
Figure 13.9 Excessively High Aggregate Demand Causes Inflation
Expansionary policy causes the economy to "heat up." In the short run, people respond by increasing output, but tight markets for labor and other resources cause inflation to rise as well at equilibrium point E
2.1 The Aggregate Supply (AS) Curve
Figure 13.3 shows how aggregate supply is related to the rate of inflation. Starting from the right, at high output levels, we can identify four important, distinct regions of the diagram.
3.5 Technology and Globalization
Following the substantial recession and disinflation of the early 1980s, output began to recover again. Fluctuations in unemployment and inflation continued, though within narrower bands than during the earlier years. From 1984 to 2004, unemployment varied from 4 percent to about 8 percent and inflation from 1 percent to about 6 percent; since 1992 inflation has never risen above 4 percent, and briefly fell to zero following the Great Recession (raising concerns about the opposite problem of deflation, as discussed in Chapter 11). Unemployment was low throughout the 1990s, but peaked again at 10% in 2010 following the Great Recession, and then declined only slowly (see Figures 13.14 and 13.15).
Consider an economy in equilibrium as depicted in Chapter 13, section 3 of your text. How would the following events change the equilibrium? 2. Government spending increases due to an impending military incursion. AS (increase / decrease / stay the same) AD (increase / decrease / stay the same) Inflation rate (increase / decrease / stay the same) Output (increase / decrease / stay the same)
Government spending increases due to an impending military incursion. AS (increase /DECREASE/ stay the same) AD (INCREASE / decrease / stay the same) Inflation rate (increase / DECREASE / stay the same) Output (INCREASE/ decrease / stay the same)
This goal (not yet reached as of late 2013) is shown in Figure 13.8.
Here we see that a larger AD shift brings the economy back into the full-employment zone. At this point, the model predicts that there could be at least a slight increase in inflation. Detection of such rising inflation would signal the Fed to cut back on its monetary expansion. Provided any inflation effect remained small, the overall effort could be judged a success
You are on the economic advisory council for the country of Dystopia. The current economic situation is as follows: Unemployment = 9% on an upward trend Government deficit = $700 billion for 3 consecutive quarters Inflation = 2% Real GDP growth for past year = -3% GDP = $9,000 billion FE = $12,000 billion
How would describe this situation (growing, inflationary/ slowing, recessionary)? What do you want to do to the economy? Since unemployed rate is high and inflation rate is low then it means that the economy is operating below its potential level. It may imply a stagnation since government deficit is constant across 3 quarters. We would like to increase the aggregate demand in the economy so that unemployment reduces.
Figure 13.8 A Greater Expansion of Aggregate Demand
If Aggregate Demand increases by a larger amount, it can bring the economy back into the full employment zone. At equilibrium point E1 the AS/AD model indicates the possibility of a slightly higher inflation level.
Figure 13.2 The Effect of Expansionary Fiscal Policy or Increased Confidence on the AD curve
If government spending increases, taxes decrease, consumers or investors become more confident, or net exports increase, demand for goods in the economy rises.
Figure 13.4 The Effect of an Increase in Inflationary Expectations on the Aggregate Supply curve
If people come to expect higher inflation, these expectations get built in to wage and price contracts, leading to a generally higher level of inflation throughout the economy
3.1 An Economy in Recession
In Figure 13.6, we bring together the AS and AD curves for the first time. The (short-run) equilibrium of the economy is shown as point E0 , at the intersection of the two curves. Depending on how we place the curves in the figure, we could illustrate an economy that is in a recession, at full employment, or in a wage-price spiral. (We temporarily omit the maximum capacity line, but we reintroduce it when we discuss inflation.) In this specific case, the fact that E0 is to the left of the full-employment range of output indicates that the economy is in a recession. Private spending, as determined in part by investor and consumer confidence, along with government and foreign sector spending, are not enough to keep the economy at full employment. The fact that the curves intersect on the flat part of the AS curve indicates that inflation (in the short run) is stable. So in this situation unemployment is the major problem. What can be done?
4.1 Classical Macroeconomics
In terms of the AS/AD model, the classical theory implies an AS curve that is quite different from the one that we have been working with, as shown in Figure 13.17. In such an economy, output would always be at its full-employment level (now shown as a distinct value, rather than a range). The AD level would determine the inflation rate, but nothing else.
Figure 13.10 The Phillips Curve in the 1960s
In the 1960s economist A.W. Phillips identified an inverse relationship between inflation and unemployment. While this basic relationship still holds true, events of the 1970s and later showed that inflation can be much more variable than the simple Phillips principle implies
1. New Classical Economics
In the simple classical model presented above, the economy is nearly always at or close to full employment. Faced with the empirical evidence of widely fluctuating output and unemployment rates, some modern-day economists—often called "new classical" economists—have come up with a number of theories that seek to explain how classical theory can be consistent with the observed fluctuations.
2.2 Shifts of the AS Curve: Inflationary Expectations When people have experienced inflation, they come to expect it.
In this way, an expected rate of inflation can start to become institutionally "built in" to an economy. As a first approximation, it is reasonable to assume that people expect something like the level of inflation that they have recently experienced (an assumption that economists call "adaptive expectations"). Thus inflation can be, to some degree, self-fulfilling.
"settling down" of the economy at a full-employment equilibrium.
Keynes did not believe that macroeconomic phenomena could be explained by assuming rational, optimizing behavior by individuals and then extrapolating from models of individual markets to the macroeconomy. Modern Keynesians argue that this inherent tendency toward market instability requires active government intervention and that the alternative—simply waiting for the market to correct itself—risks major economic damage and long-term depression.
You are on the economic advisory council for the country of Dystopia. The current economic situation is as follows: Unemployment = 9% on an upward trend Government deficit = $700 billion for 3 consecutive quarters Inflation = 2% Real GDP growth for past year = -3% GDP = $9,000 billion FE = $12,000 billion Describe one appropriate monetary policy for the current year. What parts of government or institutions are involved in making decisions about this policy?
Monetary policy changes in money supply of the country and interest rates at banks. The Federal can improve the market by reducing an interest rates at the Federal funds rate. This will give a purchase power for consumer and investors. People will less store and spend more. It will increase aggregate demand and increase the production levels of the economy, which may increase GDP, tax revenue. The US Fed Reserve is involved in the making decisions about this policy. In this case the country is Dystopia.
Figure 13.11 Rising Inflationary Expectations and Contractionary Fiscal Policy
Once inflationary expectations increase, they become difficult to reverse. Contractionary fiscal policy raises unemployment at equilibrium point E1, but lowers inflation only slightly
3.2 An Overheated Economy
Problems with inflation were a major issue in the United States starting in the late 1960s. High government spending, in particular spending on the Vietnam war, meant that fiscal policy was excessively expansionary. Monetary policy during this period tended to accommodate the fiscal expansion. Although unemployment was very low as a result, the economy started to "overheat," causing inflation to rise.
What caused this sustained recovery?
Significant advances in innovation—in particular enormous leaps in information technology, including the advent of widespread use of the Internet and information systems for business supplies, deliveries, and product design— provided a major impetus for this period of superior macroeconomic performance. This can be modeled as a period of beneficial supply shocks, as shown in Figure 13.16
Given continued unemployment and low inflation, would more macroeconomic stimulus make sense?
Some economists argued that it would, but proposals for further fiscal stimulus were not acted on by Congress, largely out of fear that deficits were already too high (for more on this debate, see Chapter 16). So the Federal Reserve stepped in with the further monetary stimulus known as "quantitative easing" (as discussed in Chapter 12). The hope was that a combination of this monetary expansion plus recovering confidence on the part of consumers and businesses could lead to a more complete recovery.
Aggregate Demand and Inflation
The AD curve in the Keynesian model used in the previous three chapters was graphed with income on the horizontal axis and output on the vertical axis. We mentioned that if output is above its full-employment level, there may be a threat of rising inflation, but nothing in the figures incorporated this idea. The graphs that we used all measured income, output, and aggregate demand without considering changes in price levels. It is time now to remedy that omission
This period of history is modeled in Figure 13.9
The AD curve moves further to the right due to the increases in government spending. It shifts from AD0 , which at E0 corresponds to a full-employment equilibrium, to AD1 , which crosses the AS curve in the wage-price spiral range. The economy became overheated, moving beyond full employment to E
2.3 Shifts of the AS Curve: Supply Shocks
The AS curve also shifts when the capacity of the economy changes. A supply shock is something that changes the ability of an economy to produce goods and services. Supply shocks can be beneficial, as when there is a bumper crop in agriculture or a new invention allows more goods or services to be made using a smaller quantity of resources. Increases in labor productivity also allow an economy to produce more goods and services.
As discussed earlier, contractionary monetary policy shifts the AD curve to the lef
The AS/ AD model predicts that the immediate effect of this policy will be to send the economy even deeper into a recession, with output falling even farther below its full-employment level, as shown by equilibrium point E1 . But there is a further effect, on inflationary expectations.
Box 13.3 Classical and Keynesian Views of Recession and Recovery
The Great Recession of 2007-9 and its aftermath— a very slow recovery that was still in progress as of 2013, four years after the formal end of the recession—have provided a new arena for the long running debate between classical and Keynesian views in economics
1.2 Shifts of the AD Curve: Spending and Taxation
The downward slope of the AD curve shown in Figure 13.1 is based on the impacts of inflation on aggregate demand. What determines the position of the curve? As discussed in our original Keynesian AD analysis, the position of the AD depends on specific levels of government spending, taxation, autonomous consumption, autonomous investment, and net exports.** Changes in these variables will cause the curve to shift.
When the economy is in recession or recovering slowly from a recession, output is below its full-employment level
The flat AS line shown in Figure 13.3 for this region indicates that, under these conditions, there is assumed to be no tendency for inflation to rise. Because a considerable amount of labor and other resources are unemployed, there is no pressure for higher wages or prices. It is also likely that because wages and prices tend to be slow in adjusting downward, inflation will not fall either—at least not right away
4.2 Keynesian Macroeconomics
The original Keynesian belief was that market economies are inherently unstable. The Keynesian notion of the influence of "animal spirits" on investment refers to the tendency of private decision-makers to become overly optimistic and create booms in investing and production. And the higher the boom, the deeper the crash. Firms that have overextended and overproduced during an upswing need time to regroup, sell off inventory, and so on, before they will be ready to go on the upswing again. Households that have overextended and overspent during a boom also need to regroup and perhaps pay down debt, before they will be willing to restart an optimistic spending bandwagon
You are on the economic advisory council for the country of Dystopia. The current economic situation is as follows: Unemployment = 9% on an upward trend Government deficit = $700 billion for 3 consecutive quarters Inflation = 2% Real GDP growth for past year = -3% GDP = $9,000 billion FE = $12,000 billion What could stall your plans? How long will it be from the time you make your decision until the policies affect the macroeconomy?
The plans could stall by many factors: Less domestic demand for domestic production Less export demand for export production Increase import demand Low GDP per head in households or low purchasing power per individual Small variety or quality of domestic production High dependency ratios Corruption in the economy (black market) Complicated rules for export production Exchange rate fluctuations Time for implementation and effectiveness of policy. Since Dystopia's economy is very dysfunction it will take long time to restore an economy. Technically it takes between 3 quarters up to 2 years or more.
Figure 13.6 Aggregate Demand and Supply Equilibrium in Recession
The position of the AD curve indicates a low level of aggregate demand, leading to an economy with unemployment at equilibrium E0 . At this point on the AS curve, inflationary pressures are low.
Figure 13.1 The Aggregate Demand curve
This analysis shows the impact of different inflation levels on Aggregate Demand. *As defined in Chapter 5, and discussed further in Chapter 14, net exports are exports minus imports, and represent a net addition to aggregate demand and GDP levels. ** The specific role of net exports will be discussed further in Chapter 14.
Just below the maximum capacity level of output, the AS curve has a very steep, positive slope
This indicates that, as an economy closely approaches its maximum capacity, it is likely to experience a substantial increase in inflation. If many employers are all trying to hire many workers and buy a lot of machinery, energy, and materials all at once, workers' wages and resource prices will tend to be bid upward. But then, to cover their labor and other costs, producers will need to raise the prices that they charge for their own goods. Then, in turn, if workers find that the purchasing power of their wages is being eroded by rising inflation, they will demand higher wages . . . which leads to higher prices, and so on
Within the full-employment range, Figure 13.3 shows a gently rising AS relationship
This is because, even well before an economy approaches the absolute maximum capacity given all its resources, producers may tend to run into "bottlenecks" in the supply of some resources. Agricultural workers may be plentiful, for example, but professional and technical workers may be in short supply. Or fuel oil may be plentiful, but there may be a shortage of natural gas. Shortages in the markets for particular kinds of labor and other inputs may lead to an acceleration of inflation in some sectors of the economy. Because the measured inflation rate represents an average for the economy as a whole, some aggregate increase in inflation may be observed.
3.4 A Hard Line Against Inflation
This was still not the end of the inflationary story of the 1970s. Although oil prices held steady and inflation moderated during the period 1975-78, oil prices jumped again in 1979 and 1980. In 1979, the price of oil was ten times higher than it had been in 1973. The overall inflation rate in the United States was more than 9 percent in 1979—and exceeded 10 percent (measured at an annual rate) during some months.
Figure 13.14 Unemployment trends 1960-present (Percentage of Labor Force)
Unemployment peaked in 1982, and again in 2010. Since 2010 unemployment has declined slowly, and was just above 7% at the end of 2013.
A New View of the Aggregate Demand (AD) Curve
We can develop a different approach to aggregate demand by viewing it in a graphical format that compares output to inflation. In this approach, the AD curve shows the effect of inflation on the macroeconomic equilibrium level. To show this graphically, we put inflation on the vertical axis, and output (Y) on the horizontal axis.* This is shown in Figure 13.1. The AD curve shown here differs from the Keynesian AD curve, since it takes into account price changes, but the points on this new curve all correspond to points where the Keynesian AD curve crosses the 45° line. This view of aggregate demand assumes that higher inflation rates will tend to reduce total demand, for several reasons: Aggregate Supply, Aggregate Demand, and Inflation: Putting I t All Together *Some versions of the AD curve use "price level" rather than inflation on the vertical axis. The authors of this text believe that using inflation better represents the reality of an economic system in which prices are rarely constant.
The developments of the early 1970s came as a shock to Phillips-curve-minded economists and policymakers. From 1969 to 1970, unemployment and inflation both rose, and both stayed fairly high through the 1970-73 period. This combination of economic stagnation (recession) and high inflation came to be known as stagflation.
What happened? In 1968, worried about rising inflation, President Lyndon Johnson persuaded Congress to enact an income tax surcharge. In our model, we show this contractionary fiscal policy as a leftward shift of the AD curve in Figure 13.11
This is a hard capacity constraint:
What happens as an economy approaches maximum capacity can be modeled using the aggregate supply (AS) curve. The AS curve shows combinations of output and inflation that can, in fact, occur within an economy, given the reality of capacity constraints
The shaded area to the left of the wage-price spiral region in Figure 13.3 indicates, as it did in the national income equilibrium graphs in Chapters 9 and 10, a range of full-employment levels of output.
While it is controversial to say exactly where that level may be, it can be thought of as an output level high enough that unemployment is not considered a national problem. And because it must be low enough to allow for at least a small measurable level of transitory unemployment, the full-employment level of output is slightly lower than the maximum capacity level of output.
supply shock:
a change in the productive capacity of an economy
3.3 Stagflation stagflation
a combination of rising inflation and economic stagnation
Stagflation
a period of slow economic growth and high unemployment (stagnation) while prices rise (inflation) —a combination of unemployment and inflation—seems to be the worst of both worlds. What policies were used to respond to the stagflation of the late 1970s and early 1980s? What factors led to improving economic conditions in the later 1980s and the 1990s?
New Keynesian macroeconomics:
a school of thought that bases its analysis on micro-level market behavior, but which justifies activist macroeconomic policies by assuming that markets have "imperfections" that can create or prolong recessions
A3. Post-Keynesian Macroeconomics
a school of thought that stresses the importance of history and uncertainty in determining macroeconomic outcome
Inflation also lowers the real money supply
defined as M/P, where M is the nominal money supply and P is the general price level. This has an effect similar to contractionary monetary policy, raising interest rates and discouraging investment
It is important to note that Keynesians
do not only favor expansionary fiscal and monetary policies. They believe that they are needed in case of recession, but under different circumstances, such as the inflationary periods that we have discussed, contractionary policy may be called for. Keynesians thus find the kind of analysis that we have presented in this chapter very useful for determining what type of policy is needed in different circumstances
The Federal Reserve
generally responds to higher inflation by raising interest rates, as discussed in Chapter 12. This also tends to lower investment and total demand
wage and price controls
government regulations setting limits on wages and prices or on the rates at which they are permitted to increase
. The result is a phenomenon called a wage-price spiral
in which pressure to produce very high levels of output leads to a steep rise in self-reinforcing inflation
This sort of increase in inflation that comes with high (but not extremely high) production
is what economists expect to happen when the economy nears a business cycle "peak." Note, however, that the AS curve has been drawn as nearly flat in part of the Y* range, indicating that combinations of full employment and stable inflation may also be possible.
When inflation rises
it reduces the value of money assets. Even if this does not reach the level of hyperinflation discussed in Chapter 11, it hurts savers and people who have money balances. This real wealth effect tends to reduce their consumption, lowering total demand
First, the vertical maximum capacity output
line indicates the hard limit on a macroeconomy's output. Even if every last resource in the economy were put into use, with everybody working flat out to produce the most they could, the economy could not produce to the right of the maximum capacity line
Similarly, in the classical view,
monetary expansions are believed to lead only to increased inflation. As we saw in our discussion of classical monetary theory in Chapter 12, the classical prescription is that the central bank should just choose a certain growth rate of the money supply or level of the interest rate to support and stick to it, without concerning itself about unemployment and output. Classical theory tends to support politically conservative policies that emphasize small government and strict rules on monetary policy. Classical economists would tend to say that the fiscal expansionary policies put into place in 2009 were unnecessary for the purposes of macroeconomic stabilization but that the Volcker contraction of the early 1980s was a good idea.
The traditional model of Keynesian business cycles
must be modified to deal with new events such as supply shocks (discussed above) and sustainability issues (discussed in Chapter 18). These require models that are flexible enough to address new issues as they arise. Such models are best built on the understanding that economies are subject to a variety of forces, many of which can swamp the market equilibrium logic that would be expected to lead to a classical situation of full-employment equilibrium
As defined in Chapter 5, and discussed further in Chapter 14
net exports are exports minus imports, and represent a net addition to aggregate demand and GDP levels
Inflation hurts
net exports by making domestically produced goods more expensive for foreigners and imports more attractive for domestic consumers. This decreases aggregate demand by decreasing net exports.*
In the real world, such steep increases in inflation are usually the result
of dramatic pressures on producers, such as often occur during a national mobilization for war. During World War II, for example, the U.S. government pushed the economy very close to its maximum capacity—placing big orders for munitions and other supplies for the front, mobilizing the necessary resources by encouraging women to enter the paid labor force, encouraging the recycling of materials on an unprecedented scale, encouraging the planting of backyard gardens to increase food production, and in general pushing people's productive efforts far beyond their usual peacetime levels. As a result, unemployment plummeted
Two major responses to the recession
the U.S. fiscal stimulus program of 2009-11 and the Federal Reserve policies of ultra low interest rates and "quantitative easing" to expand the money supply—are right out of the Keynesian playbook of expansionary fiscal and monetary policy. At the same time, policies of "austerity" (drastic spending cutbacks) implemented in many European countries reflect the classical perspective that excessive government spending is a problem, not a solution, and that budget deficits need to be eliminated. Thus the discussion has focused on the relative success or failure of these policies
We can use our AS/AD analysis to focus on one more period:
the expansion of the 1990s. From 1992 to 1998, unemployment rates and inflation rates steadily fell, as shown in Figures 13.14 and 13.15. In 1998, unemployment was 4.4 percent, the lowest it had been since 1965. Inflation was 1.6 percent, lower than it had been in more than 10 years. This was clearly the best macroeconomic performance in decades. Unemployment continued to fall for another two years, reaching 3.9 percent in 2000
maximum capacity output:
the level of output an economy would produce if every resource in the economy were fully utilized
real money supply:
the nominal money supply divided by the general price level (as measured by a price index), expressed as M/P
real wealth effect:
the tendency of consumers to increase or decrease their consumption based on their perceived level of wealth
real business cycle theory
the theory that changes in employment levels are caused by change in technological capacities or people's preferences concerning work
For example, if the government were to undertake expansionary fiscal policy
this would shift the AD curve to the right, as illustrated in Figure 13.2. At any level of inflation, there would now be aggregate demand sufficient to support a higher level of output. Alternatively, if output remained constant, there would be higher levels of inflation.
wage-price spiral:
when high demand for labor and other resources creates upward pressure on wages, which in turn leads to upward pressure on prices and, as a result, further upward pressure on wages
Only tight labor and resource markets caused by a boom will tend to increase inflation
which will come as a surprise to people and will not immediately translate into a change in expectations. For the purposes of this model, you might think of the short run as a period of some weeks or months.
The specific role of net exports
will be discussed further in Chapter 14.
Over an unspecified longer period of time
—the medium run—however, a rise in inflation due to tight markets tends to increase people's expectation of inflation.* If they expect 3 percent inflation but experience 5 percent inflation, the next time that they renegotiate contracts they may build in a 5 percent rate. Figure 13.4 shows how the AS curve shifts upward as people's expectation of inflation rises. Note that the maximum capacity of the economy has not changed— *As distinguished from the long run, discussed in the Appendix.
