Presentation on theme: "Introduction In previous models, we assumed the price level P was “stuck” in the short run. This implies a horizontal SRAS curve. Now, we consider two."— Presentation transcript:
0 AD/AS Models and Macro Policy Debates Phillips CurveAdaptive vs. Rational ExpectationsPolicy Impotency HypothesisRicardian Equivalence
1 IntroductionIn previous models, we assumed the price level P was “stuck” in the short run.This implies a horizontal SRAS curve.Now, we consider two prominent models of aggregate supply in the short run:Sticky-price modelImperfect-information model
2 Introduction Both models imply: agg. outputnatural rate of outputexpected price levela positive parameteractual price levelOther things equal, Y and P are positively related, so the SRAS curve is upward-sloping.
3 The sticky-price model Reasons for sticky prices:long-term contracts between firms and customersmenu costsfirms not wishing to annoy customers with frequent price changesAssumption:Firms set their own prices (i.e., firms have some market power)
4 The sticky-price model An individual firm’s desired price is:where a > 0.Suppose two types of firms:firms with flexible prices, set prices as abovefirms with sticky prices, must set their price before they know how P and Y will turn out:
5 The sticky-price model Assume sticky price firms expect that output will equal its natural rate. Then,To derive the aggregate supply curve, first find an expression for the overall price level.s = fraction of firms with sticky prices. Then, we can write the overall price level as…
6 The sticky-price model price set by sticky price firmsprice set by flexible price firmsSubtract (1s)P from both sides:Divide both sides by s :
7 The sticky-price model High EP High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices.High Y High P When income is high, the demand for goods is high. Firms with flexible prices set high prices.The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Y on P.
8 The sticky-price model Finally, derive AS equation by solving for Y :
9 The imperfect-information model Assumptions:All wages and prices are perfectly flexible, so that 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.Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level.Supplier does not know price level at the time she makes her production decision, so uses EP.
10 Lucas Island Metaphor Suppose P rises but EP does not. PB = 1Suppose P rises but EP does not.Supplier A thinks her relative price has risen, so she produces more.With many producers thinking this way, Y will rise whenever P rises above EP.PA = 2PA = 1PD = 1PE = 1PC = 1
11 Summary & implications Figure 13-1, p.386Idiosyncracy alert:If is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here).YPLRASSRASBoth models of agg. supply imply the relationship summarized by the SRAS curve & equation.
12 Summary & implications SRAS equation:Suppose a positive AD shock moves output above its natural rate and P above the level people had expected.SRAS2YPLRASAD2SRAS1AD1Over time, EP rises, SRAS shifts up, and output returns to its natural rate.
14 Inflation, Unemployment, and the Phillips Curve The Phillips curve states that depends onexpected inflation, E.cyclical unemployment: the deviation of the actual rate of unemployment from the natural ratesupply shocks, (Greek letter “nu”)where > 0 is an exogenous constant.
15 Comparing SRAS and the Phillips Curve SRAS curve: Output is related to unexpected movements in the price level.Phillips curve: Unemployment is related to unexpected movements in the inflation rate.
16 Adaptive expectations Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.A simple version: Expected inflation = last year’s actual inflationThen, P.C. becomes
17 Inflation inertiaIn 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.
18 Two causes of rising & falling inflation cost-push inflation: inflation resulting from supply shocksAdverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.demand-pull inflation: inflation resulting from demand shocksPositive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.
19 Graphing the Phillips curve In the short run, policymakers face a tradeoff between and u.uThe short-run Phillips curve
21 Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run.uE.g., an increase in E shifts the short-run P.C. upward.
22 The sacrifice ratioTo 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.A typical estimate of the ratio is 5.
23 The sacrifice ratioExample: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year’s GDP:GDP loss = (inflation reduction) x (sacrifice ratio) = xThis loss could be incurred in one year or spread over several, e.g., 5% loss for each of four years.The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment.
24 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.
25 Painless disinflation? Proponents of rational expectations believe that the sacrifice ratio may be very small:Suppose u = un and = 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 E will fall, perhaps by the full 4 points.Then, can fall without an increase in u.
26 Calculating the sacrifice ratio for the Volcker disinflation 1981: = 9.7%1985: = 3.0%Total disinflation = 6.7%yearuu nuu n19829.5%6.0%3.5%19839.56.03.519847.41.419857.11.1Total 9.5%
27 Calculating the sacrifice ratio for the Volcker disinflation From previous slide: Inflation fell by 6.7%, total cyclical unemployment was 9.5%.Okun’s law: 1% of unemployment = 2% of lost output.So, 9.5% cyclical unemployment = 19.0% of a year’s real GDP.Sacrifice ratio = (lost GDP)/(total disinflation)= 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation.
28 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 the classical model (Chaps. 3-8).
29 An alternative hypothesis: Hysteresis Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.Negative shocks may increase un, so economy may not fully recover.
30 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.
31 Exceeds the Falls below the Equals the Moves to a different Both models of aggregate supply discussed in Chapter 13 imply that if the price level is higher than expected, then output ______ natural rate of output.Exceeds theFalls below theEquals theMoves to a different
32 Inflation; unemployment Unemployment; inflation The classical dichotomy breaks down for a Phillips curve, which shows the relationship between a nominal variable, _____, and a real variable, _____.Output; pricesMoney; outputInflation; unemploymentUnemployment; inflation
33 According to the natural rate hypothesis, fluctuations in aggregate demand affect output in: Both the short run and long runOnly in the short runOnly in the long runIn neither the short run nor the long run
34 Stabilization Policy Should policy be active or passive? Should policy be by rule or discretion?
35 Growth rate of U.S. real GDP Percent change from 4 quarters earlierAverage growth rateThis graph is from Chapter 9. I include it here as it shows that GDP is very volatile. Question 1 asks whether policymakers should attempt to smooth out these fluctuations by using fiscal and monetary policy to alter aggregate demand.The pink shaded vertical bars denote recessions.Source of data: U.S. Department of Commerce.
36 Increase in unemployment during recessions peaktroughincrease in # of unemployed persons (millions)July 1953May 19542.11Aug 1957April 19582.27April 1960February 19611.21December 1969November 19702.01November 1973March 19753.58January 1980July 19801.68July 1981November 19824.08July 1990March 19911.67March 2001November 20011.50December 2007June 20096.14During a recession, many people lose their jobs (the average for the recessions shown in this table is 2.2 million).Advocates for activist policy believe that policymakers should use the fiscal and monetary policy tools at their disposal to try to reduce the length and severity of recessions, or prevent them if possible.As of July 31, 2009, the trough of the recession has not been identified, so I have not included it in the table. However, from the December 2007 peak through June 2009, the number of unemployed persons rose by 7.2 million (from 7.5 million in 12/2007 to 14.7 million in 6/2009). Source: BLS and FRED.Source:Business cycle dates from nber.orgIncrease in unemployment from U.S. Department of Labor, Bureau of Labor Statistics (via FRED, the St Louis Fed’s online database)36
37 Arguments for active policy Recessions cause economic hardship for millions of peopleThe Employment Act of 1946AD/AS model shows how fiscal and monetary policy can respond to shocks and stabilize the economy37
38 Arguments against active policy Policies act with long & variable lags, including:inside lag: the time between the shock and the policy response.takes time to recognize shocktakes time to implement policy, especially fiscal policyoutside lag: the time it takes for policy to affect economy.If conditions change before policy’s impact is felt, the policy may destabilize the economy.38
39 Automatic stabilizers Designed to reduce the lags associated with stabilization policy.Examples:income taxunemployment insurancewelfare39
40 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 economyMacroeconometric models40
41 The LEI index and real GDP, 1990s source of LEI data: The Conference Board41
43 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 economyMacroeconometric models Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policiesThe macroeconometric models are, in many cases, more elaborate versions of the IS-LM-AD-AS model that students learned in the preceding chapters. The parameters of each equation (e.g., the MPC or the interest rate sensitivity of investment) are estimated with real-world data; then, by changing the values of the exogenous variables, or by specifying price shocks or other changes, the macroeconometric models generate forecasts of all the endogenous variables (GDP, interest rates, unemployment, inflation) at various time horizons following the shock or or policy change.43
44 Mistakes forecasting the 1982 recession Unemployment rateThe red line is the actual unemployment rate. Each green line represents the median of 20 forecasts of the unemployment rate at the date shown. The first three forecasts all failed to predict the severity of the recession (each shows unemployment falling after a quarter or two, when in fact the unemployment rate kept rising). The last three forecasts failed to predict the speed of the recovery.Similarly, a consensus of forecasts in November 2007 predicted that U.S. unemployment would rise from 4.7% at the end of 2007 to 5.0% at the end of In May 2008, the consensus forecast was that unemployment would reach 5.5% by the end of These forecasts were far off the mark: unemployment reached 6.7% in the fourth quarter of 2008.The point here is that forecasts are often not accurate, which opponents of activist policy emphasize. And without accurate forecasts, policies that act with uncertain lags may end up destabilizing the economy.44
46 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 economists oppose policy activism.46
47 The Lucas critiqueDue 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.47
48 Should policy be conducted by rule or discretion? Question 2:Should policy be conducted by rule or discretion??48
49 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.49
50 Arguments for rules Distrust of policymakers and the political process misinformed politicianspoliticians’ interests sometimes not the same as the interests of societyThe time inconsistency of discretionary policyScenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcementDestroys policymakers’ credibility, thereby reducing effectiveness of their policies.50
51 Examples of time inconsistency 1. To encourage investment, govt announces it will not tax income from capital.But once the factories are built, govt reneges in order to raise more tax revenue.51
52 Examples of time inconsistency 2. To reduce expected inflation, the central bank announces it will tighten monetary policy.But faced with high unemployment, the central bank may be tempted to cut interest rates.52
53 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.53
54 Monetary policy rules Advocated by monetarists. a. Constant money supply growth rateAdvocated by monetarists.Stabilizes aggregate demand only if velocity is stable.54
55 Monetary policy rules a. Constant money supply growth rate b. Target growth rate of nominal GDPAutomatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target.55
56 Monetary policy rules a. Constant money supply growth rate b. Target growth rate of nominal GDPc. Target the inflation rateAutomatically reduce money growth whenever inflation rises above the target rate.Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion.56
57 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 independence of central bank.57
58 Inflation and central bank independence average inflationThis figure shows a measure of the independence of various countries’ central banks (higher numbers = greater independence). One would expect higher average inflation in countries whose central banks are less independent, as monetary policy could be used for political purposes (e.g., lowering unemployment prior to elections). And the graph shows that this is the case.This graph appears on p.460 of the text as Figure 15-2 , and was originally in Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit, and Banking, May 1993.index of central bank independence58
59 Government Debt and Budget Deficits The size of the U.S. government’s debt, and how it compares to that of other countries.Problems with measuring the budget deficit.How does government debt affect the economy?Deficit = G – TGov’t Debt = Σ Deficits
60 Indebtedness of the world’s governments CountryGov Debt (% of GDP)Japan173U.K.59Italy113Netherlands55Greece101Norway46Belgium92Sweden45U.S.A.73Spain44FranceFinland40Portugal71Ireland33Germany65KoreaCanada63Denmark28AustriaAustralia1460
61 Ratio of U.S. govt debt to GDP Revolutionary WarCivil WarWW1WW2Iraq War61
62 The U.S. experience in recent years Early 1980s through early 1990sdebt-GDP ratio: 25.5% in 1980, 48.9% in 1993due to Reagan tax cuts, increases in defense spending & entitlementsEarly 1990s through 2000$290b deficit in 1992, $236b surplus in 2000debt-GDP ratio fell to 32.5% in 2000due to rapid growth, stock market boom, tax hikes62
63 The U.S. experience in recent years Early 2000sthe return of huge deficits, due to Bush tax cuts, recession, Medicare expansion, Iraq warThe recessionfall in tax revenueshuge spending increases (bailouts of financial institutions and auto industry, stimulus package)63
64 The troubling long-term fiscal outlook The U.S. population is aging.Health care costs are rising.Spending on entitlements like Social Security and Medicare is growing.Deficits and the debt are projected to significantly increase…64
65 U.S. population age 65+, as percent of population age 20-64 actualprojectedPercent of pop. ageSource: U.S. Census Bureau, 2004, "U.S. Interim Projections by Age, Sex, Race, and Hispanic Origin," Table 2a. <http://www.census.gov/ipc/www/usinterimproj/>Source: Congressional Budget Office, “The Long-Term Budget Outlook,” June 2010
66 U.S. government spending on Medicare and Social Security, 1950-2009 Percent of GDPSource:Table 15.5—TOTAL GOVERNMENT EXPENDITURES BY MAJOR CATEGORY OF EXPENDITURE AS PERCENTAGES OF GDP: 1948–2009Historical Tables, Office of Management and Budget
67 Projected U.S. federal govt debt in two scenarios, 2000-2035 “Alternative fiscal scenario” incorporates widely-expected changes to current law, such as extension of Bush tax cutsPercent of GDPSource: The Long-Term Budget Outlook, June 2010Congressional Budget OfficeThe report contains this description of the two scenarios:“The extended-baseline scenario adheres closely to current law. It incorporates CBO's current estimate of the impact of the recently enacted health care legislation on revenues and mandatory spending… Under this scenario, the expiration of most of the tax cuts enacted in 2001 and 2003, the growing reach of the alternative minimum tax, and the way in which the tax system interacts with economic growth would result in steadily higher average tax rates…. At the same time, government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt--activities such as national defense and a wide variety of domestic programs--would decline to the lowest percentage of GDP since before World War II.“…the alternative fiscal scenario…incorporates several changes to current law that are widely expected to occur or that would modify some provisions of law that might be difficult to sustain for a long period….CBO assumed that Medicare's payment rates for physicians would gradually increase…[and] that most of the provisions of the 2001 and 2003 tax cuts would be extended…”“Extended baseline scenario” – assumes no changes to current lawActual
68 Problems measuring the deficit 1. Inflation2. Capital assets3. Uncounted liabilities4. The business cycle68
69 MEASUREMENT PROBLEM 1: Inflation Suppose the real debt is constant, which implies a zero real deficit.In this case, the nominal debt D grows at the rate of inflation:D/D = or D = DThe reported deficit (nominal) is D even though the real deficit is zero.Hence, should subtract D from the reported deficit to correct for inflation.69
70 MEASUREMENT PROBLEM 1: Inflation Correcting the deficit for inflation can make a huge difference, especially when inflation is high.Example: In 1979,nominal deficit = $28 billioninflation = 8.6%debt = $495 billion D = $495b = $43breal deficit = $28b $43b = $15b surplus70
71 MEASUREMENT PROBLEM 2: Capital Assets Currently, deficit = change in debtBetter, capital budgeting: deficit = (change in debt) (change in assets)EX: Suppose govt sells an office building and uses the proceeds to pay down the debt.under current system, deficit would fallunder capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets.Problem w/ cap budgeting: Determining which govt expenditures count as capital expenditures.71
72 MEASUREMENT PROBLEM 3: Uncounted liabilities Current measure of deficit omits important liabilities of the government:future pension payments owed to current govt workersfuture Social Security paymentscontingent liabilities, e.g., covering federally insured deposits when banks fail(Hard to attach a dollar value to contingent liabilities, due to inherent uncertainty.)72
73 MEASUREMENT PROBLEM 4: The business cycle The deficit varies over the business cycle due to automatic stabilizers (unemployment insurance, the income tax system).These are not measurement errors, but do make it harder to judge fiscal policy stance.E.g., is an observed increase in deficit due to a downturn or an expansionary shift in fiscal policy?73
74 MEASUREMENT PROBLEM 4: The business cycle Solution: cyclically adjusted budget deficit (aka “full-employment deficit”) – based on estimates of what govt spending & revenues would be if economy were at the natural rates of output & unemployment.74
75 The actual and cyclically adjusted U. S The actual and cyclically adjusted U.S. Federal budget surpluses/deficitsactualThis graph (not in the textbook) shows the actual and cyclically adjusted budget surpluses, as a percentage of potential GDP, as estimated by the Congressional Budget Office. The pink shaded bars denote recessions. (I exclude the recession because the data shown here start in 1962.)In recessions, we would expect the red line (actual surplus) to fall below the blue line (what the surplus would be if the economy were at potential GDP): Real GDP falls, causing decreases in tax revenues and increases in cyclically-sensitive outlays (such as unemployment insurance).During expansions, we would expect the red line to rise above the blue line.In the data, the relationship between actual and cyclically-adjusted surplus is not perfectly correlated with recession dates.But remember that recession dates are determined by whether GDP growth is positive or negative, while the cyclical adjustment is determined by whether actual GDP is greater than or less than potential GDP. At a trough, a recession ends and GDP begins growing, but it may take a while for actual GDP to catch up to and surpass potential GDP; thus, we shouldn’t be surprised if the red line is below the blue line in the first part of an expansion.Source:Source: Table 3, “Measuring the Effects of the Business Cycle on the Federal Budget,” June 2009Congressional Budget Office; Office of Management and Budget.cyclically-adjusted
76 We must exercise care when interpreting the reported deficit figures. The bottom lineWe must exercise care when interpreting the reported deficit figures.76
77 Is the govt debt really a problem? Consider a tax cut with corresponding increase in the government debt.Two viewpoints:1. Traditional view2. Ricardian view77
78 The traditional view Short run: Y, u Long run: Y and u back at their natural ratesclosed economy: r, ICrowding Out78
79 The Ricardian viewdue to David Ricardo (1820), more recently advanced by Robert BarroAccording to Ricardian equivalence, a debt-financed tax cut has no effect on C, S, r, I, and Y, even in the short run.79
80 The logic of Ricardian Equivalence Consumers are forward-lookingThe tax cut does not make consumers better off, so they do not increase consumption spendingInstead, they save the full tax cut in order to repay the future tax liabilityResult: Private saving rises by the amount public saving falls, leaving national saving unchangedProblem Set #2180
81 Problems with Ricardian Equivalence Myopia: Not all consumers think so far ahead, some see the tax cut as a windfall.Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut.Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.81
82 Evidence For/Against RE Reagan tax cuts (1980s)National saving fell, real interest rate rosePrivate saving may have fallen for reasons other than the tax cut, such as optimism about the economyConsumers may have expected the debt to be repaid with future spending cuts instead of future tax hikesBush I withholding experiment (1992)Income tax withholding reduced to stimulate economyThis delayed taxes but didn’t make consumers better offAlmost half of consumers increased consumptionBecause the data is subject to different interpretations, both views of govt debt survive
83 OTHER PERSPECTIVES: Balanced budgets vs. optimal fiscal policy Some politicians have proposed amending the U.S. Constitution to require balanced federal govt budget every year.Many economists reject this proposal, arguing that deficit should be used to:stabilize output & employmentsmooth taxes in the face of fluctuating incomeredistribute income across generations when appropriate83
84 OTHER PERSPECTIVES: Debt and politics “Fiscal policy is made not by angels…” – Greg Mankiw, p.487Some do not trust policymakers with deficit spending. They argue that:policymakers do not worry about true costs of their spending, since burden falls on future taxpayers84
85 OTHER PERSPECTIVES: Fiscal effects on monetary policy Govt deficits may be financed by printing moneyA high govt debt may be an incentive for policymakers to create inflation (to reduce real value of debt at expense of bond holders)85