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AD/AS Models and Macro Policy Debates Phillips Curve Adaptive vs. Rational Expectations Policy Impotency Hypothesis Ricardian Equivalence.

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Presentation on theme: "AD/AS Models and Macro Policy Debates Phillips Curve Adaptive vs. Rational Expectations Policy Impotency Hypothesis Ricardian Equivalence."— Presentation transcript:

1 AD/AS Models and Macro Policy Debates Phillips Curve Adaptive vs. Rational Expectations Policy Impotency Hypothesis Ricardian Equivalence

2 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 prominent models of aggregate supply in the short run:  Sticky-price model  Imperfect-information model

3 Introduction  Both models imply: natural rate of output a positive parameter expected price level actual price level agg. output  Other things equal, Y and P are positively related, so the SRAS curve is upward-sloping.

4 The sticky-price model  Reasons for sticky prices:  long-term contracts between firms and customers  menu costs  firms not wishing to annoy customers with frequent price changes  Assumption:  Firms set their own prices (i.e., firms have some market power)

5 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 above firms with sticky prices, must set their price before they know how P and Y will turn out:

6 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…

7 The sticky-price model  Subtract (1  s)P from both sides: price set by flexible price firms price set by sticky price firms  Divide both sides by s :

8 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.

9 The sticky-price model  Finally, derive AS equation by solving for Y :

10 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.

11 Lucas Island Metaphor  Suppose 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. P A = 1 P B = 1 P C = 1 P D = 1 P E = 1 P A = 2

12 Summary & implications Both models of agg. supply imply the relationship summarized by the SRAS curve & equation. Y P LRAS SRAS

13 Summary & implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. Y P LRAS SRAS 1 SRAS equation: AD 1 AD 2 Over time, EP rises, SRAS shifts up, and output returns to its natural rate. SRAS 2

14 Unemployment Rate Inflation Rate The 1960s

15 Inflation, Unemployment, and the Phillips Curve The Phillips curve states that  depends on  expected inflation, E .  cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate  supply shocks, (Greek letter “nu”) where  > 0 is an exogenous constant.

16 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.

17 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 inflation  Then, P.C. becomes

18 Inflation inertia In this form, the Phillips curve implies that inflation has inertia:  In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.  Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.

19 Two causes of rising & falling inflation  cost-push inflation: inflation resulting from supply shocks Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.  demand-pull inflation: inflation resulting from demand shocks Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.

20 Graphing the Phillips curve In the short run, policymakers face a tradeoff between  and u. u  The short-run Phillips curve

21 Unemployment Rate Inflation Rate

22 Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run. u  E.g., an increase in E  shifts the short-run P.C. upward.

23 The sacrifice ratio  To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate.  The sacrifice ratio measures the percentage of a year’s real GDP that must be foregone to reduce inflation by 1 percentage point.  A typical estimate of the ratio is 5.

24 The sacrifice ratio  Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year’s GDP: GDP loss = (inflation reduction) x (sacrifice ratio) = 4 x 5  This 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.

25 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.

26 Painless disinflation?  Proponents of rational expectations believe that the sacrifice ratio may be very small:  Suppose u = u n 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.

27 Calculating the sacrifice ratio for the Volcker disinflation  1981:  = 9.7% 1985:  = 3.0% yearuu nu n uu nuu n %6.0%3.5% Total 9.5% Total disinflation = 6.7%

28 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.

29 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).

30 An alternative hypothesis: Hysteresis  Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.  Negative shocks may increase u n, so economy may not fully recover.

31 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.

32 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. a) Exceeds the b) Falls below the c) Equals the d) Moves to a different

33 The classical dichotomy breaks down for a Phillips curve, which shows the relationship between a nominal variable, _____, and a real variable, _____. a) Output; prices b) Money; output c) Inflation; unemployment d) Unemployment; inflation

34 According to the natural rate hypothesis, fluctuations in aggregate demand affect output in: a) Both the short run and long run b) Only in the short run c) Only in the long run d) In neither the short run nor the long run

35 Stabilization Policy  Should policy be active or passive?  Should policy be by rule or discretion?

36 Growth rate of U.S. real GDP Percent change from 4 quarters earlier Average growth rate

37 Increase in unemployment during recessions peaktrough increase in # of unemployed persons (millions) July 1953May Aug 1957April April 1960February December 1969November November 1973March January 1980July July 1981November July 1990March March 2001November December 2007June

38 Arguments for active policy  Recessions cause economic hardship for millions of people  The Employment Act of 1946  AD/AS model shows how fiscal and monetary policy can respond to shocks and stabilize the economy

39 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 shock  takes time to implement policy, especially fiscal policy outside 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.

40 Automatic stabilizers  Designed to reduce the lags associated with stabilization policy.  Examples:  income tax  unemployment insurance  welfare

41 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. Two ways economists generate forecasts:  Leading economic indicators data series that fluctuate in advance of the economy  Macroeconometric models

42 The LEI index and real GDP, 1990s source of LEI data: The Conference Board

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44 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. Two ways economists generate forecasts:  Leading economic indicators data series that fluctuate in advance of the economy  Macroeconometric models Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policiesmodels

45 Mistakes forecasting the 1982 recession Unemployment rate

46

47 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.

48 The Lucas critique  Due to Robert Lucas who won Nobel Prize in 1995 for rational expectations.  Forecasting the effects of policy changes has often been done using models estimated with historical data.  Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables.

49 Question 2: Should policy be conducted by rule or discretion?

50 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.

51 Arguments for rules 1. Distrust of policymakers and the political process  misinformed politicians  politicians’ interests sometimes not the same as the interests of society 2. The time inconsistency of discretionary policy  Scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement  Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.

52 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.

53 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.

54 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.

55 Monetary policy rules a.Constant money supply growth rate  Advocated by monetarists.  Stabilizes aggregate demand only if velocity is stable.

56 Monetary policy rules b.Target growth rate of nominal GDP  Automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. a.Constant money supply growth rate

57 Monetary policy rules c.Target the inflation rate  Automatically reduce money growth whenever inflation rises above the target rate.  Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. a.Constant money supply growth rate b.Target growth rate of nominal GDP

58 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.

59 Inflation and central bank independence average inflation index of central bank independence

60 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 – T Gov’t Debt = Σ Deficits

61 Indebtedness of the world’s governments Country Gov Debt (% of GDP) Country Gov Debt (% of GDP) Japan173U.K.59 Italy113Netherlands55 Greece101Norway46 Belgium92Sweden45 U.S.A.73Spain44 France73Finland40 Portugal71Ireland33 Germany65Korea33 Canada63Denmark28 Austria63Australia14

62 Ratio of U.S. govt debt to GDP Revolutionary War Civil War WW1 WW2 Iraq War

63 The U.S. experience in recent years Early 1980s through early 1990s  debt-GDP ratio: 25.5% in 1980, 48.9% in 1993  due to Reagan tax cuts, increases in defense spending & entitlements Early 1990s through 2000  $290b deficit in 1992, $236b surplus in 2000  debt-GDP ratio fell to 32.5% in 2000  due to rapid growth, stock market boom, tax hikes

64 The U.S. experience in recent years Early 2000s  the return of huge deficits, due to Bush tax cuts, 2001 recession, Medicare expansion, Iraq war The recession  fall in tax revenues  huge spending increases (bailouts of financial institutions and auto industry, stimulus package)

65 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…

66 U.S. population age 65+, as percent of population age Percent of pop. age actual projected

67 U.S. government spending on Medicare and Social Security, Percent of GDP

68 Projected U.S. federal govt debt in two scenarios, Percent of GDP “Extended baseline scenario” – assumes no changes to current law “Alternative fiscal scenario” incorporates widely-expected changes to current law, such as extension of Bush tax cuts Actual

69 Problems measuring the deficit 1. Inflation 2. Capital assets 3. Uncounted liabilities 4. The business cycle

70 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 =  D  The reported deficit (nominal) is  D even though the real deficit is zero.  Hence, should subtract  D from the reported deficit to correct for inflation.

71 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 billion inflation = 8.6% debt = $495 billion  D =  $495b = $43b real deficit = $28b  $43b = $15b surplus

72 MEASUREMENT PROBLEM 2: Capital Assets  Currently, deficit = change in debt  Better, 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 fall  under 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.

73 MEASUREMENT PROBLEM 3: Uncounted liabilities  Current measure of deficit omits important liabilities of the government:  future pension payments owed to current govt workers  future Social Security payments  contingent liabilities, e.g., covering federally insured deposits when banks fail (Hard to attach a dollar value to contingent liabilities, due to inherent uncertainty.)

74 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?

75 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.

76 The actual and cyclically adjusted U.S. Federal budget surpluses/deficits cyclically- adjusted actual

77 The bottom line We must exercise care when interpreting the reported deficit figures.

78 Is the govt debt really a problem? Consider a tax cut with corresponding increase in the government debt. Two viewpoints: 1. Traditional view 2. Ricardian view

79 The traditional view  Short run:  Y,  u  Long run:  Y and u back at their natural rates  closed economy:  r,  I Crowding Out

80 The Ricardian view  due to David Ricardo (1820), more recently advanced by Robert Barro  According to Ricardian equivalence, a debt-financed tax cut has no effect on C, S, r, I, and Y, even in the short run.

81 The logic of Ricardian Equivalence  Consumers are forward-looking  The tax cut does not make consumers better off, so they do not increase consumption spending Instead, they save the full tax cut in order to repay the future tax liability  Result: Private saving rises by the amount public saving falls, leaving national saving unchanged Problem Set #21

82 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.

83 Evidence For/Against RE  Reagan tax cuts (1980s)  National saving fell, real interest rate rose  Private saving may have fallen for reasons other than the tax cut, such as optimism about the economy  Consumers may have expected the debt to be repaid with future spending cuts instead of future tax hikes  Bush I withholding experiment (1992)  Income tax withholding reduced to stimulate economy  This delayed taxes but didn’t make consumers better off  Almost half of consumers increased consumption Because the data is subject to different interpretations, both views of govt debt survive

84 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 & employment  smooth taxes in the face of fluctuating income  redistribute income across generations when appropriate

85 OTHER PERSPECTIVES: Debt and politics “Fiscal policy is made not by angels…” – Greg Mankiw, p.487  Some 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 taxpayers

86 OTHER PERSPECTIVES: Fiscal effects on monetary policy  Govt deficits may be financed by printing money  A high govt debt may be an incentive for policymakers to create inflation (to reduce real value of debt at expense of bond holders)


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