1. Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany “Economics: Public and Private Choice 9th ed.” James Gwartney, Richard Stroup, and Russell Sobel Stabilization Policy, Output, and Employment Chapter 15

2. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Economic Fluctuations —The Historical Record

3. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Economic Fluctuation – The Historical Record n Historically, the United States has experienced substantial swings in real output. n Prior to the Second World War, year-to-year changes in real GDP of 5 percent to 10 percent were experienced on several occasions. n During the last five decades, the fluctuations of real output have been more moderate.

4. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. –14 –12 –10 –8 –6 –4 –2 0 2 4 6 8 10 12 14 16 1910192019301940195019601970198019902000 Sources: Historical Statistics of the United States, p. 224; and Economic Report of the President (1999). A nnual % C hange (in real GDP) 1937–1938 Recession Great Depression 1920–1921 Recession Second World War boom First World War boom n Prior to the conclusion of the WWII, the U.S. experienced double-digit increases in real GDP (in 1918, 1922, 1935-1936, and 1941-1943). n In contrast, real output fell by 5% or greater in 1920-1921, 1930-1932, 1938, and 1946. n As illustrated here, fluctuations in real GDP have moderated during the last four decades due, most economist agree, to more appropriate macro policy (particularly monetary policy). Post-Second World War Decline in Economic Instability

5. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. Promoting Economic Stability – Activist and Non-activist Views

6. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Promoting Economic Stability -- Activist and Non-activist Views n Goals of Stabilization Policy: n Activists' Views of Stabilization Policy: u A stable growth of real GDP, u A relatively stable level of prices, u A high level of employment (low unemployment). u The self corrective mechanism works slowly if at all, u Policy-makers will be able to alter macro-policy, injecting stimulus to help pull the economy out of recession and implementing restraint to help control inflation, u According to the activist s view, policy-makers are more likely to keep the economy on track when they are free to apply stimulus or restraint based on forecasting devices and current economic indicators.

7. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Promoting Economic Stability -- Activist and Non-activist Views n Non-activists' Views of Stabilization Policy: u The self-corrective mechanism of markets works pretty well, u Greater stability would result if stable, predictable policies based on predetermined rules were followed, u Non-activists argue that the problems of proper timing and political considerations undermine the effectiveness of discretionary macro policy as a stabilization tool.

8. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. The Application of Discretionary Stabilization Policy

9. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1952195619601964196819721976198019841988199219981996 100 90 80 70 60 a C omposite I ndex of L eading I ndicators (1987 = 100) Source: Conference Board, Business Cycle Indicators. * * * * * 5 30 11 18 11 9 15 8 n Index of Leading Indicators: u Is a composite statistic based on 10 key variables that generally turn down prior to a recession and turn up before the beginning of a business expansion. u The index incorrectly forecasted recession on five occasions ( ). * Index of Leading Indicators u The index can forecast the future and help policy makers, but it is an imperfect forecasting device. u The index forecast the last 8 recessions (the arrows below show how far ahead the index predicted recession) with variable advanced notice.

10. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Application of Discretionary Stabilization Policy n Forecasting Models: n Highly complex statistical models used to improve the accuracy of macro forecasts that use past data from economic relationships to forecast future outcomes and behaviors. n To date, the record of econometric forecasting models has been mixed. u They are accurate when conditions are relatively stable but miss target when things are otherwise. u They also fail when major structural changes occur which change the relationships that their data is based upon.

11. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Application of Discretionary Stabilization Policy n Market Signals and Discretionary Monetary Policy: n Some economists believe that information supplied by certain economic markets can also provide early warning of the need to change policies. n Commodity prices, exchange rates, and other market signals are best used as supplements, rather than substitutes for, other economic indicators and forecasting devices.

12. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. Practical Problems With Discretionary Monetary Policy

13. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Practical Problems With Discretionary Macro Policy n Lags and the Problem of Timing: n Politics and Timing of Policy Changes: u After a change in policy has been undertaken, there will be a time lag before it exerts a major impact. u This means policy makers need to forecast economic conditions several months in the future in order to institute policy changes effectively. u Policy changes may be driven by political considerations rather than stabilization.

14. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. T ime Long-term Growth Rate R eal GDP Path if macro policy is timed improperly n If a forthcoming recession can be recognized quickly and more expansionary policy instituted at pt B... A B C D E F n Beginning with pt A we illustrate the hypothetical business cycle. expansionary policy may add stimulus at pt C and help minimize the magnitude of the downturn. Activists believe that discretionary policy may achieve this outcome. n However, if delays result in the adoption of the expansionary policy at C and if it does not exert its major impact until pt D... the demand stimulus will exacerbate the inflationary boom (as non-activists fear). Time Lags and the Effects of Discretionary Policy n In turn, an anti-inflationary strategy instituted at pt E may exert its primary impact at pt F... resulting in a deepening of the recession that follows. Non-activists believe poor timing of discretionary policy will result in destabilizing effects.

15. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. What is the index of leading indicators? Why is it useful to macro policy makers? Questions for Thought: 2. Why is proper timing of changes in macroeconomic policy crucially important? What are some of the practical problems that limit the effectiveness of discretionary monetary and fiscal policy as stabilization tools?

16. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. How are Expectations Formed? -- Two Theories

17. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How are Expectations Formed? -- Two Theories n Adaptive Expectations: -- individuals form their expectations about the future on the basis of data from the recent past. n Rational Expectations: -- Assumes that people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future.

18. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 12345 12.0 8.0 4.0 0 12.0 8.0 4.0 0 T ime P eriod A ctual R ate of I nflation (percent) E xpected R ate of I nflation (percent) Corresponding expected rate of inflation in next period Actual rate of inflation Adaptive Expectations Hypothesis n According to the adaptive expectations hypothesis, what actually occurs during the most recent period (or set of periods) determines people’s future expectations. n Thus, the expected future rate of inflation lags behind the actual rate by one period as expectations are altered over time. A ctual R ate of I nflation (percent) E xpected R ate of I nflation (percent)

19. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6. How Macro Policy Works -- The Implications of Adaptive and Rational Expectations

20. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How Macro Policy Works – The Implications of Adaptive and Rational Expectations n With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment. n With rational expectations, expansionary policy will not generate a systematic change in output. n Both expectations theories indicate that sustained expansionary policies will lead to inflation without permanently increasing output and employment.

21. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS AD 1 P 1 Y F SRAS 1 Y F E1E1 n Under adaptive expectations, anticipation of inflation will lag behind its actual occurrence. n Thus, a shift to a more expansionary policy would increase aggregate demand (from AD 1 to AD 2 ) and lead to a temporary increase in GDP (from Y F to Y 2 ) accompanied by a modest increase in prices (from P 1 to P 2 ). P 2 Y 2 AD 2 e2e2 Expectations and the Short-run Effects of Demand Stimulus

22. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS AD 1 P 1 Y F SRAS 1 Y F E1E1 n In contrast, under rational expectations, decision makers will quickly anticipate the inflationary impact of a demand-stimulus policy. n Thus, while a shift to a more expansionary policy would increase aggregate demand (from AD 1 to AD 2 ), resource prices and production costs would rise just as rapidly (thereby shifting SRAS to SRAS 2 ). P 2 AD 2 SRAS 2 E2E2 Y F n The net effect of demand-stimulus in the rational expectations model is an increase in prices without altering real output -- even in the short run. Expectations and the Short-run Effects of Demand Stimulus

23. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7. The Emerging Consensus View

24. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Emerging Consensus View n Monetary policy consistent with approximate price stability is the key ingredient of effective stabilization policy. n Sound policy avoids wide policy swings. n Responding to minor economic ups and downs is a mistake.

25. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 8. The Recent Stability of the U.S. Economy

26. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Recent Stability of the U.S. Economy n The objectives of stabilization policy have been less ambitious in recent years. Rather than trying to control output and employment, the focus has shifted to the achievement of price stability. n Movement toward price stability has led to a reduction in economic fluctuations.

27. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 0 35 30 25 20 15 10 5 Sources: R.E. Lipsey and D. Preston, Source Book of Statistics Relating to Construction (1966); & New York: National Bureau of Economic Research 1910–19591960–19821983–1998 32.8 22.8 4.2 Reduction in the Incidence of Recession n The U.S. economy was in recession 32.8% of the time during the 1910-1959 period and 22.8% of the time between 1960-1982. n Since that time, the economy has become even more stable, entering into recession only 4.2% of the time from 1983-1998.

28. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. State the adaptive-expectations hypothesis in your own words. How does the theory of rational expectations differ from that of adaptive expectations? Questions for Thought: 2. Why do you think there has been less economic instability during the last 16 years that any time in American history?

29. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 15