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Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

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Presentation on theme: "Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin."— Presentation transcript:

1 Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2 Chapter Objectives Alternative perspectives on macroeconomic instability Equation of exchange and monetarism New classical economists and self-correction Rules vs. discretion in conducting stabilization policy 36-2

3 Causes of Macro Instability Mainstream view –Held by most economists Price stickiness Unexpected demand shocks –Variable investment spending Unexpected supply shocks 36-3

4 Monetarist view Government interference is the problem Equation of exchange MV = PQ Stable velocity Monetary causes of instability –Inappropriate monetary policy Causes of Macro Instability 36-4

5 Real-business-cycle view –Shifts in long-run aggregate supply Price Level P1P1 Real Domestic Output Q2Q2 Q1Q1 AD 1 AD 2 AS LR1 AS LR2 Causes of Macro Instability 36-5

6 Coordination failures –Fourth modern view Limited information Expectations and self-fulfilling prophecy Unemployment equilibrium Inflation equilibrium Causes of Macro Instability 36-6

7 Self-Correction New classical view –Rational expectations theory –Monetarists Automatic correction will occur Speed of adjustment Unanticipated price-level changes Fully anticipated price-level changes 36-7

8 New Classical View of Self-Correction AD 2 AD 1 AS 1 AS 2 AS LR Price Level P1P1 P2P2 P3P3 Real Domestic Output Q1Q1 Q2Q2 a b c Self-Correction 36-8

9 New Classical View of Self-Correction AD 3 AD 1 AS 1 AS 3 AS LR Price Level P1P1 P4P4 P5P5 Real Domestic Output Q1Q1 Q4Q4 Q3Q3 a e d f Self-Correction 36-9

10 Mainstream view Downward wage inflexibility Efficiency wage theory –Greater work effort –Lower supervision costs –Reduced job turnover Insider-outsider relationships Self-Correction 36-10

11 Rules or Discretion? In support of policy rules Reduce macro instability Monetary rule –Shift AD to keep up with AS –Price stability achieved Inflation targeting Balanced budget 36-11

12 Rationale for Monetary Rule Price Level P1P1 Real Domestic Output, GDP Q1Q1 Q2Q2 P2P2 AS LR1 AS LR2 AD 1 AD

13 Rules or Discretion? In defense of discretionary stabilization policy Discretionary monetary policy –Velocity is not stable Discretionary fiscal policy –Useful during recession Increased macro stability 36-13

14 The Taylor Rule Rules: passive monetary policy Discretion: active monetary policy Hybrid policy rule to dictate Fed actions Policy responds to changes in real GDP and inflation –Use the interest rate Fed explains deviations from the rule Increase Fed credibility and reduce uncertainty 36-14

15 Key Terms monetarism equation of exchange velocity real-business-cycle theory coordination failures rational expectations theory new classical economics Taylor rule price-level surprises efficiency wage insider-outsider theory monetary rule inflation targeting 36-15

16 Next Chapter Preview… International Trade 36-16


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