1. Copyright © 2002 by Thomson Learning, Inc. to accompany Exploring Economics 3 rd Edition by Robert L. Sexton Copyright © 2005 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, 3 rd Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-324-26086-5 A Lecture Presentation

2. Copyright © 2002 by Thomson Learning, Inc. Issues in Macroeconomic Theory and Policy Chapter 25

3. Copyright © 2002 by Thomson Learning, Inc. 25.1 The Phillips Curve Periods of high unemployment still occur despite legislation committing the federal government to the goal of full employment and the development of macroeconomic theory purporting to show that full employment can be achieved by manipulating aggregate demand. Periods of high unemployment still occur despite legislation committing the federal government to the goal of full employment and the development of macroeconomic theory purporting to show that full employment can be achieved by manipulating aggregate demand.

4. Copyright © 2002 by Thomson Learning, Inc. Unemployment and Inflation Similarly, price stability, which had been achieved for long periods before the 1930s, has not been consistently observed since that time. Similarly, price stability, which had been achieved for long periods before the 1930s, has not been consistently observed since that time. In every year in the lifetimes of most students enrolled in this course, the general level of prices has risen. In every year in the lifetimes of most students enrolled in this course, the general level of prices has risen.

5. Copyright © 2002 by Thomson Learning, Inc. We usually think of inflation as an evil. We usually think of inflation as an evil. But some economists believe that inflation could actually help eliminate unemployment in the short run. But some economists believe that inflation could actually help eliminate unemployment in the short run.

6. Copyright © 2002 by Thomson Learning, Inc. If output prices rise but money wages do not go up as quickly or as much, real wages fall. If output prices rise but money wages do not go up as quickly or as much, real wages fall. At the lower real wage, unemployment is less because the lower wage makes it profitable to hire more, now cheaper, employees than before. At the lower real wage, unemployment is less because the lower wage makes it profitable to hire more, now cheaper, employees than before. Hence, with increased inflation, one might expect lower unemployment in the short run. Hence, with increased inflation, one might expect lower unemployment in the short run.

7. Copyright © 2002 by Thomson Learning, Inc. The Phillips Curve An inverse relationship between the rate of unemployment and the changing level of prices has been observed in many periods and places in history. An inverse relationship between the rate of unemployment and the changing level of prices has been observed in many periods and places in history. Credit for identifying this relationship generally goes to British economist A.H. Phillips. Credit for identifying this relationship generally goes to British economist A.H. Phillips. In the late 1950s he published a paper setting forth what has since been called the Phillips curve. In the late 1950s he published a paper setting forth what has since been called the Phillips curve.

8. Copyright © 2002 by Thomson Learning, Inc. Phillips, and many others since, have suggested that Phillips, and many others since, have suggested that at higher rates of inflation, the rate of unemployment is lower, at higher rates of inflation, the rate of unemployment is lower, while during periods of relatively or falling stable prices, there is substantial unemployment. while during periods of relatively or falling stable prices, there is substantial unemployment. The cost of lower unemployment appears to be greater inflation, and the cost of greater price stability appears to be higher unemployment. The cost of lower unemployment appears to be greater inflation, and the cost of greater price stability appears to be higher unemployment.

9. Copyright © 2002 by Thomson Learning, Inc. The actual inflation-unemployment relationship for the United States for the 1960s is shown in the next slide. The actual inflation-unemployment relationship for the United States for the 1960s is shown in the next slide. U.S. Phillips curve U.S. Phillips curve The curved line is the smooth line that best “fits” the data points. The curved line is the smooth line that best “fits” the data points.

10. Copyright © 2002 by Thomson Learning, Inc.

11. The Slope of the Phillips Curve It shows an inverse relationship between the rate of unemployment and the rate of inflation. It shows an inverse relationship between the rate of unemployment and the rate of inflation. The Phillips curve is steeper at higher rates of inflation and lower levels of unemployment. The Phillips curve is steeper at higher rates of inflation and lower levels of unemployment.

12. Copyright © 2002 by Thomson Learning, Inc. This suggests that once the economy has relatively low unemployment rates, further reductions in the unemployment rate can occur only by accepting larger increases in the inflation rate. This suggests that once the economy has relatively low unemployment rates, further reductions in the unemployment rate can occur only by accepting larger increases in the inflation rate. Once unemployment is low, it takes larger and larger doses of inflation to eliminate a given quantity of unemployment. Once unemployment is low, it takes larger and larger doses of inflation to eliminate a given quantity of unemployment.

13. Copyright © 2002 by Thomson Learning, Inc. Presumably, at lower unemployment rates, an increased part of the economy is already operating at or near full capacity, and further fiscal or monetary stimulus primarily triggers Presumably, at lower unemployment rates, an increased part of the economy is already operating at or near full capacity, and further fiscal or monetary stimulus primarily triggers inflationary pressures in sectors already at capacity, inflationary pressures in sectors already at capacity, while eliminating decreasing amounts of unemployment in those sectors where some excess capacity and unemployment still exist. while eliminating decreasing amounts of unemployment in those sectors where some excess capacity and unemployment still exist.

14. Copyright © 2002 by Thomson Learning, Inc. The Phillips Curve and Aggregate Supply and Demand The relationship between AS and AD analysis and the Phillips curve The relationship between AS and AD analysis and the Phillips curve Increased annual inflation lowering unemployment is a move up along the Phillips curve. Increased annual inflation lowering unemployment is a move up along the Phillips curve. We can see the same relationship in AD/AS model, as a result of an AD shift. We can see the same relationship in AD/AS model, as a result of an AD shift. Increasing AD, moving up along an upward-sloping, short-run AS curve, increases the price level and real output. Increasing AD, moving up along an upward-sloping, short-run AS curve, increases the price level and real output. To increase real output, firms employ more workers, so employment increases and unemployment falls. To increase real output, firms employ more workers, so employment increases and unemployment falls.

15. Copyright © 2002 by Thomson Learning, Inc.

16. 25.2 The Phillips Curve Over Time In the 1960s it became widely accepted that policy makers merely had to decide on the combination of unemployment and inflation they wanted from the Phillips curve and then simply pursue the appropriate economic policies. In the 1960s it became widely accepted that policy makers merely had to decide on the combination of unemployment and inflation they wanted from the Phillips curve and then simply pursue the appropriate economic policies.

17. Copyright © 2002 by Thomson Learning, Inc. The Phillips Curve—The 1960s A reduction in the rate of unemployment came at a cost (more inflation) as did a reduction in the amount of inflation (more unemployment). A reduction in the rate of unemployment came at a cost (more inflation) as did a reduction in the amount of inflation (more unemployment). Nonetheless, policy makers believed they could influence economic activity in a manner in which some goal could be met, though with a trade-off in terms of other macroeconomic goals. Nonetheless, policy makers believed they could influence economic activity in a manner in which some goal could be met, though with a trade-off in terms of other macroeconomic goals.

18. Copyright © 2002 by Thomson Learning, Inc. At first the empirical evidence on prices and unemployment fit the Phillips curve approach so beautifully that it is not surprising that it was embraced so rapidly and completely. At first the empirical evidence on prices and unemployment fit the Phillips curve approach so beautifully that it is not surprising that it was embraced so rapidly and completely.

19. Copyright © 2002 by Thomson Learning, Inc. Economists like Milton Friedman and Edmund Phelps, who questioned the long-term validity of the Phillips curve, were largely ignored in the 1960s. Economists like Milton Friedman and Edmund Phelps, who questioned the long-term validity of the Phillips curve, were largely ignored in the 1960s.

20. Copyright © 2002 by Thomson Learning, Inc. These economists believed there might be a short-term trade-off between unemployment and inflation, but not a permanent trade-off. These economists believed there might be a short-term trade-off between unemployment and inflation, but not a permanent trade-off. According to Friedman, the short-run trade-off comes from unanticipated inflation. According to Friedman, the short-run trade-off comes from unanticipated inflation.

21. Copyright © 2002 by Thomson Learning, Inc. Is The Phillips Curve Stable? In the 1970s (and 1980s and 1990s), economists recognized that macroeconomic decision making was not as simple as picking a point on the Phillips curve. In the 1970s (and 1980s and 1990s), economists recognized that macroeconomic decision making was not as simple as picking a point on the Phillips curve. The data from the 1970s showed the Phillips curve started to break down. The data from the 1970s showed the Phillips curve started to break down.

22. Copyright © 2002 by Thomson Learning, Inc. From 1974 through 1996, every data point was to the right of the 1960s Phillips curve, meaning a worsening trade-off between inflation and unemployment. From 1974 through 1996, every data point was to the right of the 1960s Phillips curve, meaning a worsening trade-off between inflation and unemployment.

23. Copyright © 2002 by Thomson Learning, Inc. The 1970s experienced more of both inflation and unemployment than existed in the 1960s. The 1970s experienced more of both inflation and unemployment than existed in the 1960s. However, in the 1980s, the Fed followed a very tight monetary policy to combat high inflation rates. However, in the 1980s, the Fed followed a very tight monetary policy to combat high inflation rates.

24. Copyright © 2002 by Thomson Learning, Inc. People altered their expectations of inflation downward. People altered their expectations of inflation downward. In the mid-1990s, when lower inflation was achieved and expected, the Phillips curve shifted inward, back to the level of the 1960s. In the mid-1990s, when lower inflation was achieved and expected, the Phillips curve shifted inward, back to the level of the 1960s.

25. Copyright © 2002 by Thomson Learning, Inc.

26. The Short-Run Phillips Curve Versus The Long-Run Phillips Curve The natural rate hypothesis states that the economy will self-correct to the natural rate of unemployment. The natural rate hypothesis states that the economy will self-correct to the natural rate of unemployment.

27. Copyright © 2002 by Thomson Learning, Inc. The long-run Phillips curve shows the relationship between the inflation rate and the unemployment rate when the actual and expected inflation rates are the same. The long-run Phillips curve shows the relationship between the inflation rate and the unemployment rate when the actual and expected inflation rates are the same. The long-run Phillips curve is vertical at the natural rate of unemployment. The long-run Phillips curve is vertical at the natural rate of unemployment. This is equivalent to the vertical long- run AS curve. This is equivalent to the vertical long- run AS curve.

28. Copyright © 2002 by Thomson Learning, Inc. Along the long-run Phillips curve we see that the natural rate of unemployment can occur at any rate of inflation. Along the long-run Phillips curve we see that the natural rate of unemployment can occur at any rate of inflation. That is, regardless of fiscal and monetary stimulus, output and employment will be at their natural rate in the long run. That is, regardless of fiscal and monetary stimulus, output and employment will be at their natural rate in the long run.

29. Copyright © 2002 by Thomson Learning, Inc. Starting from the natural rate of unemployment, suppose that the growth rate of the money supply increases. Starting from the natural rate of unemployment, suppose that the growth rate of the money supply increases. If it is unanticipated, it will stimulate aggregate demand. If it is unanticipated, it will stimulate aggregate demand. In the short-run, the increase in aggregate demand will increase output and decrease unemployment below the natural rate as the economy moves up along the short-run Phillips curve, increasing the actual inflation rate. In the short-run, the increase in aggregate demand will increase output and decrease unemployment below the natural rate as the economy moves up along the short-run Phillips curve, increasing the actual inflation rate.

30. Copyright © 2002 by Thomson Learning, Inc. However, over time, people adjust to the new inflation rate and the short-run Phillips curve shifts to the right. However, over time, people adjust to the new inflation rate and the short-run Phillips curve shifts to the right. If the higher inflation rate continues, the adjustment of expectations will move the economy to where the expected and actual inflation rates are equal at the natural level of output and the natural rate of unemployment. If the higher inflation rate continues, the adjustment of expectations will move the economy to where the expected and actual inflation rates are equal at the natural level of output and the natural rate of unemployment.

31. Copyright © 2002 by Thomson Learning, Inc. This reveals that there is no trade-off between the inflation rate and the unemployment rate in the long run. This reveals that there is no trade-off between the inflation rate and the unemployment rate in the long run. The policy implication is that the use of fiscal or monetary policy to alter real output from the natural level of real output or unemployment from the natural rate of unemployment is ineffective in the long run. The policy implication is that the use of fiscal or monetary policy to alter real output from the natural level of real output or unemployment from the natural rate of unemployment is ineffective in the long run.

32. Copyright © 2002 by Thomson Learning, Inc. Say there was a decrease in the rate of growth in the money supply. Say there was a decrease in the rate of growth in the money supply. If unanticipated, it would reduce aggregate demand. If unanticipated, it would reduce aggregate demand. In the short-run, the decrease in aggregate demand moves the economy down along the short-run Phillips curve, where the actual inflation rate has decreased and the unemployment rate has risen above the natural rate. In the short-run, the decrease in aggregate demand moves the economy down along the short-run Phillips curve, where the actual inflation rate has decreased and the unemployment rate has risen above the natural rate.

33. Copyright © 2002 by Thomson Learning, Inc. The decrease in aggregate demand has led to lower production and to a fall in employment. The decrease in aggregate demand has led to lower production and to a fall in employment. When people recognize that prices are not rising as rapidly as before, they adjust their expectations to reflect that fact, and the short-run Phillips curve shifts downward. When people recognize that prices are not rising as rapidly as before, they adjust their expectations to reflect that fact, and the short-run Phillips curve shifts downward. The inflation rate is now lower and unemployment and output have returned to their natural rates. The inflation rate is now lower and unemployment and output have returned to their natural rates.

34. Copyright © 2002 by Thomson Learning, Inc. In this scenario, the economy’s road to lower inflation rates has come at the expense of higher unemployment in the short run, until people’s expectations adapt to the new lower inflation rate in the long run. In this scenario, the economy’s road to lower inflation rates has come at the expense of higher unemployment in the short run, until people’s expectations adapt to the new lower inflation rate in the long run. These expectations are called adaptive expectations—individuals believe that the best indicator of the future is recent information on inflation and unemployment. These expectations are called adaptive expectations—individuals believe that the best indicator of the future is recent information on inflation and unemployment.

35. Copyright © 2002 by Thomson Learning, Inc.

36. Supply Shocks Changes in the expected inflation rate can shift the short-run Phillips curve. Changes in the expected inflation rate can shift the short-run Phillips curve. So can supply shocks. So can supply shocks. An adverse supply shock, such as higher energy prices, causes a leftward shift in the SRAS curve, with a higher price level and lower RGDP stagflation. An adverse supply shock, such as higher energy prices, causes a leftward shift in the SRAS curve, with a higher price level and lower RGDP stagflation. But the higher inflation rate and higher unemployment rate that result shift the short-run Phillips curve to the right. But the higher inflation rate and higher unemployment rate that result shift the short-run Phillips curve to the right.

37. Copyright © 2002 by Thomson Learning, Inc.

38. A favorable supply shock, causes a rightward shift in the SRAS curve with a lower price level and higher RGDP. A favorable supply shock, causes a rightward shift in the SRAS curve with a lower price level and higher RGDP. example: lower energy prices example: lower energy prices But the lower inflation rate and lower unemployment rate that result shift the short-run Phillips curve to the left. But the lower inflation rate and lower unemployment rate that result shift the short-run Phillips curve to the left.

39. Copyright © 2002 by Thomson Learning, Inc.

40. The impact of adverse or favorable shocks depend on expectations. The impact of adverse or favorable shocks depend on expectations. If people expect the changes to be permanent, then the shifted Phillips curve will stay in the new position until something else happens. If people expect the changes to be permanent, then the shifted Phillips curve will stay in the new position until something else happens. If the shock is expected to be temporary, the Phillips curve will soon shift back to its original position. If the shock is expected to be temporary, the Phillips curve will soon shift back to its original position.

41. Copyright © 2002 by Thomson Learning, Inc. If economic fluctuations are expected to be permanent and are caused primarily by supply-side shifts, then there may be a positive relationship between the inflation rate and the unemployment rate—a shifting Phillips curve. If economic fluctuations are expected to be permanent and are caused primarily by supply-side shifts, then there may be a positive relationship between the inflation rate and the unemployment rate—a shifting Phillips curve. Higher rates of inflation will be coupled with higher rates of unemployment and lower rates of inflation will be coupled with lower rates of unemployment. Higher rates of inflation will be coupled with higher rates of unemployment and lower rates of inflation will be coupled with lower rates of unemployment.

42. Copyright © 2002 by Thomson Learning, Inc.

43. 25.3 Rational Expectations Is it possible that people can anticipate the plans of policy makers and alter their behavior quickly, to neutralize the intended impact of government action? Is it possible that people can anticipate the plans of policy makers and alter their behavior quickly, to neutralize the intended impact of government action? For example, if workers see that the government is allowing the money supply to expand rapidly, they may quickly demand higher money wages in order to offset the anticipated inflation. For example, if workers see that the government is allowing the money supply to expand rapidly, they may quickly demand higher money wages in order to offset the anticipated inflation.

44. Copyright © 2002 by Thomson Learning, Inc. Can Human Behavior Counteract Government Policy? In the extreme form, if people could instantly recognize and respond to government policy changes, it might be impossible to alter real output or unemployment levels through policy actions unless they can surprise consumers and businesses. In the extreme form, if people could instantly recognize and respond to government policy changes, it might be impossible to alter real output or unemployment levels through policy actions unless they can surprise consumers and businesses. An increasing number of economists believe that there is at least some truth to this point of view. An increasing number of economists believe that there is at least some truth to this point of view.

45. Copyright © 2002 by Thomson Learning, Inc. At a minimum, most economists accept the notion that real output and the unemployment rate cannot be altered with the ease that was earlier believed; some believe that the unemployment rate can seldom be influenced by fiscal and monetary policies. At a minimum, most economists accept the notion that real output and the unemployment rate cannot be altered with the ease that was earlier believed; some believe that the unemployment rate can seldom be influenced by fiscal and monetary policies.

46. Copyright © 2002 by Thomson Learning, Inc. The Rational Expectations Theory The relatively new extension of economic theory that leads to this rather pessimistic conclusion regarding macroeconomic policy’s ability to achieve our economic goals is called the theory of rational expectations. The relatively new extension of economic theory that leads to this rather pessimistic conclusion regarding macroeconomic policy’s ability to achieve our economic goals is called the theory of rational expectations.

47. Copyright © 2002 by Thomson Learning, Inc. The notion that expectations or anticipations of future events are relevant to economic theory is not new; for decades economists have incorporated expectations into models analyzing many forms of economic behavior. The notion that expectations or anticipations of future events are relevant to economic theory is not new; for decades economists have incorporated expectations into models analyzing many forms of economic behavior. Only in the recent past, however, has a theory evolved that tries to incorporate expectations as a central factor in the analysis of the entire economy. Only in the recent past, however, has a theory evolved that tries to incorporate expectations as a central factor in the analysis of the entire economy.

48. Copyright © 2002 by Thomson Learning, Inc. Rational expectation economists believe that wages and prices are flexible, and that workers and consumers incorporate the likely consequences of government policy changes quickly into their expectations. Rational expectation economists believe that wages and prices are flexible, and that workers and consumers incorporate the likely consequences of government policy changes quickly into their expectations.

49. Copyright © 2002 by Thomson Learning, Inc. In addition, rational expectation economists believe that the economy is inherently stable after macroeconomic shocks, and that tinkering with fiscal and monetary policy cannot have the desired effect unless consumers and workers are caught off-guard (and catching them off-guard gets harder the more you try to do it). In addition, rational expectation economists believe that the economy is inherently stable after macroeconomic shocks, and that tinkering with fiscal and monetary policy cannot have the desired effect unless consumers and workers are caught off-guard (and catching them off-guard gets harder the more you try to do it).

50. Copyright © 2002 by Thomson Learning, Inc. Rational Expectations and the Consequences of Government Macroeconomic Policies Rational expectations theory suggests that government economic policies designed to alter aggregate demand to meet macroeconomic goals are of very limited effectiveness. Rational expectations theory suggests that government economic policies designed to alter aggregate demand to meet macroeconomic goals are of very limited effectiveness. When policy targets become public, it is argued, people will alter their own behavior from what it would otherwise have been, and, in so doing, they largely negate the intended impact of policy changes. When policy targets become public, it is argued, people will alter their own behavior from what it would otherwise have been, and, in so doing, they largely negate the intended impact of policy changes.

51. Copyright © 2002 by Thomson Learning, Inc. If government policy seems tilted towards permitting more inflation in order to try to reduce unemployment, people start spending their money faster than before, become more adamant in their wage and other input price demands, and so on. If government policy seems tilted towards permitting more inflation in order to try to reduce unemployment, people start spending their money faster than before, become more adamant in their wage and other input price demands, and so on.

52. Copyright © 2002 by Thomson Learning, Inc. In the process of quickly altering their behavior to reflect the likely consequences of policy changes, they make it more difficult (costly) for government authorities to meet their macroeconomic objectives. In the process of quickly altering their behavior to reflect the likely consequences of policy changes, they make it more difficult (costly) for government authorities to meet their macroeconomic objectives.

53. Copyright © 2002 by Thomson Learning, Inc. Rather than fooling people into changing real wages, and therefore unemployment, with inflation “surprises,” changes in inflation are quickly reflected into expectations with little or no effect on unemployment or real output even in the short run. Rather than fooling people into changing real wages, and therefore unemployment, with inflation “surprises,” changes in inflation are quickly reflected into expectations with little or no effect on unemployment or real output even in the short run. As a consequence, policies intended to reduce unemployment through stimulating aggregate demand will often fail to have the intended effect. As a consequence, policies intended to reduce unemployment through stimulating aggregate demand will often fail to have the intended effect.

54. Copyright © 2002 by Thomson Learning, Inc. Fiscal and monetary policy, according to this view, will work only if the people are caught off-guard or fooled by policies so that they do not modify their behavior in a way that reduces policy effectiveness. Fiscal and monetary policy, according to this view, will work only if the people are caught off-guard or fooled by policies so that they do not modify their behavior in a way that reduces policy effectiveness.

55. Copyright © 2002 by Thomson Learning, Inc. Anticipation of an Expansionary Monetary Policy In the case of an expansionary monetary policy, AD will shift to the right. In the case of an expansionary monetary policy, AD will shift to the right. As a result of anticipating the predictable inflationary consequences of that expansionary policy, the price level will immediately adjust to a new higher price level. As a result of anticipating the predictable inflationary consequences of that expansionary policy, the price level will immediately adjust to a new higher price level.

56. Copyright © 2002 by Thomson Learning, Inc. Consumers, producers, workers, and lenders who have anticipated the effects of the expansionary policy simply built the higher inflation rates into their product prices, wages, and interest rates because they realize that expansionary monetary policy can cause inflation if the economy is working close to capacity. Consumers, producers, workers, and lenders who have anticipated the effects of the expansionary policy simply built the higher inflation rates into their product prices, wages, and interest rates because they realize that expansionary monetary policy can cause inflation if the economy is working close to capacity.

57. Copyright © 2002 by Thomson Learning, Inc. Consequently, in an effort to protect themselves from the higher anticipated inflation, workers ask for higher wages, suppliers increase input prices, and producers raise their product prices. Consequently, in an effort to protect themselves from the higher anticipated inflation, workers ask for higher wages, suppliers increase input prices, and producers raise their product prices.

58. Copyright © 2002 by Thomson Learning, Inc. Because wages, prices, and interest rates are assumed to be flexible, the adjustments take place immediately. Because wages, prices, and interest rates are assumed to be flexible, the adjustments take place immediately. This increase in input costs for wages, interest, and raw materials causes the aggregate supply curve to also shift up or leftward. This increase in input costs for wages, interest, and raw materials causes the aggregate supply curve to also shift up or leftward.

59. Copyright © 2002 by Thomson Learning, Inc. So the desired policy effect of greater real output and reduced unemployment from a shift in the aggregate demand curve is offset by an upward or leftward shift in the aggregate supply curve caused by an increase in input costs. So the desired policy effect of greater real output and reduced unemployment from a shift in the aggregate demand curve is offset by an upward or leftward shift in the aggregate supply curve caused by an increase in input costs.

60. Copyright © 2002 by Thomson Learning, Inc. RGDP

61. Copyright © 2002 by Thomson Learning, Inc. Unanticipated Expansionary Policy An unanticipated increase in AD as a result of an expansionary monetary policy stimulates output and employment in the short run. An unanticipated increase in AD as a result of an expansionary monetary policy stimulates output and employment in the short run. The output is beyond the full employment level, and so is not sustainable in the long run. The output is beyond the full employment level, and so is not sustainable in the long run. The price level ends up higher than workers and other input owners expected. The price level ends up higher than workers and other input owners expected.

62. Copyright © 2002 by Thomson Learning, Inc. However, when they eventually realize that the price level has changed, they will require higher input prices, shifting SRAS left to a new long-run equilibrium at full employment and a higher price level. However, when they eventually realize that the price level has changed, they will require higher input prices, shifting SRAS left to a new long-run equilibrium at full employment and a higher price level.

63. Copyright © 2002 by Thomson Learning, Inc. In the short run, the policy expands output and employment, but only increases the price level inflation in the long run. In the short run, the policy expands output and employment, but only increases the price level inflation in the long run.

64. Copyright © 2002 by Thomson Learning, Inc. A correctly anticipated increase in AD from expansionary monetary or fiscal policy will not change real output or unemployment even in the short run. A correctly anticipated increase in AD from expansionary monetary or fiscal policy will not change real output or unemployment even in the short run. The only effect is an immediate change in the price level. The only effect is an immediate change in the price level.

65. Copyright © 2002 by Thomson Learning, Inc. The only way that monetary or fiscal policy can change output in the rational expectations model is with a surprise—an unanticipated change. The only way that monetary or fiscal policy can change output in the rational expectations model is with a surprise—an unanticipated change.

66. Copyright © 2002 by Thomson Learning, Inc.

67. When an Anticipated Expansionary Policy Change is Less Than the Actual Policy Change In the rational expectations model, when people expect a larger increase in AD than actually results from a policy change (say, from a smaller increase in the money supply than expected), it leads to a higher price level and a lower level of RGDP—a recession. In the rational expectations model, when people expect a larger increase in AD than actually results from a policy change (say, from a smaller increase in the money supply than expected), it leads to a higher price level and a lower level of RGDP—a recession. A policy designed to increase output may actually reduce output if prices and wages are flexible and the expansionary effect is less than people anticipated. A policy designed to increase output may actually reduce output if prices and wages are flexible and the expansionary effect is less than people anticipated.

68. Copyright © 2002 by Thomson Learning, Inc. a

69. Critics of Rational Expectations Theory Rational expectations theory does have its critics. Rational expectations theory does have its critics. Critics want to know if consumers and producers are completely informed about the impact that say, an increase in money supply will have on the economy. Critics want to know if consumers and producers are completely informed about the impact that say, an increase in money supply will have on the economy. In general, not all citizens will be completely informed, but key players like corporations, financial institutions, and labor organizations may well be informed about the impact of these policy changes. In general, not all citizens will be completely informed, but key players like corporations, financial institutions, and labor organizations may well be informed about the impact of these policy changes.

70. Copyright © 2002 by Thomson Learning, Inc. Are wages and other input prices really that flexible? Are wages and other input prices really that flexible? Even if decision makers could anticipate the eventual effect of policy changes on prices, prices may still be slow to adapt (e.g., what if you had just signed a three-year labor or supply contract when the new policy is implemented?). Even if decision makers could anticipate the eventual effect of policy changes on prices, prices may still be slow to adapt (e.g., what if you had just signed a three-year labor or supply contract when the new policy is implemented?).

71. Copyright © 2002 by Thomson Learning, Inc. Many economists reject the extreme rational expectations model of complete wage and price flexibility. Many economists reject the extreme rational expectations model of complete wage and price flexibility. Most still believe there is a short-run trade-off between inflation and unemployment. Most still believe there is a short-run trade-off between inflation and unemployment.

72. Copyright © 2002 by Thomson Learning, Inc. The reason is that some input prices are slow to adjust to changes in the price level. The reason is that some input prices are slow to adjust to changes in the price level. In the long run, the expected inflation rate adjusts to changes in the actual inflation rate at the natural rate of unemployment. In the long run, the expected inflation rate adjusts to changes in the actual inflation rate at the natural rate of unemployment.

73. Copyright © 2002 by Thomson Learning, Inc. 25.4 Wage and Price Controls and Indexing If monetary and fiscal policy are ineffective or counterproductive, what policies are left to control inflation? If monetary and fiscal policy are ineffective or counterproductive, what policies are left to control inflation? It is possible that the federal government could set up a comprehensive program over wages and prices—often called incomes policy. It is possible that the federal government could set up a comprehensive program over wages and prices—often called incomes policy.

74. Copyright © 2002 by Thomson Learning, Inc. Purpose of Wage and Price Controls We have imposed such controls three times in modern American history: We have imposed such controls three times in modern American history: during World War II during World War II during the Korean War during the Korean War in 1971 near the end of the Vietnam War in 1971 near the end of the Vietnam War

75. Copyright © 2002 by Thomson Learning, Inc. Wage and price controls involve either Wage and price controls involve either a complete freeze on wages and prices at pre ‑ control levels or a complete freeze on wages and prices at pre ‑ control levels or some rigid limits as to the increases in wages and prices that will be permitted. some rigid limits as to the increases in wages and prices that will be permitted. One or more government agencies are created to monitor the program. One or more government agencies are created to monitor the program.

76. Copyright © 2002 by Thomson Learning, Inc. Implementing Price Controls Without Government Regulation Sometimes voluntary guidelines or guideposts are established to avoid forcing companies and unions to limit their price and wage levels. Sometimes voluntary guidelines or guideposts are established to avoid forcing companies and unions to limit their price and wage levels. This approach avoids the expense and political acrimony associated with establishing a control bureaucracy. This approach avoids the expense and political acrimony associated with establishing a control bureaucracy. Sometimes the “jawboning” gets pretty intense. Sometimes the “jawboning” gets pretty intense. Such guidelines can come close to being mandatory controls. Such guidelines can come close to being mandatory controls.

77. Copyright © 2002 by Thomson Learning, Inc. Justifications for Wage and Price Controls There are two justifications given for wage and price controls. There are two justifications given for wage and price controls. By limiting price increases by law, the government directly reduces the rate of inflation legally allowed. By limiting price increases by law, the government directly reduces the rate of inflation legally allowed. Especially with respect to wage controls, it is argued that wage and price controls lower the inflationary expectations of workers and their unions, reducing the “inflation psychology” that contributes to cost ‑ push inflation. Especially with respect to wage controls, it is argued that wage and price controls lower the inflationary expectations of workers and their unions, reducing the “inflation psychology” that contributes to cost ‑ push inflation.

78. Copyright © 2002 by Thomson Learning, Inc. If Wage and Price Controls Have These Advantages, Why Are They Not Used More Often? Wage and price controls have several major disadvantages, which are very likely to be viewed as greater than the advantages, except possibly during wartime situations when aggregate demand is growing very rapidly. Wage and price controls have several major disadvantages, which are very likely to be viewed as greater than the advantages, except possibly during wartime situations when aggregate demand is growing very rapidly.

79. Copyright © 2002 by Thomson Learning, Inc. There is the problem of enforcing the controls. There is the problem of enforcing the controls. Black markets (illegal sales) often develop. Black markets (illegal sales) often develop. These problems are often very hard to solve. These problems are often very hard to solve.

80. Copyright © 2002 by Thomson Learning, Inc. Another, even more fundamental problem with wage and price controls is that they lead to shortages of goods, services, and workers. Another, even more fundamental problem with wage and price controls is that they lead to shortages of goods, services, and workers. Inflationary pressures are not eradicated but rather disguised, manifesting themselves not in price increases but in the lack of desired goods or human resources. Inflationary pressures are not eradicated but rather disguised, manifesting themselves not in price increases but in the lack of desired goods or human resources.

81. Copyright © 2002 by Thomson Learning, Inc. Severe and prolonged controls can lead to a very serious misallocation of resources, as a result. Severe and prolonged controls can lead to a very serious misallocation of resources, as a result.

82. Copyright © 2002 by Thomson Learning, Inc. Straightforward supply and demand analysis indicates the misallocation of resources due to wage and price controls. Straightforward supply and demand analysis indicates the misallocation of resources due to wage and price controls. At the legal price ceiling, the quantity demanded exceeds the quantity supplied and shortages arise. At the legal price ceiling, the quantity demanded exceeds the quantity supplied and shortages arise. Price Controls Lead to a Misallocation of Resources

83. Copyright © 2002 by Thomson Learning, Inc.

84. Examples of Problems With Price Controls Problems with price controls are illustrated by the 1973 Arab oil boycott, when the federal government imposed price ceilings on gasoline that prevented gas prices from rising as they normally would have in response to reduced supply. Problems with price controls are illustrated by the 1973 Arab oil boycott, when the federal government imposed price ceilings on gasoline that prevented gas prices from rising as they normally would have in response to reduced supply.

85. Copyright © 2002 by Thomson Learning, Inc. At the ceiling price, quantity demanded exceeded quantity supplied; gas stations ran out of gas, were often closed, or placed a limit on the amount of gas they would sell. At the ceiling price, quantity demanded exceeded quantity supplied; gas stations ran out of gas, were often closed, or placed a limit on the amount of gas they would sell. When drivers were able to buy gas, they often not only filled their tanks but also several containers they carried along to reduce the risk of being unable to buy gas when they needed it. When drivers were able to buy gas, they often not only filled their tanks but also several containers they carried along to reduce the risk of being unable to buy gas when they needed it.

86. Copyright © 2002 by Thomson Learning, Inc. In the former Soviet Union, where price-control ‑ related shortages were commonplace, citizens typically carried briefcases or even suitcases and large quantities of cash, in case they were able to purchase a normally unavailable good. In the former Soviet Union, where price-control ‑ related shortages were commonplace, citizens typically carried briefcases or even suitcases and large quantities of cash, in case they were able to purchase a normally unavailable good.

87. Copyright © 2002 by Thomson Learning, Inc. Rather than just buy the product for themselves, they would buy several items for their friends and relatives as well, to keep them from having to stand in line for hours, often in vain, trying to buy it. Rather than just buy the product for themselves, they would buy several items for their friends and relatives as well, to keep them from having to stand in line for hours, often in vain, trying to buy it.

88. Copyright © 2002 by Thomson Learning, Inc. Examples of Problems Created by Wage Controls In the case of prolonged wage controls, shortages of personnel can occur. In the case of prolonged wage controls, shortages of personnel can occur. Wages serve as market signals. Wages serve as market signals. Rising wages in an occupation increases an occupation's attractiveness, leading to new entrants of workers. Rising wages in an occupation increases an occupation's attractiveness, leading to new entrants of workers. If the government decrees that salaries in that field could not rise enough, the increase in the quantity of new workers supplied will not occur and a shortage will arise. If the government decrees that salaries in that field could not rise enough, the increase in the quantity of new workers supplied will not occur and a shortage will arise.

89. Copyright © 2002 by Thomson Learning, Inc. Whether the gains from wage and price controls in the form of reduced inflation outweigh the costs in the form of shortages and inefficient resource allocation is debatable. Whether the gains from wage and price controls in the form of reduced inflation outweigh the costs in the form of shortages and inefficient resource allocation is debatable. This is a normative issue where honest, informed people can differ in their perceptions of costs and benefits. This is a normative issue where honest, informed people can differ in their perceptions of costs and benefits.

90. Copyright © 2002 by Thomson Learning, Inc. An example was the debate over the removal of price controls on natural gas. An example was the debate over the removal of price controls on natural gas. One side argued that controls should be removed to end shortages and enhance long ‑ term supply. One side argued that controls should be removed to end shortages and enhance long ‑ term supply. The other side argued that removing controls would lead to inflated prices for gas and inflated profits for gas producers, while causing hardships to lower income users of gas. The other side argued that removing controls would lead to inflated prices for gas and inflated profits for gas producers, while causing hardships to lower income users of gas.

91. Copyright © 2002 by Thomson Learning, Inc. Keeping Prices Down Without the Use of Price Controls The attempt to control prices politically can take another form. The attempt to control prices politically can take another form. The presence of monopolistic elements in an industry can lead to higher prices for that industry’s products than would be the case for a more competitive industry. The presence of monopolistic elements in an industry can lead to higher prices for that industry’s products than would be the case for a more competitive industry.

92. Copyright © 2002 by Thomson Learning, Inc. By stimulating price competition among private firms, the government may be able to help in reducing inflationary pressures. By stimulating price competition among private firms, the government may be able to help in reducing inflationary pressures. However, there has been relatively little actual use of antitrust laws to try to reduce inflation pressures. Moreover, monopoly power can also be artificially created by government regulations. However, there has been relatively little actual use of antitrust laws to try to reduce inflation pressures. Moreover, monopoly power can also be artificially created by government regulations.

93. Copyright © 2002 by Thomson Learning, Inc. Could Indexing Reduce the Costs of Inflation? Another approach to some of the problems posed by inflation is indexing. Another approach to some of the problems posed by inflation is indexing. Inflation poses substantial equity and distributional problems only when it is unanticipated or unexpected. Inflation poses substantial equity and distributional problems only when it is unanticipated or unexpected.

94. Copyright © 2002 by Thomson Learning, Inc. One means of protecting parties against unanticipated price increases is to write contracts that automatically change prices of goods or services whenever the overall price level changes, effectively rewriting agreements in terms of dollars of constant purchasing power. One means of protecting parties against unanticipated price increases is to write contracts that automatically change prices of goods or services whenever the overall price level changes, effectively rewriting agreements in terms of dollars of constant purchasing power.

95. Copyright © 2002 by Thomson Learning, Inc. By making as many contracts as possible payable in dollars of constant purchasing power, those involved can protect themselves against unanticipated changes in inflation. By making as many contracts as possible payable in dollars of constant purchasing power, those involved can protect themselves against unanticipated changes in inflation.

96. Copyright © 2002 by Thomson Learning, Inc. Why Isn’t Indexing More Extensively Used? Indexing seems to eliminate most of the wealth transfers associated with unexpected inflation. Why then is it not more commonly used? Indexing seems to eliminate most of the wealth transfers associated with unexpected inflation. Why then is it not more commonly used? One main argument against indexing is that it could worsen inflation. One main argument against indexing is that it could worsen inflation.

97. Copyright © 2002 by Thomson Learning, Inc. As prices go up, wages and certain other contractual obligations would also automatically increase. As prices go up, wages and certain other contractual obligations would also automatically increase. e.g., rents e.g., rents This immediate and comprehensive reaction to price increases will lead to greater inflationary pressures. This immediate and comprehensive reaction to price increases will lead to greater inflationary pressures.

98. Copyright © 2002 by Thomson Learning, Inc. Other Problems Associated With Indexing If inflation gets bad enough, it may become almost impossible administratively to maintain the indexing scheme. If inflation gets bad enough, it may become almost impossible administratively to maintain the indexing scheme. There are other inefficiencies, as well. There are other inefficiencies, as well.

99. Copyright © 2002 by Thomson Learning, Inc. During the German hyperinflation of the early 1920s, prices at one point rose so rapidly that workers demanded to be paid twice a day, at noon and at the end of work. During the German hyperinflation of the early 1920s, prices at one point rose so rapidly that workers demanded to be paid twice a day, at noon and at the end of work. During their lunch hour, workers would rush money home to their wives, who would then run out and buy real goods before price increases further eroded purchasing power. During their lunch hour, workers would rush money home to their wives, who would then run out and buy real goods before price increases further eroded purchasing power.

100. Copyright © 2002 by Thomson Learning, Inc. Indexing also reduces the ability for relative price changes to allocate resources where they are more valuable. Indexing also reduces the ability for relative price changes to allocate resources where they are more valuable.

101. Copyright © 2002 by Thomson Learning, Inc. Not everything can be indexed, so indexing would cause wealth redistribution plus the cost of negotiating cost of living (COLA) clauses. Not everything can be indexed, so indexing would cause wealth redistribution plus the cost of negotiating cost of living (COLA) clauses. Excessive inflation leads to great inefficiency, as well as a loss of confidence in the issuer of money, namely the government. Excessive inflation leads to great inefficiency, as well as a loss of confidence in the issuer of money, namely the government.