MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 11/29/2018 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Stabilization Policy PowerPoint by Beth Ingram University of Iowa Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Key Concepts Credibility Rules versus Discretion Time Consistency Phillips Curve Credibility Rules versus Discretion Time Consistency

Decrease in Demand Keynesian view Price Level LRAS AD AS P0 P1 Y1 Y0 Real GDP

Decrease in Demand Keynesian view Price Level LRAS Government responds by increasing demand AD AS Increase G Decrease T Increase M P0 P1 Y1 Y0 Real GDP

Increase in Demand Keynesian view Price Level LRAS AD AS P1 P0 Y0 Y1 Real GDP

Increase in Demand Keynesian view Price Level LRAS Government responds by decreasing demand AD AS Decrease G Increase T Decrease M P0 Y0 Real GDP

Decrease in supply Keynesian stabilization response Price Level LRAS Government responds by increasing demand AD AS Big increase in price P0 Y0 Real GDP

Arguments against Stabilization Policy Uncertainty Policy Lags (informational lag, decsion lag and implementation lag) Problems with Fiscal Policy Ricardian Equivalence (if debt is issued people will anticpate tax in future. Thus raising tax and issuing debt has no impact) Consumer Expectations Crowding Out Monetary Policy

Automatic Stabilizer Taxation: During recession tax receipt decreases. Increasing disposable income Unemployment Benefit or government spending in transfer payment increase as more people are unemployed Thus automatic stabilizer increases government deficit increases (vicervera in boom)

Rate of Inflation Anticipated by Consumers Phillips Curve Inflation = Expected Inflation + A*(Natural Rate Unemployment – Actual Unemployment) Rate of Inflation Anticipated by Consumers Rate of Unemployment when all resources are fully employed at long-run level

What do we see in the data? Inflation versus Unemployment Wage Inflation versus Unemployment Is the relationship exploitable in the short run? Negative correlation between unemployment and inflation (bill phillip)

US Phillips Curve, 1945 - 1970

Inflation and unemployment, United States, 1983–2000

Inflation and unemployment, Japan, 1983–2000.

Inflation and unemployment, France, 1983–2000.

Why negative correlation Wages cannot adjust as rapidly as price During boom: Price is high wage is low and so more people get employed During Contraction: Price falls but wage remain same and so less people employed When wage and price gets adjusted unemployment returns to natural rate

Modified Phillip Curve Inflation = Expected Inflation + A*(Natural Rate Unemployment – Actual Unemployment +Supply Shock Negative Correlation only occurs change in demand side. If supply shock occurs entire curve will shift leading to stagflation (high Unemployment and high inflation) To reduce inflation by 1% the unemployment should be increase by 1/A % Known as sacrifice ratio

Graphically… Inflation 10% 5% U < UN U > UN 0% Unemployment Natural Rate

Graphically… Inflation 10% 5% 0% 2% Unemployment 5% Natural Rate

Expectations catch up with reality 11/29/2018 Expectations catch up with reality Inflation 10% 5% Initially the inflation expectation is 3%. To reduce the unemployment government increased the aggregate demand. Now the umeployment falls but the inflation rises. Three things can happen, A. Real wage never rises unemployment will remain lower. B. Inflation expectation will be low than actual C. Owing to inflation wage increases anf the employment returns back to natural rate Milton Firedman said that using phillip curve will only increase inflation as there are different Phillip curve at different level of inflation expectation 3% Unemployment Natural Rate

Time Inconsistency Scenario Success of government action today will depend on private sectors belief about what government will do tomorrow Talk is cheap

Prisoner’s Dilemma -1, -1 -9, 0 0, -9 -6, -6 Prisoner 2 Don’t Talk 11/29/2018 Prisoner’s Dilemma Prisoner 2 Don’t Talk Talk -1, -1 -9, 0 0, -9 -6, -6 Don’t Talk Prisoner 1 Talk If neither talk, get convicted of minor crime. If both talk, get convicted of major crime.

Stabilization Policy -3,0 3, -3 -5, -3 0, 0 Citizens’ Expectations 11/29/2018 Stabilization Policy Citizens’ Expectations High Inflation Low Inflation -3,0 3, -3 -5, -3 0, 0 High Inf. Policy Maker Low Inf. If neither talk, get convicted of minor crime. If both talk, get convicted of major crime. If expectations = reality, then unemployment = natural rate If expectations < reality, then unemployment is low If expectations > reality, then unemployment is high

Stabilization Policy -3,0 -3, -3 -5, -3 0, 0 Citizens’ Expectations 11/29/2018 Stabilization Policy Citizens’ Expectations High Inflation Low Inflation -3,0 -3, -3 -5, -3 0, 0 High Inf. Policy Maker Low Inf. If neither talk, get convicted of minor crime. If both talk, get convicted of major crime. Zero payoff means private sector is indifferent if their exectation matches with real Regardless of private sector’s expectation government will choose high inflation. So less optimal outcome is achieved

Rules versus Discretion Can rules solve time consistency problem? Can rules solve credibility problem? Two examples of rules European Union UK Code for Fiscal Stability

European Union A fiscal deficit of over 3% can only be run in exceptional circumstances: Natural Disasters Temporary overshooting (e.g. associated with a one-off payment) Serious economic decline. (GDP decline of 0.75% or more with declines between 0.75% and 2% subject to the discretion of the Council of Ministers) If circumstances not met, the offending country must make a non-interest bearing deposit of 0.2% of GDP with a further 0.1% for every percentage point above the 3% mark in subsequent years. If the deficit is still excessive after two years, the deposit becomes a fine.

UK Code for Fiscal Stability Public Debt as a proportion of national income will be held at a stable and prudent level over the economic cycle. The Golden Rule. Over the economic cycle, the government will borrow only to finance investment and not to fund current consumption.

Summary Stabilization Policy Difficulties with stabilization policy Phillips curve and discretionary policy Time inconsistency Rules and Discretion Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.