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

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

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

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)

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:

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…

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

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.

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

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.

Lucas Island Metaphor Suppose P rises but EP does not. PB = 1 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. PA = 2 PA = 1 PD = 1 PE = 1 PC = 1

Summary & implications Figure 13-1, p.386 Idiosyncracy alert: If  is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here). Y P LRAS SRAS Both models of agg. supply imply the relationship summarized by the SRAS curve & equation.

Summary & implications SRAS equation: Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. SRAS2 Y P LRAS AD2 SRAS1 AD1 Over time, EP rises, SRAS shifts up, and output returns to its natural rate.

Inflation Rate The 1960s Unemployment Rate

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.

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.

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

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.

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.

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

Inflation Rate Unemployment Rate

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.

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.

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.

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.

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

Calculating the sacrifice ratio for the Volcker disinflation 1981:  = 9.7% 1985:  = 3.0% Total disinflation = 6.7% year u u n uu n 1982 9.5% 6.0% 3.5% 1983 9.5 6.0 3.5 1984 7.4 1.4 1985 7.1 1.1 Total 9.5%

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.

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).

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

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.

Exceeds the Falls below the Equals the Moves to a different 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. Exceeds the Falls below the Equals the Moves to a different

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

According to the natural rate hypothesis, fluctuations in aggregate demand affect output in: Both the short run and long run Only in the short run Only in the long run In neither the short run nor the long run

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

Growth rate of U.S. real GDP Percent change from 4 quarters earlier Average growth rate This graph is from Chapter 9. I include it here as it shows that GDP is very volatile. Question 1 asks whether policymakers should attempt to smooth out these fluctuations by using fiscal and monetary policy to alter aggregate demand. The pink shaded vertical bars denote recessions. Source of data: U.S. Department of Commerce.

Increase in unemployment during recessions peak trough increase in # of unemployed persons (millions) July 1953 May 1954 2.11 Aug 1957 April 1958 2.27 April 1960 February 1961 1.21 December 1969 November 1970 2.01 November 1973 March 1975 3.58 January 1980 July 1980 1.68 July 1981 November 1982 4.08 July 1990 March 1991 1.67 March 2001 November 2001 1.50 December 2007 June 2009 6.14 During a recession, many people lose their jobs (the average for the recessions shown in this table is 2.2 million). Advocates for activist policy believe that policymakers should use the fiscal and monetary policy tools at their disposal to try to reduce the length and severity of recessions, or prevent them if possible. As of July 31, 2009, the trough of the 2008-2009 recession has not been identified, so I have not included it in the table. However, from the December 2007 peak through June 2009, the number of unemployed persons rose by 7.2 million (from 7.5 million in 12/2007 to 14.7 million in 6/2009). Source: BLS and FRED. Source: Business cycle dates from nber.org Increase in unemployment from U.S. Department of Labor, Bureau of Labor Statistics (via FRED, the St Louis Fed’s online database) 36

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 37

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. 38

Automatic stabilizers Designed to reduce the lags associated with stabilization policy. Examples: income tax unemployment insurance welfare 39

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 40

The LEI index and real GDP, 1990s source of LEI data: The Conference Board 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 Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies The macroeconometric models are, in many cases, more elaborate versions of the IS-LM-AD-AS model that students learned in the preceding chapters. The parameters of each equation (e.g., the MPC or the interest rate sensitivity of investment) are estimated with real-world data; then, by changing the values of the exogenous variables, or by specifying price shocks or other changes, the macroeconometric models generate forecasts of all the endogenous variables (GDP, interest rates, unemployment, inflation) at various time horizons following the shock or or policy change. 43

Mistakes forecasting the 1982 recession Unemployment rate The red line is the actual unemployment rate. Each green line represents the median of 20 forecasts of the unemployment rate at the date shown. The first three forecasts all failed to predict the severity of the recession (each shows unemployment falling after a quarter or two, when in fact the unemployment rate kept rising). The last three forecasts failed to predict the speed of the recovery. Similarly, a consensus of forecasts in November 2007 predicted that U.S. unemployment would rise from 4.7% at the end of 2007 to 5.0% at the end of 2008. In May 2008, the consensus forecast was that unemployment would reach 5.5% by the end of 2008. These forecasts were far off the mark: unemployment reached 6.7% in the fourth quarter of 2008. The point here is that forecasts are often not accurate, which opponents of activist policy emphasize. And without accurate forecasts, policies that act with uncertain lags may end up destabilizing the economy. 44

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. 46

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. 47

Should policy be conducted by rule or discretion? Question 2: Should policy be conducted by rule or discretion? ? 48

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. 49

Arguments for rules Distrust of policymakers and the political process misinformed politicians politicians’ interests sometimes not the same as the interests of society 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. 50

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. 51

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. 52

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. 53

Monetary policy rules Advocated by monetarists. a. Constant money supply growth rate Advocated by monetarists. Stabilizes aggregate demand only if velocity is stable. 54

Monetary policy rules a. Constant money supply growth rate 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. 55

Monetary policy rules a. Constant money supply growth rate b. Target growth rate of nominal GDP 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. 56

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. 57

Inflation and central bank independence average inflation This figure shows a measure of the independence of various countries’ central banks (higher numbers = greater independence). One would expect higher average inflation in countries whose central banks are less independent, as monetary policy could be used for political purposes (e.g., lowering unemployment prior to elections). And the graph shows that this is the case. This graph appears on p.460 of the text as Figure 15-2 , and was originally in Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit, and Banking, May 1993. index of central bank independence 58

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

Indebtedness of the world’s governments Country Gov Debt (% of GDP) Japan 173 U.K. 59 Italy 113 Netherlands 55 Greece 101 Norway 46 Belgium 92 Sweden 45 U.S.A. 73 Spain 44 France Finland 40 Portugal 71 Ireland 33 Germany 65 Korea Canada 63 Denmark 28 Austria Australia 14 60

Ratio of U.S. govt debt to GDP Revolutionary War Civil War WW1 WW2 Iraq War 61

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 62

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 2008-2009 recession fall in tax revenues huge spending increases (bailouts of financial institutions and auto industry, stimulus package) 63

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… 64

U.S. population age 65+, as percent of population age 20-64 actual projected Percent of pop. age 20-64 Source: U.S. Census Bureau, 2004, "U.S. Interim Projections by Age, Sex, Race, and Hispanic Origin," Table 2a. <http://www.census.gov/ipc/www/usinterimproj/> Source: Congressional Budget Office, “The Long-Term Budget Outlook,” June 2010 http://www.cbo.gov/doc.cfm?index=11579

U.S. government spending on Medicare and Social Security, 1950-2009 Percent of GDP Source: Table 15.5—TOTAL GOVERNMENT EXPENDITURES BY MAJOR CATEGORY OF EXPENDITURE AS PERCENTAGES OF GDP: 1948–2009 Historical Tables, Office of Management and Budget http://www.whitehouse.gov/omb/budget/Historicals

Projected U.S. federal govt debt in two scenarios, 2000-2035 “Alternative fiscal scenario” incorporates widely-expected changes to current law, such as extension of Bush tax cuts Percent of GDP Source: The Long-Term Budget Outlook, June 2010 Congressional Budget Office http://www.cbo.gov/doc.cfm?index=11579 The report contains this description of the two scenarios: “The extended-baseline scenario adheres closely to current law. It incorporates CBO's current estimate of the impact of the recently enacted health care legislation on revenues and mandatory spending… Under this scenario, the expiration of most of the tax cuts enacted in 2001 and 2003, the growing reach of the alternative minimum tax, and the way in which the tax system interacts with economic growth would result in steadily higher average tax rates…. At the same time, government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt--activities such as national defense and a wide variety of domestic programs--would decline to the lowest percentage of GDP since before World War II. “…the alternative fiscal scenario…incorporates several changes to current law that are widely expected to occur or that would modify some provisions of law that might be difficult to sustain for a long period….CBO assumed that Medicare's payment rates for physicians would gradually increase…[and] that most of the provisions of the 2001 and 2003 tax cuts would be extended…” “Extended baseline scenario” – assumes no changes to current law Actual

Problems measuring the deficit 1. Inflation 2. Capital assets 3. Uncounted liabilities 4. The business cycle 68

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. 69

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 = 0.086  $495b = $43b real deficit = $28b  $43b = $15b surplus 70

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. 71

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.) 72

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? 73

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. 74

The actual and cyclically adjusted U. S The actual and cyclically adjusted U.S. Federal budget surpluses/deficits actual This graph (not in the textbook) shows the actual and cyclically adjusted budget surpluses, as a percentage of potential GDP, as estimated by the Congressional Budget Office. The pink shaded bars denote recessions. (I exclude the 1960-61 recession because the data shown here start in 1962.) In recessions, we would expect the red line (actual surplus) to fall below the blue line (what the surplus would be if the economy were at potential GDP): Real GDP falls, causing decreases in tax revenues and increases in cyclically-sensitive outlays (such as unemployment insurance). During expansions, we would expect the red line to rise above the blue line. In the data, the relationship between actual and cyclically-adjusted surplus is not perfectly correlated with recession dates. But remember that recession dates are determined by whether GDP growth is positive or negative, while the cyclical adjustment is determined by whether actual GDP is greater than or less than potential GDP. At a trough, a recession ends and GDP begins growing, but it may take a while for actual GDP to catch up to and surpass potential GDP; thus, we shouldn’t be surprised if the red line is below the blue line in the first part of an expansion. Source: Source: Table 3, “Measuring the Effects of the Business Cycle on the Federal Budget,” June 2009 Congressional Budget Office; Office of Management and Budget. http://www.cbo.gov/doc.cfm?index=10299&zzz=39114 cyclically-adjusted

We must exercise care when interpreting the reported deficit figures. The bottom line We must exercise care when interpreting the reported deficit figures. 76

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 77

The traditional view Short run: Y, u Long run: Y and u back at their natural rates closed economy: r, I Crowding Out 78

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. 79

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 80

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. 81

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

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 83

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 84

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) 85