15.0 Policy: The Promise and the Problems

Nice assumptions at the micro level gave us Pareto optimality 1. No market failure- markets exist and adjust smoothly and quickly 2. No market power- a fair race, no advantages exist

These nice assumptions mean that the macroeconomy will quickly and smoothly adjust to full employment

If AD is intersecting AS left of LAS, Y* is less than Y F There is demand-deficient unemployment In millions of micro labor markets, there is a excess supply (or a deficient demand) for workers

For many workers, The current wage is above the equilibrium wage Macro unemployment is nothing more than the aggregate consequence of millions of excess supplies in micro markets

An adjustment process occurs Workers offer to work for less until an equilibrium is reached Since wages are a factor price and a change in factor prices moves AS AS will shift downward

Suppose AD is very high, like during a war An excess demand for factors exists

An adjustment process occurs Employers offer higher wages in a tight labor market Process continues until an equilibrium is reached Since wages are a factor price and a change in factor prices moves AS AS will shift upward

If the nice assumptions are true, the economy has amazing potential for self- adjustment Adam Smith wrote about the “invisible hand” in Wealth of Nations in 1776 The level of efficiency in the microeconomy will determine how quickly the macroeconomy can adjust

The quality of the invisible hand is analogous to how realistic our nice assumptions are If the nice assumptions are realistic, then the macroeconomy will always quickly adjust back towards full employment If they are not realistic, the economy can get stuck in a bad situation like high unemployment

Question becomes – What should a government do?

Preamble to the U.S. Constitution- lists purposes of the U.S. government such as promoting a common good for all

Sharp debate between Non-interventionists – laissez-faire They believe the system works pretty well, and government just screws up the process And interventionists- Who say thoughtful government policy is needed to overcome shortcomings in the system

Non-interventionists think “thoughtful policy” is an oxymoron Government intrusion is a threat to liberty

Interventionists think That waiting for the invisible hand is a naive belief with dreadful consequences If we wait for the long-run adjustments to fix things, “In the long run we’re all dead” People suffer in the meantime

Most economists agree that an ideal would be full employment (at the natural rate) and a stable price level This represents the greatest wealth for the nation, but it doesn’t necessarily mean a just distribution of wealth among individuals

In reality, we seldom approach that situation of full employment and stable price level AS and AD shocks do often occur, and serious macro consequences exist We’ll look at some problems that have occurred Then we’ll look at the tools that the government has at its disposal

Until the 1970’s, most economists believed all shocks to the macroeconomy were Caused by AD shifts If AS is fixed, Lower unemployment means more inflation Higher unemployment means less inflation

This either/or relationship was described in a paper in 1958 by A.W. Phillips He used historical data The Phillips curve represented this trade-off view

The Phillips curve was thought of as gospel But events in the late 1960’s and 1970’s caused economists to rethink the situation

Rising prices at full employment Set off a wage-price spiral Especially easy for workers to demand raises in a tight labor market

Expectations of inflation can remain even with demand-deficient unemployment Those who have jobs are still fighting to maintain the value of their wages Stagflation – a wage-price spiral with demand-deficient unemployment

1976 election Carter defeated Ford by mentioning the misery index - defined as unemployment rate plus inflation rate this was an unofficial measure of stagflation 17.6% - inf. 9.1 plus unemp. 8.5

1980 election Reagan used the same measure to zap Carter 4 years later still 17.1% - unemployment down to 5.8%, but inf. 11.3%

Ford and Carter faced the worst of both worlds- High inflation and high unemployment This flew in the face of Phillips curve trade- off logic Plus, each faced OPEC oil shocks which moved AS up even further

The role of the government Government policy can influence the economy G and T are directly determined by the government I, X, and M can be dramatically influenced by the government

Should government intervene? Smart people differ on this question Some say always, some say never The mainstream is a very wide body of thought, and most mainstream economists say “Maybe, it depends on the situation”

There are three dimensions of macro policy Monetary policy Fiscal policy Trade Policy We will examine each

Keep in mind that in these debates Differences of opinion go back to a fundamental philosophical difference of belief About the realism of the micro adjustment process