1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Stabilization Policy 2 nd edition

16-2 Key Concepts Phillips Curve Credibility Rules versus Discretion Time Consistency

16-3 Decrease in Demand Keynesian view Price Level Real GDP AD AS P0P0 Y0Y0 Y1Y1 P1P1 LRAS

16-4 Decrease in Demand Keynesian view Price Level Real GDP AD AS P0P0 Y0Y0 Y1Y1 P1P1 LRAS Government responds by increasing demand Increase G Decrease T Increase M

16-5 Increase in Demand Keynesian view Price Level Real GDP AD AS P0P0 Y0Y0 Y1Y1 P1P1 LRAS

16-6 Increase in Demand Keynesian view Price Level Real GDP AD AS P0P0 Y0Y0 LRAS Government responds by decreasing demand Decrease G Increase T Decrease M

16-7 Decrease in supply Keynesian stabilization response Price Level Real GDP AD AS P0P0 Y0Y0 LRAS Government responds by increasing demand Big increase in price

16-8 Arguments against Stabilization Policy Uncertainty Demand or supply shocks? Policy Lags => decrease stability Informational, decision, and implementation lags Problems with Fiscal Policy Public investment and social goals may conflict with stabilization goals Ricardian Equivalence Consumer Expectations Crowding Out Monetary Policy Can only affect long-term rates through expectations of inflation and future interest rates

16-9 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

16-10 US Phillips Curve,

16-11 Inflation and unemployment, United States, 1983–2000

16-12 Inflation and unemployment, Japan, 1983–2000.

16-13 Inflation and unemployment, France, 1983–2000.

16-14 Graphically… Inflation Unemployment Natural Rate 10% 5% 0% U > U N U < U N

16-15 Graphically… Inflation Unemployment Natural Rate 10% 5% 0% 2% 5%

16-16 Expectations catch up with reality Inflation Unemployment Natural Rate 10% 5% 0%

16-17 Phillips Curve There is no usable long-run tradeoff between inflation and output Expectations-augmented Philips may allow for short- run tradeoff Complications to short-run tradeoff: supply shocks Can lower inflation without increasing unemployment: lower inflation expectations Importance of policymakers credibility Possible to lower inflation without costly unemployment Phillips curve exist as a short-run tradeoff the government faces when it uses demand management it may not be visible empirically

16-18 Time Inconsistency Scenario Time Inconsistency: when the future arrives it may no longer be optimal to carry out plans “Gov’t will not negotiate with terrorist” “Monetary policy will not be inflationary” Your child, Laura, has just graduated from high school, and is planning to attend State U in the fall. How should she spend her summer? Working to help pay for tuition (parents’ preference) Playing computer games (Laura’s preference) You tell her the following If she works, you will help with tuition If she plays, she’s on her own in August

16-19 Time Inconsistency Will you do what you say you’re going to do? Play Work Laura Pay for College Don’t Pay Pay for College Don’t Pay What you say…

16-20 Time Inconsistency Will you do what you say you’re going to do? Play Work Laura Pay for College Don’t Pay Pay for College Don’t Pay What Laura thinks…

16-21 What is likely to happen? ?

16-22 Stabilization Policy Government’s preferences Low inflation and low unemployment Stronger preference for low unemployment

16-23 Stabilization Policy -3,03, -3 -5, -30, 0 Low Inflation Low Inf. High Inflation High Inf. Citizens’ Expectations Policy Maker Private sector negotiates its wage, central bank responds If expectations = reality, then unemployment = natural rate If expectations < reality, then W/P low, unemployment is low If expectations > reality, then W/P high, unemployment is high Government’s preferences Low inflation and low unemployment Stronger preference for low unemployment

16-24 Rules versus Discretion Why rules are preferred over discretion Information, decision, and implementation lags => stabilization policy destabilizes Uncertain impact on aggregate demand Time inconsistency Can rules solve time consistency problem? Preference must be for low inflation Can rules solve credibility problem? Two examples of rules Monetary Policy: New Zealand Fiscal Policy: EU stability pact

16-25 Rules Friedman’s Rule Grow money supply at a certain, fixed percent each year Remove instability from discretion Reaction Function Rules Taylor Rule: policy response based on set rule Predictability, but flexibility Nominal GDP targeting Stabilize nominal spending Allow demand & supply shocks

16-26 Summary Stabilization Policy Difficulties with stabilization policy Phillips curve and discretionary policy Time inconsistency Rules and Discretion