19 Current Issues in Macro Theory and Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Causes of Macro Instability Mainstream view Held by most economists Price stickiness Unexpected demand shocks Variable investment spending Unexpected supply shocks LO1 19-2

Causes of Macro Instability Monetarist view Government interference is the problem Equation of exchange MV = PQ Stable velocity Monetary causes of instability Inappropriate monetary policy LO1 19-3

Causes of Macro Instability Real-business-cycle view Shifts in long-run aggregate supply Price Level P1P1 Real Domestic Output Q2Q2 Q1Q1 AD 1 AD 2 AS LR1 AS LR2 LO1 19-4

Causes of Macro Instability Coordination failures Fail to reach equilibrium because of lack of coordination mechanism Limited information Expectations and self-fulfilling prophecy Unemployment equilibrium Inflation equilibrium LO1 19-5

Does the Economy Self Correct? New classical view Rational expectations theory Monetarists Automatic correction will occur Speed of adjustment Unanticipated price-level changes Fully anticipated price-level changes LO2 19-6

New Classical View of Self-Correction AD 2 AD 1 AS 1 AS 2 AS LR Price Level P1P1 P2P2 P3P3 Real Domestic Output Q1Q1 Q2Q2 a b c Does the Economy Self Correct? LO3 19-7

New Classical View of Self-Correction AD 3 AD 1 AS 1 AS 3 AS LR Price Level P1P1 P4P4 P5P5 Real Domestic Output Q1Q1 Q4Q4 Q3Q3 a e d f Does the Economy Self Correct? LO3 19-8

Does the Economy Self Correct? Mainstream view Downward wage inflexibility Efficiency wage theory Greater work effort Lower supervision costs Reduced job turnover Insider-outsider relationships LO3 19-9

Rules or Discretion? In support of policy rules Reduce macro instability Monetary rule Shift AD to keep up with AS Price stability achieved Inflation targeting Balanced budget LO

Rules or Discretion? Price Level P1P1 Real Domestic Output, GDP Q1Q1 Q2Q2 P2P2 AS LR1 AS LR2 AD 1 AD 2 LO

Rules or Discretion? Defense of discretionary stabilization policy Discretionary monetary policy Velocity is not stable Discretionary fiscal policy Useful during recession Policy successes LO

Rules or Discretion? LO

The Taylor Rule Rules: Passive monetary policy Discretion: Active monetary policy Hybrid policy rule to dictate Fed actions Policy responds to changes in real GDP and inflation Fed explains deviations from the rule Increase Fed credibility and reduce uncertainty 19-14