1. Stabilization in an Integrated World Economy
Chapter 18
Stabilization in an Integrated World Economy

2. Introduction The period since 1984 is known as the “Great Moderation.”
The variability of U.S. real GDP has been more than 50% lower than was true from though 1983.
Can policymakers really contribute to greater macroeconomic stability?
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3. Learning Objectives
Explain why the actual unemployment rate might depart from the natural rate of unemployment
Describe why economic theory implies that there may be an inverse relationship between the inflation rate and the unemployment rate, reflected by the Phillips curve
Evaluate how expectations affect the actual relationship between the inflation rate and the unemployment rate
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4. Learning Objectives (cont'd)
Understand the rational expectations hypothesis and its implications for economic policymaking
Identify the central features of the real- business-cycle challenge to active policymaking
Distinguish among alternative modern approaches to strengthening the case for active policymaking
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5. Chapter Outline Active Versus Passive Policymaking
The Natural Rate of Unemployment
Rational Expectations and the Policy Irrelevance Proposition
Another Challenge to Policy Activism: Real Business Cycles
Modern Approaches to Rationalizing Active Policymaking
Summing Up: Economic Factors Favoring Active Versus Passive Policymaking
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6. Did You Know That...
Between 1900 and 1945, a recession typically lasted 19 months, and since the average duration has fallen to 9 months?
The average expansion between and 1945 lasted about 31 months and the average duration since has been 50 months?
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7. Active Versus Passive Policymaking
Active (Discretionary) Policymaking
All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy
Examples
Monetary and fiscal policy
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8. Active Versus Passive Policymaking (cont'd)
Passive (Nondiscretionary) Policymaking
Policymaking that is carried out in response to a rule
Examples
Monetary rule
Balancing the budget over the business cycle
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9. Policy Example: Will Bernanke Opt for Passivity via Inflation Targeting?
The current Fed chair has long been a proponent of inflation-targeting.
The Fed would passively adjust the money supply as appropriate.
There would be a single objective: a target rate of inflation.
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10. The Natural Rate of Unemployment
Two components of the natural rate of unemployment
Frictional unemployment
Structural unemployment
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11. The Natural Rate of Unemployment (cont'd)
Structural unemployment results from
A mismatch of worker training and skills with requirements of employers
Government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work
Union activity that sets wages above the equilibrium level and also restricts the mobility of labor
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12. The Natural Rate of Unemployment (cont'd)
The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium
When all workers and employers have fully adjusted to any changes in the economy
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13. Example: The U.S. Natural Rate of Unemployment
Question
How has the natural rate of unemployment changed over the years?
Answer
It rose from the 1950s until the late 1980s and then gradually declined.
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14. Figure 18-1 Estimated Natural Rate of Unemployment in the United States
Sources: Economic Report of the President; Economic Indicators, various issues.
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15. Example: The U.S. Natural Rate of Unemployment (cont'd)
For critical analysis
Of the factors that create structural unemployment, which ones do you think explained the gradual trend upward in the natural rate of unemployment from the late 1940s until the 1990s in the United States?
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16. The Natural Rate of Unemployment (cont'd)
Departures from the natural rate of unemployment
Deviations of the actual from the natural rate are called cyclical unemployment.
Deviations observed over the course of nationwide business fluctuations
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17. Figure 18-2 Impact of an Increase in Aggregate Demand on Real GDP and Unemployment
Monetary or fiscal policy leads to increase in AD, and the unemployment rate falls below the natural rate
SRAS shifts, the price level is higher and the unemployment rate rises to the natural rate, real GDP returns to the LRAS level
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18. Figure 18-3 Impact of a Decline in Aggregate Demand on Real GDP and Unemployment
Monetary or fiscal policy leads to decline in AD and the unemployment rate rises above the natural rate
SRAS shifts, the price level is lower, and the unemployment rate falls to the natural rate, the new equilibrium is reached
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19. The Natural Rate of Unemployment (cont'd)
The Phillips curve: a rationale for active policymaking?
The greater the unexpected increase in aggregate demand, the greater the amount of inflation that results in the short run, and the lower the unemployment rate.
The greater the unexpected decrease in aggregate demand, the greater the deflation that results in the short run, and the higher the unemployment rate.
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20. The Natural Rate of Unemployment (cont'd)
The Phillips Curve
A curve showing the relationship between unemployment and changes in wages or prices
It was long thought to reflect a trade-off between unemployment and inflation.
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21. Figure 18-4 The Phillips Curve
Higher inflation and
lower unemployment
The Phillips curve implies a policy trade-off between inflation and unemployment
Can policymakers fine-tune the economy?
Zero inflation and natural rate of unemployment, U*
Deflation and higher unemployment
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22. The Natural Rate of Unemployment (cont'd)
Nonaccelerating Inflation Rate of Unemployment (NAIRU)
The rate of unemployment below which the rate of inflation tends to rise and above which the rate of inflation tends to fall
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23. Figure 18-5 A Shift in the Phillips Curve
There is a change in the expected inflation rate
The curve shifts to incorporate new expectations
PC0 shows expectations at zero inflation
PC5 reflects a higher expected inflation rate, such as 5%
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24. International Policy Example: The Effects of Higher Inflation on Inflation Expectations
Economists measured the effects of a short-lived increase in inflation on expectations regarding future inflation.
Conclusion: higher actual inflation has a significant effect regarding long-term inflation expectations.
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25. The Phillips Curve The U.S. experience with the Phillips curve
Economists Milton Friedman and E.S. Phelps published pioneering studies.
The apparent trade-off suggested by the Phillips curve could not be exploited by activist policymakers.
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26. The Phillips Curve (cont'd)
The U.S. experience with the Phillips curve
Attempts to reduce the unemployment rate by inflating the economy would be thwarted by higher inflation expectations.
Activist policymaking would be offset; the trade-off between unemployment and inflation would disappear.
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27. Figure 18-6 The Phillips Curve: Theory versus Data
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28. Rational Expectations and the Policy Irrelevance Proposition
Rational Expectations Hypothesis
Individuals base their forecasts (expectations) about the future values of economic variables on all available past and current information.
These expectations incorporate individuals’ understanding about how the economy operates, including the operation of monetary and fiscal policy.
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29. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
New classical model
A modern version of the classical model in which wages and prices are flexible
There is pure competition in all markets.
The rational expectations hypothesis is assumed to be working.
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30. Figure 18-7 Response to an Unanticipated Rise in Aggregate Demand
Long-run equilibrium after adjustment yields Y1 with P3
Short-run equilibrium increases output to Y2 with P2
Assume the mS increases unexpectedly to M2 and AD increases to AD2
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31. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
The response to anticipated policy
If the increase in the money supply was anticipated
The higher price level would be anticipated
Workers and suppliers would demand higher wages and prices immediately
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32. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
The conclusion that policy actions have no real effects in the short run if the policy actions are anticipated and none in the long run even if the policy actions are unanticipated
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33. Figure 18-8 Effects of an Anticipated Rise in Aggregate Demand
According to the rational expectations hypothesis the SRAS will shift simultaneously with the increase in AD
Policy will have no impact on output
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34. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
Under the assumption of rational expectations on the part of decision makers in the economy, anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP.
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35. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
Regardless of the nature of the anticipated policy, the unemployment rate will equal the natural rate, and real GDP will be determined solely by the economy’s long-run aggregate supply curve.
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36. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
Questions
What must people know?
What happens if they don’t know everything?
What are the implications?
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37. Rational Expectations and the Policy Irrelevance Proposition (cont'd)
The policy dilemma
Policy irrelevance proposition seems to suggest only mistakes have real effects
Policymakers powerless to push real GDP and unemployment back to long-run levels when entering recessionary period
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38. Figure 18-9 Effects of an Unanticipated Rise in Aggregate Demand, Panel (a)
Even with rational expectations, an unanticipated change in AD can affect real GDP in the short run
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39. Figure 18-9 Effects of an Unanticipated Rise in Aggregate Demand, Panel (b)
In the long run people will figure out the Fed’s actions and prices will increase and output will return to long-run equilibrium
Policy will have no impact on output
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40. Another Challenge to Policy Activism: Real Business Cycles
The distinction between real and monetary shocks
Many economists argue real (as opposed to purely monetary) forces might help explain aggregate economic fluctuations.
Real business cycles and aggregate supply shocks produced economic stagnation with high inflation “stagflation.”
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41. Figure 18-10 Effects of a Reduction in the Supply of Resources
If the reduction in the resource is permanent, the LRAS will also shift
A reduction in the supply of a resource shifts SRAS to the left
The position of LRAS depends on our resource endowments
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42. Another Challenge to Policy Activism: Real Business Cycles (cont'd)
Questions regarding real business cycle theory
What impact would an oil shock have on aggregate demand?
Can we explain the Great Depression with the real business cycle theory?
What about the apparent wage and price rigidity within the economy?
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43. Modern Approaches to Rationalizing Active Policymaking
Market clearing models of the economy may not fully explain business cycles.
“Sticky” wages and prices remain important, some economists contend.
New Keynesians have tried to refine the theory of aggregate supply.
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44. Modern Approaches to Rationalizing Active Policymaking (cont'd)
Small Menu Costs
Costs that deter firms from changing prices in response to demand changes
Examples—the costs of renegotiating contracts or printing new price lists
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45. Example: U.S. Price Stickiness— In the Eye of the Beholder?
Question
Are prices sticky?
Answer
Although price stickiness occurs in some industries, prices of many goods appear flexible.
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46. Figure 18-11 Estimated Intervals Between Price Changes in Selected Industries
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47. Modern Approaches to Rationalizing Active Policymaking (cont'd)
New Keynesian Inflation Dynamics
In new Keynesian theory, the pattern of inflation exhibited by an economy with growing aggregate demand—initial sluggish adjustment of the price level in response to increased aggregate demand followed by higher inflation later
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48. Figure 18-12 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (a)
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49. Figure 18-12 Short- and Long-Run Adjustments in the New Keynesian Sticky-Price Theory, Panel (b)
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50. Modern Approaches to Rationalizing Active Policymaking (cont'd)
An alternative to the Keynesian scenario uses the bounded rationality theory.
People cannot process all the information that confronts them, so they approximate.
Wages and prices are neither fully flexible or completely rigid as a result.
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51. Table Issues That Must Be Assessed in Determining the Desirability of Active versus Passive Policymaking
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52. Improved policymaking? A more resilient economy? A lucky break?
Issues and Applications: Can Active Policymaking Take Credit for the “Great Moderation”?
Improved policymaking?
A more resilient economy?
A lucky break?
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53. Figure 18-13 Quarterly Real GDP Growth Rates Since 1952
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54. Summary Discussion of Learning Objectives
Why the actual unemployment rate might depart from the natural rate of unemployment
Unanticipated changes in aggregate demand
Philips curve
A curve showing an inverse relationship between the rate of inflation and the rate of unemployment
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55. Summary Discussion of Learning Objectives (cont'd)
How expectations affect the actual relationship between the inflation rate and the unemployment rate
The Phillips curve shifts
Rational expectations, market clearing, and policy ineffectiveness
Policy irrelevance theorem
Only unanticipated policy actions affect short-run real GDP.
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56. Summary Discussion of Learning Objectives (cont'd)
The real-business-cycle challenge to active policymaking
To the extent aggregate supply shocks contribute to real business cycles, the case for active policymaking is weakened.
Modern approaches to bolstering the case for active policymaking
New Keynesian approach views wages and prices as sufficiently inflexible.
Discretionary policy actions can stabilize real GDP in the short run.
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57. Stabilization in an Integrated World Economy
End of Chapter 18
Stabilization in an Integrated World Economy