C hapter 28 Can Government Really Stabilize the Economy? © 2002 South-Western.

CChapter 28hapter 28

Can Government Really Stabilize the Economy?

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• The Classical School of Employment and Inflation

• The Keynesian School of Employment and Inflation

• The Neo-Keynesian School of Employment and Inflation

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Economic PrinciplesEconomic Principles

• The Rational Expectations School of Employment and Inflation

• The Supply-Side School of Employment and Inflation

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Economic PrinciplesEconomic Principles

• Phillips Curve Analysis

• Automatic Stabilizers

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The Nature of The Nature of Economic AdviceEconomic Advice

Economists live in a world of limited information, and so their analysis leads to different and sometimes even highly conflicting conclusions and recommendations.

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The Classical SchoolThe Classical School

Classical economics

The school of thought that emphasizes the natural tendency for an economy to move toward equilibrium at full employment without inflation. It argues against government intervention.

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The Classical SchoolThe Classical School

According to the classical school, unemployment is only a temporary phenomenon, caused by wage rates climbing above the equilibrium rate.

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The Classical SchoolThe Classical School

Persistently high unemployment, according to the classical school, occurs because labor unions and policy makers interfere with the competitive process, preventing wages from reaching equilibrium.

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EXHIBIT 1 CLASSICAL DETERMINATION OF UNEMPLOYMENT

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Exhibit 1: Classical Exhibit 1: Classical Determination of Determination of UnemploymentUnemployment

1. What happens in Exhibit 1 if policy makers establish a $10 minimum wage?

• There will be an excess labor supply (unemployment) of 4,000 workers.

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Exhibit 1: Classical Exhibit 1: Classical Determination of Determination of UnemploymentUnemployment

2. What is the equilibrium wage rate in Exhibit 1, and what is the level of unemployment at the equilibrium wage rate?

• The equilibrium wage rate is $6.

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Exhibit 1: Classical Exhibit 1: Classical Determination of Determination of UnemploymentUnemployment

2. What is the equilibrium wage rate in Exhibit 1, and what is the level of unemployment at the equilibrium wage rate?

• At the equilibrium wage rate of $6 the quantity of labor demanded equals the quantity of labor supplied.

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The Classical SchoolThe Classical School

Stabilization policy

The use of countercyclical monetary and fiscal policy by the government and the Fed to stabilize the economy.

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The Classical SchoolThe Classical School

1. What is the quantity theory of money equation?

• P = MV/Q

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The Classical SchoolThe Classical School

1. What is the quantity theory of money equation?

• P = MV/Q

• “P” is the price level, “M” is the money supply, “V” is money velocity, and “Q” is the quantity of goods and services produced.

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The Classical SchoolThe Classical School

2. What is the relationship between the money supply “M” and the price level “P” in the quantity theory of money equation?

• If resources are fully employed and if money velocity “V” is constant, then the price level “P” depends on the quantity of money “M.”

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The Classical SchoolThe Classical School

3. How does the classical school use the quantity theory of money equation to find the money supply growth rate that is consistent with zero inflation?

• If the growth rate of “M” equals the “Q” growth rate, then the price level remains unchanged.

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The Classical SchoolThe Classical School

3. How does the classical school use the quantity theory of money equation to find the money supply growth rate that is consistent with zero inflation?

• In this view, inflation occurs when the annual rate of growth in the money supply exceeds the annual rate of growth of full-employment real GDP.

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The Keynesian SchoolThe Keynesian School

Keynesian economics

The school of thought that emphasizes the possibility that an economy can be in equilibrium at less than full employment (or with inflation). It argues that with government intervention, equilibrium at full employment without inflation can be achieved by managing aggregate demand.

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The Keynesian SchoolThe Keynesian School

Keynesian economics rejects the classical economists’ basic premise concerning competitive markets and flexible prices.

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EXHIBIT 2 KEYNESIAN VIEW OF DEMAND AND PRICES IN THE SWIMSUIT MARKET

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Exhibit 2: Keynesian View Exhibit 2: Keynesian View of Demand and Prices in of Demand and Prices in

the Swimsuit Marketthe Swimsuit Market

How does the price of swimsuits change as demand decreases from D to D’?

• Price remains at $30 since the swimsuit supply curve is horizontal.

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EXHIBIT 3A AGGREGATE DEMAND, GDP, AND EMPLOYMENT

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EXHIBIT 3B AGGREGATE DEMAND, GDP, AND EMPLOYMENT

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Exhibit 3: Aggregate Exhibit 3: Aggregate Demand, GDP, and Demand, GDP, and

EmploymentEmployment• Note that the AD-AS equilibrium in Exhibit 3 occurs at less than full employment.

• If aggregate demand does not change, unemployment is chronic.

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Exhibit 3: Aggregate Exhibit 3: Aggregate Demand, GDP, and Demand, GDP, and

EmploymentEmployment

1. Why is the Keynesian aggregate supply curve a horizontal line up to the full-employment level of real GDP?

• It reflects the Keynesian view that the price level does not rise as long as there is any unemployment.

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Exhibit 3: Aggregate Exhibit 3: Aggregate Demand, GDP, and Demand, GDP, and

EmploymentEmployment

2. If aggregate demand increases from AD’ to AD’’ in panel a, what must occur in panel b?

• The aggregate expenditure curve must shift upwards from AE’ to AE’’.

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Exhibit 3: Aggregate Exhibit 3: Aggregate Demand, GDP, and Demand, GDP, and

EmploymentEmployment

2. If aggregate demand increases from AD’ to AD’’ in panel a, what must occur in panel b?

• The aggregate expenditure curve must shift upwards from AE’ to AE’’.

• The vertical distance between AE’ and AE’’ is the resulting inflationary gap.

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The Keynesian SchoolThe Keynesian School

If equilibrium occurs at less than the full-employment output level, Keynesians argue that fiscal policy stimulus should be used to increase aggregate demand.

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The Keynesian SchoolThe Keynesian School

Keynesian countercyclical policy calls for deficit-spending and expansionary monetary policy during recessions, and surplus budgets and contractionary monetary policy during times of prosperity.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

Traditional Keynesian policy was ill-prepared for the combination of high unemployment rates and high inflation rates (“stagflation”) in the 1970s and early 1980s.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

Phillips curve

A graph showing the inverse relationship between the economy’s rate of unemployment and rate of inflation.

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EXHIBIT 4 THE PHILLIPS CURVE

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Exhibit 4: The Exhibit 4: The Phillips CurvePhillips Curve

Economist A.W. Phillips found an inverse relationship between inflation and unemployment after studying data for 1861-1957 in Britain.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

Neo-Keynesian economics

The school of thought that emphasizes the possibility that an economy can be in equilibrium at less than full employment with inflation. It argues that by managing aggregate demand, government can achieve the most acceptable combination of unemployment and inflation.

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EXHIBIT 5 THE NEO-KEYNESIAN AGGREGATE SUPPLY CURVE

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Exhibit 5: The Neo-Exhibit 5: The Neo-Keynesian Aggregate Keynesian Aggregate

Supply CurveSupply Curve

How does the Phillips curve relate to the neo-Keynesian aggregate supply curve?

• Development of the Phillips curve caused neo-Keynesians to modify the formerly flat portion of the aggregate supply curve at output levels below full employment.

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Exhibit 5: The Neo-Exhibit 5: The Neo-Keynesian Aggregate Keynesian Aggregate

Supply CurveSupply Curve

How does the Phillips curve relate to the neo-Keynesian aggregate supply curve?

• The Phillips curve reflects a new intermediate, upward-sloping segment of the Keynesian aggregate supply curve up to the full-employment output level.

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EXHIBIT 6 THE PHILLIPS CURVE DURING THE 1960s

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Exhibit 6: The Phillips Exhibit 6: The Phillips Curve During the 1960sCurve During the 1960s

Were the data from the 1960s consistent with the predicted shape of the Phillips curve?

• Yes. Data from the 1960s reveal the inverse relationship between inflation and unemployment rates.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

According to the neo-Keynesians, why does a fall in the rate of unemployment cause the rate of inflation to rise?

• During periods of rapid economic growth when unemployment rates are low, firms are more likely to accept workers’ demands for higher wages.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

According to the neo-Keynesians, why does a fall in the rate of unemployment cause the rate of inflation to rise?

• That occurs because firms can more easily pass along higher costs to consumers in the form of higher prices during times of economic prosperity.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

Many economists attribute the stagflation of the 1970s and early 1980s to the OPEC oil price increases, which acted as adverse supply shocks.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

The Humphrey-Hawkins Act of 1978 initially identified a 4 percent rate of unemployment and a 3 percent rate of inflation as acceptable and reasonable policy targets.

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EXHIBIT 7 RATES OF INFLATION AND UNEMPLOYMENT: 1970–90

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Exhibit 7: Rates of Exhibit 7: Rates of Inflation and Inflation and

Unemployment: 1970-90Unemployment: 1970-90

Were the data from 1970-90 consistent with the predicted shape of the Phillips curve?

• No. The scatter of points seem to bear no resemblance to the well-defined Phillips curve of the 1960s, as shown in Exhibit 6.

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EXHIBIT 8 SHIFTING PHILLIPS CURVES

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Exhibit 8: Shifting Phillips Exhibit 8: Shifting Phillips CurvesCurves

How did neo-Keynesians manage to make the data from 1970-90 consistent with the predicted shape of the Phillips curve?

• They argued that the 1970-90 data are consistent with a Phillips curve that shifts over time.

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EXHIBIT 9 SHIFTING PHILLIPS CURVES

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Exhibit 9: Shifting Phillips Exhibit 9: Shifting Phillips CurvesCurves

According to neo-Keynesian theory, why do Phillips curves shift over time?

• Expansionary policy that reduces unemployment and raises inflation (along a given Phillips curve) also raises costs and lowers profit, causing firms to cut production and employment.

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Exhibit 9: Shifting Phillips Exhibit 9: Shifting Phillips CurvesCurves

According to neo-Keynesian theory, why do Phillips curves shift over time?

• Therefore the unemployment rate increases at the new, higher rate of inflation, putting the economy on a new, higher Phillips curve.

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The Neo-Keynesian The Neo-Keynesian SchoolSchool

In the long run the rate of unemployment remains unchanged in spite of government stabilization policy, but the dynamics of the economic activity that the government sets in motion generates accelerating rate of inflation.

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The Rational Expectations The Rational Expectations SchoolSchool

Rational expectations

The school of thought that emphasizes the impossibility of government reducing the economy’s rate of unemployment by managing aggregate demand.

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The Rational Expectations The Rational Expectations SchoolSchool

Rational expectations economists believe that workers are not only rational but also smart enough to learn from experience how best to overcome the effects of the government’s fiscal policy.

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EXHIBIT 10 RATIONAL EXPECTATIONS MODEL

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Exhibit 10: Rational Exhibit 10: Rational Expectations ModelExpectations Model

According to rational expectations theory, why does the Phillips curve fail to hold?

• Workers correctly anticipate a higher rate of inflation from expansionary policy and demand higher wages.

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Exhibit 10: Rational Exhibit 10: Rational Expectations ModelExpectations Model

According to rational expectations theory, why does the Phillips curve fail to hold?

• These wage demands erase any short-term profit that firms would have made. As a result, the unemployment rate remains unchanged, but the rate of inflation increases.

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EXHIBIT 11 U.S. RATES OF UNEMPLOYMENT AND INFLATION: 1992–99

Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000).

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Supply-Side EconomicsSupply-Side Economics

Supply-side economics

The school of thought that emphasizes the possibility of achieving full employment without inflation.

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Supply-Side EconomicsSupply-Side Economics

Supply-side economics

It argues that through tax reductions, spending cuts, and deregulation, government creates the proper incentives for the private sector to increase aggregate supply.

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EXHIBIT 12 THE LAFFER CURVE

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Exhibit 12: The Laffer Exhibit 12: The Laffer CurveCurve

According to the Laffer curve, what happens to total tax revenue if relatively high tax rates are reduced?

• Reductions in high tax rates increase after-tax profit, which induces suppliers to increase aggregate supply, and workers to work longer.

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Exhibit 12: The Laffer Exhibit 12: The Laffer CurveCurve

According to the Laffer curve, what happens to total tax revenue if relatively high tax rates are reduced?

• The increase in real GDP is proportionately larger than the decline in the tax rate.

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Exhibit 12: The Laffer Exhibit 12: The Laffer CurveCurve

According to the Laffer curve, what happens to total tax revenue if relatively high tax rates are reduced?

• Consequently, total tax revenues increase when relatively high tax rates are reduced, because the high tax rates stifle incentive.

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Supply-Side EconomicsSupply-Side Economics

To supply-siders, the myriad of government regulations affects almost every industry in the economy, reducing productivity and undermining industrial efficiency.

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Supply-Side EconomicsSupply-Side Economics

Crowding out

A fall in private investment spending caused by an increase in government spending.

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EXHIBIT 13 SUPPLY-SIDE EFFECTS ON UNEMPLOYMENT AND INFLATION

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Exhibit 13: Supply-Side Exhibit 13: Supply-Side Effects on Unemployment Effects on Unemployment

and Inflationand InflationAccording to supply-side economists, what causes aggregate supply to increase in Exhibit 13?

• If government reduces its spending, more investment capital would be made available at lower rates of interest to private sector suppliers.

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Exhibit 13: Supply-Side Exhibit 13: Supply-Side Effects on Unemployment Effects on Unemployment

and Inflationand InflationAccording to supply-side economists, what causes aggregate supply to increase in Exhibit 13?

• Combined with lower tax rates and less government regulation, lower government spending shifts the AS curve outward, reducing prices and increasing output.

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Is There A Consensus?Is There A Consensus?

Real-world events of the 1970s, 1980s, and 1990s have brought macroeconomists together.

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Automatic StabilizersAutomatic Stabilizers

Automatic stabilizers

Structures in the economy that tend to add to aggregate demand when the economy is in recession, and subtract from aggregate demand when the economy is inflationary.

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Automatic StabilizersAutomatic Stabilizers

Automatic stabilizers

Unemployment insurance payments and benefits and the progressive income tax are two such automatic stabilizers.

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Automatic StabilizersAutomatic Stabilizers

How does our personal income tax structure work to automatically stabilize the macroeconomy?

• Because the personal income tax is progressive, as incomes grow, tax revenues grow even faster, which reduces disposable income and thus consumption spending.

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Automatic StabilizersAutomatic Stabilizers

How does our personal income tax structure work to automatically stabilize the macroeconomy?

• During a recession incomes fall, and income tax revenues fall even faster, which reduces the decline in disposable income and thus in consumption spending.