AD/AS Models and Macro Policy Debates

1
AD/AS Models and Macro Policy Debates
Phillips Curve
Adaptive vs. Rational Expectations
Policy Impotency Hypothesis
Ricardian Equivalence
2
Introduction

• In previous models, we assumed the price level P
  was stuck in the short run.
• This implies a horizontal SRAS curve.
• Now, we consider two prominent models of
  aggregate supply in the short run
• Sticky-price model
• Imperfect-information model

3
Introduction

• Both models imply

• Other things equal, Y and P are positively
  related, so the SRAS curve is upward-sloping.

4
The sticky-price model

• Reasons for sticky prices
• long-term contracts between firms and customers
• menu costs
• firms not wishing to annoy customers with
  frequent price changes
• Assumption
• Firms set their own prices (i.e., firms have
  some market power)

5
The sticky-price model

• An individual firms desired price is

• where a gt 0.
• Suppose two types of firms
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
  before they know how P and Y will turn out

6
The sticky-price model

• Assume sticky price firms expect that output will
  equal its natural rate. Then,

• To derive the aggregate supply curve, first find
  an expression for the overall price level.
• s fraction of firms with sticky prices.
  Then, we can write the overall price level as

7
The sticky-price model

• Subtract (1?s)P from both sides

• Divide both sides by s

8
The sticky-price model

• High EP ? High PIf firms expect high prices,
  then firms that must set prices in advance will
  set them high.Other firms respond by setting
  high prices.
• High Y ? High P When income is high, the
  demand for goods is high. Firms with flexible
  prices set high prices.
• The greater the fraction of flexible price
  firms, the smaller is s and the bigger is the
  effect of ?Y on P.

9
The sticky-price model

• Finally, derive AS equation by solving for Y

10
The imperfect-information model

• Assumptions
• All wages and prices are perfectly flexible, so
  that all markets clear.
• Each supplier produces one good, consumes many
  goods.
• Each supplier knows the nominal price of the good
  she produces, but does not know the overall price
  level.

11
The imperfect-information model

• Supply of each good depends on its relative
  price the nominal price of the good divided by
  the overall price level.
• Supplier does not know price level at the time
  she makes her production decision, so uses EP.

12
Lucas Island Metaphor

• Suppose P rises but EP does not.
• Supplier thinks her relative price has risen, so
  she produces more.
• With many producers thinking this way, Y will
  rise whenever P rises above EP.

PB 1
PA 1
PA 2
PD 1
PE 1
PC 1
13
Summary implications

• Both models of agg. supply imply the relationship
  summarized by the SRAS curve equation.

14
Summary implications

• Suppose a positive AD shock moves output above
  its natural rate and P above the level people
  had expected.

Over time, EP rises, SRAS shifts up,and
output returns to its natural rate.
15
The 1960s
Inflation Rate
Unemployment Rate
16
Inflation, Unemployment, and the Phillips Curve

• The Phillips curve states that ? depends on
• expected inflation, E?.
• cyclical unemployment the deviation of the
  actual rate of unemployment from the natural rate
• supply shocks, ? (Greek letter nu).

where ? gt 0 is an exogenous constant.
17
Comparing SRAS and the Phillips Curve

• SRAS curve Output is related to unexpected
  movements in the price level.
• Phillips curve Unemployment is related to
  unexpected movements in the inflation rate.

18
Adaptive expectations

• Adaptive expectations an approach that assumes
  people form their expectations of future
  inflation based on recently observed inflation.
• A simple version Expected inflation last
  years actual inflation

• Then, P.C. becomes

19
Inflation inertia

• In this form, the Phillips curve implies that
  inflation has inertia
• In the absence of supply shocks or cyclical
  unemployment, inflation will continue
  indefinitely at its current rate.
• Past inflation influences expectations of current
  inflation, which in turn influences the wages
  prices that people set.

20
Two causes of rising falling inflation

• cost-push inflation inflation resulting from
  supply shocks
• Adverse supply shocks typically raise production
  costs and induce firms to raise prices,
  pushing inflation up.
• demand-pull inflation inflation resulting from
  demand shocks
• Positive shocks to aggregate demand cause
  unemployment to fall below its natural rate,
  which pulls the inflation rate up.

21
Graphing the Phillips curve

• In the short run, policymakers face a tradeoff
  between ? and u.

22
Inflation Rate
The 1970s
Unemployment Rate
23
The 1980s
Inflation Rate
Unemployment Rate
24
The 1990s
Inflation Rate
Unemployment Rate
25
The 2000s
Inflation Rate
Unemployment Rate
26
Inflation Rate
Unemployment Rate
27
Shifting the Phillips curve

• People adjust their expectations over time, so
  the tradeoff only holds in the short run.

E.g., an increase in E? shifts the short-run
P.C. upward.
28
The sacrifice ratio

• To reduce inflation, policymakers can contract
  agg. demand, causing unemployment to rise above
  the natural rate.
• The sacrifice ratio measures the percentage of a
  years real GDP that must be foregone to reduce
  inflation by 1 percentage point.
• A typical estimate of the ratio is 5.

29
The sacrifice ratio

• Example To reduce inflation from 6 to 2
  percent, must sacrifice 20 percent of one years
  GDP
• GDP loss (inflation reduction) x (sacrifice
  ratio) 4 x
  5
• This loss could be incurred in one year or spread
  over several, e.g., 5 loss for each of four
  years.
• The cost of disinflation is lost GDP. One could
  use Okuns law to translate this cost into
  unemployment.

30
Rational expectations

• Ways of modeling the formation of expectations
• adaptive expectations People base their
  expectations of future inflation on recently
  observed inflation.
• rational expectationsPeople base their
  expectations on all available information,
  including information about current and
  prospective future policies.

31
Painless disinflation?

• Proponents of rational expectations believe that
  the sacrifice ratio may be very small
• Suppose u un and ? E? 6,
• and suppose the Fed announces that it will do
  whatever is necessary to reduce inflation from 6
  to 2 percent as soon as possible.
• If the announcement is credible, then E? will
  fall, perhaps by the full 4 points.
• Then, ? can fall without an increase in u.

32
Calculating the sacrifice ratio for the Volcker
disinflation

• 1981 ? 9.7
• 1985 ? 3.0

Total disinflation 6.7
year u u n u?u n
1982 9.5 6.0 3.5
1983 9.5 6.0 3.5
1984 7.4 6.0 1.4
1985 7.1 6.0 1.1
Total 9.5
33
Calculating the sacrifice ratio for the Volcker
disinflation

• From previous slide Inflation fell by 6.7,
  total cyclical unemployment was 9.5.
• Okuns law 1 of unemployment 2 of lost
  output.
• So, 9.5 cyclical unemployment 19.0 of a
  years real GDP.
• Sacrifice ratio (lost GDP)/(total disinflation)
• 19/6.7 2.8 percentage points of GDP were
  lost for each 1 percentage point reduction in
  inflation.

34
The natural rate hypothesis

• Our analysis of the costs of disinflation, and of
  economic fluctuations in the preceding chapters,
  is based on the natural rate hypothesis

Changes in aggregate demand affect output and
employment only in the short run. In the long
run, the economy returns to the levels of
output, employment, and unemployment described
by the classical model (Chaps. 3-8).
35
An alternative hypothesis Hysteresis

• Hysteresis the long-lasting influence of
  history on variables such as the natural rate of
  unemployment.
• Negative shocks may increase un, so economy may
  not fully recover.

36
Hysteresis Why negative shocks may increase the
natural rate

• The skills of cyclically unemployed workers may
  deteriorate while unemployed, and they may not
  find a job when the recession ends.
• Cyclically unemployed workers may lose their
  influence on wage-setting then, insiders
  (employed workers) may bargain for higher wages
  for themselves.
• Result The cyclically unemployed outsiders
  may become structurally unemployed when the
  recession ends.

37
Stabilization Policy

• Should policy be active or passive?
• Should policy be by rule or discretion?

38
Should policy be active or passive?
39
Growth rate of U.S. real GDP
Percent change from 4 quarters earlier
40
Increase in unemployment during recessions
peak trough increase in of unemployed persons (millions)
July 1953 May 1954 2.11
Aug 1957 April 1958 2.27
April 1960 February 1961 1.21
December 1969 November 1970 2.01
November 1973 March 1975 3.58
January 1980 July 1980 1.68
July 1981 November 1982 4.08
July 1990 March 1991 1.67
March 2001 November 2001 1.50
Increase from 12/2007 thru 6/2009 7.2 million!!!
41
Arguments for active policy

• Recessions cause economic hardship for millions
  of people.
• The Employment Act of 1946 It is the
  continuing policy and responsibility of the
  Federal Government topromote full employment and
  production.
• The model of aggregate demand and supply (Chaps.
  9-13) shows how fiscal and monetary policy can
  respond to shocks and stabilize the economy.

42
Arguments against active policy

• Policies act with long variable lags,
  including
• inside lag the time between the shock and the
  policy response.
• takes time to recognize shock
• takes time to implement policy, especially
  fiscal policy
• outside lag the time it takes for policy to
  affect economy.

If conditions change before policys impact is
felt, the policy may destabilize the economy.
43
Automatic stabilizers

• definition policies that stimulate or depress
  the economy when necessary without any deliberate
  policy change.
• Designed to reduce the lags associated with
  stabilization policy.
• Examples
• income tax
• unemployment insurance
• welfare

44
Forecasting the macroeconomy

• Because policies act with lags, policymakers must
  predict future conditions.
• Two ways economists generate forecasts
• Leading economic indicators data series that
  fluctuate in advance of the economy
• Macroeconometric models

45
The LEI index and real GDP, 1990s
source of LEI dataThe Conference Board
46
Forecasting the macroeconomy

• Because policies act with lags, policymakers must
  predict future conditions.
• Two ways economists generate forecasts
• Leading economic indicators data series that
  fluctuate in advance of the economy
• Macroeconometric modelsLarge-scale models with
  estimated parameters that can be used to forecast
  the response of endogenous variables to shocks
  and policies

47
Mistakes forecasting the 1982 recession
Unemployment rate
48
Forecasting the macroeconomy

• Because policies act with lags, policymakers must
  predict future conditions.

The preceding slides show that the forecasts are
often wrong. This is one reason why some
economists oppose policy activism.
49
The Lucas critique

• Due to Robert Lucaswho won Nobel Prize in 1995
  for rational expectations.
• Forecasting the effects of policy changes has
  often been done using models estimated with
  historical data.
• Lucas pointed out that such predictions would not
  be valid if the policy change alters expectations
  in a way that changes the fundamental
  relationships between variables.

50
An example of the Lucas critique

• Prediction (based on past experience)An
  increase in the money growth rate will reduce
  unemployment.
• The Lucas critique points out that increasing the
  money growth rate may raise expected inflation,
  in which case unemployment would not necessarily
  fall.

51
The Jurys out

• Looking at recent history does not clearly answer
  Question 1
• Its hard to identify shocks in the data.
• Its hard to tell how outcomes would have been
  different had actual policies not been used.

The Great Moderation?
52
Question 2

• Should policy be conducted by rule or discretion?

?
53
Rules and discretion Basic concepts

• Policy conducted by rule Policymakers announce
  in advance how policy will respond in various
  situations, and commit themselves to following
  through.
• Policy conducted by discretionAs events occur
  and circumstances change, policymakers use their
  judgment and apply whatever policies seem
  appropriate at the time.

54
Arguments for rules

• 1. Distrust of policymakers and the political
  process
• misinformed politicians
• politicians interests sometimes not the same as
  the interests of society

55
Arguments for rules

• 2. The time inconsistency of discretionary policy
• def A scenario in which policymakers have an
  incentive to renege on a previously announced
  policy once others have acted on that
  announcement.
• Destroys policymakers credibility, thereby
  reducing effectiveness of their policies.

56
Examples of time inconsistency

• 1. To encourage investment, govt announces it
  will not tax income from capital.
• But once the factories are built, govt reneges
  in order to raise more tax revenue.

57
Examples of time inconsistency

• 2. To reduce expected inflation, the central
  bank announces it will tighten monetary policy.
• But faced with high unemployment, the central
  bank may be tempted to cut interest rates.

58
Examples of time inconsistency

• 3. Aid is given to poor countries contingent on
  fiscal reforms.
• The reforms do not occur, but aid is given
  anyway, because the donor countries do not want
  the poor countries citizens to starve.

59
Monetary policy rules

• a. Constant money supply growth rate
• Advocated by monetarists.
• Stabilizes aggregate demand only if velocity is
  stable.

60
Monetary policy rules
a. Constant money supply growth rate

• b. Target growth rate of nominal GDP
• Automatically increase money growth whenever
  nominal GDP grows slower than targeted decrease
  money growth when nominal GDP growth exceeds
  target.

61
Monetary policy rules
a. Constant money supply growth rate
b. Target growth rate of nominal GDP

• c. Target the inflation rate
• Automatically reduce money growth whenever
  inflation rises above the target rate.
• Many countries central banks now practice
  inflation targeting, but allow themselves a
  little discretion.

62
Central bank independence

• A policy rule announced by central bank will work
  only if the announcement is credible.
• Credibility depends in part on degree of
  independence of central bank.

63
Inflation and central bank independence
average inflation
index of central bank independence
64
Government Debt and Budget Deficits

• The size of the U.S. governments debt, and how
  it compares to that of other countries.
• Problems with measuring the budget deficit.
• How does government debt affect the economy?

Deficit G T
Govt Debt S Deficits
65
Indebtedness of the worlds governments
Country Gov Debt ( of GDP) Country Gov Debt ( of GDP)
Japan 173 U.K. 59
Italy 113 Netherlands 55
Greece 101 Norway 46
Belgium 92 Sweden 45
U.S.A. 73 Spain 44
France 73 Finland 40
Portugal 71 Ireland 33
Germany 65 Korea 33
Canada 63 Denmark 28
Austria 63 Australia 14
66
Ratio of U.S. govt debt to GDP
67
The U.S. experience in recent years

• Early 1980s through early 1990s
• debt-GDP ratio 25.5 in 1980, 48.9 in 1993
• due to Reagan tax cuts, increases in defense
  spending entitlements
• Early 1990s through 2000
• 290b deficit in 1992, 236b surplus in 2000
• debt-GDP ratio fell to 32.5 in 2000
• due to rapid growth, stock market boom, tax hikes

68
The U.S. experience in recent years

• Early 2000s
• the return of huge deficits, due to Bush tax
  cuts, 2001 recession, Medicare expansion, Iraq
  war
• The 2008-2009 recession
• fall in tax revenues
• huge spending increases (bailouts of financial
  institutions and auto industry, stimulus package)

69
The troubling long-term fiscal outlook

• The U.S. population is aging.
• Health care costs are rising.
• Spending on entitlements like Social Security and
  Medicare is growing.
• Deficits and the debt are projected to
  significantly increase

70
Percent of U.S. population age 65
23
Percent of pop.
actual
projected
20
17
14
11
8
5
1950
1960
1970
1980
1990
2000
2010
2020
2030
2040
2050
71
U.S. government spending on Medicare and Social
Security
Percent of GDP
72
CBO projected U.S. federal govt debt in two
scenarios
300
250
200
Percent of GDP
150
100
50
0
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
73
Problems measuring the deficit

• 1. Inflation
• 2. Capital assets
• 3. Uncounted liabilities
• 4. The business cycle

74
MEASUREMENT PROBLEM 1 Inflation

• Suppose the real debt is constant, which implies
  a zero real deficit.
• In this case, the nominal debt D grows at the
  rate of inflation
• ?D/D ? or ?D ? D
• The reported deficit (nominal) is ? D even
  though the real deficit is zero.
• Hence, should subtract ? D from the reported
  deficit to correct for inflation.

75
MEASUREMENT PROBLEM 1 Inflation

• Correcting the deficit for inflation can make a
  huge difference, especially when inflation is
  high.
• Example In 1979,
• nominal deficit 28 billion
• inflation 8.6
• debt 495 billion
• ? D 0.086 ? 495b 43b
• real deficit 28b ? 43b 15b surplus

76
MEASUREMENT PROBLEM 2 Capital Assets

• Currently, deficit change in debt
• Better, capital budgetingdeficit (change in
  debt) ? (change in assets)
• EX Suppose govt sells an office building and
  uses the proceeds to pay down the debt.
• under current system, deficit would fall
• under capital budgeting, deficit unchanged,
  because fall in debt is offset by a fall in
  assets.
• Problem w/ cap budgeting Determining which govt
  expenditures count as capital expenditures.

77
MEASUREMENT PROBLEM 3 Uncounted liabilities

• Current measure of deficit omits important
  liabilities of the government
• future pension payments owed to current govt
  workers
• future Social Security payments
• contingent liabilities, e.g., covering federally
  insured deposits when banks fail
• (Hard to attach a dollar value to contingent
  liabilities, due to inherent uncertainty.)

78
MEASUREMENT PROBLEM 4 The business cycle

• The deficit varies over the business cycle due to
  automatic stabilizers (unemployment insurance,
  the income tax system).
• These are not measurement errors, but do make it
  harder to judge fiscal policy stance.
• E.g., is an observed increase in deficit due to
  a downturn or an expansionary shift in fiscal
  policy?

79
MEASUREMENT PROBLEM 4 The business cycle

• Solution cyclically adjusted budget deficit
  (aka full-employment deficit) based on
  estimates of what govt spending revenues would
  be if economy were at the natural rates of output
  unemployment.

80
The actual and cyclically adjusted U.S. Federal
budget surpluses/deficits
actual
cyclically-adjusted
81
The bottom line
We must exercise care when interpreting the
reported deficit figures.
82
Is the govt debt really a problem?

• Consider a tax cut with corresponding increase in
  the government debt.
• Two viewpoints
• 1. Traditional view
• 2. Ricardian view

83
The traditional view

• Short run ?Y, ?u
• Long run
• Y and u back at their natural rates
• closed economy ?r, ?I

Crowding Out
84
The Ricardian view

• due to David Ricardo (1820), more recently
  advanced by Robert Barro
• According to Ricardian equivalence, a
  debt-financed tax cut has no effect on
  consumption, national saving, the real interest
  rate, investment, net exports, or real GDP, even
  in the short run.

85
The logic of Ricardian Equivalence

• Consumers are forward-looking, know that a
  debt-financed tax cut today implies an increase
  in future taxes that is equal in present value
  to the tax cut.
• The tax cut does not make consumers better off,
  so they do not increase consumption spending.
• Instead, they save the full tax cut in order to
  repay the future tax liability.
• Result Private saving rises by the amount
  public saving falls, leaving national saving
  unchanged.

86
Problems with Ricardian Equivalence

• Myopia Not all consumers think so far ahead,
  some see the tax cut as a windfall.
• Borrowing constraints Some consumers cannot
  borrow enough to achieve their optimal
  consumption, so they spend a tax cut.
• Future generations If consumers expect that
  the burden of repaying a tax cut will fall on
  future generations, then a tax cut now makes them
  feel better off, so they increase spending.

87
Evidence against Ricardian Equivalence?

• Early 1980s Reagan tax cuts increased deficit.
  National saving fell, real interest rate rose
• 1992Income tax withholding reduced to stimulate
  economy.
• This delayed taxes but didnt make consumers
  better off.
• Almost half of consumers increased consumption.

88
Evidence against Ricardian Equivalence?

• Proponents of R.E. argue that the Reagan tax cuts
  did not provide a fair test of R.E.
• Consumers may have expected the debt to be repaid
  with future spending cuts instead of future tax
  hikes.
• Private saving may have fallen for reasons other
  than the tax cut, such as optimism about the
  economy.
• Because the data is subject to different
  interpretations, both views of govt debt survive.

89
OTHER PERSPECTIVES Balanced budgets vs.
optimal fiscal policy

• Some politicians have proposed amending the U.S.
  Constitution to require balanced federal govt
  budget every year.
• Many economists reject this proposal, arguing
  that deficit should be used to
• stabilize output employment
• smooth taxes in the face of fluctuating income
• redistribute income across generations when
  appropriate

90
OTHER PERSPECTIVES Debt and politics

• Fiscal policy is not made by angels Greg
  Mankiw, p.487
• Some do not trust policymakers with deficit
  spending. They argue that
• policymakers do not worry about true costs of
  their spending, since burden falls on future
  taxpayers
• since future taxpayers cannot participate in the
  decision process, their interests may not be
  taken into account
• This is another reason for the proposals for a
  balanced budget amendment

91
OTHER PERSPECTIVES Fiscal effects on monetary
policy

• Govt deficits may be financed by printing money
• A high govt debt may be an incentive for
  policymakers to create inflation (to reduce real
  value of debt at expense of bond holders)

92
Clicker Questions
93
In the sticky-price model, the relationship
between output and the price level depends on

1. The target real wage rate
2. The target nominal wage rate
3. The proportion of firms with flexible prices
4. The implicit agreements between workers and firms

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94
Both models of aggregate supply discussed in
Chapter 13 imply that if the price level is
higher than expected, then output ______ natural
rate of output.

1. Exceeds the
2. Falls below the
3. Equals the
4. Moves to a different

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95
The classical dichotomy breaks down for a
Phillips curve, which shows the relationship
between a nominal variable, _____, and a real
variable, _____.

1. Output prices
2. Money output
3. Inflation unemployment
4. Unemployment inflation

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96
According to the natural rate hypothesis,
fluctuations in aggregate demand affect output in

1. Both the short run and long run
2. Only in the short run
3. Only in the long run
4. In neither the short run nor the long run

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97
The time between a shock to the economy and the
policy actions responding to that shock is called
the

1. Automatic stabilizer
2. Time inconsistency of policy
3. Inside lag
4. Outside lag

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98
The fact that traditional methods of policy
evaluation do not take into account the impact of
policy on expectations is known as

1. The political business cycle
2. The Lucas critique
3. Okuns Law
4. Stabilization policy

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99
Policy is conducted by rule if policymakers

1. Announce in advance how policy will respond to
   various situations and commit themselves to
   following through on this announcement
2. Are free to size up the situation case by case
   and choose whatever policy seems appropriate at
   the time
3. Set policy according to election results
4. Manipulate policy to ensure both low inflation
   and unemployment on election day

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100
A monetary policy rule that targets nominal GDP
would _____ money growth when nominal GDP rises
above the target and ______ money growth when
nominal GDP falls below the target.

1. Reduce raise
2. Raise reduce
3. Reduce reduce
4. Raise raise

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101
The amount by which government spending exceeds
government revenues is called the _____, and the
accumulation of past government borrowing is
called the ____.

1. Deficit debt
2. Debt deficit
3. Devaluation deflation
4. Deflation devaluation

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102
Assume that the nominal interest rate is 11
percent, the inflation rate is 8 percent, and
government debt at the beginning of the year
equals 4 trillion. By how much is the
government budget deficit overstated as a result
of inflation?

1. 0.12 trillion
2. 0.32 trillion
3. 0.44 trillion
4. 0.80 trillion

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103
The debt of the US government is underreported in
the view of many economists because all of the
following liabilities are excluded except

1. Future pensions of government employees
2. Debt owed to foreigners
3. Future Social Security benefits
4. Government guarantees of student loans

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104
According to the traditional viewpoint, a tax cut
without a cut in government spending

1. Stimulates consumer spending and reduces national
   saving
2. Stimulates consumer spending and increases
   national saving
3. Has no effect on consumer spending but reduces
   national saving
4. Has no effect on consumer spending but reduces
   private saving

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105
According to the theory of Ricardian equivalence,
if consumers are forward-looking, they will view
a tax cut that has no plans to reduce government
spending as ______, so their consumption will
______.

1. Additional disposable income increase
2. Additional disposable income remain unchanged
3. A rescheduling of taxes into the future increase
4. A rescheduling of taxes into the future remain
   unchanged

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