Issues in Macroeconomic Theory and Policy 25.1
25 c h a p t e r
UNEMPLOYMENT AND INFLATION Despite legislation committing the federal government to the goal of full employment and the development of macroeconomic theory arguing that full employment can be achieved by manipulating aggregate demand, periods of high unemployment still occur.
We usually think of inflation as an evil—higher prices mean lower real incomes for people on fixed incomes, while those with the power to raise the prices charged for goods or services they provide may actually benefit. Nevertheless, some economists believe that inflation could actually help eliminate unemployment. For example, if output prices rise but money wages do not go up as quickly or as much, real wages fall. At the lower real wage, unemployment is less because the lower wage makes it profitable to hire more, now cheaper, employees than before. The result is real wages that are closer to the full-employment equilibrium wage that clears the labor market. Hence, with increased inflation, one might expect lower unemployment in the short run.
THE PHILLIPS CURVE In fact, an inverse relationship between the rate of unemployment and the changing level of prices has been observed in many periods and places in history.
Credit for identifying this relationship generally goes to British economist A. H. Phillips, who in the late 1950s published a paper setting forth what has since been called the Phillips curve. Phillips and many others since have suggested that at higher rates of inflation, the rate of unemployment is 556 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy The Phillips Curve s e c t i o n 25.1 _ What is the Phillips curve?
_ How does the Phillips curve relate to the aggregate supply and demand model?
David Horsey © 2001 lower, while during periods of relatively stable or falling prices, unemployment is substantial. In short, the cost of lower unemployment appears to be greater inflation, and the cost of greater price stability appears to be higher unemployment.
Exhibit 1 shows the actual inflation-unemployment relationship for the United States for the 1960s. The points in this graph represent the combination of the inflation rate and the rate of unemployment in each of the ten years of the decade. The curved line—the Phillips curve—is the smooth line that best “fits” the data points.
THE SLOPE OF THE PHILLIPS CURVE In examining Exhibit 1, it is evident that the slope of the Phillips curve is not the same throughout its length. The curve is steeper at higher rates of inflation and lower levels of unemployment. This suggests that once the economy has relatively low unemployment rates, further reductions in the unemployment rate can occur only if the economy can accept larger increases in the inflation rate.
Once the unemployment rate is low, it takes larger and larger doses of inflation to eliminate a given quantity of unemployment. Presumably, at lower unemployment rates, an increased part of the economy is already operating at or near full capacity.
Further fiscal or monetary stimulus primarily triggers inflationary pressures in sectors already at capacity, while eliminating decreasing amounts of unemployment in those sectors where some excess capacity and unemployment still exist.
THE PHILLIPS CURVE AND AGGREGATE SUPPLY AND DEMAND In Exhibit 2, we see the relationship between aggregate supply and demand analysis and the Phillips curve. Suppose the economy has moved from a 2 percent annual inflation rate to a 4 percent inflation rate, and the unemployment rate has simultaneously fallen from 5 percent to 4 percent. In the Phillips curve, we see this as a move up the curve from point A to point B in Exhibit 2(a). We can see a similar relationship in the AD/AS model in Exhibit 2(b). Imagine that there is an increase in aggregate demand. Consequently, the price level increases from PL1 to PL2 (the inflation rate rises) and output increases from RGDP1 to RGDP2 (the unemployment rate falls). To increase output, firms employ more workers, so employment increases and unemployment falls—the movement from point A to point B in Exhibit 2(b).
The Phillips Curve 557 1 2 3 4 5 6 7 61 64 62 65 66 67 68 69 Unemployment Rate (percent per year) Inflation Rate (percent per year) 6 5 4 3 2 1 0 63 60 Phillips Curve The Phillips Curve Relationship, United States, 1960s SECTION 25.1 EXHIBIT 1 The Phillips curve illustrates an inverse relationship between the rate of unemployment and the rate of inflation. The slope of the Phillips curve becomes more steep as the unemployment rate drops, indicating that at very low unemployment rates, further decreases in unemployment can occur only if the economy can accept much larger increases in inflation rates.
558 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy a. Phillips Curve b. Aggregate Supply and Demand Unemployment Rate 0 Inflation Rate Phillips Curve A B 1 5 4 3 2 1 2 3 4 5 RGDP (trillions of dollars) (5 percent unemployment) 0 RGDP1 RGDP2 PL 1 PL2 Price Level AD2 AS A B AD1 (4 percent unemployment) The Phillips Curve and the AD/AS Curves SECTION 25.1 EXHIBIT 2 As shown in (b), if the aggregate supply curve is positively sloped, an increase in aggregate demand will cause higher prices and higher output (lower unemployment); a decrease in aggregate demand will cause lower prices and lower output (higher unemployment). This same trade-off is illustrated in the Phillips curve in (a), in the shift from point A to point B.
1. The inverse relationship between the rate of unemployment and the rate of inflation is called the Phillips curve.
2. The Phillips curve relationship can also be seen indirectly from the AD/AS model.
1. How does the rate of inflation affect real wage rates if nominal wages rise less or more slowly than output prices?
2. How does the change in real wage rates (relative to output prices) as inflation increases affect the unemployment rate?
3. What is the argument for why the Phillips curve is relatively steeper at lower rates of unemployment and higher rates of inflation?
4. For a given upward-sloping short-run aggregate supply curve, how does an increase in aggregate demand correspond to a movement up and to the left along a Phillips curve?
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THE PHILLIPS CURVE—THE 1960S It became widely accepted in the 1960s that to pursue the appropriate economic policies, policymakers merely had to decide on the combination of unemployment and inflation they wanted from the Phillips curve. To be sure, a reduction in the rate of unemployment came at a cost (more inflation), as did a reduction in the amount of inflation (more unemployment). Nonetheless, policymakers believed they could influence economic activity so that some goals could be met, though with a tradeoff in terms of other macroeconomic goals. The empirical evidence on prices and unemployment seemed to fit the Phillips curve approach so beautifully at first that it is not surprising that it was embraced so rapidly and completely. Economists like Milton Friedman and Edmund Phelps, who questioned the long-term validity of the Phillips curve, were largely ignored in the 1960s. These economists believed there might be a short-term trade-off between unemployment and inflation but not a permanent trade-off. That is, a trade-off happens in the short run but not in the long run. According to Friedman, the short-run trade-off comes from unanticipated inflation.
IS THE PHILLIPS CURVE STABLE?
Starting in the 1970s, economists recognized that macroeconomic decision making was not as simple as picking a point on a stable Phillips curve. As shown in Exhibit 1, the data from the 1970s indicates that the Phillips curve starts to break down. In fact, from 1974 through 1996, every data point has been to the right of the 1960s Phillips curve, meaning a worsening trade-off between inflation and unemployment.
In 1975, for example, the unemployment rate was 8.5 percent and the inflation rate was 9.1 percent.
In short, the 1970s experienced more of both inflation and unemployment than existed in the 1960s. Many economists believe this was due to the adverse supply shocks—the higher energy prices of 1973–1975 and 1979–1981. However, in the 1980s, the Fed followed a very tight monetary policy to combat the high inflation rates. This aggressive monetary policy coupled with foreign competition, deregulation, and a decline in OPEC’s monopoly power led to a reduction in the price level. That is, as people altered their expectations of inflation downward, the Phillips curve shifted inward to PC2 and eventually in the late 1990s to PC3. In fact, in the mid-1990s, when lower rates of inflation were achieved and anticipated, the Phillips curve shifted inward back to the level of the 1960s.
Let us now take a closer look at how expectations can affect the Phillips curve.
THE SHORT-RUN PHILLIPS CURVE VERSUS THE LONG-RUN PHILLIPS CURVE The natural rate hypothesis states that the economy will self-correct to the natural rate of unemployment.
Let us examine the reason behind the natural rate hypothesis. Suppose the economy is at point A in Exhibit 2(a). At that point, the inflation rate is 3 percent and the unemployment rate is at the natural rate, 5 percent. Now suppose the growth rate of the money supply increases. The increase in the growth rate of the money supply stimulates aggregate demand.
In the short run, the increase in aggregate demand increases output and decreases unemployment.
As the economy moves up along the shortrun Phillips curve, from point A to point B, the actual inflation rate increases from 3 percent to 6 percent, and the unemployment rate falls below the natural rate to 3 percent.
Because the increase in inflation was unanticipated, real wages fall. Firms are now receiving higher prices relative to their input costs, so they expand output. Consequently, unemployment rates fall, seen in Exhibit 2(a) as a movement along the short-run Phillips curve from A to B. Eventually, workers (and other input owners) realize that their real wages have fallen because of the increase in the The Phillips Curve Over Time 559 The Phillips Curve Over Time s e c t i o n 25.2 _ How reliable is the Phillips curve?
_ Is the Phillips curve stable over time?
_ What is the difference between the long-run and short-run Phillips curves?
inflation rate that was not initially anticipated—in short, they were fooled in the short run. Workers now vigorously negotiate for higher wages. This increases costs to producers, and as a result, they reduce output and unemployment rises—causing a rightward shift in the short-run Phillips curve in Exhibit 2(a).
In short, the higher-than-expected inflation rate shifts the short-run Phillips curve to the right. If the 6 percent inflation rate continues, the adjustment of expectations will move the economy from point B to point C, where the expected and actual inflation rates are equal at the natural level of output and the natural rate of unemployment.
In the long run, the economy moves from A to C as inflation increases from 3 percent to 6 percent.
This reveals that there is no trade-off between the inflation rate and the unemployment rate in the long run. The policy implication is that the use of fiscal or monetary policy to alter real output from the natural level of real output or unemployment from the natural rate of unemployment is ineffective in the long run.
Alternatively, suppose the rate of growth in the money supply decreases as a result of the Federal Reserve System’s inflationary concerns. The decrease in the rate of growth in the money supply reduces aggregate demand. In the short run, the decrease in aggregate demand moves the economy down along the short-run Phillips curve from point C to point D, where the actual inflation rate has decreased from 6 percent to 3 percent and the unem- 560 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy 14 13 12 11 10 9 8 7 6 5 4 3 2 1 98 96 61 62 72 91 77 82 78 81 80 66 68 69 Unemployment Rate (percent per year) Inflation Rate (percent per year) 0 2 1 3 4 5 6 7 10 9 8 94 63 60 86 84 85 83 99 65 67 95 93 89 90 70 73 76 92 71 97 75 79 74 PC3 1974–1982 PC2 1983–1993 PC1 1960–69; 1994–2002 88 87 64 01 02 The Phillips Curve, United States, 1960–2002 SECTION 25.2 EXHIBIT 1 The Phillips curve relationship breaks down in the 1970s; it no longer neatly fits the observations, and it does not have a consistent, pronounced negative slope, calling into question the notion that one can continue to “buy” full employment with inflation. In fact, the points of the 1970s and early 1980s, where we had both higher rates of inflation and higher rates of unemployment, may be indicative of the adverse supply shocks from higher energy prices. However, in the 1980s and again in the 1990s, people altered their expectations of inflation downward, and the Phillips curve shifted inward to PC2 and eventually all the way back to PC1, the level of the 1960s.
ployment rate has risen above the natural rate to 7 percent. The decrease in aggregate demand leads to lower production and a higher unemployment rate.
Initially, the reduction in the inflation rate is unanticipated, and real wages rise; firms are now receiving lower prices relative to their input costs, so they reduce their output. This leads to a higher unemployment rate, as seen in the movement from point C to point D in Exhibit 2(b). If this new inflation rate remains steady at 3 percent, the actual and expected inflation rates will eventually become the same. The growth in wages will slow, lowering the cost of production, increasing output, and lowering the unemployment rate as the short-run Phillips curve shifts leftward in Exhibit 2(b).
If the 3 percent inflation rate continues, the adjustment of expectations will move the economy from point D to point E in Exhibit 2(b), where the expected and actual inflation rates are equal at the natural level of output and the natural rate of unemployment.
In this scenario, a lower inflation rate comes at the expense of higher unemployment in the short run, until people adapt their expectations to the new lower inflation rate in the long run. These expectations are called adaptive expectations—individuals believe that the best indicator of the future is recent information on inflation and unemployment.
SUPPLY SHOCKS Earlier in this chapter, we assumed that the inverse relationship in the short-run Phillips curve was created by changes in aggregate demand. Further, as we have just seen, a change in the expected inflation rate can cause a shift in the short-run Phillips curve.
However, there is another explanation for a change in the short-run Phillips curve—supply shocks.
Many economists believe that the higher energy prices in the early and late 1970s created an adverse supply shock. Higher oil prices had important implications for the macroeconomy because they meant higher production costs for many goods and services. Higher production costs caused a leftward shift in the SRAS curve from SRAS1 to SRAS2, as seen in Exhibit 3(a). Because the leftward shift in SRAS was greater than the rightward shift in AD, the price level increased from PL1 to PL2 and RGDP fell from RGDP1 to RGDP2 in Exhibit 3(a).
The adverse supply shock led to a higher price level The Phillips Curve Over Time 561 a. An Increase in the Growth of the Money Supply b. Reduction in the Growth of the Money Supply SRPC' (High inflation of 6%) SRPC (Low inflation of 3%) Inflation Rate Natural Rate of Unemployment Unemployment Rate 0 5 A B C 3 3 6 LRPC SRPC (High inflation of 6%) SRPC' (Low inflation of 3%) Inflation Rate 0 5 E D C 7 3 6 LRPC Natural Rate of Unemployment Unemployment Rate The Short-Run and Long-Run Phillips Curve SECTION 25.2 EXHIBIT 2 The economy initially moves along the short-run Phillips curve (SRPC) as actual inflation deviates from expected inflation. When expected inflation rates then adapt to actual inflation rates, the SRPC shifts to intersect the long-run Phillips curve (LRPC) at the new inflation rate—point C in (a) and point E in (b). If the actual inflation rate remains at the new level, then output returns to the natural level of real output, and unemployment returns to the natural rate of unemployment at that inflation rate on the LRPC.
and less output—stagflation. A stagnant economy means fewer jobs and a higher unemployment rate.
With a higher price level, there is a higher inflation rate (the percentage change in the price level from the previous year) and a higher rate of unemployment.
The short-run Phillips curve shifts to the right from SRPC1 to SRPC2, in Exhibit 3(b). At point B, there is a higher rate of inflation and a higher rate of unemployment than at point A.
A favorable supply shock (large technological improvements, bountiful harvest, or lower energy prices) lowers the inflation rate and lowers the rate of unemployment. Specifically, a favorable supply shock lowers the costs of production and causes a rightward shift in the SRAS curve from SRAS1 to SRAS2, as seen in Exhibit 4(a). Because the rightward shift in SRAS is greater than the rightward shift in AD, the price level falls from PL1 to PL2, and RGDP rises from RGDP1 to RGDP2 in Exhibit 4(a). The favorable supply-side shock leads to a lower price level and greater output. A growing economy means more jobs and a lower unemployment rate. With a lower price level, there is a lower inflation rate and a lower rate of unemployment; the short-run Phillips curve shifts to the left, from SRPC1 to SRPC2 in Exhibit 4(b). That is, at point B there is a lower rate of inflation and a lower rate of unemployment than at point A. For example, in the late 1990s, a number of economists believed we witnessed a favorable supply shock because of rapidly changing new technology, favorable exchange rates, and lower oil prices, all of which led to lower production costs. This caused the aggregate supply curve to shift to the right—a higher level of RGDP and a lower price level—and the Phillips curve shifted to the left—a lower inflation rate and a lower unemployment rate.
It is important to note that the impact of an adverse or favorable shock depends on expectations.
If people expect the change to be permanent, the Phillips curve will stay in the new position until something else changes. As we are finding out, expectations can have widespread implications in the macroeconomy. However, if the shock is expected to be temporary, the Phillips curve will soon shift back to its original position. For example, people 562 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy a. Aggregate Demand and Aggregate Supply b. The Phillips Curve Price Level RGDP 0 RGDP2 RGDP1 PL2 PL1 A B SRAS1 SRAS2 Inflation Rate Unemployment Rate 0 A B SRPC1 SRPC2 AD Adverse Supply Shock SECTION 25.2 EXHIBIT 3 The higher energy prices in the early and late 1970s created an adverse supply shock. In (a), the higher production costs causes a leftward shift in the SRAS curve from SRAS1 to SRAS2, an increase in the price level from PL1 to PL2, and decrease in RGDP from RGDP1 to RGDP2.
With a higher price level comes a higher inflation rate, and with less output comes a higher rate of unemployment. The short-run Phillips curve shifts to the right from SRPC1 to SRPC2 in (b). At point B, both the inflation rate and the unemployment rate are higher than at point A.
viewed the supply shocks of the 1970s as permanent and the Phillips curve shifted to the right—a new position with a higher rate of inflation and a higher rate of unemployment.
In sum, if people expect economic fluctuations to be permanent and caused primarily by supplyside shifts, then there may be a positive relationship between the inflation rate and the unemployment rate—a shifting Phillips curve. Higher rates of inflation will be coupled with higher rates of unemployment, and lower rates of inflation will be coupled with lower rates of unemployment.
Price Level and RGDP over Time The favorable supply shock of the late 1990s gave way to the recession of 2001. Most economists blame the 2001 recession on the sharp fall in the stock market, the corporate accounting scandals, and the war on terrorism. All of these factors reduced aggregate demand and pushed the economy into a recession. Because of changes like this, the equilibrium level of prices and RGDP are always changing.
In Exhibit 5, we have traced out the pattern of RGDP and the price level. According to the Bureau of Economic Analysis, both the price level and RGDP have been rising over the last thirty years. So what is responsible for the changes? It is both aggregate demand and aggregate supply. Aggregate demand has risen because of a growing population (which impacts consumption and investment spending), increases in government spending, and increases in the money supply. Aggregate supply is generally increasing as well, with improvements in labor productivity and technology. However, as long as the aggregate demand curve is increasing more rapidly than the long run aggregate supply curve, there will tend to be inflation and economic growth.
The Phillips Curve Over Time 563 a. Aggregate Demand and Aggregate Supply b. The Phillips Curve Price Level RGDP 0 RGDP1 RGDP2 PL2 PL1 A B SRAS1 SRAS2 AD Inflation Rate Unemployment Rate 0 A B SRPC1 SRPC2 Favorable Supply Shock SECTION 25.2 EXHIBIT 4 In (a), lower costs of production caused by the favorable supply shock causes a rightward shift in the SRAS curve from SRAS1 to SRAS2, the price level falls from PL1 to PL2, and RGDP rises from RGDP1 to RGDP2. The favorable supply-side shock leads to a lower price level and greater output. With a lower price level comes a lower inflation rate and a lower rate of unemployment. The short-run Phillips curve shifts to the left, from SRPC1 to SRPC2 in (b). At point B, both the inflation rate and the unemployment rate are lower than at point A.
564 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy Inflation—already modest by the mid-1990s—continued to subside, even as unemployment dropped far below its then estimated 6 percent natural level. And unburdened by a restrictive monetary policy, the economy grew faster than anyone anticipated.
Why didn’t inflation take off, as economists expected?
Experts have offered many explanations, from the impact of global competition and the strong dollar to the Asian crisis and productivity gains from the new high-tech economy.
But the most intriguing may be one suggested by a recent study by George A. Akerlof of the University of California at Berkeley and William Dickens and George Perry of the Brookings Institution. In the study, the three economists find that unemployment can be reduced below its normal natural rate without sparking a rise in inflation—if the reduction occurs in a climate of already moderate inflation.
To see why, you have to first understand natural rate theory.
Most economists once bought the Phillips curve notion that accepting higher inflation would allow you to achieve lower unemployment.
But economists Milton Friedman and Edmund Phelps in the 1970s suggested that such gains don’t last. Over the long run, they argued, employers and workers seek to maintain their real incomes by adding higher inflation to their wage bargains and prices, causing joblessness to rise again.
Thus, every economy presumably has a natural level of sustainable unemployment below which inflation tends to accelerate.
What Akerlof, Dickens, and Perry find, however, is that this level declines when inflation is low and stable. At such times, companies and people tend to ignore past inflation and thus don’t fully offset it in wages and prices. As a result, companies hire more people and sell more goods, which means less unemployment and more output.
As evidence, the researchers cite survey data from 1954 to 1999, which show that employees and employers are far more likely to incorporate inflationary expectations into wage and price hikes in periods of high inflation (over 4 percent) than in low-inflation periods (under 3 percent). They then use these data to estimate the trade-offs between unemployment and inflation over the postwar period.
The results suggest that the natural rate of unemployment is about 5 percent when core inflation is running over 6 percent.
But when inflation is in a stable, moderate range of between 2 percent and 4 percent, unemployment can be safely kept as low as 4 percent. At that point, reducing inflation still further would raise unemployment, while pushing unemployment below 4 percent would boost inflation.
That, so it seems, is the lesson Greenspan’s pragmatic Fed learned. When unemployment fell below 5 percent in the mid- 1990s, core inflation was only 3 percent or so, and the Fed didn’t panic. Its calm restraint allowed the New Economy to flower and millions of Americans to join the ranks of the employed.
SOURCE: “Why Fed Policy Worked So Well,” http://www.businessweek.
com/2000/00_52/b3713111.htm 12 1 2 A STUDY UPDATES THE PHILLIPS CURVE In The NEWS 120 110 100 90 80 70 60 50 40 30 20 3,500 4,000 4,500 5,000 5,500 6,000 6,500 7,000 7,500 8,000 1996 Real GDP in Billions of 1996 Dollars Price Level (GDP deflator)(1996 = 100) 8,500 9,000 9,500 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1997 1998 1999 2000 2001 0 U.S. Price Level and RGDP SECTION 25.2 EXHIBIT 5 The price level and real GDP has risen over the last 30 years. As long as aggregate demand is increasing more rapidly than aggregate supply (long run), there will tend to be inflation with economic growth.
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
Unemployment Rate Core Inflation* Natural Unemployment Rate (6%) ’90 0 2 4 6 8 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 SECTION 25.2 EXHIBIT 6 After joblessness sank, inflation stayed low.
Rational Expectations 565 Rational Expectations s e c t i o n 25.3 _ What is the rational expectations theory?
_ What do critics say about the rational expectations theory?
CAN HUMAN BEHAVIOR COUNTERACT GOVERNMENT POLICY?
Is it possible that people can anticipate the plans of policymakers and alter their behavior quickly to neutralize the intended impact of government action?
For example, if workers see that the government is allowing the money supply to expand rapidly, they may quickly demand higher money wages to offset the anticipated inflation. In the extreme form, if people could instantly recognize and respond to government policy changes, it might be impossible to alter real output or unemployment levels through policy actions, because government policymakers could no longer surprise consumers and businesses. An increasing number of economists believe that there is at least some truth to this point of 1. The Phillips curve depicting the period of high inflation and unemployment in the 1970s no longer suggests the strong inverse relationship between the two variables that was evident in the 1960s.
2. The short-run Phillips curve relationship is seen as unstable and not a permanent relationship between unemployment and inflation rates.
3. The long-run Phillips curve shows the relationship between the inflation rate and the unemployment rate when the actual and expected inflation rates are the same.
4. Along the long-run Phillips curve, the natural rate of unemployment can occur at any rate of inflation.
5. If economic fluctuations are expected to be permanent, and caused primarily by supply-side shifts, then there may be a positive relationship between the inflation rate and the unemployment rate—a shifting short-run Phillips curve.
Higher rates of inflation will be coupled with higher rates of unemployment and lower rates of inflation will be coupled with lower rates of unemployment.
1. Is the Phillips curve stable over time?
2. Why would you expect there to be no relationship between inflation and unemployment in the long run?
3. Why is the economy being on the long-run Phillips curve equivalent to its being on the long-run aggregate supply curve?
4. Why would inflation have to accelerate over time to keep unemployment below its natural rate (and real output above its natural level) for a sustained period?
5. What does the long-run Phillips curve say about the relationship between macroeconomic policy stimulus and unemployment in the long run?
s e c t i o n c h e c k view. At a minimum, most economists accept the notion that real output and the unemployment rate cannot be altered with the ease that was earlier believed; some believe that the unemployment rate can seldom be influenced by fiscal and monetary policies.
THE RATIONAL EXPECTATIONS THEORY The relatively new extension of economic theory that leads to this rather pessimistic conclusion regarding macroeconomic policy’s ability to achieve our economic goals is called the theory of rational expectations. The notion that expectations or anticipations of future events are relevant to economic theory is not new; for decades, economists have incorporated expectations into models analyzing many forms of economic behavior. Only in the recent past, however, has a theory evolved that tries to incorporate expectations as a central factor in the analysis of the entire economy.
The interest in rational expectations has grown rapidly in the last decade. Acknowledged pioneers in the development of the theory include Professor Robert Lucas of the University of Chicago and Professor Thomas Sargent of the University of Minnesota.
In 1995, Professor Lucas won the Nobel Prize for his work in rational expectations.
Rational expectation economists believe that wages and prices are flexible and that workers and consumers incorporate the likely consequences of government policy changes quickly into their expectations.
In addition, rational expectation economists believe that the economy is inherently stable after macroeconomic shocks and that tinkering with fiscal and monetary policy cannot have the desired effect unless consumers and workers are caught “off guard” (and catching them off guard gets harder the more you try to do it).
RATIONAL EXPECTATIONS AND THE CONSEQUENCES OF GOVERNMENT MACROECONOMIC POLICIES Rational expectations theory, then, suggests that government economic policies designed to alter aggregate demand to meet macroeconomic goals are of very limited effectiveness. When policy targets become public, it is argued, people will alter their own behavior from what it would otherwise have been to maximize their own utility, and in so doing, they largely negate the intended impact of policy changes. If government policy seems tilted towards permitting more inflation to try to reduce unemployment, people start spending their money faster than before, become more adamant in their demands for wages and other input prices, and so on.
In the process of quickly altering their behavior to reflect the likely consequences of policy changes, they make it more difficult (costly) for government authorities to meet their macroeconomic objectives.
Rather than fooling people into changing real wages, and therefore unemployment, with inflation “surprises,” changes in inflation are quickly reflected into expectations with little or no effect on unemployment or real output even in the short run.
As a consequence, policies intended to reduce unemployment through stimulating aggregate demand will often fail to have the intended effect. Fiscal and monetary policy, according to this view, will work only if the people are caught off guard or are fooled by policies and thus do not modify their behavior in a way that reduces policy effectiveness.
ANTICIPATION OF AN EXPANSIONARY MONETARY POLICY Consider the case in which there is an increase in aggregate demand as a result of an expansionary monetary policy. This increase is reflected in Exhibit 1 in the shift from AD1 to AD2. Because the 566 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy Price Level RGDP 0 RGDPNR PL1 PL2 LRAS SRAS2 SRAS1 AD1 AD2 Rational Expectations and the AD/AS Model SECTION 25.3 EXHIBIT 1 Expansionary monetary policy (or fiscal policy) will not affect RGDP if wages and prices are completely flexible, as in the rational expectations model. This means that the SRAS curve will shift leftward from SRAS1 to SRAS2 at the same time as the AD curve. Therefore, an expansionary policy, an increase in aggregate demand from AD1 to AD2, will lead to a higher price level but no change in RGDP or unemployment.
predictable inflationary consequences of that expansionary policy, prices immediately adjust to a new level at PL2. Consumers, producers, workers, and lenders who anticipated the effects of the expansionary policy simply build the higher inflation rates into their product prices, wages, and interest rates. That is, consumers, producers, and workers realize that expansionary monetary policy can cause inflation if the economy is working close to capacity. Consequently, in an effort to protect themselves from the higher anticipated inflation, workers ask for higher wages, suppliers increase input prices, and producers raise their product prices.
Because wages, prices, and interest rates are assumed to be flexible, the adjustments take place immediately.
This increase in input costs for wages, interest, and raw materials caus...
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