Exploring Economics - 4e - Chapter 30.pdf - po ang - Januszek66

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CHAPTER

I SSUES IN M ACROECONOMIC

T HEORY AND P OLICY

30.1

The Phillips Curve

30.3 Rational Expectations and Real

Business Cycles

30.2 The Phillips Curve over Time

30.4 Controversies in Macroeconomic Policy

fter 10 years of unprecedented economic

growth, the economy started to slip into a

recession in early 2001, although it was one of

the mildest recessions on record. This recession

was set off by a serious drop in investment spend-

ing. The technology sector led to higher productivity

during the 1990s, but the bursting of the dot-com

bubble resulted in considerable loss in stock market

wealth. The slowdown in the tech sector started to

affect other segments of the economy. This situa-

tion, coupled with the terrorist attacks, created a

negative shock that rippled through the economy,

especially in the travel sector. Hotels and airlines

were hit particularly hard. The corporate account-

ing scandals of Enron and WorldCom also influ-

enced investment attitudes. Uncertainty and fading

optimism reduced both investment and consump-

tion spending and reduced aggregate demand. To

combat, or weaken, the recession, the government

stimulated aggregate demand with increases in

government expenditures for security and defense,

the tax cut of 2001, and aggressive reductions

in the federal funds rate by the Federal Reserve.

The Fed started to cut its federal funds rate by

0.5 percentage point (it usually only changes the

rate by 0.25%) in January of 2001. In the week

following the attacks on the World Trade Center

(September 2001), it temporarily set the federal

funds rate as low as 1.25 percent. By November

2001, the recession was officially over but the fed-

eral funds rate had fallen from 6.5 percent to 2 per-

cent—4.5 percent lower than the previous year. The

Fed looked like it had done its job.

Was it the best way to stabilize the economy?

We begin our chapter by asking whether policymak-

ers face a trade-off between inflation and unemploy-

ment. If a trade-off is inevitable, does it exist in the

short run and the long run? If the economy is faced

with a recessionary or an inflationary gap, how

quickly will it recover to its long-run equilibrium

position? And what is the best way to stabilize the

economy? Should policymakers use expansionary

and contractionary monetary and fiscal policies?

Or should policymakers allow the economy to self-

correct? Macroeconomists do not completely agree

on this question, a topic we will discuss throughout

this chapter.

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Monetary and Fiscal Policy

MODULE 7

SECTION

30.1

The Phillips Curve

What is the Phillips curve?

How does the Phillips curve relate to the

aggregate supply and demand model?

UNEMPLOYMENT AND INFLATION

Despite legislation committing the federal govern-

ment to the goal of full employment and the devel-

opment of macroeconomic theory arguing that full

employment can be achieved by manipulating aggre-

gate 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.

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 relationship

suggests that once the economy has relatively low

unemployment rates, further reductions in the unem-

ployment 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 elimi-

nating decreasing amounts of unemployment in those

sectors where some excess capacity and unemploy-

ment still exist.

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 suggested that at higher rates of infla-

tion, the rate of unemployment is lower, while during

periods of relatively stable or falling prices, unem-

ployment 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 10 years of the decade. The curved line—the

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 moved from a 2 percent annual

inflation rate to a 4 percent inflation rate, and the

unemployment rate simultaneously fell from 5 percent

to 4 percent. In the Phillips curve, we see this shift 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 an increase in

aggregate demand occurs. Consequently, the price level

increases from PL 1 to PL 2 (the inflation rate rises) and

output increases from RGDP 1 to RGDP 2 (the unem-

ployment rate falls). To increase output, firms employ

more workers, so employment increases and unem-

ployment falls—the movement from point A to point B

in Exhibit 2(b).

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Issues in Macroeconomic Theory and Policy

CHAPTER 30

SECTION 30.1

E XHIBIT 1

The Phillips Curve Relationship, United States, 1960s

Phillips

Curve

Unemployment Rate

(percent per year)

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 low unem-

ployment rates, further decreases in unemployment can occur only if the economy can accept much larger increases

in inflation rates.

SECTION 30.1

E XHIBIT 2

The Phillips Curve and the AD/AS Curves

a. Phillips Curve

b. Aggregate Supply and Demand

PL 2

PL 1

Phillips

Curve

AD 2

AD 1

RGDP 1 RGDP 2

Unemployment Rate

(5 percent

unemployment)

(4 percent

unemployment)

Real GDP (trillions of dollars)

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.

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Monetary and Fiscal Policy

MODULE 7

SECTION * CHECK

The inverse relationship between the rate of unemployment and the rate of inflation is called the

Phillips curve.

The Phillips curve relationship can also be seen indirectly from the AD/AS model.

How does the rate of inflation affect real wage rates if nominal wages rise less or more slowly than output

prices?

How does the change in real wage rates (relative to output prices) as inflation increases affect the unemploy-

ment rate?

What is the argument for why the Phillips curve is relatively steeper at lower rates of unemployment and higher

rates of inflation?

For a given upward-sloping short-run aggregate supply curve, how does an increase in aggregate demand corre-

spond to a movement up and to the left along a Phillips curve?

SECTION

30.2 The Phillips Curve over Time

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?

THE PHILLIPS CURVE—THE 1960S

It became widely accepted in the 1960s that to

pursue the appropriate economic policies, policy-

makers 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 trade-off in terms

of other macroeconomic goals. The empirical evi-

dence 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 such as 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 worsen-

ing 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 situation 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 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 PC 2 and eventually in the late

1990s to PC 3 . In fact, in the mid-1990s, when lower

rates of inflation were achieved and anticipated, the

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Issues in Macroeconomic Theory and Policy

CHAPTER 30

SECTION 30.2

E XHIBIT 1

The Phillips Curve, United States, 1960–2003

PC 3 1974–1982

PC 2 1983–1993

PC 1

1960–1969; 1994–2003

03 94

Unemployment Rate

(percent per year)

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 PC 2 and eventually all the way back to PC 1 , the level of the 1960s.

Phillips curve shifted inward back to the level of the

1960s. Let us now take a closer look at how expecta-

tions can affect the Phillips curve.

growth rate of the money supply increases. The increase

in the growth rate of the money supply stimulates aggre-

gate demand. In the short run, the increase in aggregate

demand increases output and decreases unemployment.

As the economy moves up along the short-run Phillips

curve, from point A to point B, the actual inflation rate

increases from 3 percent to 6 percent, and the unem-

ployment rate falls below the natural rate to 3 percent.

Because the increase in inflation was unantici-

pated, 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 inflation rate that

was not initially anticipated—in short, they were

fooled in the short run. Workers now vigorously

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 per-

cent. Now suppose the

natural rate

hypothesis

states that the economy will self-

correct to the natural rate of

employment

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