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 causes the aggregate supply curve to shift up or leftward, shown as the movement from SRAS1 to SRAS2 in Exhibit 1. So the desired policy effect of greater real output and reduced unemployment from a shift in the aggregate demand curve is offset by an upward or leftward shift in the aggregate supply curve caused by an increase in input costs.
UNANTICIPATED EXPANSIONARY POLICY Again, consider the case in which there is an increase in aggregate demand as a result of an expansionary monetary policy. However, this time it is unanticipated. The increase in the money supply is reflected in Exhibit 2 in the shift from AD1 to AD2.
This unanticipated change in monetary policy stimulates output and employment in the short run, as the equilibrium moves from point A to point B. At the new short-run equilibrium, the output is at RGDP2 and the price level is at PL2. This output is beyond RGDPNR, so it is not sustainable in the long run. Because it is unanticipated, workers and other input owners are expecting price level to remain at PL1, rather than PL2. However, when input owners eventually realize that the actual price level has changed, they will require higher input prices, shifting the SRAS from SRAS1 to SRAS2. At point C, we see that output has returned to RGDPNR but at a higher price level, PL3.
This means that when the expansionary policy is unanticipated, it leads to a short-run expansion in output and employment. But in the long run, the Rational Expectations 567 Price Level RGDP 0 C B A LRAS RGDPNR RGDP2 PL2 PL3 PL1 SRAS1 AD1 SRAS2 AD2 (Unanticipated) An Expansionary Policy That Is Unanticipated SECTION 25.3 EXHIBIT 2 An unanticipated change in monetary policy stimulates output and employment in the short run, as the equilibrium moves from point A to point B. At the new short-run equilibrium, the output is at RGDP2 and the price level is at PL2. Because the expansionary policy is unanticipated, workers and other input owners are expecting the price level to remain at PL1, rather than PL2. When input owners eventually realize that the actual price level has changed, they will require higher input prices, shifting the SRAS curve from SRAS1 to SRAS2. At point C, we see that output has returned to RGDPNR but at a higher price level, PL3. If the expansionary policy is unanticipated, it leads to a short-run expansion in output and employment. In the long run, however, the impact of the change in the expansionary policy is a higher price level.
only impact of the change in monetary policy is a higher price level—inflation. In short, when the change is correctly anticipated, there is no change in real output from an expansionary monetary (or fiscal) policy. However, if the expansionary monetary (fiscal) policy is unanticipated, there is a shortrun increase in RGDP and employment but in the long run, just a higher price level.
In fact, the only way that monetary or fiscal policy can change output in the rational expectations model is with a surprise—an unanticipated change. For example, on April 18, 2001, between regularly scheduled meetings of the Federal Open Market Committee, the Fed surprised financial markets with an aggressive half-point cut in the interest rate. The Fed was trying to boost consumer confidence and impact falling stock market wealth.
The surprise reduction in the interest rate sent the stock market soaring as the Dow posted its third largest single-day point gain, and the NASDAQ had its fourth largest percentage gain. Fed Chairman Greenspan hoped that this would shift the AD curve rightward, leading to higher levels of output.
WHEN AN ANTICIPATED EXPANSIONARY POLICY CHANGE IS LESS THAN THE ACTUAL POLICY CHANGE In the context of the rational expectations model (wages and prices are flexible), suppose people are expecting a large increase in the money supply as a result of expansionary monetary policy. This causes the anticipated price level to increase from PL1 to PL3 when the anticipated aggregate demand increases from AD1 to AD3, as seen in Exhibit 3. If 568 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy Price Level RGDP 0 RGDP2 RGDPNR PL2 PL3 PL1 C A B LRAS SRAS1 AD1 AD2 (Actual) SRAS2 AD3 (Anticipated) An Actual Expansionary Policy That Is Less Than the Anticipated Policy SECTION 25.3 EXHIBIT 3 If people are expecting a large increase in the money supply as a result of expansionary monetary policy, the anticipated price level increases from PL1 to PL3 and the anticipated AD shifts from AD1 to AD3. Because wages and prices are completely flexible, the SRAS shifts leftward from SRAS1 to SRAS2 at the same time the AD curve shifts to the right. But if the actual increase in the money supply only shifts AD from AD1 to AD2, the economy moves from point A to point B rather than to point C. This leads to a higher price level but a lower level of RGDP—a recession, not the intended policy prescription.
people anticipate the new price level PL3, wages and other input prices adjust quickly, and the SRAS shifts leftward from SRAS1 to SRAS2. But what if the increase in the money supply ends up being less than people anticipated? Say the actual increase in the money supply only shifts AD from AD1 to AD2.
That is, the economy moves from point A to point B rather than to point C as many had expected.
This leads to a higher price level but a lower level of RGDP—a recession.
That is, a policy designed to increase output may actually reduce output if prices and wages are flexible and the expansionary effect is less than people anticipated.
CRITICS OF RATIONAL EXPECTATIONS THEORY Of course, rational expectations theory does have its critics. Critics want to know if consumers and producers are completely informed about the impact that, say, an increase in money supply will have on the economy. In general, all citizens will not be completely informed, but key players like corporations, financial institutions, and labor organizations may well be informed about the impact of these policy changes. But there are other problems, too. For example, are wages and other input prices really that flexible? That is, even if decision makers could anticipate the eventual effect of policy changes on prices, those prices may still be slow to adapt (e.g., what if you had just signed a three-year labor or supply contract when the new policy was implemented?).
Most economists reject the extreme rational expectations model of complete wage and price flexibility.
In fact, most economists still believe there is a short-run trade-off between inflation and unemployment because some input prices are slow to adjust to changes in the price level. However, in the long run, the expected inflation rate adjusts to changes in the actual inflation rate at the natural rate of unemployment, RGDPNR.
Rational Expectations 569 1. Rational expectation economists believe that wages and prices are flexible and thus should be left alone. They also believe that workers and consumers form rational expectations that essentially negate the desired effect of a policy change.
2. Critics of rational expectations theory believe that most people are not truly informed about the effects of a policy change and therefore do not adjust their behavior. Additionally, they question whether prices and wages are really that flexible.
1. What is the rational expectations theory?
2. Why could an unexpected change in inflation change real wages and unemployment, while an expected change in inflation could not?
3. Why can the results of rational expectations be described as generating the long-run results of a policy change in the short run?
4. In a world of rational expectations, why is it harder to reduce unemployment below its natural rate but potentially easier to reduce inflation rates?
5. Even if individuals could quickly anticipate the consequences of government policy changes, how could long-term contracts (e.g., three-year labor agreements and 30-year fixed-rate mortgages) and the costs of changing price lists and catalogues result in unemployment still being affected by those policy changes?
6. Why do expected rainstorms have different effects on people than unexpected rainstorms?
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PURPOSE OF WAGE AND PRICE CONTROLS If monetary and fiscal policy are ineffective or counterproductive, what policies are left to control inflation? It is possible that the federal government could set up a comprehensive program over nominal wages and prices, often called incomes policy.
One method to deal with existing inflationary pressures is to impose controls on wages and/or prices.
We have imposed such controls three times in modern American history, during World War II, during the Korean War, and in 1971 near the end of the Vietnam War. Wage and price controls involve either a complete freeze on wages and prices at precontrol levels or some rigid limits as to the increases in wages and prices that will be permitted. One or more government agencies are created to monitor the program.
IMPLEMENTING PRICE CONTROLS WITHOUT GOVERNMENT REGULATION Sometimes it is thought that it is more desirable to establish voluntary guidelines or guideposts than to force companies and unions to limit their price and wage levels. This approach avoids the expense and political acrimony associated with establishing a control bureaucracy. Sometimes the “jawboning”— the verbal pressuring or persuasion—gets pretty intense.
The one memorable instance of jawboning in modern history came in the early 1960s, when President Kennedy became angered when major steel producers announced price increases. All sorts of pressures were placed on steel makers, who were summoned to Washington, pleaded with, and even threatened with possible legal action under the antitrust laws. Finally, one company decided not to go along with the price increases, and then other companies quickly fell in line. In 1978, voluntary wage and price guidelines were imposed by the Carter administration.
Those guidelines explicitly stated that pressure would be used by the government to ensure compliance, making them virtually mandatory controls.
JUSTIFICATIONS FOR WAGE AND PRICE CONTROLS Two justifications are given for wage and price controls.
First, by limiting price increases by law, the government directly reduces the rate of inflation legally allowed. In this connection, it is interesting to note that during the four years of direct U.S. involvement in World War II, when price controls were in effect, consumer prices rose only a bit more than 20 percent, despite a huge increase in aggregate demand. Second, especially with respect to wage controls, it is argued that wage and price controls lower the inflationary expectations of workers and their unions, reducing the “inflation psychology” that contributes to cost-push inflation.
IF WAGE AND PRICE CONTROLS HAVE THESE ADVANTAGES, WHY ARE THEY NOT USED MORE OFTEN?
Wage and price controls also have several major disadvantages, which are very likely to be viewed as being greater than the advantages, except possibly during wartime situations when aggregate demand is growing very rapidly. The problem of enforcing the controls has already been mentioned. With millions of businesses, products, and workers in our economy, the administrative problem of monitoring wages and prices is immense, and any effective enforcement is likely to be costly. Black markets (illegal sales) often develop. These problems are often very hard to solve.
To give one example, suppose the price administrators say that next year's models of automobiles can be priced 4 percent higher than this year's. Suppose now that an automaker brings out a new model selling for only 3 percent more than the old 570 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy Wage and Price Controls and Indexing s e c t i o n 25.4 _ How are wage and price controls imposed and what purpose do they serve?
_ What are some problems associated with wage and price controls?
_ What is indexing and how can it be used?
model. At the same time, however, suppose that the new model is slightly smaller than the old one, has less “frills” than the previous model, has a slightly smaller engine, and so forth. Is the automaker in violation of the price control? The company would say no, because the price is up only 3 percent. Others might say yes, because the new product is inferior to the old one in several ways.
Another even more fundamental problem with wage and price controls is that they lead to shortages of goods, services, and workers. With these controls, inflationary pressures are not eradicated but rather disguised, manifesting themselves not as price increases but as a lack of desired goods or human resources. As a result, severe and prolonged controls can lead to a serious misallocation of resources.
PRICE CONTROLS LEAD TO A MISALLOCATION OF RESOURCES Straightforward supply and demand analysis indicates the misallocation of resources due to wage and price controls, as illustrated in Exhibit 1. Suppose the demand and supply for refrigerators are indicated by D1 and S in Exhibit 1. The equilibrium price of refrigerators, P1, is determined by the intersection of the demand and supply curves. Suppose that recent stock market wealth has led to higher income and an increase in demand for refrigerators to D2. If the market is allowed to work without intervention, the price of refrigerators would increase to the new equilibrium price of P2, where D2 intersects S. But suppose wage and price controls are imposed and the price controllers consider an increase in price from P1 to P2 to be unacceptably large, declaring instead that the price can only rise to the government ceiling price, PCEILING. At the price ceiling, however, the quantity demanded exceeds the quantity supplied and shortages arise.
EXAMPLES OF PROBLEMS WITH PRICE CONTROLS During the 1973 Arab oil boycott, the federal government imposed price ceilings on gasoline that prevented gas prices from rising as they normally would have in response to reduced supply. At the ceiling price, quantity demanded exceeded quantity supplied; gas stations ran out of gas, were often closed, or placed a limit on the amount of gas they would sell. When drivers were able to buy gas, they often filled not only their tanks but also several containers they carried along to reduce the risk of being unable to buy gas when they needed it. In the former Soviet Union, where price control-related shortages were commonplace, citizens typically carried briefcases or even suitcases and large quantities of cash, in case they were able to purchase a normally unavailable good. Rather than buying the product just for themselves, they would buy several items for their friends and relatives as well, to keep them from having to stand in line for hours, often Wage and Price Controls and Indexing 571 D1 P1 PCEILING PCEILING P2 D2 Price of Refrigerators Quantity of Refrigerators 0 S Shortage The Impact of Price Controls SECTION 25.4 EXHIBIT 1 Suppose that price controls exist and the ceiling price on refrigerators is set at PCEILING. Suppose for some reason the demand for refrigerators rises from D1 to D2. Without controls, price would be P2. Price controls lead to a quantity demanded that is greater than quantity supplied, resulting in a shortage.
in vain, trying to buy it. Winston Churchill once aptly termed a society with rigid price controls as a “queuetopia” (the British commonly use the term queue to refer to a long line.)
EXAMPLES OF PROBLEMS CREATED BY WAGE CONTROLS In the case of prolonged wage controls, shortages of personnel can occur. Wages serve as market signals.
Rising wages in an occupation increase that occupation's attractiveness, leading to the entrance of new workers. In the early 1970s, for example, newly trained accountants were earning much more than other new college graduates. Predictably, there was a supply response, as accounting majors became much more numerous in colleges. By the late 1970s, the salary (or price) of accountants started to fall a bit relative to other occupations. If, however, the government had decreed that the salaries of new accountants in the five years after 1972 could not rise above, say, $12,000 a year, the increase in the quantity of new accountants supplied would not have occurred. An accountant shortage would have developed, causing all sorts of problems for businesses needing accurate evaluations of their financial performance, individuals needing their tax returns prepared, and so forth.
Whether the gains from wage and price controls in the form of reduced inflation outweigh the costs in the form of shortages and inefficient resource allocation is debatable. This is a normative issue where honest, informed people can differ in their perceptions of costs and benefits. The classic illustration of this was the monumental, prolonged debate in the U.S. Congress in 1977 over the removal of price controls on natural gas. One side argued that controls should be removed to end shortages and enhance long-term supply. The other side argued that removing controls would lead to inflated prices for gas and inflated profits for gas producers, while causing hardships to lower-income users of gas. Eventually the issue was resolved by easing, but not completely removing, the controls until 1993.
KEEPING PRICES DOWN WITHOUT THE USE OF PRICE CONTROLS The attempt to control prices politically can take another form. The presence of monopolistic elements in an industry can lead to higher prices for that industry's products than would be the case for a more competitive industry. By stimulating price competition among private firms, the government may be able to help reduce inflationary pressures.
In recent years, the possibility of using the antitrust laws to attack alleged monopoly influences in certain industries with rapidly increasing prices—such as the prescription drug industry—has been considered.
However, despite much talk, there has been relatively little actual use of antitrust laws to try to reduce inflation pressures. Moreover, monopoly power can also be artificially created by government regulations; such has been the case in transportation.
The relaxation of price regulation of airlines, for example, led to lower airfares in the late 1970s.
COULD INDEXING REDUCE THE COSTS OF INFLATION?
Another approach to some of the problems posed by inflation is indexing. As you recall, inflation poses substantial equity and distributional problems only when it is unanticipated or unexpected.
One means of protecting parties against unanticipated price increases is to write contracts that automatically change the prices of goods or services whenever the overall price level changes, effectively rewriting agreements in terms of dollars of constant purchasing power. Wages, loans, and mortgage payments—everything possible—would be changed every month or so by an amount equal to the percentage change in some broad-based price index. Thus, if prices rose by 1.2 percent this month and your last month's wage was $1,000, your wage this month would be $1,012 ($1,000 3 1.012). By making as many contracts as possible payable in dollars of constant purchasing power, those involved could protect themselves against unanticipated changes in inflation.
WHY ISN'T INDEXING MORE EXTENSIVELY USED?
Indexing seems to eliminate most of the wealth transfers associated with unexpected inflation. Why then is it not more commonly used? One main argument against indexing is that it can worsen inflation.
As prices go up, wages and certain other contractual obligations (e.g., rents) also automatically increase. This immediate and comprehensive reaction to price increases leads to greater inflationary 572 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy Wage and Price Controls and Indexing 573 http://sextonxtra.swlearning.com To work more with this Chapter's concepts, log on to Sexton Xtra! now.
pressures. One price increase leads to a second, which in turn leads to a third, and so on.
OTHER PROBLEMS ASSOCIATED WITH INDEXING We might ask, so what? If prices rise rapidly but wages, rents, and so forth move up with prices, real wages and rents remain constant. However, if inflation gets bad enough, it could become almost impossible administratively to maintain the indexing scheme. The index, to be effective, might have to be changed every few days, but the information to make such frequent changes is not currently available.
To get the necessary information quickly, then, might be quite expensive, involving a small army of price-checking bureaucrats and a massive electronic communications system. There are other inefficiencies as well. During the German hyperinflation of the early 1920s, prices at one point rose so rapidly that workers demanded to be paid twice a day, at noon and at the end of the workday. During their lunch hour, workers would rush money to their wives, who would then run out and buy real goods before prices increased further.
Other big problems include the fact that indexing reduces the ability for relative price changes to allocate resources where they are more valuable.
Not everything can be indexed, so indexing would cause wealth redistribution. In addition, costs would necessarily be incurred as a result of renegotiating cost-of-living (COLA) clauses.
Excessive inflation, then, leads to great inefficiency, as well as to a loss of confidence in the issuer of money—namely, the government. Furthermore, inflation influences world trade patterns.
Limited indexing, in fact, has already been adopted, as some wage and pension payments are changed with changes in the cost-of-living index. Whether on balance those escalator clauses are “good” or “bad” is a debatable topic—a normative judgment that we will leave to the reader to make.
1. Wage and price controls can be imposed by government regulation or “voluntarily” with the use of moral suasion. The purpose of such controls is to reduce inflation and lower future inflation expectations.
2. Besides enforcement problems, wage and price controls lead to shortages of goods and personnel as well as misallocations of goods.
3. Indexing is a process of adjusting payment contracts to automatically adjust for changes in inflation.
Indexing reduces the impact of inflation on the distribution of income but may also intensify the inflationary effects of expansionary monetary policy by increasing inflationary pressures.
1. In what ways might “voluntary” government inflation guidelines not be completely voluntary?
2. If holding down legal price increases through price controls reduces official inflation rates, why are black markets likely to arise?
3. How might wage and price controls lead to shortages of goods and services (a “queuetopia”)?
4. How might wage and price controls lead to the production of inferior products over time?
5. If each possible good was indexed to changes in the general price level, would it be very easy for relative price changes to signal changing relative scarcities? Why or why not?
s e c t i o n c h e c k 574 CHAPTER TWENTY-FIVE | Issues in Macroeconomic Theory and Policy 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.
The short-run Phillips curve relationship is unstable and not a permanent relationship between unemployment and inflation rates. 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.
Along the long-run Phillips curve, the natural rate of unemployment can occur at any rate of inflation.
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 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.
Rational expectation economists believe that wages and prices are flexible and thus should be left alone. They also believe that workers and consumers form rational expectations that essentially negate the desired effect of a policy change. Critics of rational expectations theory believe that most people are truly not informed about the effects of a policy change and therefore do not adjust their behavior.
Additionally, they question whether prices and wages are really that flexible.
Wage and price controls can be imposed by government regulation, or “voluntarily” with the use of moral suasion. The purpose of such controls is to reduce inflation and lower future inflation expectations.
Besides the problems of enforcing wage and price controls, these policies lead to shortages of goods and personnel as well as misallocations of goods.
Summar y natural rate hypothesis 559 adaptive expectations 561 theory of rational expectations 566 incomes policy 570 indexing
572 K e y Ter m s a n d C o n c e p t s 1. Abraham Lincoln once said “You can fool all of the people some of the time, and some of the people all of the time, but you cannot fool all of the people all of the time.” How can a central bank that conducts monetary policy “fool people” and thereby affect the level of unemployment in the economy? What happens if people begin to anticipate future monetary policy correctly based upon past experience?
2. Predict the impact an unexpected decrease in the money supply would have on the following variables in the short run and in the long run.
a. the inflation rate b. the unemployment rate c. real output d. real wages 3. Predict whether unemployment will increase or decrease as a result of each of the following monetary policies. If it is unanticipated? What if it is anticipated?
a reduction in the discount rate from 6 percent to 5.5 percent b. an open market sale by the Federal Reserve Bank c. an increase in the required reserve ratio from 10 percent to 12 percent
R e v i e w Q u e s t i o n s
Review Questions 575
4. Suppose the following data represent points along a short-run Phillips curve. Is the data consistent with what you would expect? Why or why not?
Inflation Rate Unemployment Rate A 0% 5% B 1% 4.5% C 2% 3.75% D 3% 2.75% E 4% 1.5% 5. How do Cost-of-Living Adjustments weaken the ability of the central bank to exploit the trade-off between inflation and unemployment?
6. How are the long-run Phillips curve and the long-run aggregate supply curve related?
7. How would each of the following likely affect long-run and/or short-run aggregate supply and employment in the macroeconomy?
a. an increase in the productivity of the labor force due to increased education b. the coldest year in a century leads to frequent ice and snow storms c. major advances in computer and internet technologies 8. If nominal wages and productivity increase by the same amount throughout the macroeconomy, would you expect aggregate supply to increase, decrease, or stay the same? What if productivity increases more than nominal wages?
9. Why do economists who believe people form rational expectations have little faith that announced changes in monetary policy will have substantial effects on real output?
10. Does stagflation contradict the theory of the Phillips curve?
11. Visit the Sexton Web site for this chapter at http://sexton.swlearning.com, and click on the Interactive Study Center button. Under Internet Review Questions, click on the Dismal Scientist Chartroom link. Examine the chart of U.S. productivity growth over the last several decades. Based on this information, in what years does it appear that the economy experience adverse supply shocks?
12. Visit the Sexton Web site for this chapter at http://sexton.swlearning.com, and click on the Interactive Study Center button. Under Internet Review Questions, click on the Conference Board's Latest Index of Leading Economic Indicators link and find the change in the index of labor cost per unit of output in the manufacturing sector over the last few months. As a result of these changes, would you expect unemployment in the manufacturing sector to increase or decrease?
REVIEW QUESTIONS
CHAPTER 25: ISSUES IN MACROECONOMIC THEORY AND POLICY
25.1: The Phillips Curve
1. How does the rate of inflation affect real wage rates, if nominal wages rise less or more slowly than output prices?
When nominal wages rise less or more slowly than output prices, real (adjusted for inflation) wages fall.
2. How does the change in real wage rates (relative to output prices) as inflation increases affect the unemployment rate?
The fall in real wage rates (relative to output prices) as inflation increases reduces the unemployment rate, because the lower real wage rates make it profitable to hire more, now relatively cheaper, employees than before.
3. What is the argument for why the Phillips curve is relatively steeper at lower rates of unemployment and higher rates of inflation?
The argument is that once capacity utilization if high and unemployment is low, an increased part of the economy is already operating at or near full capacity, and further fiscal or monetary policy stimulus primarily triggers inflationary pressures in sectors already at capacity, while eliminating decreasing amounts of unemployment in those fewer sectors where excess capacity and high unemployment still exists.
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?
For a given upward-sloping short-run aggregate supply curve, an increase in aggregate demand moves the economy up along thee short-run aggregate supply curve to an increased price level and increased real GDP. The increase in the price level is an increase in inflation and the increase in real GDP is accompanied by a decrease in unemployment, so the same effects is shown by a move up (higher inflation) and to the left (lower unemployment) along a Phillips curve.
25.2: The Phillips Curve Over Time 1. Is the Phillips curve stable over time?
No. While the short-run Phillips curve was once considered to be stable, economists now recognize that it is unstable, and does not represent a permanent relationship between unemployment and inflation rates.
2. Why would you expect there to be no relationship between inflation and unemployment in the long run?
This is the natural rate hypothesis. You would expect there to be no relationship between inflation and unemployment in the long run because the long run represents what happens once people have completely adjusted to changed conditions.
Therefore, in the long run, actual and expected rates of inflation are the same, and change rates of inflation do not change people's “real” behavior (reflected in unemployment and real GDP) because those changes are not unexpected.
3. Why is the economy being on the long-run Phillips curve equivalent to its being on the long-run aggregate supply curve?
Unemployment equals its natural rate along the long-run Phillips curve. Real GDP is equal to its natural level along the long-run aggregate supply curve. But the natural level of real GDP is the output level consistent with unemployment equal to its natural rate, so points on both curves illustrate the same results.
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 of time?
Inflation would have to accelerate over time to keep unemployment below its natural rate (and real output above its natural level) for a sustained period of time because over time, people would adapt to any given level of inflation.
Therefore, at a given rate of inflation, unemployment would return to its natural rate over time. To keep people “fooled” into unemployment below its natural rate requires more inflation than people expected, and to maintain this requires accelerating inflation over time.
5. What does the long-run Phillips curve say about the relationship between macroeconomic policy stimulus and unemployment in the long run?
The vertical long-run Phillips curve indicates that there is no relationship between macroeconomic policy stimulus and unemployment in the long run, once people have had time to completely adapt to it. Unemployment will equal its natural SC-44 Section Check Answers rate in the long run, and macroeconomic policy will therefore only change the inflation rate in the long run.
25.3: Rational Expectations 1. What is the rational expectations theory?
The rational expectations theory incorporates expectations as a central factor in the analysis of the entire economy. It is essentially the idea that people will rationally anticipate the predictable future consequences of present decisions, and change their behavior today to reflect those future consequences. For example, this would mean that people can anticipate the inflationary long run consequences of macroeconomic policies adopted today, and that anticipation leads them to change their current behavior in a way that can quickly neutralize the intended impact of a government action.
2. Why could an unexpected change in inflation change real wages and unemployment, while an expected change in inflation could not?
An unexpected change in inflation could change real wages and unemployment precisely because it was unexpected, and people were “fooled” into changing their behavior (in the short run). An expected change in inflation would not change real wages and unemployment because no one is fooled, so no one changes their real behavior as a result.
3. Why can the results of rational expectations be described as generating the long-run results of a policy change in the short run?
The long run refers to the situation once people have had time to completely adjust their behavior to current circumstances.
But under rational expectations, the long run consequences will be anticipated and responded to today, so that people have completely adjusted their behavior to new policies in the short run. Therefore, the results of rational expectations can be described as generating the long-run results of a policy change in the short run.
4. In a world of rational expectations, why is it harder to reduce unemployment below its natural rate but potentially easier to reduce inflation rates?
Reducing unemployment below its natural rate requires that inflation is greater than expected. But under rational expectations, people are not fooled by inflationary policies (unless they are surprises), so this is very hard to do. It is potentially easier to reduce inflation rates under rational expectations, though, because people will be more quickly convinced that inflation will fall when credible government policies are put in place, and it will not take an extended period of high unemployment before they adapt to the lower inflation rate that results.
5. Even if individuals could quickly anticipate the consequences of government policy changes, how could long-term contracts (e.g., three-year labor agreements and 30-year fixed rate mortgages) and the costs of changing price lists and catalogs result in unemployment still being affected by those policy changes?
Even if individuals could quickly anticipate the consequences of government policy changes, long term contracts can't be instantly adjusted, so the real prices and wages subject to such contracts will be at least temporarily changed by inflation “surprises,” at least until such contracts can be rewritten.
Similarly, price lists and catalogs will not be changed instantly when new policies are adopted, because of the cost of doing so, and those prices will not instantly adapt to new inflationary expectations. Since these prices will be “wrong” for a period after new policies are adopted, real wages and prices, and therefore unemployment, can still be affected for a period of time by policy changes.
6. Why do expected rainstorms have different effects on people than unexpected rainstorms?
Expected rainstorms don't catch you by surprise, so you prepare for them in a way that minimizes their effects (umbrellas, jackets, etc.). Unexpected rainstorms catch you by surprise, and have much greater effects, because they haven't been prepared for.
25.4: Wage and Price Controls and Indexing 1. In what ways might “voluntary” government inflation guidelines not be completely voluntary?
“Voluntary” government inflation guidelines are not completely voluntary because such guidelines are backed up with threats of involuntary controls or other consequences for those that don't comply with them.
2. If holding down legal price increases through price controls reduces official inflation rates, why are black markets likely to arise?
Price controls hold official prices below their equilibrium levels, creating shortages at those prices. The shortages at official prices leads to black markets, where unofficial prices can move up toward their equilibrium levels.
3. How might wage and price controls lead to shortages of goods and services (a “queuetopia”)?
For wage and price controls to restrain price increases, they must be held below their equilibrium levels. But below equilibrium prices will lead to shortages of those goods and services, and often queues as a result.
4. How might wage and price controls lead to the production of inferior products over time?
Wage and price controls lead to shortages at official prices.
Since prices for given quality goods are not allowed to rise, the same sort of adjustment to a higher price per “unit” of quality is accomplished by lowering quality instead.
5. If each possible good were indexed to changes in the general price level, would it be very easy for relative price changes to signal changing relative scarcities? Why or why not?
When all prices tend to change together (e.g., when one price goes up, the price level goes up, and so other indexed prices also go up as a result), it is harder for relative prices to change to reflect changing relative scarcity.