This document discusses fiscal and monetary policy and their effects on inflation, unemployment, and economic stabilization. It covers topics such as: - How fiscal policy can be expansionary or contractionary through increasing or decreasing government spending and taxation. - How fiscal policy affects aggregate demand and the budget balance. - How monetary policy can be expansionary or contractionary through increasing or decreasing the money supply. - The relationship between inflation, unemployment, and the output gap as depicted by the Phillips Curve. - How expectations can cause shifts in the Phillips Curve in the long run.

1. Inflation, Unemployment,
and Stabilization Policies

2. Fiscal Policy and Aggregate
Demand
 Fiscal policy: the setting of the level of govt
spending and taxation by govt policymakers
 Expansionary fiscal policy
 an increase in G and/or decrease in T
 shifts AD right
 Contractionary fiscal policy
 a decrease in G and/or increase in T
 shifts AD left
 Fiscal policy has two effects on AD.

3.  What happens to the economy in the short run
with an increase in government spending? Long
run?

4. Budget Balance
 Budget surplus –an excess of tax revenue over
government spending
 Budget deficit – a shortfall of tax revenue from
government spending
 Expansionary fiscal policy makes a budget surplus
smaller or a budget deficit bigger
 Contractionary fiscal policy makes a budget surplus
bigger or a budget deficit smaller.
 If taxes and government change by the same amount,
the government purchases will have a larger effect on
Real GDP than a change in taxes
 Changes in a budget balance are the result not the cause
of fluctuations in the economy.

5. Business Cycle and the Cyclically
Adjusted Budget Balance
 During a recession, budget deficits tend to occur.
 During an expansion, budget surpluses tend to
occur.
 The budget deficit almost always rises when the
unemployment rate rises and falls when the
unemployment rate falls.
 Why does this happen?
 Automatic stabilizers
 During recessions – tax revenue goes down and
unemployment benefits, food stamps go up

6. Cyclically adjusted budget balance
 An estimate of what the budget balance would be
if real GDP were exactly equal to potential output.
 Takes into account extra tax revenue the
government would collect and transfers it would
save if a recessionary gap were eliminated or the
revenue the government would lose and the extra
transfers it would make if an inflationary gap were
eliminated.
 Should the Budget be balanced?
 NO

7. Deficits, Surpluses, and Debts
 Fiscal year – runs from October 1 to September 30 and
is labeled according to the calendar year in which it
ends.
 Fiscal year 2009 began on October 1, 2008 and ended on
September 30, 2009.
 Federal Debt continues to increase.
 Public debt: government debt held by individuals and
institutions outside the government.
 End of 2009, the federal government’s public debt was
“only” $7.6 trillion or 53% of GDP
http://www.usdebtclock.org/

8. Problems Posed by Rising
Government Debt
 1) Crowding out
 2) Today’s deficits, by increasing the government’s debts,
place financial pressure on future budgets.
 2009 federal government paid 2.7% of GDP or $383 billion in
interest on its debt.
 Greece pays 5.4% of GDP on the interest
 Government has to use more and more of the budget on the
interest payment rather than important programs for the people.
 Governments have a hard time paying, they print more money
and the country suffers from inflation and an a financial crisis.

9. Deficits and Debts
 To assess the ability of governments to pay their debt, we use
the debt-GDP ratio, the government debt as a percentage of
GDP.
 A country wants to avoid going over 90%.
 The problem with the U.S. Debt is not the current situation,
but implicit liabilities – spending promises made by
governments that are effectively a debt despite the fact that
they are not included in the usual debt statistics.
 Social Security and Medicare
 Baby Boomers born between 1946 and 1964 are retiring, so
they stop paying taxes and start collecting Social Security and
Medicare.
 2008 31 retirees receiving benefits for every 100 workers;
2030 – 46 per 100, 2050 48 per 100, 2080 51 per 100

10. Monetary Policy and the Interest
Rate
 Fed increases MS, interest rates?
 Fed decreases MS, interest rates?
 Who decides the
interest rate?
 The Fed sets target
federal funds rate,
desired level for the
federal funds rate.

11. Monetary Policy
 Expansionary Monetary Policy: monetary policy
that increases aggregate demand
 BLLL – Increases MS, lowers interest rates,
increases C and I
 Contractionary Monetary Policy: monetary
policy that decreases aggregate demand
 SHHH – Decreases MS, raises interest rates,
decreases C and I

12. Taylor Rule
 In 1993, economist John Taylor suggested that
monetary policy follow a simple rule that took in
account both the business cycle and the inflation
rate.
 Taylor rule for monetary policy – a rule for
setting the federal funds rate that takes into
account both the inflation rate and the output
gap.
 Federal funds rate = 1 + (1.5 x inflation rate) + (0.5 x output gap)
 Fed uses some form of the Taylor rule.

13. Inflation Targeting
 Fed wants inflation low, but positive.
 Fed does not explicitly target inflation, but its agreed upon
that its about 2%.
 Some central banks do explicitly target inflation.
 Inflation targeting – occurs when the central bank sets an
explicit target for the inflation rate and sets monetary
policy in order to hit that target.
 Bank of England: 2%, New Zealand: 1to 3%
 Advocates argue it creates greater transparency and
accountability
 Critics argue there may be extreme circumstances that call
for the inflation rate to fall out of the target area.

14. Money, Output, & Prices in the Long
Run
 Central banks sometimes print money not to
fight a recessionary gap, but for a government to
pay its bills, this destabilizes the economy.
 In the long run, changes in the money supply
will effect the price level and not change the real
aggregate output.
 In the short run, the money supply can change
aggregate output and price level.

15. The Effects of a Monetary Injection
 Assume that the economy is currently in equilibrium and the Fed
suddenly increases the supply of money.
 The supply of money shifts to the right.
 The equilibrium value of money falls and the price level rises.
 When an increase in the money supply makes dollars more
plentiful, the result is an increase in the price level that makes
each dollar less valuable.
 Quantity theory of money – a theory asserting that the quantity
of money available determines the price level and that the
growth rate in the quantity of money available determines the
inflation rate.

16. A Brief Look at the Adjustment
Process
 The immediate effect of an increase in the money supply is to
create an excess supply of money.
 People try to get rid of this excess supply in a variety of ways
 They may buy goods and services with the funds.
 They may use these excess funds to make loans to others. These loans are
then likely used to buy goods and services
 In either case, the increase in the money supply leads to an increase in the
demand for goods and services.
 Because the supply of goods and services has not changed, the result of
an increase in the demand for goods and services will be higher prices.

17. The Classical Dichotomy and
Monetary Neutrality
 In the 18th century, David Hume and other economists wrote
about the relationship between monetary changes and important
macroeconomic variables such as production, employment, real
wages, and real interest rates.
 They suggested and economic variables should be divided into
two groups: nominal variables and real variables.
 Nominal variables – variables measured in monetary units
 Real variables – variables measured in physical units.

18. The Classical Dichotomy and
Monetary Neutrality
 Classical dichotomy – the theoretical separation of nominal
and real variables.
 Prices in the economy are nominal, but relative prices are real
 Hume suggested that different forces influence real and nominal
variables.
 According to Hume, changes in the money supply affect nominal
variables but not real variables.
 Monetary neutrality – the proposition that changes in the
money supply do not affect real variables.

19. Velocity and the Quantity Equation
 Velocity of money – the rate at which money changes hands.
 To calculate velocity, we divide nominal GDP by the quantity of
money
 Velocity = nominal GDP/money supply
 If P is the price level (the GDP Deflator), Y is real GDP, and M
is the quantity of money.
 Velocity = P x Y
M
Rearranging, we get the quantity equation.
M x V = P x Y

20. Velocity and the Quantity Equation
 Quantity equation – the equation M x V = P x Y,
which relates the quantity of money, the velocity of
money, and the dollar value of the economy’s output of
goods and services.
 The quantity equation shows that an increase in the quantity
of money must be reflected in one of the other three
variables.
 Specifically, the price level must rise, output must rise, or
velocity must fall.

21. Velocity and the Quantity Equation
 We can now explain how an increase in the quantity of money
affects the price level using the quantity equation.
 The velocity of money is relatively stable over time.
 When the central bank changes the quantity of money (M), it will
proportionately change the nominal value of output (P x Y)
 The economy’s output of goods and services (Y) is determined primarily
by available resources and technology. Because money is neutral, changes
in the money supply do not affect output.
 This must mean that P increases proportionately with the change in M.

22. Classical Model of the Price Level
 The real quantity of money is always at its long-run equilibrium
level.
 Assume: the effect of a change in the money supply on the
aggregate price level takes place instanteously rather than over a
long period of time.
 Assumption used when high inflation is occurring, poor
assumption in the short run.
 Under periods of high inflation, expectations have changed, and
workers and firms are quick to change prices and wages.
 Hence the SRAS shifts rapidly when persistent high inflation
occurs.

23. Zimbabwe  Summer of 2008 achieved
the world’s highest inflation
rate: 11 million percent a year

24. The Inflation Tax
 Some countries use money creation to pay for spending instead of
using tax revenue
 Inflation tax – the revenue the government raises by creating
money, reduction in the value of money held by the public caused
by inflation.
 The inflation tax is a tax on everyone who holds money.
 Almost all hyperinflations follow the same pattern.
 The government has a high level of spending and inadequate tax
revenue to pay for its spending
 The government’s ability to borrow funds is limited
 As a result, it turns to printing money to pay for its spending
 The large increases in the money supply lead to large amounts
of inflation
 The hyperinflation ends when the government cuts its spending
and eliminates the need to create new money.

25. Hyperinflation
 People will use something else for medium of
exchange
 In Germany in the 1920s, they used lumps of
coal or eggs as a medium of exchange.

26. Cost-Push Inflation
 Inflation that is caused by
a significant increase in
the price of an input with
economy-wide
importance.
 For example, the oil crisis
of the 1970s which led to
an increase in energy
prices in the US, causing
a leftward shift of the
aggregate supply curve,
increasing the price level.

27. Demand-Pull Inflation
 Inflation that is caused by an increase in
aggregate demand.
 “Too much money chasing too few goods.”

28. Output Gap and the Unemployment
Rate
 The percentage difference between the actual level of
real GDP and potential output is called the output gap.
 When the actual aggregate output is equal to potential
output, the actual unemployment rate is equal to the
natural rate of unemployment.
 When the output gap is positive (inflationary gap), the
unemployment rate is below the natural rate. When the
output gap is negative (a recessionary gap), the
unemployment rate is above the natural rate.

29. Inflation and Unemployment
 In the long run, inflation & unemployment are
unrelated:
 The inflation rate depends mainly on growth in the
money supply.
 Unemployment (the “natural rate”) depends on the
minimum wage, the market power of unions,
efficiency wages, and the process of job search.
 In the short run,
society faces a trade-off between
inflation and unemployment.

30. The Phillips Curve
 Origins of the Phillips Curve
 In 1958, an economists named Alban W. Phillips published an article discussing
the negative correlation between inflation rates and unemployment rates in the
United Kingdom.
 American economists Paul Samuelson and Robert Solow showed a similar
relationship between inflation and unemployment for the United States two years
later.
 The belief was that low unemployment is related to high aggregate demand, and
high aggregate demand puts upward pressure on prices. Likewise, high
unemployment is related to low aggregate demand, and low aggregate demand
pulls price levels down.
 Phillips Curve: a curve that shows the short-run tradeoff between inflation and
unemployment.
 Samuelson and Solow believed that the Phillips curve offered policymakers a
menu of possible economic outcomes. Policymakers could use monetary and
fiscal policy to choose any point on the curve.

31. Aggregate Demand, Aggregate
Supply, and the Philips Curve
 The Phillips curve shows the combination of inflation
and unemployment that arise in the short run due to
shifts in the aggregate demand curve.
 The greater the aggregate demand for goods and
services, the greater the economy’s output and the
higher the price level. Greater output means lower
unemployment. Whatever the previous year’s price level
happens to be, the higher the rate of inflation.

32. Deriving the Phillips Curve
 Suppose P = 100 this year.
 The following graphs show two possible
outcomes for next year:
A. Agg demand low,
small increase in P (i.e., low inflation),
low output, high unemployment.
B. Agg demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.

33. Deriving the Phillips Curve
u-rate
inflation
PC
A. Low agg demand, low inflation, high u-rate
B. High agg demand, high inflation, low u-rate
Y
P
SRAS
AD1
AD2
Y1
103
A
105
Y2
B
6%
3% A
4%
5%
B

34. Aggregate Demand, Aggregate
Supply, and the Phillips Curve
 Given that monetary and fiscal policy can both shift the
aggregate demand curve, these types of policies can
move the economy along the Philips curve.
 Increases in the money supply, increases in government
spending, or decreases in taxes increase aggregate demand
and move the economy to a point on the Philips curve with
lower unemployment and higher inflation.
 Decreases in the money supply, decreases in government
spending, or increases in taxes all lower aggregate demand
and move the economy to a point on the Philips curve with
higher unemployment and lower inflation.

35. The Phillips Curve: A Policy Menu?
 Since fiscal and monetary policy affect aggregate
demand, the PC appeared to offer policymakers a
menu of choices:
 low unemployment with high inflation
 low inflation with high unemployment
 anything in between
 1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.

36. Evidence for the Phillips Curve?
During the 1960s,
U.S. policymakers
opted for reducing
unemployment
at the expense of
higher inflation

37. Shifts in the Phillips Curve: The Role
of Expectations
 The Long-Run Phillips Curve
 Shows the relationship between unemployment and inflation
after expectations of inflation have had time to adjust to
experience.
 In 1968, economist Milton Friedman argued that monetary
policy is only able to choose a combination of unemployment
and inflation for a short period of time. At the same time,
economist Edmund Phelps wrote a paper suggesting the
same thing.
 This true because, in the long run, monetary growth has no
real effects. This means that it cannot affect the factors that
determine the economy’s unemployment rate.
 Thus, in the long run, we would not expect there to be a
relationship between unemployment and inflation. This must
mean that, in the long run, the Philips curve is vertical.

38. Shifts in the Philips Curve: The Role
of Expectations
 The Long-Run Phillips Curve
 The vertical Phillips curve occurs because, in the
long run, the aggregate supply curve is vertical as
well. Thus, increases in aggregate demand lead only
to changes in the price level and have no effect on
the economy’s level of output. Thus, in the long run,
unemployment will not change when aggregate
demand changes, but inflation will.
 The long-run aggregate supply curve occurs at the
economy’s natural rate of output; thus, the Phillips
curve occurs at the natural rate of unemployment.

39. The Vertical Long-Run Phillips Curve
u-rate
inflation
In the long run, faster money growth only causes
faster inflation.
Y
P
LRAS
AD1
AD2
natural rate
of output
natural rate of
unemployment
P1
P2
LRPC
low
infla-
tion
high
infla-
tion

40. Reconciling Theory and
Evidence
 Evidence (from ’60s):
PC slopes downward.
 Theory (Friedman and Phelps’ work):
PC is vertical in the long run.
 To bridge the gap between theory and evidence,
Friedman and Phelps introduced a new variable:
expected inflation – a measure of how much people
expect the price level to change.
 Expected inflation is the most important factor, other
than the unemployment rate, affecting inflation
 People base their expectations about inflation on
experience.

41. The Phillips Curve Equation
Short run
Fed can reduce u-rate below the natural u-
rate by making inflation greater than
expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate whether
inflation is high or low.

42. How Expected Inflation Shifts the
PC
Initially, expected &
actual inflation = 3%,
unemployment =
natural rate (6%).
Fed makes inflation
2% higher than expected, u-rate
falls to 4%.
In the long run,
expected inflation increases to 5%,
PC shifts upward,
unemployment returns to its
natural rate.
u-rate
inflation
PC1
LRPC
6%
3%
PC2
4%
5%
A
B C

43. Expectations and the Short-Run
Phillips Curve
 The short-run aggregate supply curve is upward sloping because of misperceptions
about relative prices, sticky wages, and sticky prices. These perceptions, wages, and
prices adjust over time, so that the positive relationship between the price level and the
quantity of goods and services supplied occurs only in the short run.
 This same logic applies to the Phillips curve. The tradeoff between inflation and
unemployment holds only in the short run.
 The expected level of inflation is an important factor in understanding the difference
between the long-run and the short-run Phillips curves. Expected inflation measures
how much people expect the overall price level to change.
 The expected rate of inflation is one variable that determines the position of the short-
run aggregate-supply curve. This is true because the expected price level affects the
perceptions of relative prices that people form and the wages and prices that they set.
 In the short-run, people’s expectations are somewhat fixed. Thus, when the Fed
increases the money supply, aggregate demand increases along the upward sloping
short-run aggregate supply curve. Output grows (unemployment falls) and the price
level rises (inflation increases).
 Eventually, however, people will respond by changing their expectations of the price
level. Specifically, they will begin expecting a higher rate of inflation.

44. Expectations and the Short-Run
Philips Curve
If policymakers want to take advantage
of the short-run tradeoff between
unemployment and inflation, it may lead
to negative consequences.
Suppose the economy is at point A and
policymakers wish to lower the
unemployment rate. Expansionary
monetary policy or fiscal policy is used to
shift aggregate demand to the right. The
economy moves to point B, with a lower
unemployment rate and a higher rate of
inflation.
Over time, people get used to this new
level of inflation and raise their
expectations of inflation. This leads to an
upward shift of the short-run Philips
curve. The economy ends up at point C,
with a higher inflation rate than at point
A, but the same level of unemployment.
u-rate
inflation
PC1
LRPC
6%
3%
PC2
4%
5%
A
B C

45. Nonaccelerating inflation rate of
unemployment (NAIRU)
 The unemployment rate at which inflation does not
change over time.
 Trying to keep the unemployment rate below the
NAIRU will only lead to everaccelerating inflation and
will not be maintained.
 Economists believe that there is a NAIRUA and there
is no tradeoff of the unemployment rate and the
inflation rate in the short term.
 NAIRU is another name for the natural rate of
unemployment.

46. The Natural Experiment for the
Natural-Rate Hypothesis
 Natural-rate hypothesis – the claim that unemployment eventually returns
to its normal, or natural rate, regardless of the rate of inflation.
 The figure on the next slide shows the unemployment rate and inflation rate.
It is easy to see the inverse relationship between these variables.
 Beginning in the late 1960s, the government followed policies that increased
aggregate demand.
 Government spending rose because of Vietnam War.
 The Fed increased the money supply to try to keep interest rates down.
 As a result of these policies, the inflation rate remained fairly high. However,
even though inflation remained high, unemployment did not remain low.
 The simple inverse relationship between the two variables began to disappear
in 1970.
 This occurred because people’s inflation expectations adjusted to the higher
rate of inflation and the unemployment rate returned to its natural rate of
around 5 to 6 percent.
 Government can NOT keep the unemployment rate low, it should try to keep
it stable at the natural rate.

47. The Breakdown of the Phillips Curve
Early 1970s:
unemployment increased,
despite higher inflation.
Friedman & Phelps’
explanation:
expectations were
catching up with
reality.

48. Shifts in the Phillips Curve:
The Role of Supply Shocks
 In 1974, OPEC increased the price of oil sharply. This increased
the cost of producing many goods and services and therefore
resulted in higher prices.
 Supply shock – an event that directly alters firms’ costs and
prices, shifting the economy’s aggregate-supply curve and thus
the Philips curve.
 Graphically, we could represent this supply shock as a shift in
the short-run aggregate-supply curve to the left.
 The decrease in equilibrium output and the increase in the price
level left the economy with stagflation.

49. How an Adverse Supply Shock Shifts the
PC
u-rate
inflation
SRAS shifts left, prices rise, output & employment fall.
Inflation & u-rate both increase as the PC shifts upward.
Y
P
SRAS1
AD PC1
PC2
A
B
SRAS2
A
Y1
P1
Y2
B
P2

50. The 1970s Oil Price Shocks
Supply shocks & rising expected
inflation worsened the PC tradeoff.

51. Shifts in the Phillips Curve:
The Role of Supply Shocks
 Given this turn of events, policymakers are left with a less
favorable short-run tradeoff between unemployment and
inflation.
 If they increase aggregate demand to fight unemployment,
they will raise inflation further.
 If they lower aggregate demand to fight inflation, they will
raise unemployment further.
 The less favorable tradeoff between unemployment and inflation
can be shown by a shift of the short-run Phillips curve. The shift
may be permanent or temporary, depending on how people
adjust their expectations of inflation.
 During the 1970s, the Fed decided to accommodate the supply
shock by increasing the supply of money. This increased the level
of expected inflation.

52. The Cost of Reducing Inflation
 Disinflation: a reduction in the inflation rate
 To reduce inflation,
Fed must slow the rate of money growth, which
reduces agg demand.
 Short run: output falls and unemployment rises.
 Long run: output & unemployment return to
their natural rates.

53. Disinflationary Monetary Policy
Contractionary monetary policy
moves economy from A to B.
Over time,
expected inflation falls, PC
shifts downward.
In the long run,
point C:the natural rate of
unemployment,
and lower inflation. u-rate
inflation
PC2
LRPC
PC1
natural rate of
unemployment
B
A
C

54. The Cost of Reducing Inflation:
The Sacrifice Ratio
 To reduce the inflation rate, the Fed must follow
contractionary monetary policy.
 When the Fed slows the rate of growth of the
money supply, aggregate demand falls.
 This reduces the level of output in the economy,
increasing unemployment.

55. The Cost of Reducing Inflation:
The Sacrifice Ratio
The economy moves from point A
along the short-run Philips curve to
point B, which has a lower inflation
rate but a higher unemployment
rate.
Over time, people begin to adjust
their inflation expectations
downward and the short-run Philips
curve shifts. The economy moves
from point B to point C, where
inflation is lower and the
unemployment rate is back to its
natural rate. u-rate
inflation
PC2
LRPC
PC1
natural rate of
unemployment
B
A
C

56. The Cost of Reducing Inflation:
The Sacrifice Ratio
 Therefore, to reduce inflation, the economy must suffer
through a period of high unemployment and low
output.
 Sacrifice ratio – the number of percentage points of
annual output lost in the process of reducing inflation
by 1 percentage point
 A typical estimate of the sacrifice ratio is 5. This implies
that for each percentage point inflation is decreased,
output falls by 5 percent.

57. The Cost of Reducing Inflation:
Rational Expectations and the
Possibility of Costless Disinflation
 Rational expectations – the theory according to which people
optimally use all the information they have, including
information about government policies, when forecasting the
future.
 Proponents of rational expectations believe that when
government policies change, people alter their expectations
about inflation.
 Therefore, if the government makes a credible commitment to a
policy of low inflation, people would be rational enough to lower
their expectations of inflation immediately. This implies that the
short-run Philips curve would shift quickly without any extended
period of high unemployment.

58. Rational Expectations, Costless
Disinflation?
 Rational expectations: a theory according to which people
optimally use all the information they have, including info
about govt policies, when forecasting the future
 Early proponents:Robert Lucas, Thomas Sargent, Robert
Barro
 Implied that disinflation could be much less costly…
 The bottom line of the rational expectations theory is that
government intervention is not necessary or useful for
stabilizing the economy.

59. Rational Expectations, Costless
Disinflation?
 Suppose the Fed convinces everyone it is
committed to reducing inflation.
 Then, expected inflation falls,
the short-run PC shifts downward.
 Result:
Disinflations can cause less unemployment
than the traditional sacrifice ratio predicts.

60. The Cost of Reducing Inflation:
The Volcker Disinflation
 Paul Volcker worked at reducing the level of inflation during the 1980s.
 As inflation fell, unemployment rose. In fact, the United States experienced
its deepest recession since the Great Depression.
 Some economists have offered this as proof that the idea of a costless
disinflation suggested by rational-expectations theorists is not possible.
However, there are two reasons why we might not want to reject the rational-
expectations theory so quickly.
 The cost (in terms of lost output) of the Volcker disinflation was not as large as
many economists had predicted.
 While Volcker promised that he would fight inflation, many people did not believe
him. Few people thought that inflation would fall as quickly as it did; this likely
kept the short-run Philips curve from shifting quickly.

61. The Volcker Disinflation
Disinflation turned out to be very costly:
u-rate near
10% in
1982-83

62. The Cost of Reducing Inflation:
The Greenspan Era
 Greenspan became the chairman of the Federal Reserve in 1987.
 In 1986, OPEC’s agreement with its members broke down and oil prices fell.
The result of this favorable supply shock was a drop in both inflation and
unemployment.
 The rest of the 1990s witnessed a period of economic prosperity. Inflation
gradually dropped, approaching zero by the end of the decade.
Unemployment also reached a low level, leading many people to believe that
the natural rate of unemployment has fallen.
 The economy ran into problems in 2001 due to the end of the dot.com stock
market bubble, the 9-11 terrorist attacks, and the corporate accounting
scandals that reduced aggregate demand. Unemployment rose as the economy
experienced its first recession in a decade.

63. The Greenspan Era: 1987-2006
Inflation and unemployment
were low during most of
Alan Greenspan’s years
as Fed Chairman.

64. Case Study: Why were Inflation and
Unemployment so Low at the End of
the 1990s?
 At the end of the 1990s, the unemployment rate and the inflation
rate were lower than the United States had seen in many years.
 This likely implies that the short-run Philips curve has drifted
leftward, giving the United States a more favorable tradeoff
between inflation and unemployment
 Causes of this movement in the short-run Philips curve include
reductions in expected inflation, lower commodity prices,
changes in the stability of the labor force, and technological
advancements.

65. Favorable Supply Shocks in the
’90s
 Declining commodity prices
(including oil)
 Labor-market changes
(reduced the natural rate of unemployment)
 Technological advance
(the information technology boom of 1995-
2000)

66. 1990s: The End of the Phillips Curve?
 During the 1990s, inflation fell to about 1%,
unemployment fell to about 4%.Many felt PC
theory was no longer relevant.
 Many economists believed the Phillips curve was
still relevant; it was merely shifting down:
 Expected inflation fell due to the policies of Volcker
and Greenspan.
 Three favorable supply shocks occurred.

67. Deflation
 A falling aggregate price level.
 Causes the lender to gain while the borrower loses since
the borrower has to back the loan with a dollar with a
greater value.
 Borrowers stop spending, lenders are less likely to
increase spending sharply. Causing aggregate demand to
decline decreasing prices more.
 Debt deflation – the reduction in aggregate demand
arising from the increase in the real burden of
outstanding debt caused by deflation.

68. Effects of Expected Deflation
 Zero bound: nominal interest rate cannot go
below zero. So if deflation is occurring lenders
would rather hold on to their cash rather than lend
it out.
 Zero bound can reduce the effectiveness of
monetary policy.
 Liquidity trap: a situation in which conventional
monetary policy is ineffective because nominal
interest rates are up against the zero bound.
 2008 & 2009 the Fed was at zero bound.

69. Main Approaches to
Macroeconomics
 1) Classical economics, which originated in 1776 with Adam Smith’s
Wealth of Nations, was the dominant economic thinking until the mid-
1850s.
 Uses a laissez-faire approach, meaning the government should not
interfere in the market because the market can regulate itself.
 Economists should focus on how to encourage savings and investment
in order to increase economic growth over the long-term.
 The economy will fluctuate, and growth will slow down from time to
time. But no remedy by government can improve on the performance
of the market, fine-tuning economy will backfire
 The AS will shift back to equilibrium.
 Believe the quantity theory of money – both velocity and the quantity
of g&s sold per period are fairly stable
 Classical economists also believe in Say’s Law.

70. Classical Economics
 Say’s Law – the idea that supply creates its own demand. In other
words, when supplying goods, workers earn money to spend or
save, and savings end up being borrowed and spent on business
investments.
 There should be no problem finding demand for the goods and
services produced, because the income from making them will
be spent purchasing them. This supports the classical
contention that the government does not need to concern itself
with policies that maintain demand at a desirable level.
 Critics of Say’s law argue that savings might not equal
investment because the interest rate does not fluctuate freely
enough to clear the capital market.
 Wages fluctuate quickly, flexible prices
 Input and output prices will stay in line with each other, as output
prices change input prices will change quickly
 Cannot be fooled by money illusion

71. Keynesian Economics
 Great Depression cannot be explained by Classical theory.
 So an economist named John Maynard Keynes develops a
theory to explain it.
 John Maynard Keynes published The General Theory of Employment,
Interest, and Money in 1936.
 Believe fiscal policy is more effective than monetary policy
 Keynes’s focus was on short-run economic issues. He agreed
with the classical approach only for when the economy is at
potential output. The general theory he spoke of was that when
the economy is not producing at full output, laissez-faire
approaches will not work, because the economy can get stuck in
a rut, as was happening at the time with the Great Depression.

72. Keynesian Economics
 The Paradox of Thrift: Keynesians point out that savings will not
always equal investment. If there is a recession, then there is great
uncertainty about what will happen in the future, causing firms to
reduce their investment plans. When savings do not translate into
investment, the aggregate expenditures in the economy are reduced by
new savings, which moves the economy further into a recession.
 The classical economists would let wages drop because they assume
that all other things are equal, but Keynes points out that all other
things are not equal since a decrease in wages leads to a decrease in
income, which leads to decreased aggregate demand, which means
decreased production from firms, which means less output and even
more unemployment.
 Keynes argued that in order to get out of recessions and have any
chance for long-term economic growth, the government must take an
active role in encouraging aggregate demand, by increasing government
spending or decreasing taxes.

73. Keynesian Economics
 Keynes blamed the existence of unemployment and the inability of the
economy to self-adjust to full-employment output largely on “sticky” wages,
particularly in the downward direction. Keynesians argue that wage contracts
are typically adjusted no more than once a year, and such influences as
unions, tradition, and a reluctance to threaten company morale effectively
prohibit decreases in wages. If wages cannot adjust to match changes in price
levels, deviations from full employment output might persist until the
government steps in with monetary or fiscal policy to bolster or tame the
economy. This is in contrast with the classical economists’ preference of
laissez-faire (hands off) governmental policy.
 Believe in liquidity trap: is a situation where monetary policy is unable to
stimulate an economy, either through lowering interest rates or increasing
the money supply. Liquidity traps typically occur when expectations of
adverse events (e.g., deflation, insufficient aggregate demand) make persons
with liquid assets unwilling to invest.

74. Keynesian Economics
 Argued “animal spirits” (business confidence)
causes the change in the business cycle.
 The ideas of Keynes lead to macroeconomic
policy activism – the use of monetary and
fiscal policy to smooth out the business cycle.
 Franklin Roosevelt engaged in deficit spending,
macroeconomic policy activism to get the U.S.
out of the Great Depression.
 Eventually economists will realize the limits to
macroeconomic policy activism.

75. Monetarism
 Government's proper economic
roles is to control the rate of
inflation by controlling the
amount of money in circulation
 Money supply is the primary tool
to bring economic stability
 Argued the Great Depression
occurred because of the
contraction of the money supply
 Increase money supply at a rate
equal to the average growth in real
output (GDP increases by 3%,
grow MS by 3%.
 Fed allow the money supply to
grow at a constant rate. (Every
year regardless of business cycle)

76. Monetarism
 Monetarism – asserts that GDP will grow steadily if the
money supply grows steadily.
 Not politicized, fiscal policy cut taxes, whose taxes get the cut.
Monetary policy lower the interest rates, everyone gets a lower
rate.
 Believe fiscal and monetary policy intended to fine tune
economy, threatens to destabilize the economy.
 Convinced economists the importance of monetary policy.
 Changes in government spending will crowd out private
spending
 As money supply changes, interest rates change which change
many other factors that affect spending

77. Monetarism
 Discretionary monetary policy – the use of changes in
the interest rate or the money supply to stabilize the
economy.
 Experiences lags, but smaller than the lags in fiscal
policy
 Believe in the quantity theory of money, but believe V and
Y are stable in the short run, not constant like Classical
economist (Believed in a slow steady growth of money)
 Changes in the money supply can then change the Q.
 Velocity of money in early 1980s becomes erratic due to
financial innovations and Monetarism takes a hit.

78. Hypothesis of Economics
 Natural Rate Hypothesis
 Political Business Hypothesis – occurs when
politicians use macroeconomic policy to serve
political ends.
 Winner of elections depends upon the state of the
economy. Incumbent wins if economy is going well
6 months before election
 If there is a tradeoff to exploit, politicians can use
expansionary policy a year before election to
guarantee victory.

79. Neoclassical Economics
 Markets to be free & freedom creates greater
opportunities
 People have rational preferences among outcomes that
can be identified and associated with a value.
 Individuals maximize utility and firms maximize profits
 People act independently on the basis of full and
relevant information.
 New Classical Macroeconomics – an approach to
the business cycle that returns to the classical view that
shifts in the aggregate demand curve affect only the
aggregate price level, not aggregate output

80. Rational Expectations
 The view that individuals and firms make decisions
optimally, using all available information
 Long-term wage contracts will take into account past
inflation rates and the current monetary and fiscal
policies.
 As a result high expected inflation should be negotiated
into the contract
 Hence no tradeoff of unemployment and inflation in the
long run.
 Monetary policy can only change the unemployment
rate if it comes as a surprise.

81. New Keynesian Economics
 Market imperfections can lead to price stickiness
for the economy as a whole.
 For example, monopolies do not have to
perfectly price an item since if the price is too
high they will sell less but with more profit per
sale.

82. Real Business Cycle
 Claims that fluctuations in the rate of growth of
total factor productivity cause the business cycle.
 Output is determined by the given level of factor
inputs
 Slowdowns in productivity growth or a pause in
technological progress are the main causes of
recessions.
 Initially did not believe aggregate demand affected
the output, today it includes an upward sloping
aggregate supply curve to this impact.

83. Using Policy to Stabilize the
Economy
 The Case for Active Stabilization Policy
 Example: The government reduces its spending to cut the budget
deficit, lowering aggregate demand (shifting the curve to the left).
 The Fed can offset this government action by increasing the money supply.
 This would lower interest rates and boost spending, shifting the aggregate-
demand curve back to the right.
 Policy instruments are often used in this manner to stabilize
demand. Economic stabilization has been an explicit goal of U.S.
policy since the Employment Act of 1946.
 One implication of the Employment Act is that the government should
respond to changes in the private economy in order to stabilize aggregate
demand.
 The second implication of the Employment Act is that the government
should respond to changes in the private economy in order to stabilize
aggregate demand.

84. Using Policy to Stabilize the
Economy
 The Employment Act occurred in response to a book by John
Maynard Keynes, an economist who emphasized the important
role of aggregate demand in explaining short-run fluctuations in
the economy.
 Keynes also felt strongly that the government should stimulate
aggregate demand whenever necessary to keep the economy at
full employment.
 Keynes felt that aggregate demand responds strongly to
pessimism and optimism. When consumers are pessimistic,
aggregate demand is low, output is low, and unemployment
is increased. When consumers are optimistic, aggregate
demand is high, output is high, and unemployment is low.
 It is possible for the government to adjust monetary and
fiscal policy in response to optimistic or pessimistic views.
This helps stabilize aggregate demand, keeping output stable
at full employment.

85. The Case for Active
Stabilization Policy
 Keynes: “animal spirits” cause waves of pessimism
and optimism among households and firms, leading
to shifts in aggregate demand and fluctuations in
output and employment.
 Also, other factors cause fluctuations, e.g.,
 booms and recessions abroad
 stock market booms and crashes
 If policymakers do nothing, these fluctuations are
destabilizing to businesses, workers, consumers.

86. The Case for Active
Stabilization Policy
 Proponents of active stabilization policy
believe the govt should use policy
to reduce these fluctuations:
 when GDP falls below its natural rate,
should use expansionary monetary or fiscal policy to
prevent or reduce a recession
 when GDP rises above its natural rate,
should use contractionary policy to prevent or reduce
an inflationary boom

87. The Case Against Active
Stabilization Policy
 Some economists believe that fiscal and monetary policy tools
should only be used to help the economy achieve long-run
goals, such as low inflation and economic growth.
 The primary argument against active policy is that these policy
tools may affect the economy with a long lag.
 With monetary policy, the change in money supply leads to
a change in interest rates. This change in interest rates
affects investment spending. However, investment decisions
are usually made well in advance, so the effects from
changes in investment will not likely be felt in the economy
very quickly.
 The lag in fiscal policy is generally due to the political
process. Changes in spending and taxes must be approved
by both the House and the Senate (after going through
committees in both houses).
 By the time these policies take effect, the condition of the
economy may have changed. This could lead to even larger

88. The Case Against Active
Stabilization Policy
 Monetary policy affects economy with a long lag:
 firms make investment plans in advance,
so I takes time to respond to changes in r
 most economists believe it takes at least
6 months for mon policy to affect output and
employment
 Fiscal policy also works with a long lag:
 Changes in G and T require Acts of Congress.
 The legislative process can take months or years.

89. The Case Against Active
Stabilization Policy
 Due to these long lags,
critics of active policy argue that such policies may
destabilize the economy rather than help it:
By the time the policies affect agg demand,
the economy’s condition may have changed.
 These critics contend that policymakers should
focus on long-run goals, like economic growth and
low inflation.

90. Keynesians in the White House
1961:
John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors
were followers of Keynes.
2001:
George W Bush pushed for a
tax cut that helped the economy
recover from a recession that
had just begun.

91. Automatic Stabilizers
 Automatic stabilizers – changes in fiscal policy that stimulate
aggregate demand when the economy goes into a recession without
policymakers having to take any deliberate action.
 The most important automatic stabilizer is the tax system.
 When the economy falls into a recession, incomes and profits fall.
 The personal income tax depends on the level of households’ incomes and
the corporate income tax depends on the level of firm profits.
 This implies that the government’s tax revenue falls during a recession. This
tax cut stimulates aggregate demand and reduces the magnitude of this
economic downturn.

92. Automatic Stabilizers
 Government spending is also an automatic
stabilizer.
 More individuals become eligible for transfer
payments during a recession.
 These transfer payments provide additional income
to recipients, stimulating spending.
 Thus, just like the tax system, our system of
transfer payments helps to reduce the size of short-
run economic fluctuations.