MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

1. MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Stabilization Policy

2. Key Concepts • Phillips Curve • Credibility • Rules versus Discretion • Time Consistency

3. Decrease in Demand Keynesian view Price Level LRAS AD AS P0 P1 Y1 Y0 Real GDP

4. Decrease in Demand Keynesian view Price Level LRAS Government responds by increasing demand AD AS Increase G Decrease T Increase M P0 P1 Y1 Y0 Real GDP

5. Increase in Demand Keynesian view Price Level LRAS AD AS P1 P0 Y0 Y1 Real GDP

6. Increase in Demand Keynesian view Price Level LRAS Government responds by decreasing demand AD AS Decrease G Increase T Decrease M P0 Y0 Real GDP

7. Decrease in supply Keynesian stabilization response Price Level LRAS Government responds by increasing demand AD AS Big increase in price P0 Y0 Real GDP

8. Arguments against Stabilization Policy • Uncertainty • Demand or supply shocks? • Policy Lags => decrease stability • Informational, decision, and implementation lags • Problems with Fiscal Policy • Public investment and social goals may conflict with stabilization goals • Ricardian Equivalence • Consumer Expectations • Crowding Out • Monetary Policy • Can only affect long-term rates through expectations of inflation and future interest rates

9. Phillips Curve Inflation = Expected Inflation + A*(Natural Rate Unemployment – Actual Unemployment) Rate of Inflation Anticipated by Consumers Rate of Unemployment when all resources are fully employed at long-run level

10. US Phillips Curve, 1945 - 1970

11. Inflation and unemployment, United States, 1983–2000

12. Inflation and unemployment, Japan, 1983–2000.

13. Inflation and unemployment, France, 1983–2000.

14. Graphically… Inflation 10% 5% U < UN U > UN 0% Unemployment Natural Rate

15. Graphically… Inflation 10% 5% 0% 2% Unemployment 5% Natural Rate

16. Expectations catch up with reality Inflation 10% 5% 0% Unemployment Natural Rate

17. Phillips Curve • There is no usable long-run tradeoff between inflation and output • Expectations-augmented Philips may allow for short-run tradeoff • Complications to short-run tradeoff: supply shocks • Can lower inflation without increasing unemployment: lower inflation expectations • Importance of policymakers credibility • Possible to lower inflation without costly unemployment • Phillips curve exist as a short-run tradeoff the government faces when it uses demand management • it may not be visible empirically

18. Time Inconsistency Scenario • Time Inconsistency: when the future arrives it may no longer be optimal to carry out plans • “Gov’t will not negotiate with terrorist” • “Monetary policy will not be inflationary” • Your child, Laura, has just graduated from high school, and is planning to attend State U in the fall. How should she spend her summer? • Working to help pay for tuition (parents’ preference) • Playing computer games (Laura’s preference) • You tell her the following • If she works, you will help with tuition • If she plays, she’s on her own in August

19. Time Inconsistency • Will you do what you say you’re going to do? Pay for College Don’t Pay Play What you say… Laura Pay for College Work Don’t Pay

20. Time Inconsistency • Will you do what you say you’re going to do? What Laura thinks… Pay for College Don’t Pay Play Laura Pay for College Work Don’t Pay

21. What is likely to happen? ?

22. Stabilization Policy • Government’s preferences • Low inflation and low unemployment • Stronger preference for low unemployment

23. Stabilization Policy • Government’s preferences • Low inflation and low unemployment • Stronger preference for low unemployment Citizens’ Expectations High Inflation Low Inflation High Inf. Policy Maker Low Inf. • Private sector negotiates its wage, central bank responds • If expectations = reality, then unemployment = natural rate • If expectations < reality, then W/P low, unemployment is low • If expectations > reality, then W/P high, unemployment is high

24. Rules versus Discretion Why rules are preferred over discretion • Information, decision, and implementation lags => stabilization policy destabilizes • Uncertain impact on aggregate demand • Time inconsistency • Can rules solve time consistency problem? • Preference must be for low inflation • Can rules solve credibility problem? • Two examples of rules • Monetary Policy: New Zealand • Fiscal Policy: EU stability pact

25. Rules • Friedman’s Rule • Grow money supply at a certain, fixed percent each year • Remove instability from discretion • Reaction Function Rules • Taylor Rule: policy response based on set rule • Predictability, but flexibility • Nominal GDP targeting • Stabilize nominal spending • Allow demand & supply shocks

26. Summary • Stabilization Policy • Difficulties with stabilization policy • Phillips curve and discretionary policy • Time inconsistency • Rules and Discretion