Macroeconomics

1. Macroeconomics Module 14: Policy Applications

2. Policy Applications • When does it make sense to use fiscal policy or monetary policy? • How are Keynesian and neoclassical perspectives applied in the real world? • Under what circumstances do fiscal and monetary policy work well, or not so well, in managing the economy? • For the activist Keynesians, what are the limits to fiscal and monetary policy that you would endorse, and why? • For the laissez-faire neoclassicals, what is the minimalist fiscal and monetary policy that makes sense, and why? • How is macroeconomic policy is the real world more complicated than in theory?

3. Viewpoints on Government Policy • Neoclassical Perspective • Neoclassical economists favor low taxes to stimulate aggregate supply and economic growth • favor limited government spending • passive monetary policy • Keynesian Perspective • the economy can be in equilibrium at a level of GDP that does not correspond to potential • government has a responsibility to manage the economy • encourage stimulating the economy during recessionary times and slowing the economy down during booms • Liquidity Trap: Keynesian idea that when interest rates are very low, people are willing to hold cash, rather than put it into financial markets, eliminating the ability for expansionary monetary policy to work

4. The Phillips Curve • Contractionary Fiscal Policy: tax increases or cuts in government spending designed to decrease aggregate demand and reduce inflationary pressures • Expansionary Fiscal Policy: tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession • Phillips Curve: the tradeoff between unemployment and inflation • Stagflation: a simultaneous increase in between unemployment and inflation

5. The Discovery of the Phillips Curve • In the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying 60 years of data for the British economy and he discovered an apparent inverse (or negative) relationship between unemployment and wage inflation • The original Keynesian view using the AD-AS model was that AS was “L”-shaped • Most Keynesian economists today have a more nuanced view of the AS curve

6. Policy Implications: No Phillips Curve Tradeoff in the Long Run • Neoclassical Phillips Curve • “[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.” • Natural Rate Hypothesis: Neoclassical view that since the long run aggregate supply curve is vertical, the long run Phillips Curve is also vertical; there is no tradeoff in the long run between inflation and unemployment • Keynesian Phillips Curve • Changes in inflationary expectations and supply shocks) cause the Phillips Curve to be vertical with no long run tradeoff between inflation and unemployment

7. New Classical Economics: Rational Expectations New Classical Economists ask why people don’t learn that they consistently underestimate inflation? Shouldn’t they learn from their mistakes? If individuals are rational, shouldn’t they use all available information to improve their predictions of inflation, not just past values of it?  • Adaptive Expectations: the idea that people extrapolate from past values of some economic variable to predict future values of that variable  • Demand Management Policy: using monetary and fiscal policy to influence aggregate demand, and thus, real GDP and employment  • Rational Expectations: predictions equal to the predictions of the underlying economic model

8. Adaptive versus Rational Expectations • The natural rate hypothesis argues that while there may be a tradeoff between inflation and unemployment in the short run, there is no tradeoff in the long run • Rational expectations says that economic agents should use all the information they have about how the economy operates to make predictions about economic variables in the future • These ideas were formalized by John Muth, who said expectations are rational if they produce predictions equal to the predictions of the underlying economic model • If economic agents have rational expectations, demand management policy can never be effective

9. Perspectives on Crowding Out • Early Neoclassicals criticized Keynesian views about fiscal policy for ignoring the “crowding out” effect.  • Crowding out: expansionary fiscal policy causes interest rates to rise, which reduces business investment, limiting the effects of the fiscal expansion. • How much does it occur? • Neoclassicals argue for complete crowding out, meaning that fiscal policy was completely ineffective since an increase in government spending would be completely offset by a decrease in private investment spending with no net effect on aggregate demand. • Keynesians argue for incomplete crowding out; thus, fiscal policy would be weaker than originally thought, but still effective to a certain degree.

10. Ricardian Equivalence: How Government Borrowing Affects Private Saving • Ricardian Equivalence: the theory that rational private households might increase their saving in anticipation of future tax liabilities from government borrowing, and vice versa • Twin Deficits: deficits that occur when a country is running both a trade and a budget deficit

11. Policy Lags • Recognition or Data Lag • The time it takes to determine that a recession has occurred • Legislative or Decision Lag • The time it takes to pass a bill • Implementation or Transmission Lag • The time it takes to start the projects or execute the monetary policy • Impact or Effectiveness Lag • The time it takes for the new policy to play out

12. Policy Implications: Dampening Business Cycles vs. Laissez-Faire • Three Goals for Macroeconomics • Full employment • Stable prices (low inflation) • Economic growth • Economy tends to growth over time as a result of increases in the quantity and quality of labor and capital and improvements in technology • Neoclassical economists are predisposed towards market outcomes and are suspicious of using aggregate demand to manage the economy • Keynesian economists are suspicious of market outcomes and lean towards demand management policies

13. Policy Implications • What economic viewpoint focuses on aggregate demand to reduce unemployment and to stimulate the economy during a recession? • What economic view believes if aggregate demand rises rapidly it leads to inflationary pressures?

14. Policy Implications: Dampening Business Cycles vs. Laissez-Faire cont. • Unemployment can be divided into two categories • Cyclical unemployment • Natural rate of unemployment • Keynesian economists worry about the loss of jobs and income that may persist over time • Neoclassicals think that given the real world complications of fiscal and monetary policy discussed above, it is too difficult to get them right. Better to simply let the economy adjust back to potential output on its own

15. Responding to Real Shocks to the Economy • Changes in aggregate demand always result in unemployment going one way, while inflation goes the other • Changes in aggregate supply push inflation and unemployment in the same direction at the same time • If the shock is positive, shifting AS to the right, this is very, very good since both inflation and unemployment fall • if the shock is negative, shifting AS to the left, the output is not good since both inflation and unemployment rise

16. Summary of Macroeconomic Policy Recommendations • Keynesian • Believe that the costs of allowing the economy to recover from recessionary and inflationary gaps are too high • Believe in promoting economic growth • Favor government investment in • Infrastructure • Government spending • Tax cuts for research and developments • Human capital • Education • Neoclassical • Do not believe in “fine-tuning” the economy • Prefer to focus policy on economic growth • Economic growth is fostered by a stable economic environment with a low rate of inflation

17. Quick Review • Summarize the neoclassical views on the effectiveness of fiscal and monetary policy • Summarize the Keynesian views on the effectiveness of fiscal and monetary policy, including the importance of the expenditure multiplier • What is the Phillips Curve and its impact on the theories of Keynesian economics? • How does the Phillips Curve derive from the aggregate supply curve? • What is the difference between the Keynesian and Neoclassical views of the Phillips Curve? • How does the theory of rational expectations mean that demand management policy is ineffective? • What is Ricardian equivalence and how does government borrowing affect private spending? • What is the difference between types of policy lags?

18. More Quick Review • How does policy lags, policy imprecision, time, and politics complicate or compromise the effectiveness of fiscal and monetary policies? • Compare and contrast Keynesian and Neoclassical policy responses to business cycles • Why is there no good policy response to a negative aggregate supply shock? • What is the difference between monetary policies a neoclassical economist would recommend to promote economic growth and those a Keynesian economist would recommend?