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Chapter 28

Chapter 28. Can Government Really Stabilize the Economy?. Economic Principles. The classical school of employment and inflation The Keynesian school of employment and inflation The neo-Keynesian school of employment and inflation. Economic Principles.

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Chapter 28

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  1. Chapter 28 Can Government Really Stabilize the Economy? Gottheil — Principles of Economics, 7e

  2. Economic Principles • The classical school of employment and inflation • The Keynesian school of employment and inflation • The neo-Keynesian school of employment and inflation Gottheil — Principles of Economics, 7e

  3. Economic Principles • The rational expectations school of employment and inflation • The supply-side school of employment and inflation Gottheil — Principles of Economics, 7e

  4. Economic Principles • Phillips curve analysis • Automatic stabilizers Gottheil — Principles of Economics, 7e

  5. The Nature of Economic Advice Economists live in a world of limited information, and so their analysis leads to different and sometimes even highly conflicting conclusions and recommendations. Gottheil — Principles of Economics, 7e

  6. Why Does the Economy Generate Inflation and Unemployment Most economists agree that the most demanding macroeconomic issue is economic stability: Why do unemployment and inflation exist, and what should be done about them? Gottheil — Principles of Economics, 7e

  7. EXHIBIT 1 U.S. RATES OF UNEMPLOYMENT AND INFLATION, 1970–2007 (percent) Source: Economic Report of the President, Washington, D.C., 2006. Inflationdata.com, http://inflatiodata.com/inflation/Inflation_Rate/HistoricalInflation.aspx?dsInflation_curre. Gottheil — Principles of Economics, 7e

  8. Exhibit 1: U.S. Rates of Unemployment and Inflation, 1970–2007 Exhibit 1 details the years of unemployment and inflation in the United States. What does it show in general? • Moderate successes when compared to the 1930s—when unemployment soared to 25 percent of the labor. Gottheil — Principles of Economics, 7e

  9. Why Does the Economy Generate Inflation and Unemployment Name the five mainstream schools of economic thought? • Neo-Keynesian • Classical • Keynesian • Rational • Supply-Side • Expectations Gottheil — Principles of Economics, 7e

  10. Why Does the Economy Generate Inflation and Unemployment Stabilization policy • The use of countercyclical monetary and fiscal policy by the government and the Fed to stabilize the economy. Gottheil — Principles of Economics, 7e

  11. The Classical School Classical economics • The school of thought that emphasizes the natural tendency for an economy to move toward equilibrium at full employment without inflation. It argues against government intervention. Gottheil — Principles of Economics, 7e

  12. The Classical School According to the classical school, unemployment is only a temporary phenomenon, caused by wage rates climbing above the equilibrium rate. Gottheil — Principles of Economics, 7e

  13. The Classical School Persistently high unemployment, according to the classical school, occurs because labor unions and policy makers interfere with the competitive process, preventing wages from reaching equilibrium. Gottheil — Principles of Economics, 7e

  14. EXHIBIT 2 CLASSICAL DETERMINATION OF UNEMPLOYMENT Gottheil — Principles of Economics, 7e

  15. Exhibit 2: Classical Determination of Unemployment 1. What happens in Exhibit 2 if policy makers establish a $10 minimum wage? • There will be an excess labor supply (unemployment) of 4,000 workers. Gottheil — Principles of Economics, 7e

  16. Exhibit 2: Classical Determination of Unemployment 2. What is the equilibrium wage rate in Exhibit 2, and what is the level of unemployment at the equilibrium wage rate? • The equilibrium wage rate is $6. Gottheil — Principles of Economics, 7e

  17. Exhibit 2: Classical Determination of Unemployment 2. What is the equilibrium wage rate in Exhibit 2, and what is the level of unemployment at the equilibrium wage rate? • At the equilibrium wage rate of $6 the quantity of labor demanded equals the quantity of labor supplied. Gottheil — Principles of Economics, 7e

  18. The Classical School 1. What is the quantity theory of money equation? • P = MV/Q Gottheil — Principles of Economics, 7e

  19. The Classical School 1. What is the quantity theory of money equation? • P = MV/Q • P is the price level, M is the money supply, V is money velocity, and Q is the quantity of goods and services produced. Gottheil — Principles of Economics, 7e

  20. The Classical School 2. What is the relationship between the money supply M and the price level P in the quantity theory of money equation? • If resources are fully employed and if money velocity V is constant, then the price level P depends on the quantity of money M. Gottheil — Principles of Economics, 7e

  21. The Classical School 3. How does the classical school use the quantity theory of money equation to find the money supply growth rate that is consistent with zero inflation? • If the growth rate of M equals the Q growth rate, then the price level remains unchanged. Gottheil — Principles of Economics, 7e

  22. The Classical School 3. How does the classical school use the quantity theory of money equation to find the money supply growth rate that is consistent with zero inflation? • In this view, inflation occurs when the annual rate of growth in the money supply exceeds the annual rate of growth of full-employment real GDP. Gottheil — Principles of Economics, 7e

  23. The Keynesian School Keynesian economics • The school of thought that emphasizes the possibility that an economy can be in equilibrium at less than full employment (or with inflation). It argues that with government intervention, equilibrium at full employment without inflation can be achieved by managing aggregate demand. Gottheil — Principles of Economics, 7e

  24. The Keynesian School Keynesian economics rejects the classical economists’ basic premise concerning competitive markets and flexible prices. Gottheil — Principles of Economics, 7e

  25. EXHIBIT 3 KEYNESIAN VIEW OF DEMAND AND PRICES IN THE SWIMSUIT MARKET Gottheil — Principles of Economics, 7e

  26. Exhibit 3: Keynesian View of Demand and Prices in the Swimsuit Market How does the price of swimsuits change as demand decreases from D to D′? • Price remains at $30 since the swimsuit supply curve is horizontal. Gottheil — Principles of Economics, 7e

  27. EXHIBIT 4A AGGREGATE DEMAND, GDP, AND EMPLOYMENT Gottheil — Principles of Economics, 7e

  28. EXHIBIT 4B AGGREGATE DEMAND, GDP, AND EMPLOYMENT Gottheil — Principles of Economics, 7e

  29. Exhibit 4: Aggregate Demand, GDP, and Employment • Note that the AD-AS equilibrium in Exhibit 4 occurs at less than full employment. • If aggregate demand does not change, unemployment is chronic. Gottheil — Principles of Economics, 7e

  30. Exhibit 4: Aggregate Demand, GDP, and Employment 1. Why is the Keynesian aggregate supply curve a horizontal line up to the full-employment level of real GDP? • It reflects the Keynesian view that the price level does not rise as long as there is any unemployment. Gottheil — Principles of Economics, 7e

  31. Exhibit 4: Aggregate Demand, GDP, and Employment 2. If aggregate demand increases from AD′ to AD″ in panel a, what must occur in panel b? • The aggregate expenditure curve must shift upwards from AE′ to AE″. Gottheil — Principles of Economics, 7e

  32. Exhibit 4: Aggregate Demand, GDP, and Employment 2. If aggregate demand increases from AD′ to AD″ in panel a, what must occur in panel b? • The aggregate expenditure curve must shift upwards from AE′ to AE″. • The vertical distance between AE′and AE″is the resulting inflationary gap. Gottheil — Principles of Economics, 7e

  33. The Keynesian School If equilibrium occurs at less than the full-employment output level, Keynesians argue that fiscal policy stimulus should be used to increase aggregate demand. Gottheil — Principles of Economics, 7e

  34. The Keynesian School Keynesian countercyclical policy calls for deficit-spending and expansionary monetary policy during recessions, and surplus budgets and contrac-tionary monetary policy during times of prosperity. Gottheil — Principles of Economics, 7e

  35. The Neo-Keynesian School Traditional Keynesian policy was ill-prepared for the combination of high unemployment rates and high inflation rates (“stagflation”) in the 1970s and early 1980s. Gottheil — Principles of Economics, 7e

  36. The Neo-Keynesian School Phillips curve • A graph showing the inverse relationship between the economy’s rate of unemployment and rate of inflation. Gottheil — Principles of Economics, 7e

  37. EXHIBIT 5 THE PHILLIPS CURVE Gottheil — Principles of Economics, 7e

  38. Exhibit 5: The Phillips Curve Economist A. W. Phillips found an inverse relationship between inflation and unemployment after studying data for 1861–1957 in Britain. Gottheil — Principles of Economics, 7e

  39. The Neo-Keynesian School Neo-Keynesian economics • The school of thought that emphasizes the possibility that an economy can be in equilibrium at less than full employment with inflation. It argues that by managing aggregate demand, government can achieve the most acceptable combination of unemployment and inflation. Gottheil — Principles of Economics, 7e

  40. EXHIBIT 6 THE NEO-KEYNESIAN AGGREGATE SUPPLY CURVE Gottheil — Principles of Economics, 7e

  41. Exhibit 6: The Neo-Keynesian Aggregate Supply Curve How does the Phillips curve relate to the neo-Keynesian aggregate supply curve? • Development of the Phillips curve caused neo-Keynesians to modify the formerly flat portion of the aggregate supply curve at output levels below full employment. Gottheil — Principles of Economics, 7e

  42. Exhibit 6: The Neo-Keynesian Aggregate Supply Curve How does the Phillips curve relate to the neo-Keynesian aggregate supply curve? • The Phillips curve reflects a new intermediate, upward-sloping segment of the Keynesian aggregate supply curve up to the full-employment output level. Gottheil — Principles of Economics, 7e

  43. EXHIBIT 7 THE PHILLIPS CURVE DURING THE 1960s Gottheil — Principles of Economics, 7e

  44. Exhibit 7: The Phillips Curve during the 1960s Were the data from the 1960s consistent with the predicted shape of the Phillips curve? • Yes. Data from the 1960s reveal the inverse relationship between inflation and unemployment rates. Gottheil — Principles of Economics, 7e

  45. The Neo-Keynesian School According to the neo-Keynesians, why does a fall in the rate of unemployment cause the rate of inflation to rise? • During periods of rapid economic growth when unemployment rates are low, firms are more likely to accept workers’ demands for higher wages. Gottheil — Principles of Economics, 7e

  46. The Neo-Keynesian School According to the neo-Keynesians, why does a fall in the rate of unemployment cause the rate of inflation to rise? • That occurs because firms can more easily pass along higher costs to consumers in the form of higher prices during times of economic prosperity. Gottheil — Principles of Economics, 7e

  47. The Neo-Keynesian School Many economists attribute the stagflation of the 1970s and early 1980s to the OPEC oil price increases, which acted as adverse supply shocks. Gottheil — Principles of Economics, 7e

  48. The Neo-Keynesian School The Humphrey-Hawkins Act of 1978 initially identified a 4 percent rate of unemployment and a 3 percent rate of inflation as acceptable and reasonable policy targets. Gottheil — Principles of Economics, 7e

  49. EXHIBIT 8 RATES OF INFLATION AND UNEMPLOYMENT: 1970–1990 Gottheil — Principles of Economics, 7e

  50. Exhibit 8: Rates of Inflation and Unemployment: 1970–1990 Were the data from 1970–1990 consistent with the predicted shape of the Phillips curve? • No. The scatter of points seem to bear no resemblance to the well-defined Phillips curve of the 1960s, as shown in Exhibit 6. Gottheil — Principles of Economics, 7e

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