Carlos Andres Rodriguez Herrera 1 30 23 Principles of Macroeconomics ECON 2002 01 Chapter 17 Stabilization in an Integrated World Economy Introduction For more than 50 years many economists have used an inverse relationship involving the unemployment rate and real GDP as a guide to macroeconomic policymaking Since 2009 however the relationship appears to have broken down If the inverse relationship does not return the case for discretionary policymaking will be weakened What you learn in this chapter will help you understand why this policy implication follows if the relationship between unemployment and real GDP no longer holds Learning Objectives Explain why the actual unemployment rate might depart from the natural rate of unemployment Describe why there may be an inverse relationship between the inflation rate and the unemployment rate reflected by the Philips curve Evaluate how expectations affect the actual relationship between the inflation rate and the unemployment rate Understand the rational expectations hypothesis and its implications for economic Distinguish among alternative modern approaches to strengthening the case for active policymaking policymaking Chapter Outline Active Versus Passive Policymaking The Natural Rate of Unemployment Rational Expectations the Policy Irrelevance Proposition and Real Business Cycles Modern Approaches to Justifying Active Policymaking Is There a New Keynesian Philips Curve Summing Up Economic Factors Favoring Active Versus Passive Policymaking Active Versus Passive Policymaking Active Discretionary Policymaking All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy Examples are monetary and fiscal policy Passive Nondiscretionary Policymaking Policymaking that is carried out in response to a rule Not in response to an actual or potential change in overall economic activity Examples include a monetary rule The Ohio State University 1 The Natural Rate of Unemployment Two components of the natural rate of unemployment Frictional unemployment Structural unemployment Frictional unemployment Arises because individuals take the time to search for the best job opportunities Much of the unemployment is of this type except when there is a recession or depression Structural unemployment results from 1 Government imposed minimum wage laws laws restricting entry into occupations and welfare and unemployment insurance benefits that reduce incentives to work 2 Union activity that sets wages above the equilibrium level and also restricts the mobility of labor Natural Rate of Unemployment The rate of unemployment that is estimated to prevail in long run macroeconomic equilibrium When all workers and employers have fully adjusted to any changes in the economy Departures from the natural rate of unemployment Deviations of the actual from the natural rate are called cyclical unemployment Deviations observed over the course of nationwide business fluctuations The Philips curve a rationale for active policymaking 1 The greater the unexpected increases in aggregate demand the greater the amount of inflation that results in the short run and the lower the unemployment rate 2 The greater the unexpected decrease in aggregate demand the greater the deflation that results in the short run and the higher the unemployment rate The Philips Curve A curve showing the relationship between unemployment and changes in wages or prices It was long thought to reflect a trade off between unemployment and inflation Rational Expectations the Policy Irrelevance Proposition and Real Business Cycles Rational Expectations Hypothesis 1 Individuals base their forecasts expectations about the future values of economic variables on all available past and current information 2 These expectations incorporate individuals understanding about how the economy operates including the operation of monetary and fiscal policy New classical approach A modern version of the classical model in which wages an prices are flexible There is pure competition in all markets The rational expectations hypothesis is assumed to be working Policy Irrelevance Proposition The conclusion that policy actions have no real effects in the short run if the policy actions are anticipated and none in the long run even if the policy actions are unanticipated A key assumption people don t persistently make the same mistakes in forecasting the future Under the assumption of rational expectations on the part of decision makers in the economy Carlos Andres Rodriguez Herrera 1 30 23 Anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP Regardless of the nature of the anticipated policy the unemployment rate will equal the natural rate and real GDP will be determined solely by the economy s long run aggregate supply curve The policy dilemma Policy irrelevance proposition seems to suggest only mistakes have real effects Policymakers powerless to push real GDP and unemployment back to long run levels when entering recessionary period The distinction between real and monetary shocks Many economists argue real as opposed to purely monetary forces might help explain aggregate economic fluctuations Real business cycles represent another challenge to policy activism Stagflation A situation characterized by lower real GDP lower employment and a higher unemployment rate during the same period that the rate of inflation increases In Figure 17 7 real GDP declines at the same time the price level rises Modern Approaches to Justifying Active Policymaking Sticky wages and prices remain important some economists contend Market clearing model of the economy may not fully explain business cycles New Keynesians have tried to refine the theory of aggregate supply Small Menu Costs Costs that deter firms from changing prices in response to demand changes Examples the costs of renegotiation contracts or printing new price lists New Keynesian Inflation Dynamics In new Keynesian theory the pattern of inflation exhibited by an economy with growing aggregated demand initial sluggish adjustment of the price level in response to increased aggregate demand followed by higher inflation later Is There a New Keynesian Phillips Curve A fundamental thrust of the new Keynesian theory is that activist policymaking can promote economic stability The U S experience with the Phillips curve Attempts to reduce the