Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies,...

Current Issues in Macro Theory and Policy

Chapter 36

McGraw-Hill/Irwin

Chapter Objectives

• Alternative perspectives on macroeconomic instability

• Equation of exchange and monetarism

• New classical economists and self-correction

• Rules vs. discretion in conducting stabilization policy

Causes of Macro Instability

• Mainstream view–Held by most economists

• Price stickiness• Unexpected demand shocks

–Variable investment spending

• Unexpected supply shocks

• Monetarist view

• Government interference is the problem

• Equation of exchange MV = PQ

• Stable velocity

• Monetary causes of instability–Inappropriate monetary policy

• Real-business-cycle view–Shifts in long-run aggregate supply

Real Domestic Output

ASLR1ASLR2

• Coordination failures–Fourth modern view

• Limited information• Expectations and self-fulfilling

prophecy• Unemployment equilibrium• Inflation equilibrium

Self-Correction

• New classical view –Rational expectations theory–Monetarists

• Automatic correction will occur• Speed of adjustment• Unanticipated price-level

changes• Fully anticipated price-level

changes36-7

New Classical View of Self-Correction

AS2ASLR

Self-Correction

New Classical View of Self-Correction

P1P4P5

Q1Q4 Q3

Self-Correction

• Mainstream view• Downward wage inflexibility• Efficiency wage theory

–Greater work effort–Lower supervision costs–Reduced job turnover

• Insider-outsider relationships

Self-Correction

Rules or Discretion?

• In support of policy rules• Reduce macro instability• Monetary rule

–Shift AD to keep up with AS

–Price stability achieved

• Inflation targeting• Balanced budget

Rationale for Monetary Rule

Real Domestic Output, GDPQ1 Q2

ASLR1 ASLR2

Rules or Discretion?

• In defense of discretionary stabilization policy

• Discretionary monetary policy–Velocity is not stable

• Discretionary fiscal policy–Useful during recession

• Increased macro stability

The Taylor Rule

• Rules: passive monetary policy• Discretion: active monetary policy• Hybrid policy rule to dictate Fed actions• Policy responds to changes in real GDP

and inflation– Use the interest rate

• Fed explains deviations from the rule• Increase Fed credibility and reduce

uncertainty36-14

Key Terms

• monetarism• equation of exchange• velocity• real-business-cycle

theory• coordination failures• rational expectations

theory• new classical

economics• Taylor rule

• price-level surprises• efficiency wage• insider-outsider

theory• monetary rule• inflation targeting

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International Trade

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