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Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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Page 1: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Current Issues in Macro Theory and Policy

Chapter 36

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Page 2: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. 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

36-2

Page 3: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Causes of Macro Instability

• Mainstream view–Held by most economists

• Price stickiness• Unexpected demand shocks

–Variable investment spending

• Unexpected supply shocks

36-3

Page 4: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

• Monetarist view

• Government interference is the problem

• Equation of exchange MV = PQ

• Stable velocity

• Monetary causes of instability–Inappropriate monetary policy

Causes of Macro Instability

36-4

Page 5: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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

Pri

ce L

evel

P1

Real Domestic Output

Q2 Q1

AD1

AD2

ASLR1ASLR2

Causes of Macro Instability

36-5

Page 6: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

• Coordination failures–Fourth modern view

• Limited information• Expectations and self-fulfilling

prophecy• Unemployment equilibrium• Inflation equilibrium

Causes of Macro Instability

36-6

Page 7: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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

Page 8: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

New Classical View of Self-Correction

AD2

AD1

AS1

AS2ASLR

Pri

ce L

evel

P1

P2

P3

Real Domestic Output

Q1 Q2

a

b

c

Self-Correction

36-8

Page 9: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

New Classical View of Self-Correction

AD3

AD1

AS1

AS3

ASLRP

rice

Lev

el

P1P4P5

Real Domestic Output

Q1Q4 Q3

a

e

d

f

Self-Correction

36-9

Page 10: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

• Mainstream view• Downward wage inflexibility• Efficiency wage theory

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

• Insider-outsider relationships

Self-Correction

36-10

Page 11: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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

36-11

Page 12: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Rationale for Monetary Rule

Pri

ce L

evel

P1

Real Domestic Output, GDPQ1 Q2

P2

ASLR1 ASLR2

AD1

AD2

36-12

Page 13: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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

36-13

Page 14: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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

Page 15: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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

36-15

Page 16: Current Issues in Macro Theory and Policy Chapter 36 Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Next Chapter Preview…

International Trade

36-16


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