Week 10 Lecture 19

Macroeconomic Policy Reference: Bernanke, Olekalns and Frank - Chapter 10 (This is a new chapter in the 4th edition of BOF) Key Issues

Stabilization Policy and Accommodation

Inflationary Expectations and Credibility

AS Effects of Fiscal Policy

2

Role for Stabilisation Policy AD-AS model implies that economy is eventually self-correcting (y eventually returns to y*). If actual economy is slow to self-correct, AD-AS model implies there is scope for use of fiscal and monetary policy to respond to shocks (stabilisation policy)

3

AD Shocks and Stabilisation Policy With AD shocks stabilisation policy will act to reinforce the self-correction process. AS Inflation Negative AD

e Shock 1

AD AD1 y1 y* y

4

AD Shocks and Stabilisation Policy Self-correction AS Inflation

e Expansionary 1 monetary/fiscal

policy AD AD1 y1 y* y

Both factors act to restore original equilibrium (y=y*)

5

AS Shocks and Stabilisation Policy With AS shocks policy-makers face a trade-off. AS1 AS Inflation 1 Negative AS

e Shock

AD y1 y* y

6

AS Shocks and Stabilisation Policy

Accommodate shock (higher inflation rate) AS1 AS 2 1 Expansionary

e monetary/fiscal policy

AD1 AD y1 y* y

7

AS Shocks and Stabilisation Policy

Non-accommodation (return to inflation target) AS1 AS Inflation 1 AS1 returns to AS

e (in long-run)

AD y1 y* y

8

Anchored Inflation Expectations Speed at which the AS curve returns to its previous position, depends on how strongly peoples expectations are anchored to initial inflation rate. If increase in inflation rate is seen as being temporary and central bank will not accommodate, it is less likely to feed into expectations of inflation and wage/price changes.

9

Central Bank Reputation and Credibility Credibility refers to the degree of belief that the public has in the willingness of a central bank to keep its promises (e.g. to keep inflation low). Even if this may impose short-run costs on the economy. Influences on Credibility

Central bank independence

Publically announced inflation target

Reputation effects

10

Aggregate Supply Effects of Fiscal Policy Fiscal policy can affect potential output (as well as y)

- Government can increase public capital (or infrastructure)

- Taxes and transfers can affect incentives to work and produce

- Changes in marginal income tax rates can affect labour supply decisions