Lecture 11: Monetary and Fiscal Policy - webarchiv.ethz.chwebarchiv.ethz.ch/.../Lecture12.pdf · Fall Term 2009 Lecture 11: Monetary and Fiscal Policy Principles of Macroeconomics

Fall Term 2009

Lecture 11: Monetary and Fiscal PolicyPrinciples of Macroeconomics Prof. Dr. Jan-Egbert Sturm

Fall Term 2009 2Principles of Macroeconomics - Lecture 12

General Information

22.9. Introduction Ch. 1,229.9. National Accounting Ch. 10, 11

6.10. Production and Growth Ch. 1213.10. Saving and Investment Ch. 1320.10. Unemployment Ch. 1527.10. The Monetary System Ch. 16, 173.11. International Trade (incl. Basic Concepts of Supply, Demand,

Welfare)Ch. 3, 7, 9

10.11. Open Economy Macro Ch. 1817.11. Open Economy Macro Ch. 1924.11. Aggregate Demand and Aggregate Supply Ch. 201.12. Monetary and Fiscal Policy Ch. 218.12. Phillips Curve Ch. 2215.12. Summing up: The Financial Crisis


Automatic Stabilizers

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.Automatic stabilizers include the tax system and some forms of government spending, such as unemployment benefits.


Fiscal Stimulus during 2008-2010 (% of 2007-GDP)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Icel

and

Spa

inIre

land

Uni

ted

Kin

gdom

Cyp

rus

Finl

and

Hon

g K

ong

Sin

gapo

reD

enm

ark

Sw

eden

Luxe

mbo

urg

Uni

ted

Sta

tes

Aus

tralia

Japa

nC

zech

Rep

ublic

Kor

eaN

ethe

rland

sIs

rael

Slo

veni

aB

elgi

umC

anad

aN

ew Z

eala

ndA

ustri

aP

ortu

gal

Fran

ceN

orw

ayG

reec

eIta

lyG

erm

any

Sw

itzer

land

Taiw

anSl

ovak

Mal

ta

Source: IMF World Economic Outlook, 2009 October


Gross Debt-to-GDP Ratio in the G7

Source: IMF World Economic Outlook, 2009 October

0

20

40

60

80

100

120

140

80-84 85-89 90-94 95-99 00-04 05-09 10-14

Canada Germany France United Kingdom Italy Japan USA

% of GDP

Fall Term 2009

Lecture 12: The Phillips CurvePrinciples of Macroeconomics Prof. Dr. Jan-Egbert Sturm


General Information22.9. Introduction Ch. 1,229.9. National Accounting Ch. 10, 11

6.10. Production and Growth Ch. 1213.10. Saving and Investment Ch. 1320.10. Unemployment Ch. 1527.10. The Monetary System Ch. 16, 173.11. International Trade (incl. Basic Concepts of Supply, Demand,

Welfare)Ch. 3, 7, 9

10.11. Open Economy Macro Ch. 1817.11. Open Economy Macro Ch. 1924.11. Aggregate Demand and Aggregate Supply Ch. 201.12. Monetary and Fiscal Policy Ch. 218.12. Phillips Curve Ch. 2215.12. Summing up: The Financial Crisis


Remember: Natural Rate of Unemployment

The natural rate of unemployment is unemployment that does not go away on its own even in the long runThere are two reasons why there is a positive natural rate of unemployment:1. job search (frictional unemployment)2. wage rigidity (structural unemployment)

– Minimum-wage laws– Unions– Efficiency wages


Remember: The Classical Dichotomy

The quantity equation: M × V = P × Yrelates the quantity of money (M) to the nominal value of output (P × Y)

The quantity equation shows that an increase in money must be reflected in one of three other variables:

The price level must rise,the quantity of output must rise, orthe velocity of money must fall

The velocity of money is considered to be (relatively) fixedThe classical dichotomy

Real economic variables do not change with changes in moneyHence, changes in money supply only affect the price level


Remember: A Contraction in Aggregate Demand

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS

Long-runaggregate

supply

Aggregatedemand, AD

AP

Y

AD2

1. A decrease inaggregate demand . . .

2. . . . causes output to fall in the short run

CP3

BP2

Y2

3. . . . adaption of price expectations


Remember: A Monetary Injection

MS2Moneysupply, MS

Aggregatedemand, AD

YY

P

Money demand at price level P

AD2

Quantityof Money

0

InterestRate

r

r2

(a) The Money Market (b) The Aggregate-Demand Curve

Quantityof Output

0

PriceLevel

3. . . . which increases the quantity of goods and services demanded at a given price level.

2. . . . theequilibriuminterest ratefalls . . .

1. When the CBincreases themoney supply . . .


Short-Run Trade-Off between Inflation and Unemployment

Society faces a short-run tradeoffbetween unemployment and inflation.If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.


THE PHILLIPS CURVE

The Phillips curve shows the short-run trade-off between inflation and unemployment.


The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2


Aggregate Demand, Aggregate Supply, and the Phillips Curve

The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.A higher level of output results in a lower level of unemployment.


How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply


0

InflationRate

(percentper year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregatedemand

Highaggregate demand

(output is8,000)

B

4

6

(output is7,500)

A

7

2

8,000(unemployment

is 4%)

106 B

(unemploymentis 7%)

7,500

102 A


Percentage change in real GDP

Okun’s Law

19511984

1999

2000

1993

1982

1975

Change in unemployment rate

10

-3 -2 -1 0 1 2 43

8

6

4

2

0

-2

Okun’s Law states that a one-percent decrease in unemployment is associated with two percentage points of additional growth in real GDP

Okun’s Law states that a one-percent decrease in unemployment is associated with two percentage points of additional growth in real GDP


Employment development in Switzerland

-5

-4

-3

-2

-1

0

1

2

3

4

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

% (y-o-y)

GDP growth

-4

-3

-2

-1

0

1

2

3

4

5% (y-o-y)

Sources: seco, BFS, KOF

Employment growth


Full-time equivalent employment vs. GDP

-3.0

-2.0

-1.0

0

1.0

2.0

-1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0

Empl

oym

ent

GDP (2-years average)Source: BFS and KOF


Shifts in the Phillips Curve

The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.


The Long-Run Phillips Curve

In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.

As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.Monetary policy could be effective in the short run but not in the long run.


The Long-Run Phillips Curve

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

BHighinflation

Lowinflation

A2. . . . but unemploymentremains at its natural ratein the long run.

1. When the CB increases the growth rate of the money supply, the rate of inflation increases . . .


The Meaning of “Natural”

The “natural” rate of unemployment is the rate to which the economy gravitates in the long run.The natural rate is not necessarily desirable, nor is it constant over time.Monetary policy cannot change the natural rate, but other government policies that strengthen labor markets can.


How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

Natural rateof output

Natural rate ofunemployment

0

PriceLevel

P

Aggregatedemand, AD

Long-run aggregatesupply

Long-run Phillipscurve


UnemploymentRate

0

InflationRate


2. . . . raisesthe pricelevel . . .

1. An increase in the money supplyincreases aggregatedemand . . .

AAD2

B

A

4. . . . but leaves output and unemploymentat their natural rates.

3. . . . andincreases theinflation rate . . .

P2B


Reconciling Theory and Evidence

Question: How can classical macroeconomic theories predicting a vertical long run Phillips curve be reconciled withthe evidence that, in the short run, there is a tradeoff betweenunemployment and inflation?


The Short-Run Phillips Curve

Expected inflation measures how much people expect the overall price level to change.In the long run, expected inflation adjusts to changes in actualinflation.The CB’s ability to create unexpected inflation exists only in the short run.

Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.


The Short-Run Phillips Curve

This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.

The Unemployment Rate =

( )Natural rate of unemployment - a Actual inflation

Expectedinflation−

SRAS: ( )eY Y P Pα= + −


(percent per year)

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate

1968

1966

19611962

1963

1967

19651964

The Phillips Curve in the 1960s (USA)


The Natural Experiment for the Natural-Rate Hypothesis

The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.Historical observations support the natural-rate hypothesis.The concept of a stable Phillips curve broke down in the in the early ’70s.During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.WHY?


1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

1973

1966

1972

1971

19611962

1963

1967

19681969 1970

19651964

The Breakdown of the Phillips Curve (USA)


How Expected Inflation Shifts the Short-Run Phillips Curve

Unemployment Rate0 Natural rate ofunemployment


Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.

CB

A


Shifts In The Phillips Curve: The Role Of Supply Shocks

Historical events have shown that the short-run Phillips curve can shift due to changes in expectations. The short-run Phillips curve also shifts because of shocks to aggregate supply.

Adverse changes in aggregate supply can worsen the short-run trade-off between unemployment and inflation.An adverse supply shock gives policymakers a less favorabletrade-off between inflation and unemployment.

A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge.

This shifts the economy’s aggregate supply curve…. . . and as a result, the Phillips curve.


An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregatedemand


UnemploymentRate

0

InflationRate


3. . . . andraises the price level . . .

AS2 Aggregatesupply, AS

A1. An adverseshift in aggregate supply . . .

4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


Two causes of rising & falling inflation

demand-pull inflation: inflation resulting from demand shocks.Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.

cost-push inflation: inflation resulting from supply shocks.Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.


World economic growth and the oil price

Source: IMF

0

1

2

3

4

5

6

7

70-74 75-79 80-84 85-89 90-94 95-99 00-04 05-09

GDP growth, constant prices (PPP) Real oil price (in 2000 USD)Oil price (USD per barrel) avg. real GDP growth (PPP)

%

0

20

40

60

80

100

120

140USD per barrel


Shifts in the Phillips Curve: The role of supply shocks

In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum.

Fight the unemployment battle by expanding aggregate demand and accelerate inflation.Fight inflation by contracting aggregate demand and endure even higher unemployment.


1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1972

19751981

1976

19781979

1980

1973

1974

1977

The Supply Shocks of the 1970s


United States

0

2

4

6

8

10

12

14

3 4 5 6 7 8 9 10

Unemployment

Infla

tion


United States

0

2

4

6

8

10

12

14

3 4 5 6 7 8 9 10

Unemployment

Infla

tion

60

69

92

76

79

80

83

86


United States

0

2

4

6

8

10

12

14

3 4 5 6 7 8 9 10

Unemployment

Infla

tion

84

92

79

80

99

73

74

86


The Cost of Reducing Inflation

To reduce inflation, the CB has to pursue contractionarymonetary policy. When the CB slows the rate of money growth, it contracts aggregate demand.This reduces the quantity of goods and services that firms produce.This leads to a rise in unemployment.


Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate

0 Natural rate ofunemployment


Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.

BC

A


The Sacrifice Ratio

To reduce inflation, an economy must endure a period of high unemployment and low output.When the CB combats inflation, the economy moves down the short-run Phillips curve.The economy experiences lower inflation but at the cost of higher unemployment.The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.

An estimate of the sacrifice ratio is five.To reduce inflation from about 10% to 4% in 1979 would have required an estimated sacrifice of 30% of annual output!


Rational Expectations and the Possibility of Costless Disinflation

The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.


Rational expectations

Ways of modeling the formation of expectations: adaptive expectations: People base their expectations of future inflation on recently observed inflation.rational expectations:People base their expectations on all available information, including information about current and prospective future policies.


Rational Expectations and the Possibility of Costless Disinflation

Expected inflation explains why there is a trade-off between inflation and unemployment in the short run but not in the long run.How quickly the short-run trade-off disappears depends on how quickly expectations adjust.The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.


The Volcker Disinflation

When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the United States’ foremost problems.Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high unemployment (about 10 percent in 1983).


1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C

Figure 11 The Volcker Disinflation


The Greenspan Era

Alan Greenspan’s term as Fed chairman began with a favorable supply shock.

In 1986, OPEC members abandoned their agreement to restrict supply.This led to falling inflation and falling unemployment.


1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



19841991

1985

19921986

19931994

198819871995

199620021998

1999

20002001

19891990

1997

Figure 12 The Greenspan Era


United States

0

2

4

6

8

10

12

14

3 4 5 6 7 8 9 10

Unemployment

Infla

tion

84

92

79

80

99

73

74

86


United States

0

2

4

6

8

10

12

14

3 4 5 6 7 8 9 10

Unemployment

Infla

tion

60

69

84

92

76

79

80

8399

73

74

70

71

75

72

86


Germany

-1

0

1

2

3

4

5

6

7

8

0 2 4 6 8 10

Unemployment

Infla

tion


Germany

-1

0

1

2

3

4

5

6

7

8

0 2 4 6 8 10

Unemployment

Infla

tion

97

92

91

86

85

81

75

74

70

60

76

77

78


Germany

-1

0

1

2

3

4

5

6

7

8

0 2 4 6 8 10

Unemployment

Infla

tion

97

92

91

86

85

81

74

70

60

99

79


Germany

-1

0

1

2

3

4

5

6

7

8

0 2 4 6 8 10

Unemployment

Infla

tion

97

92

91

86

85

81

75

74

70

60

99

7976

77

78


Summary

The Phillips curve describes a negative relationship between inflation and unemployment.By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment.By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.


Summary

The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run.The long-run Phillips curve is vertical at the natural rate of unemployment.The short-run Phillips curve also shifts because of shocks to aggregate supply.An adverse supply shock gives policymakers a less favorable trade-off between inflation and unemployment.


Summary

When the CB contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve.This results in temporarily high unemployment.The cost of disinflation depends on how quickly expectations of inflation fall.

Documents

Lecture 11: Monetary and Fiscal Policy - webarchiv.ethz.chwebarchiv.ethz.ch/.../Lecture12.pdf · Fall Term 2009 Lecture 11: Monetary and Fiscal Policy Principles of Macroeconomics