A. Fiscal Policy

1

• A. Fiscal Policy

2
The Keynesian View of Fiscal Policy

• Keynesian theory highlights the potential of
  fiscal policy as a tool capable of reducing
  fluctuations in demand.

• When an economy is operating below its potential
  output, the Keynesian model suggests that the
  government should institute expansionary fiscal
  policy -- it should either

• increase the governments purchases of goods
  services, and/or,

• cut taxes.

3
Expansionary Fiscal Policy to Promote
Full-Employment

• We begin in the short run at Y1, below the
  economys potential capacity (YF). There are 2
  routes to long-run full-employment equilibrium.

• Policymakers could wait for both lower wages and
  resource prices to reduce costs, increase supply
  to SRAS3 and restore equilibrium at YF.

• Alternatively, expansionary fiscal policy could
  stimulate aggregate demand (shift AD1 to AD2) and
  guide the economy back to E2, at YF.

4
The Keynesian View of Fiscal Policy

• When inflation is a potential problem, the
  Keynesian analysis suggests a shift toward a more
  restrictive fiscal policy

• reduce government spending, and/or,
• raise taxes.
• Keynesians challenged the view that the
  governments should always be balance its budget.

• Rather than balancing the budget annually,
  Keynesians argued that counter-cyclical policy
  should be used to offset fluctuations in
  aggregate demand.

5
Restrictive Fiscal Policy to Combat Inflation

• Strong demand such as AD1 will temporarily lead
  to an output rate beyond the economys long-run
  potential (YF).

• If maintained, the high level of demand will lead
  to the long-run equilibrium E3 at a higher price
  level (as SRAS shifts back to SRAS3).

• However, restrictive fiscal policy could restrain
  demand from expanding to AD2 in the first place
  and guide the economy to a non-inflationary
  equilibrium (E2).

6
Fiscal Policy and the Crowding-out Effect

• The Crowding-out Effect -- indicates that
  the increased borrowing to finance a
  budget deficit will push real interest rates up
  and thereby retard private spending,
  reducing the stimulus effect of
  expansionary fiscal policy.

• The implications of the crowding-out analysis are
  symmetrical.
• Restrictive fiscal policy will reduce real
  interest rates and "crowd in" private spending.
• Crowding-out Effect in an open economy --
  Larger budget deficits and higher real interest
  rates also lead to an inflow of capital,
  appreciation in the dollar, and a decline
  in net exports.

7
A Visual Presentation of the Crowding-Out Effect
in an Open Economy

• An increase in govt. borrowing to finance an
  enlarged budget deficit places upward pressure
  on real interest rates.

• This retards private investment and thereby
  Aggregate Demand.

• In an open economy, higher interest rates attract
  capital from abroad.

• As foreigners buy more dollars to buy U.S. bonds
  and other financial assets, the dollar
  appreciates.

• In turn, the appreciation of the dollar causes
  net exports to fall.

• Thus, as a result of increased budget deficits,
  higher interest rates trigger reductions in both
  private investment and net exports, which weaken
  the expansionary impact of a budget deficit.

8
The New Classical View of Fiscal Policy

• The New classical view stresses that

• debt financing merely substitutes higher future
  taxes for lower current taxes, and thus,
• budget deficits affect the timing of taxes, but
  not their magnitude.

• New Classics argue that when debt is substituted
  for taxes
• people will save the increased income so they
  will be able to pay the higher future taxes,
  thus,
• the budget deficit does not stimulate aggregate
  demand.

9
The New Classical View of Fiscal Policy

• Similarly, the real interest rate is unaffected
  by deficits since people will save more in order
  to pay the higher future taxes.

• According to the new classical view, fiscal
  policy is completely impotent. It does not
  effect output, employment, or real interest rates.

10
New Classical View -- Higher Expected Future
Taxes Crowd-out Private Spending

• New Classical economists emphasize that budget
  deficits merely substitute future taxes for
  current taxes.

• If households did not anticipate the higher
  future taxes, aggregate demand would increase
  (from AD1 to AD2).

• However, demand remains unchanged at AD1 when
  households fully anticipate the future increase
  in taxes and, so, save for them.

11
New Classical View -- Higher Expected Future
Taxes Crowd-out Private Spending

• In order to finance the budget deficit, the govt
  borrows from the loanable funds market,
  increasing the demand (from D1 to D2).

• According to the new classical view, people will
  save more in order to pay the higher future taxes
  implied by the increases in debt. This will
  increase the supply of loanable funds to S2.

• This permits the government to borrow the funds
  to finance the deficit without pushing up the
  interest rate.

12
Fiscal Policy -- Problems with Proper Timing

• Various time lags make proper timing of changes
  in discretionary fiscal policy difficult.

• Discretionary fiscal policy is like a two-edged
  sword it can both harm and help.

• If timed correctly, it may reduce economic
  instability.
• If timed incorrectly, however, it may increase
  economic instability.

13
Why Proper Timing of Fiscal Policy is Difficult

• We begin long-run equilibrium (E0) at the price
  level P0 and output Y0. At this output, only
  the natural rate of unemployment is present.

• An investment slump and business pessimism result
  in an unanticipated decline in AD (to AD1).
  Output falls and unemployment increases.

• After a time, policymakers institute expansionary
  fiscal policy seeking to shift AD back to AD0,
  but by the time fiscal policy begins to exert its
  primary effect, private investment has recovered
  and decision makers have become increasingly
  optimistic about the future.

14
Why Proper Timing of Fiscal Policy is Difficult
Price level
SRAS
AD1
Goods Services(real GDP)

• Thus, just as AD begins shifting back to AD0 by
  its own means, the effects of fiscal policy
  over-shift AD to AD2.

• The price level in the economy rises as the
  economy is now overheated.

• Unless the expansionary fiscal policy is
  reversed, wages and other resource prices will
  eventually increase, shifting SRAS back to SRAS2
  (driving the price level up to P3).

15
Fiscal Policy -- Problems with Proper Timing

• Automatic Stabilizers -- without any new
  legislative action, they tend to increase
  the budget deficit (or reduce the surplus)
  during a recession and increase the
  surplus (or reduce the deficit) during an
  economic boom.

• Examples of Automatic Stabilizers

• Unemployment Compensation
• Corporate Profit Tax
• A Progressive Income Tax

16
Fiscal Policy as a Tool -- A Modern Synthesis

• The proper timing of discretionary fiscal policy
  is both difficult to achieve and of crucial
  importance.

• Automatic stabilizers reduce the fluctuation of
  aggregate demand and help to direct the economy
  toward full-employment.
• Fiscal policy is much less potent than the early
  Keynesian view implied.

17
Supply-side Effects of Fiscal Policy

• From a supply-side viewpoint, the marginal tax
  rate is of crucial importance

• A reduction in marginal tax rates increases the
  reward derived from added work, investment,
  saving, and other activities that become less
  heavily taxed.

• High marginal tax rates will tend to retard total
  output because they will

• Discourage work effort and reduce the productive
  efficiency of labor,
• Adversely affect the rate of capital formation
  and the efficiency of its use, and,
• Encourage individuals to substitute less desired
  tax-deductible goods for more desired
  non-deductible goods.

18
Supply-side Effects of Fiscal Policy

• Thus, changes in marginal tax rates, particularly
  high marginal rates, may exert an impact on
  aggregate supply because the changes will
  influence the relative attractiveness of
  productive activity in comparison to leisure and
  tax avoidance.

• Impact of supply-side effects

• Are likely to take place over a lengthy time
  period.
• There is some evidence that countries with high
  taxes grow more slowlyFrance and Germany versus
  United Kingdom.
• While the significance of supply-side effects are
  controversial, there is evidence they are
  important for taxpayers facing extremely high
  rate, say rates of 40 percent and above.

19
Tax Rate Effects and Supply-Side Economics

• What are the supply-side effects of a reduction
  in marginal tax rates?

• The lower marginal tax rates increase the
  incentive to earn and use resources efficiently.
  AD1 shifts out to AD2, and as the effects of the
  tax cut are long-run as well as short-run, both
  SRAS and LRAS shift out.

• If the lower tax rates are financed by budget
  deficits, aggregate demand may expand by a larger
  amount than aggregate supply, leading to an
  increase in the price level.

20

• B. Money and the Banking System

21
What Is Money?

• A Medium of Exchange-- An asset that is used to
  buy and sell goods services.

• A Store of Value-- An asset that will allow
  people to transfer purchasing power from one
  period to another.
• A Unit of Account-- The units of measurement
  used by people to post prices and keep track
  of revenues and costs.

22
The Supply of Money

• The components of the M1 money supply are

• Currency
• Checking Deposits (including demand deposits and
  interest-earning checking deposits)
• Traveler's checks

• The M2 money supply is a broader measure that
  includes

• M1,
• Savings,
• Time deposits, and,
• Money mutual funds.

23
The Business of Banking

• The banking industry includes

• savings and loans,
• credit unions, and,
• commercial banks.

• Banks accept deposits and use part ofthem to
  extend loans and make investments.

• Banks are profit-seeking institutions.
• Banks play a central role in the capital
  (loanable funds) market

• They help to bring together people who want to
  save for the future with those who want to borrow
  in order to undertake investment projects.

• The banking system is a fractional reserve
  system -- Banks maintain only a fraction of
  their assets in reserves to meet the
  requirements of depositors.

24
How Banks Create Money by Extending Loans

• Under a fractional reserve system, an increase in
  reserves will permit banks to extend additional
  loans and thereby expand the money supply (create
  additional checking deposits).

1,000.00
200.00
160.00
128.00
102.40
81.92
65.54
52.43
209.71

• When banks are required to maintain 20 reserves
  against demand deposits, the creation of 1,000
  of new reserves will potentially increase the
  supply of money by 5,000.

25
How Banks Create Money by Extending Loans

• The lower the percentage of the reserve
  requirement, the greater is the potential
  expansion in the money supply resulting from the
  creation of new reserves.

• The fractional reserve requirement places a
  ceiling on potential money creation from new
  reserves.

• The actual deposit multiplier will be less than
  the potential because
• Some persons will hold currency rather than bank
  deposits.
• Some banks may not use all their excess reserves
  to extend loans.

26
The Three Tools the Fed Uses to Control
the Money Supply

• Reserve requirements-- a of a specified
  liability category (for example transaction
  accounts) that banking institutions are
  required to hold as reserves against that type
  of liability.

• When the Fed lowers the required reserve ratio,
  it creates excess reserves and allows banks to
  extend additional loans, expanding the money
  supply.
• Raising the reserve requirements has the opposite
  effect.

27
The Three Tools the Fed Uses to Control
the Money Supply

• Open Market Operations-- the buying and selling
  of U.S. Government securities (national debt
  in the form of bonds) by the Fed.

• This is the primary tool used by Fed.
• When the Fed buys bonds the money supply will
  expand, because
• the bond buyers will acquire money, and,
• bank reserves will increase, placing banks in a
  position to expand the money supply through the
  extension of additional loans.
• When the Fed sells bonds the money supply will
  contract because
• bond buyers are giving up money in exchange for
  securities, and,
• the reserves available to banks will decline,
  causing them to extend fewer loans.

28
The Three Tools the Fed Uses to Control
the Money Supply

• Discount Rate-- the interest rate the Fed
  charges banking institutions for borrowed
  funds.

• An increase in the discount rate is restrictive
  (decreases the money supply) because it
  discourages banks from borrowing from the Federal
  Reserve to extend new loans.
• A reduction in the discount rate is expansionary
  (increases the money supply) because it makes
  borrowing from the Federal Reserve less costly.

29
Monetary Base and Money Supply
a Travelers checks are included in this category.

• The monetary base (currency plus bank reserves)
  provides the foundation for the money supply.

• Currency in circulation contributes directly to
  the money supply . . .

while bank reserves provide the
underpinnings for checking deposits.

• Fed actions that alter the monetary base will
  affect the money supply

• By increasing reserve requirements, buying bonds,
  or increasing the discount rate, the Fed can
  reduce the money supply.

• By decreasing reserve requirements, selling
  bonds, or decreasing the discount rate, the Fed
  can increase the money supply.

30
Ambiguities in the Meaning and Measurement of
the Money Supply

• Interest earning checking deposits

• Less costly to hold than currency and demand
  deposits.
• Their introduction in the early 1980s changed
  the nature of the M1 money supply.

• Widespread use of the U.S. dollar outside of the
  United States

• More than one-half and perhaps as much as
  two-thirds of U.S. currency is held overseas.
• This reduces the reliability of the M1 money
  supply measure.

31
Ambiguities in the Meaning and Measurement of
the Money Supply

• Sweeping of various interest-earning checking
  accounts into Money Market Deposit Accounts

• The increasing availability of low-fee stock and
  bond mutual funds

• Debit Cards and Electronic Money

• Summary

• Recent financial innovations and other structural
  changes have blurred the meaning of money and
  reduced the reliability of the various money
  supply measures.
• In the Computer-Age, continued change in this
  area is likely.

32

• C. Monetary Policy

33
The Demand and Supply of Money

• The quantity of money people want to hold (the
  demand for money) is inversely related to the
  money rate of interest, because higher interest
  rates make it more costly to hold money instead
  of interest-earnings assets like bonds.

34
The Demand and Supply of Money

• The supply of money is vertical because it is
  determined by the Fed.

35
The Demand and Supply of Money

• Equilibrium -- The money interest rate will
  gravitate toward the rate where the quantity
  of money people want to hold (the demand) is
  just equal to the stock of money the Fed has
  supplied (the supply).

Quantity of money
36
Transmission of Monetary Policy

• When the Fed shifts to a more expansionary
  monetary policy, it will generally buy additional
  bonds thereby expanding the money supply.

• This increase in the money supply (shifting S1 to
  S2 in the market for money) will supply the
  banking system with additional reserves.

• Both the Feds bond purchases and the banks use
  of the additional reserves to extend new loans
  will increase the supply of loanable funds
  (shifting S1 to S2 in the loanable funds market)
  . . .

and put downward pressure on the
real rate of interest (reduction to r2).
Qb
Q2
37
Transmission of Monetary Policy

• As the real rate of interest falls, aggregate
  demand increases (to AD2).

• Since the effects of the monetary expansion were
  unanticipated, the expansion in AD leads to a
  short-run increase in current output (from Y1 to
  Y2) . . .

and increase in prices (from P1 to
P2) inflation.

• The path that monetary policy takes through the
  macroeconomic system is called the Transmission
  of Monetary Policy.

• The impact of a shift in monetary policy is
  generally transmitted through interest rates,
  exchange rates, and asset prices.

Real Interest Rate
Price Level
D
Quantity of Loanable Funds
Goods Services (Real GDP)
Q2
Y1
Y2
38
A Shift to a More Expansionary Monetary Policy

• During expansionary monetary policy the Fed may
  buy bonds, reduce the discount rate, or reduce
  the reserve requirements for deposits.

• The Fed generally buys bonds, which
• increases bond prices, and,
• creates additional bank reserves, while it,
• places downward pressure on real interest rates.

• As a result, an unanticipated shift to a more
  expansionary policy will stimulate aggregate
  demand and thereby increase both output and
  employment.

39
The Effects ofExpansionary Monetary Policy

• If the impact of an increase in aggregate demand
  accompanying expansionary monetary policy is felt
  when the economy is operating below capacity, the
  policy will help direct the economy back to a
  long-run full-employment output equilibrium (YF).

• In this case, the increase in output from Y1 to
  YF will be long term.

40
The Effects ofExpansionary Monetary Policy

• In contrast, if the demand-stimulus effects are
  imposed on an economy already at full-employment
  (YF), they will lead to excess demand, higher
  product prices, and temporarily higher output
  (Y2).

• In the long-run, the strong demand will push up
  resource prices, shifting short run aggregate
  supply (from SRAS to SRAS2).

• The price level rises to P3 (from P2) and output
  falls back to full-employment output once again
  (YF from it temporary high,Y2).

41
Monetary Policy in the Long Run

• The Quantity Theory of Money

Y
M
V
P

• If V and Y are constant, than an increase in M
  would lead to a proportional increase in P.

42
Monetary Policy in the Long Run

• The Long-Run Implications of Modern Analysis

• In the long run, the primary impact will be on
  prices rather than on real output.
• When expansionary monetary policy leads to rising
  prices, decision makers eventually anticipate the
  higher inflation rate and build it into their
  choices.
• As this happens, money interest rates, wages, and
  incomes will reflect the expectation of
  inflation, and so real interest rates, wages, and
  output will return to their long-run normal
  levels.

43
The Long-run Effects of More Rapid Expansion in
the Money Supply

• Here we illustrate the long-term impact of an
  increase in the annual growth rate of the money
  supply from 3 to 8 percent.

• Initially, prices are stable (P100) when the
  money supply is expanding by 3 annually.

• The acceleration in the growth rate of the money
  supply increases aggregate demand (shifting to
  AD2).

• At first, real output may expand beyond the
  economys potential (YF), however low
  unemployment and strong demand create upward
  pressure on wages and other resource prices,
  shifting AS to AS2.

3 growth
44
The Long-run Effects of More Rapid Expansion in
the Money Supply

• Output returns to its long-run potential (YF),
  and the price level increases to P105 (e2).

• If more rapid monetary growth continues in
  subsequent periods, AD and AS will continue to
  shift upward, leading to still higher prices (e3
  and points beyond).

• The net result of this process is sustained
  inflation.

8 growth
3 growth
45
The Long-run Effects of More Rapid Expansion in
the Money Supply
Q

• When prices are stable, supply and demand in the
  loanable funds market are in balance at a real
  and nominal interest rate of 4.

• If more rapid monetary expansion leads to a
  long-term 5 inflation rate, borrowers and
  lenders will build the higher inflation rate into
  their decision making.

• As a result, the nominal interest rate ( i ) will
  rise to 9 -- the 4 real rate plus the 5
  inflationary premium.

46
Monetary Policy When Effects Are Anticipated

• When the effects of policy are anticipated prior
  to their occurrence, the short-run impact of an
  increase in the money supply is similar to its
  impact in the long run.

• Nominal prices and interest rates rise, but real
  output remains unchanged.

47
The Short-run Effects of AnAnticipated Monetary
Expansion

• When decision makers fully anticipate the effects
  of a monetary expansion, the expansion does not
  alter real output even in the short-run.

• Suppliers, including resource suppliers, build
  the expected price rise into their decisions.
  The anticipated inflation leads to a rise in
  nominal costs (including wages) causing aggregate
  supply to decline (shifts to SRAS2).

• While nominal wages, prices, and interests rates
  rise, their real counter-parts are unchanged
  and so, inflation without any change in output.

48
Interest Rates and Monetary Policy

• While the Fed can strongly influence short-term
  interest rates, its impact on long-term rates is
  much more limited.

• Interest rates can be a misleading indicator of
  monetary policy

• In the long run, expansionary monetary policy
  leads to inflation and high interest rates,
  rather than low interest rates.
• Similarly, restrictive monetary policy, when
  pursued over a lengthy time period, leads to low
  inflation and low interest rates.

49
The Effects of Monetary Policy -- A Summary

• An unanticipated shift to a more expansionary
  (restrictive) monetary policy will temporarily
  stimulate (retard) output and employment.

• The stabilizing effects of a change in monetary
  policy are dependent upon the state of the
  economy when the effects of the policy change are
  observed.

• Persistent growth of the money supply at a rapid
  rate will cause inflation.

• Money interest rates and the inflation rate will
  be directly related.

• There will be only a loose year-to-year
  relationship between shifts in monetary policy
  and changes in output and prices.

50

• D. Stabilization Policy, Output and Employment

51
Promoting Economic Stability -- Activist
and Non-activist Views

• Goals of Stabilization Policy

• A stable growth of real GDP,
• A relatively stable level of prices,
• A high level of employment (low unemployment).

• Activists' Views of Stabilization Policy

• The self corrective mechanism works slowly if at
  all,
• Policy-makers will be able to alter macro-policy,
  injecting stimulus to help pull the economy out
  of recession and implementing restraint to help
  control inflation,
• According to the activist s view, policy-makers
  are more likely to keep the economy on track when
  they are free to apply stimulus or restraint
  based on forecasting devices and current economic
  indicators.

52
Promoting Economic Stability -- Activist
and Non-activist Views

• Non-activists' Views of Stabilization Policy

• The self-corrective mechanism of markets works
  pretty well,
• Greater stability would result if stable,
  predictable policies based on predetermined rules
  were followed,
• Non-activists argue that the problems of proper
  timing and political considerations undermine the
  effectiveness of discretionary macro policy as a
  stabilization tool.

53
Practical Problems With Discretionary
Macro Policy

• Lags and the Problem of Timing

• After a change in policy has been undertaken,
  there will be a time lag before it exerts a major
  impact.
• This means policy makers need to forecast
  economic conditions several months in the future
  in order to institute policy changes effectively.

• Politics and Timing of Policy Changes

• Policy changes may be driven by political
  considerations rather than stabilization.

54
How are Expectations Formed? -- Two Theories

• Adaptive Expectations-- individuals form their
  expectations about the future on the basis
  of data from the recent past.

• Rational Expectations-- Assumes that people use
  all pertinent information, including data on
  the conduct of current policy, in forming
  their expectations about the future.

55
Adaptive Expectations Hypothesis
Actual Rateof Inflation(percent)
Expected Rateof Inflation(percent)

• According to the adaptive expectations
  hypothesis, what actually occurs during the most
  recent period (or set of periods) determines
  peoples future expectations.

• Thus, the expected future rate of inflation lags
  behind the actual rate by one period as
  expectations are altered over time.

56
How Macro Policy Works The Implications of
Adaptive and Rational Expectations

• With adaptive expectations, an unanticipated
  shift to a more expansionary policy will
  temporarily stimulate output and employment.

• With rational expectations, expansionary policy
  will not generate a systematic change in output.
  
• Both expectations theories indicate that
  sustained expansionary policies will lead to
  inflation without permanently increasing output
  and employment.

57
Expectations and the Short-run Effects of Demand
Stimulus

• Under adaptive expectations, anticipation of
  inflation will lag behind its actual occurrence.

• Thus, a shift to a more expansionary policy would
  increase aggregate demand (from AD1 to AD2) and
  lead to a temporary increase in GDP (from YF to
  Y2) accompanied by a modest increase in prices
  (from P1 to P2).

58
Expectations and the Short-run Effects of Demand
Stimulus

• In contrast, under rational expectations,
  decision makers will quickly anticipate the
  inflationary impact of a demand-stimulus policy.

• Thus, while a shift to a more expansionary policy
  would increase aggregate demand (from AD1 to
  AD2), resource prices and production costs would
  rise just as rapidly (thereby shifting SRAS to
  SRAS2).

• The net effect of demand-stimulus in the rational
  expectations model is an increase in prices
  without altering real output -- even in the short
  run.

59
The Phillips Curve Before the Inflation of the
1970s

• This exhibit is from the 1969 Economic Report of
  the President. Each dot represents the inflation
  and unemployment rate for that year. The report
  stated clearly that the chart reveals a fairly
  close association of more rapid price increases
  with lower rates of unemployment. Economists
  refer to this link as the Phillips Curve.

• In the 1960s it was widely believed that policy
  makers could pursue expansionary macroeconomic
  policies and thereby permanently reduce the
  unemployment rate.

• More recent experience has caused most economists
  to reject this view.

60
Early Views About the Phillips Curve

• During the 1960s, most economists thought there
  was an inverse relationship between inflation and
  unemployment.

• This led to the belief that even though
  expansionary policies would lead to some
  inflation, they would also result in a
  long-lasting lower rate of unemployment.
• Stability of the inflation-unemployment
  relationship proved to be an illusion.

• As the inflation rate rose from 3 in the late
  1960s to double-digit levels during 1974-1975,
  the rate of unemployment rose from less than 4
  to more than 8.
• As high rates of inflation continued in the
  latter half of the 1970s, so too did the high
  rates of unemployment.

61
Early Views About the Phillips Curve

• The error of early Phillips Curve proponents--
  Failure to consider expectations

• Integration of expectations into the Phillips
  curve analysis indicates that any trade-off
  between inflation and unemployment will be
  short-lived.
• An unanticipated shift to a more expansionary
  policy may temporarily reduce the unemployment
  rate, but when decision makers come to anticipate
  the higher rate of inflation, unemployment will
  return to its natural rate.
• Even high rates of inflation will fail to reduce
  unemployment once they are anticipated by
  decision makers.

62
The AD/AS Model, Adaptive Expectations, and the
Phillips Curve

• We begin at full-employment output YF (pt A in
  both frames).

• With adaptive expectations, a shift to a more
  expansionary policy will increase prices, expand
  output beyond full-employment, and reduce the
  unemployment rate below its natural level (a move
  to pt B in both frames).

• Decision makers, though, will eventually
  anticipate the rising prices and incorporate them
  into their decision making (shifting SRAS to
  SRAS2, returning output to its full-employment
  level YF, and increasing unemployment back to
  the natural rate a move to pt C in both frames).

• If the inflationary policy continues, and
  decision makers anticipate it, the AD and SRAS
  curves will shift upward without an increase in
  output and employment this leads to the
  vertical Long Run Phillips Curve.

63
Expectations and Shifts in the Phillips Curve

• Point C illustrates the economy experiencing 4
  inflation that was anticipated by decision
  makers, and because the inflation was anticipated
  the natural rate of unemployment is present.

• With adaptive expectations, demand stimulus
  policies that result in a still higher rate of
  inflation (8 for example) would once again
  temporarily reduce the unemployment rate below
  its long-run, normal rate (moving from C to D
  along PC2).

• After a time, decision makers would come to
  anticipate the higher inflation rate, and the
  short-run Phillips curve would shift still
  further to the right to PC3 (a movement from D to
  E).

• Once the higher rate is anticipated, if macro
  planners try to decelerate the rate of inflation,
  unemployment will temporarily rise above its
  long-run natural rate (for example from E to F).

64
Expectations and the Modern View of the
Phillips Curve

• There is exists no permanent tradeoff between
  inflation and unemployment.

• Demand stimulus will lead to inflation without
  permanently reducing unemployment below the
  natural rate.
• Like LRAS, the Long-Run Phillips Curve is
  vertical at the natural rate of unemployment.
• When inflation is greater than anticipated,
  unemployment falls below the natural rate.

• When the inflation rate is steady neither
  rising nor falling the actual rate of
  unemployment will equal the economys natural
  rate of unemployment.

65
The Phillips Curve and Macro-policy

• The early view that there was a trade-off between
  inflation and unemployment helped promote the
  more expansionary macro policy of the 1970s.

• Rejection of this view during the 1980s created
  an environment more conducive to price stability.

• In turn, the increase in price level stability
  contributed to the lower unemployment rates of
  the 1990s.

• In the long-run, expansionary policy in pursuit
  of lower unemployment leads to higher rates of
  both inflation and unemployment.

66
The Phillips Curve and Macro-policy

• There are two important lessons to be learned
  from the Phillips curve era

• Expansionary macro policy will not reduce the
  rate of unemployment, at least not for long.
• Macro policy, particularly monetary policy, can
  achieve persistently low rates of inflation,
  which will help promote low rates of
  unemployment.

• There is no inconsistency between low (and
  stable) rates of inflation and low rates of
  unemployment.