Macro Policy Debate: Active or Passive

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Macro
ECON
McEachern 2008-2009
17
CHAPTER
Macro Policy Debate Active or Passive?
Designed by Amy McGuire, B-books, Ltd.
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Active Policy vs. Passive Policy

• Active approach
• Economy relatively unstable
• Fluctuations from private sector
• Government intervention
• Discretionary fiscal or monetary policy
• Passive approach
• Economy relatively stable
• Natural market forces
• Automatic stabilizers

LO1
3
Closing a Contractionary Gap

• Passive approach
• Self-correcting forces
• Increase SRAS
• Automatic stabilizers
• No discretionary policy
• Active approach
• Sticky wages
• Stimulate aggregate demand
• Fiscal Policy
• Monetary policy

LO1
4
Exhibit 1
LO1
Closing a Contractionary Gap
At a short-run equilibrium unemployment gt
natural rate. Passive approach - panel (a) - high
unemployment eventually causes wages to fall,
reducing the cost of doing business shifts the
SRAS curve rightward from SRAS130 to
SRAS120potential output at b. Active approach -
panel (b) - shift the AD curve from AD to AD'. If
the active policy works perfectly, the economy
moves to its potential output at c.
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Closing a Expansionary Gap

• Passive approach
• Self-correcting forces
• Decrease SRAS
• Automatic stabilizers
• No discretionary policy
• Active approach
• Sticky wages
• Decrease aggregate demand
• Fiscal Policy
• Monetary policy

LO1
6
Exhibit 2
LO1
Closing a Expansionary Gap
At d short-run equilibrium 14.2 trillion
gtpotential output. Unemployment lt natural rate.
Passive approach - panel (a) - no change in
policy higher negotiated wage higher costs
shifts SRAS curve to SRAS140. New equilibrium, e
higher price level, lower output and employment.
Active policy - reduce aggregate demand - panel
(b) new equilibrium - c - closing the
expansionary gap without increasing the price
level.
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Problems with Active Policy

• Timely adoption and implementation
• Identify potential output
• Identify natural rate of unemployment
• Forecast AD and AS, passive approach
• Tools to achieve results quickly
• Forecast effects of active policy
• Coordination
• Implementation
• Timing lags

LO1
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The Problem of Lags

• Recognition lag
• Decision-making lag
• Implementation lag
• Longer for fiscal policy
• Effectiveness lag

LO1
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LO1
Active Versus Passive Presidential Candidates

• Third quarter 1990 recession
• Sluggish recovery
• Federal deficit 300 billion
• No discretionary fiscal policy
• Monetary policy
• Presidential election 1992
• Republican President George H. W. Bush
• Political liabilities
• Sluggish recovery
• Ballooning federal deficits
• Democrat challenger Bill Clinton

Case Study
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LO1
Active Versus Passive Presidential Candidates

• Clinton
• Bush
• Not done enough to
  revive the economy
• Responsible for
  federal deficits
• Cannot be trusted broke no new taxes
• Promises
• Raise tax on the rich
• Cut tax on middle class
• Create jobs through government spending

Case Study
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LO1
Active Versus Passive Presidential Candidates

• Clinton
• Stronger role for government
• Active approach
• Bush
• Stronger role for
  private sector
• Passive approach
• George W. Bush
• 3 tax cuts to stimulate the economy
• Growth in government spending
• Additional jobs

Case Study
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Monetary Policy Inflation Expectations
LO2

• Rational expectations
• All available information
• Future actions of policy makers
• Potential output natural rate
• Fed policy pronouncements
• Sustain potential output
• Stable price level
• Fed actions
• Unexpected expansionary policy
• Higher equilibrium output
• Higher price level

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Exhibit 3
LO2
Short-Run Effects of an Unexpected Expansionary
Monetary Policy
At a, workers and firms expect a price level of
130 supply curve SRAS130 reflects that
expectation.
If the Fed unexpectedly pursues an expansionary
monetary policy, the aggregate demand curve
becomes AD rather than AD. Output in the short
run (at point b) exceeds its potential, but in
the long run costs increase, shifting SRAS
leftward until the economy produces its potential
output at point c (the resulting supply curve is
not shown). The short-run effect of an
unexpected monetary expansion is greater output,
but the long-run effect is just a higher price
level.
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Anticipating Monetary Policy
LO2

• Potential output High price level
• Fed policy pronouncements
• Sustain potential output
• Stable price level
• Firms dont trust Fed
• Expect higher price level
• Fed actions
• Expected expansionary policy
• Potential output higher price level
• Fully anticipated expansionary policy
• No effect on output, employment

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Exhibit 4
LO2
Short-Run Effects of the Fed Pursuing a More
Expansionary Policy Than Announced
The Fed announces it plans to keep prices stable
at 142. Workers and firms, however, do not
believe this. Based on their experience, they
expect expansionary monetary policy. The
short-run AS curve, SRAS152, reflects their
expectations. If the Fed follows the announced
stable-price policy, aggregate demand will be
AD', and short-run output at point d will be less
than the economys potential output of 14.0
trillion
To keep the economy performing at its potential,
the Fed must stimulate aggregate demand as much
as workers and firms expect (shown by point e),
but this is inflationary.
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Policy Credibility
LO2

• Economy potential output
• Unexpected expansionary policy
• Temporary increase output, employment
• Costs
• Inflation in the long term
• Credibility loss
• Hyperinflation
• Anti-inflation policy cold turkey
• Announce and execute tough measures

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LO2
Central Bank Independence and Price Stability

• Most independent central banks
• Germany, Switzerland
• Lowest inflation
• Least independent central bank
• Spain, New Zealand, Australia, Italy
• Highest inflation (4 times higher)
• Trend greater central bank independence
• European Central Bank
• Price stability

Case Study
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Policy Rules vs. Discretion

• Limitations on discretion
• Complex interactions among economic aggregates
• Lags
• Rules and rational expectations
• Fully anticipated monetary policy
• No effect on output
• Change price level

LO3
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The Phillips Curve

• Inverse relationship
• Unemployment rate
• Rate of change in nominal wages (inflation)
• Short-run Phillips curve
• Long-run Phillips curve

LO4
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Exhibit 5
LO4
Hypothetical Phillips Curve
The Phillips curve shows an inverse relation
between unemployment and inflation. Points a and
b lie on the Phillips curve and represent
alternative combinations of inflation and
unemployment that are attainable as long as the
curve itself does not shift. Points c and d are
off the curve.
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The Short-Run Phillips Curve

• Short-run Phillips curve
• Labor contracts
• Given price level
• Given expected inflation
• Inflation as expected
• Unemployment natural rate
• Inflation gt expected
• Unemployment lt natural rate
• Inflation lt expected
• Unemployment lt natural rate

LO4
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Exhibit 6
LO4
Aggregate Supply Curve and Phillips Curves in the
Short Run and Long Run
Expected price level103 (3 higher than current
level) and AD actual price level103 potential
output point a unemploymentnatural rate5
If AD gt expected (AD') price level105 gt
expected outputgtpotential higher inflation
lower unemployment.
If ADltexpected (AD) price level101ltexpected
outputltpotential lower inflation higher
unemployment.
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The Long-Run Phillips Curve

• Price level gt expected
• Short run Output gt potential
• Long run Output potential
• Higher inflation
• Higher unemployment
• Price level lt expected
• Short run Output lt potential
• Long run Output potential
• Fall in inflation
• Lower unemployment

LO4
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The Long-Run Phillips Curve

• Long-run Phillips curve
• Vertical line
• Economys natural rate of unemployment
• Workers and employers
• Fully adjust to unexpected changes in AD
• Long run, for flexible prices and wages
• Unemployment
• Independent of inflation

LO4
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The Natural Rate Hypothesis

• Long run
• Natural rate of unemployment
• Independent of AD stimulus
• Fiscal policy
• Monetary policy
• Optimal policy in long run
• Results in low inflation

LO4
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Exhibit 7
LO4
Short-Run Phillips Curves Since 1960