Transcript 17-18 The Natural Rate of Unemployment (cont`d)

Chapter 17
Stabilization in
an Integrated
World Economy
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Introduction
The “5yr5yr rate” is a measure of the average annual
expected inflation rate 5 to 10 years in the future, as
derived from interest rates on government bonds.
Financial market participants interpret an increase in
this rate as a signal of higher inflation in the current
year.
In this chapter, you will learn that this interpretation is
consistent with predictions offered by a theory
proposed by economists known as “new Keynesians.”
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Learning Objectives
• Explain why the actual unemployment rate
might depart from the natural rate of
unemployment
• Describe why there may be an inverse
relationship between the inflation rate and
the unemployment rate, reflected by the
Phillips curve
• Evaluate how expectations affect the
actual relationship between the inflation
rate and the unemployment rate
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Learning Objectives (cont'd)
• Understand the rational expectations
hypothesis and its implications for
economic policymaking
• Distinguish among alternative modern
approaches to strengthening the case for
active policymaking
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Chapter Outline
• Active Versus Passive Policymaking
• The Natural Rate of Unemployment
• Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles
• Modern Approaches to Justifying Active
Policymaking
• Is There a New Keynesian Phillips Curve?
• Summing Up: Economic Factors Favoring Active
versus Passive Policymaking
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Did You Know That ...
• A number of economists have determined from
data collected from U.S. retail price scanners that
prices of most items remain unchanged for longer
intervals during holiday periods than at other
times of the year?
• As you will learn in this chapter, a key modern
economic theory suggests that even relatively
small costs of changing prices can lead to
widespread price stickiness.
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Active Versus Passive Policymaking
• Active (Discretionary) Policymaking
– All actions on the part of monetary and fiscal
policymakers that are undertaken in response
to or in anticipation of some change in the
overall economy
– Examples are monetary and fiscal policy
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Active Versus Passive Policymaking
(cont'd)
• Passive (Nondiscretionary) Policymaking
– Policymaking that is carried out in response to
a rule
– Not in response to an actual or potential
change in overall economic activity
– Examples include a monetary rule
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The Natural Rate of Unemployment
• Two components of the natural rate of
unemployment
– Frictional unemployment
– Structural unemployment
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The Natural Rate of Unemployment
(cont’d)
• Frictional unemployment
– Arises because individuals take the time to
search for the best job opportunities
– Much of the unemployment is of this type,
except when there is a recession or depression
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The Natural Rate of Unemployment
(cont'd)
• Structural unemployment results from
1. Government-imposed minimum wage laws,
laws restricting entry into occupations, and
welfare and unemployment insurance benefits
that reduce incentives to work
2. Union activity that sets wages above the
equilibrium level and also restricts the mobility
of labor
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The Natural Rate of Unemployment
(cont'd)
• Natural Rate of Unemployment
– The rate of unemployment that is estimated to
prevail in long-run macroeconomic equilibrium
– When all workers and employers have fully
adjusted to any changes in the economy
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Example: The U.S. Natural Rate of
Unemployment
• In 1982, the unemployment rate was about 10%.
• By the early 2000s, it was at this level once
again.
• Figure 17-1 shows that the actual rate of
unemployment has varied over the decades.
• Why does the natural rate of unemployment differ
from the actual rate of unemployment?
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Figure 17-1 Estimated Natural Rate of
Unemployment in the United States
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The Natural Rate of Unemployment
(cont'd)
• Departures from the natural rate of
unemployment
– Deviations of the actual from the natural rate
are called cyclical unemployment.
– Deviations observed over the course of
nationwide business fluctuations
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Figure 17-2 Impact of an Increase in Aggregate
Demand on Real GDP and Unemployment
Monetary or fiscal policy
leads to increase in AD, and
the unemployment rate falls
below the natural rate
SRAS shifts, the price level is
higher and the unemployment
rate rises to the natural rate, real
GDP returns to the LRAS level
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Figure 17-3 Impact of a Decline in Aggregate
Demand on Real GDP and Unemployment
Monetary or fiscal policy
leads to decline in AD and
the unemployment rate
rises above the natural rate
SRAS shifts, the price level is
lower, and the unemployment
rate falls to the natural rate,
the new equilibrium is reached
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The Natural Rate of Unemployment
(cont'd)
• The Phillips curve: a rationale for active
policymaking?
1. The greater the unexpected increase in
aggregate demand, the greater the amount of
inflation that results in the short run, and the
lower the unemployment rate
2. The greater the unexpected decrease in
aggregate demand, the greater the deflation
that results in the short run, and the higher
the unemployment rate
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The Natural Rate of Unemployment
(cont'd)
• The Phillips Curve
– A curve showing the relationship between
unemployment and changes in wages or prices
– It was long thought to reflect a trade-off
between unemployment and inflation
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Figure 17-4 The Phillips Curve, Panel (a)
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Figure 17-4 The Phillips Curve, Panel (b)
Higher inflation and
lower unemployment
The Phillips curve implies a
policy trade-off between
inflation and unemployment
Zero inflation and
natural rate of
unemployment, U*
Can policymakers fine-tune
the economy?
Deflation and higher
unemployment
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The Natural Rate of Unemployment
(cont'd)
• Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
– The rate of unemployment below which the
rate of inflation tends to rise and above which
the rate of inflation tends to fall
– The unemployment rate consistent with a
steady inflation rate can potentially change
during the course of cyclical adjustments
– Thus, the NAIRU typically varies by a relatively
greater and more frequent amount than the
natural rate of unemployment
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Figure 17-5 A Shift in the Phillips
Curve
• There is a change in the
expected inflation rate
• The curve shifts to incorporate
new expectations
• PC0 shows expectations
at zero inflation
• PC5 reflects a higher expected
inflation rate, such as 5%
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Why Not … ignore media headlines about
inflation?
• Instead of the headline inflation rate,
policymakers prefer looking at the core inflation
rate, which is the rate of change in average prices
excluding food and energy prices.
• Nevertheless, economists also found that
movements in the headline inflation rate provide
a better indication of how much the price level
will rise in the longer term than changes in the
core inflation rate.
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles
• Rational Expectations Hypothesis
1. Individuals base their forecasts (expectations)
about the future values of economic variables
on all available past and current information
2. These expectations incorporate individuals’
understanding about how the economy
operates, including the operation of monetary
and fiscal policy
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• New classical approach
– A modern version of the classical model in
which wages and prices are flexible
– There is pure competition in all markets
– The rational expectations hypothesis is assumed
to be working
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Figure 17-6 Responses to Anticipated and
Unanticipated Increases in Aggregate Demand
Short-run equilibrium
increases output to Y2
with P2
Long-run equilibrium
after adjustment yields
Y1 with P3
Assume the money
supply increases
unexpectedly to M2 and
AD increases to AD2
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• The response to anticipated policy
– If the increase in the money supply was
anticipated
• The higher price level would be anticipated
• Workers and suppliers would demand higher wages
and prices immediately
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• Policy Irrelevance Proposition
– The conclusion that policy actions have no real
effects in the short run if the policy actions are
anticipated and none in the long run even if the
policy actions are unanticipated
– A key assumption: people don’t persistently
make the same mistakes in forecasting the
future
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• Under the assumption of rational
expectations on the part of decision
makers in the economy:
– Anticipated monetary policy cannot alter either
the rate of unemployment or the level of real
GDP
– Regardless of the nature of the anticipated
policy, the unemployment rate will equal the
natural rate, and real GDP will be determined
solely by the economy’s long-run aggregate
supply curve
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• Questions
– What must people know?
– What happens if they don’t know everything?
– What are the implications?
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• The policy dilemma
– Policy irrelevance proposition seems to suggest
only mistakes have real effects
– Policymakers powerless to push real GDP and
unemployment back to long-run levels when
entering recessionary period
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• The distinction between real and monetary
shocks
– Many economists argue real (as opposed to
purely monetary) forces might help explain
aggregate economic fluctuations
– Real business cycles represent another
challenge to policy activism
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• Questions regarding real business cycle
theory:
– What impact would an oil shock have on
aggregate demand?
– Can we explain the Great Depression with the
real business cycle theory?
– What about the apparent wage and price
rigidity within the economy?
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17-34
Figure 17-7 Effects of a Reduction in the
Supply of Resources
If the reduction in the
resource is permanent,
the LRAS will also shift
A reduction in the
supply of a resource
shifts SRAS to the
left
The position of LRAS
depends on our resource
endowments
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Rational Expectations, the Policy Irrelevance
Proposition, and Real Business Cycles (cont’d)
• Stagflation
– A situation characterized by lower real GDP,
lower employment, and a higher unemployment
rate during the same period that the rate of
inflation increases
– In Figure 17-7, real GDP declines at the same
time the price level rises
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Modern Approaches to Justifying Active
Policymaking
• Market clearing models of the economy
may not fully explain business cycles
• “Sticky” wages and prices remain
important, some economists contend
• New Keynesians have tried to refine the
theory of aggregate supply
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Modern Approaches to Justifying Active
Policymaking (cont'd)
• Small Menu Costs
– Costs that deter firms from changing prices
in response to demand changes
– Examples—the costs of renegotiating
contracts or printing new price lists
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Example: Small Menu Costs in the U.S.
Market for Imported Beer
• Economists at the Federal Reserve Bank of New
York find that the cost of changing prices of
imported beers in the United States is only about
0.1 percent of revenues for beer retailers, and 0.4
percent for the beer manufacturers.
• So, these retailers change their prices of imported
beer slightly more often than manufacturers.
• Also, both retailers and manufacturers allow
lengthy intervals—one year or longer—to pass
before adjusting those prices.
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Modern Approaches to Rationalizing
Active Policymaking (cont'd)
• New Keynesian Inflation Dynamics
– In new Keynesian theory, the pattern of
inflation exhibited by an economy with growing
aggregate demand—initial sluggish adjustment
of the price level in response to increased
aggregate demand followed by higher inflation
later
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Figure 17-8 Short- and Long-Run Adjustments in
the New Keynesian Sticky-Price Theory,
Panel (a)
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Figure 17-8 Short- and Long-Run Adjustments in
the New Keynesian Sticky-Price Theory,
Panel (b)
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Policy Example: Moderating the Great
Recession Is Harder Than Anticipated
• In 2009, the federal government increased its
spending substantially.
• The Council of Economic Advisers suggested that
every $1.00 of government expenditures would
raise real GDP by $1.60.
• Later Robert Barro of Harvard University found
that each $1 of government expenditures replaced
$1 of private spending that otherwise would have
occurred, leaving no net impact on real GDP.
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Is there a New Keynesian Phillips Curve?
• The U.S. experience with the Phillips curve
– Economists Milton Friedman and E.S. Phelps
published pioneering studies
– The apparent trade-off suggested by the
Phillips curve could not be exploited by activist
policymakers
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Is there a New Keynesian Phillips Curve?
(cont'd)
• The U.S. experience with the Phillips curve
– Attempts to reduce the unemployment rate by
inflating the economy would be thwarted by
higher inflation expectations
– Activist policymaking would be offset; the
trade-off between unemployment and inflation
would disappear
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Figure 17-9 The Phillips Curve: Theory
versus Data
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Is there a New Keynesian Phillips Curve?
(cont’d)
• New Keynesians say all that matters for is
whether such a relationship between
inflation and unemployment is exploitable
in the near term
• If so, policymakers can intervene as soon
as unemployment and real GDP vary from
their long-run levels, thusly dampening
cyclical fluctuations and making them
short-lived
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Is there a New Keynesian Phillips Curve?
(cont’d)
• Two factors that affect inflation:
– Anticipated future inflation
– Average inflation-adjusted (real) per-unit costs
that firms incur in production
• Empirical evidence does indicate that these
two factors are associated with higher
observed rates of inflation
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Is there a New Keynesian Phillips Curve?
(cont’d)
• Are New Keynesians correct?
– Not all economists agree
– The new classical theory already indicates that
when prices are flexible, higher inflation
expectations should reduce short-run aggregate
supply and contribute to increased inflation
– All macroeconomic theories suggest that
various factors that push up firms’ production
costs should have the same effect on short-run
aggregate supply and inflation in a flexible-price
economy
– How often do firms really adjust their prices?
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Summing Up: Economic Factors Favoring Active
versus Passive Policymaking
• Most economists agree that active policymaking is
unlikely to exert sizable long-run effects on any
nation’s economy
• Most agree that aggregate supply shocks
contribute to business cycles
• Some argue that monetary and fiscal policy
actions can offset, at least in the short run and
possibly in the long-run the effects that aggregate
demand shocks would otherwise have on real GDP
and unemployment
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17-50
Table 17-1 Issues That Must Be Assessed in
Determining the Desirability of Active versus Passive
Policymaking
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You Are There: Fed Discretion—Based on What
the Fed Forecasts or What It Observes?
• During the years leading to the financial
meltdown in 2008, the Fed’s forecasts of inflation
were persistently lower than actual inflation.
• Thus, it is likely that Fed policymaking would
have been more effective if the Fed had based its
discretionary policies on the inflation rates it
actually observed instead of on inflation
forecasts.
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Issues & Applications: Inflation Expectations and the
“5yr5yr Rate”
• The theory of new Keynesian inflation dynamics
predicts that an increase in expectations of future
inflation exerts upward pressure on the current
inflation rate.
• One measure of longer-term inflation
expectations is the “5yr5yr rate,” which is the
difference between interest rates on traditional
securities and Treasury inflation-protected
securities (TIPS) maturing between 5 and 10
years from now.
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Summary Discussion of Learning
Objectives
• Why the actual unemployment rate might
depart from the natural rate of
unemployment
– Unanticipated changes in aggregate demand
• Philips curve
– A curve showing an inverse relationship
between the rate of inflation and the rate of
unemployment
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17-54
Summary Discussion of Learning
Objectives (cont'd)
• How expectations affect the actual
relationship between the inflation rate and
the unemployment rate
– Theory predicts that there will be a Phillips
curve relationship only when expectations are
unchanged
– The Phillips curve shifts
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Summary Discussion of Learning
Objectives (cont'd)
• Rational expectations, policy ineffectiveness, and
real-business-cycle theory
– Rational expectations hypothesis
– Only unanticipated policy actions affect short-run real
GDP
– Policy irrelevance theorem
– Technological changes and labor market shocks can
induce business fluctuations, called real business cycles,
which weaken the case for active policymaking
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Summary Discussion of Learning
Objectives (cont'd)
• Modern approaches to bolstering the case for
active policymaking
– New Keynesian approach suggests that firms facing
costs of adjusting their prices may be slow to change
in the face of variations in demand
– Prices and wages are sufficiently inflexible in the short
run that there is an exploitable relationship between
inflation and real GDP
– Discretionary policy actions can stabilize real GDP in
the short run
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