19Current Issues in Macro Theory and

Policy

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Causes of Macro Instability

• Mainstream view

• Held by most economists

• Price stickiness

• Unexpected demand shocks

•Variable investment spending

• Unexpected supply shocks

LO1 19-2

Causes of Macro Instability

• Monetarist view

• Government interference is the problem

• Equation of exchange MV = PQ

• Stable velocity

• Monetary causes of instability

• Inappropriate monetary policy

LO1 19-3

Causes of Macro Instability

• Real-business-cycle view• Shifts in long-run aggregate supply

Pri

ce L

evel

P1

Real Domestic Output

Q2 Q1

AD1

AD2

ASLR1ASLR2

LO1 19-4

Causes of Macro Instability

• Coordination failures

• Fail to reach equilibrium because of lack of coordination mechanism

• Limited information

• Expectations and self-fulfilling prophecy

•Unemployment equilibrium

•Inflation equilibrium

LO1 19-5

Does the Economy Self Correct?

• New classical view

• Rational expectations theory

• Monetarists

• Automatic correction will occur

•Speed of adjustment

•Unanticipated price-level changes

•Fully anticipated price-level changes

LO2 19-6

• New Classical View of Self-Correction

AD2

AD1

AS1

AS2ASLR

Pri

ce L

evel

P1

P2

P3

Real Domestic Output

Q1 Q2

a

b

c

Does the Economy Self Correct?

LO3 19-7

• New Classical View of Self-Correction

AD3

AD1

AS1

AS3

ASLR

Pri

ce L

evel

P1P4P5

Real Domestic Output

Q1Q4 Q3

a

e

d

f

Does the Economy Self Correct?

LO3 19-8

Does the Economy Self Correct?

• Mainstream view

• Downward wage inflexibility

• Efficiency wage theory

• Greater work effort

• Lower supervision costs

• Reduced job turnover

• Insider-outsider relationships

LO3 19-9

Rules or Discretion?

• In support of policy rules

• Reduce macro instability

• Monetary rule

•Shift AD to keep up with AS

•Price stability achieved

• Inflation targeting

• Balanced budget

LO4 19-10

Rules or Discretion?P

rice

Lev

el

P1

Real Domestic Output, GDPQ1 Q2

P2

ASLR1 ASLR2

AD1

AD2

LO4 19-11

Rules or Discretion?

• Defense of discretionary stabilization policy

• Discretionary monetary policy

•Velocity is not stable

• Discretionary fiscal policy

•Useful during recession

• Policy successes

LO4 19-12

Rules or Discretion?

LO4 19-13

The Taylor Rule

• Rules: Passive monetary policy

• Discretion: Active monetary policy

• Hybrid policy rule to dictate Fed actions

• Policy responds to changes in real GDP and inflation

• Fed explains deviations from the rule

• Increase Fed credibility and reduce uncertainty

19-14