Problems in the Macroeconomy: Inflation and Unemployment
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Transcript of Problems in the Macroeconomy: Inflation and Unemployment
Problems in the Macroeconomy:Inflation and Unemployment
Chapter 11 and Chapter 12
Problems•When the economy is overheated,
inflation is the problem.•When the economy is under performing,
unemployment is the problem.
The Historical Record of U.S. Economic Growth
Source: U.S. Department of Commerce.
National Business Activity, 1880 to the Present
Sources: American Business Activity from 1790 to Today, 67th ed., AmeriTrust Co., January 1996, plus author’s estimates.
Revised
Revised
Why does growth matter?Allows wages and incomes to rise.
Standard of living increases
Takes the pressure of scarce resources… (why?)
Macroeconomic ProblemsHigh inflation rateHigh unemployment rateHigh interest ratesLow economic growth or stagnation
Is there relationship between unemployment and inflation
•From 1940- to 1960’s – economists insisted yes.
•From 1960 forward, economists acknowledge short-run relationship majority of times.
•Theory was discredited in 1980’s, but some economists still use the relationship as a given.
The Phillips Curve•Shows the short-run trade-off between
unemployment and inflation.▫unemployment rate increases? inflation
rate falls.▫unemployment rate decreases? inflation
rate rises.
The Phillips Curve•Its position is determined by the
capability and the incentive of the economy to produce.
•PC relates annual rates of inflation and annual rates of unemployment (December figures.)
•There is an inverse relationship.
Figure 11-1. The Phillips Curve
unemployment
infla
tion
PC
Movement Along the Phillips Curve•In the short run, assume no change in the
capability or the incentive of the economy to produce.
•Increased total spending causes a movement upward and to the left on the Phillips Curve.▫inflation rate increases▫unemployment rate decreases
Figure 11-2. Movement Along the Phillips Curve
unemployment
infla
tion
movement due toincreased spending
inflation increasesand unemploymentdecreases
Reminders:
•When wages and prices are flexible, increase in prices (general level of prices – PL) will stimulate the economy – businesses hire, people leave unemployed, wages increase (nominally.)
•When prices decrease – businesses do not hire, income is not earned, unemployment rises.
Movement Along the Phillips Curve•In the short run, assume no change in the
capability or the incentive of the economy to produce.
•Increased total spending causes a movement upward and to the left on the Phillips Curve.▫inflation rate increases▫unemployment rate decreases
Figure 11-2. Movement Along the Phillips Curve
unemployment
infla
tion
movement due toincreased spending
inflation increasesand unemploymentdecreases
Movement Along the Phillips Curve•In the short run, assume no change in the
capability or the incentive of the economy to produce.
•Decreased total spending causes a movement downward and to the right on the Phillips Curve.▫inflation rate decreases▫unemployment rate increases
Figure 11-3. Movement Along the Phillips Curve
unemployment
infla
tion
movement due todecreased spending
inflation decreasesand unemploymentincreases
Shifting the Phillips Curve•The Phillips Curve shifts leftward and
downward toward the origin if:▫production costs are lowered▫productivity is increased▫the incentive to work more or harder is
increased•Both the unemployment rate and the
inflation rate will decrease.
Figure 11-4. Shifting the Phillips Curve Left
unemployment
infla
tion
lower costs orincreasedproductivity shifts the PC to the left.inflation and unemployment bothdecrease
PC1
PC2
Shifting the Phillips Curve•The Phillips Curve shifts rightward and
upward away from the origin if:▫production costs are increased▫productivity is decreased▫the incentive to work more or harder is
decreased•Both the unemployment rate and the
inflation rate will increase.
Figure 11-5. Shifting the Phillips Curve Right
unemployment
infla
tion
higher costs ordecreasedproductivity shifts the PC to the right.inflation and unemploymentboth increase
PC1
PC2
Source: U.S. Department of Labor, Bureau of Labor Statistics
More Than a Century of Unemployment
Inflation and Deflation in U.S. History
Source: U.S. Department of Labor, Bureau of Labor Statistics
The Macroeconomic Goal•Full-employment
▫operate on the institutional PPC▫zero cyclical unemployment
•Also called:▫the “Natural Rate” of unemployment▫the “Non-Accelerating Inflation Rate of
Unemployment”
Figure 11-13. Full-Employment and the Phillips Curve
unemployment
infla
tion
full-employment
left side:overheatedeconomy
right side:underperformingeconomy
PC
What’s Next?•We know that the economy will begin to
self-correct from either of the two economic problems: ▫high unemployment in an underperforming
economy▫high inflation in an overheated economy
•We know that self-correction takes a long time and we are impatient.
•Next: We study how the government can form a policy to “fix” the economy more rapidly.
Macroeconomic PoliciesGovernment uses to fix economy
•Three policy options are available:▫Fiscal policy – in which the President and
Congress manipulate Federal spending and tax laws.
▫Monetary policy – in which the Federal Reserve manipulates the money supply and interest rates.
▫Supply-side policy – in which the President and Congress manipulate government regulations, incentive programs, and tax laws.
Fiscal Policy• Fiscal Policy = taxing and spending by
government (federal = Congress.)•The budget consists of government
spending (G) and tax revenues (T).•Fiscal policy can increase G or decrease T
to cause an increase in total spending.•Fiscal policy can decrease G or increase T
to cause a decrease in total spending.
Budget Deficit•A budget deficit occurs when G > T, that
is, spending exceeds tax receipts.•The government must borrow to pay the
bills.▫Added borrowing increases the already
huge national debt.▫If the government increases borrowing,
there are fewer available funds for the private sector to borrow. This is “crowding out”.
Fiscal Policy for an Underperforming Economy
•Unemployment is one of the main problems.
•Solution: Jumpstart the economy by either increasing G or decreasing T, or both.
• AD shifts to the right.•It also triggers the multiplier effect.•This action will increase the budget
deficit.
Figure 12-1. Fiscal Policy for an Underperforming Economy
employment
infla
tion
full-employment
left side:underperformingeconomy
right side:overheatedeconomy
the economyis here to begin with.
“jump-start”
multipliereffect1
2
3
4unemploymentfalls but inflationincreases
AS
AD1
AD2
Fiscal Policy for an Overheated Economy
•Inflation is the other major problem.•Solution: Jumpstart the economy by either
decreasing G or increasing T, or both.• AD shifts to the left.• It also triggers the multiplier effect.•This action will decrease the budget
deficit.
Figure 12-2. Fiscal Policy for an Overheated Economy
employment
infla
tion
full-employment
left side:underperformingeconomy
right side:overheatedeconomy
1the economyis here at thestart
2“jump-start”
3multipliereffect
4inflation decreasesand unemploymentrises to full-employ-ment level
AD2
AD1
Problems with Fiscal Policy•There are several time lags in devising
and implementing the policy.•Politics will cause arguments on how to
implement.▫Those who favor big government will want
to increase G to fight unemployment and increase T to fight inflation.
▫Those who think government is already too big will want to decrease T to fight unemployment and decrease G to fight inflation.
Automatic Stabilizers•Fiscal action that does work right away
are the two automatic stabilizers:▫Income tax withholding law.▫Unemployment compensation law.
As a recession begins, layoffs reduce taxes withheld and
generate applicants for unemployment compensation.
So T decreases and G increases, counteracting the downturn. The opposite occurs in recovery.
Monetary Policy for an Underperforming Economy
•Unemployment is the main problem.•Solution: Jumpstart the economy by
implementing an “easy money” policy, most likely by buying government securities in the open market.
• AD shifts to the right.
•It also triggers the multiplier effect.
Monetary Policy in an Underperforming Economy•The Fed conducts an “easy money” policy.
▫lower the required reserve ratio▫lower the discount rate▫buy government securities in the open
market•All increase money supply, increase
lending, and lower interest rates•Total spending increases.
Figure 12-3. Monetary Policy for an Underperforming Economy
employment
infla
tion
full-employment
left side:underperformingeconomy
right side:overheatedeconomy
the economyis here to begin with.
Fed buyssecurities
multipliereffect1
2
3
4unemploymentfalls but inflationincreases
AS
AD1
AD2
Monetary Policy for an Overheated Economy
•Inflation is the main problem.•Solution: Jumpstart the economy by
implementing an “tight money” policy, most likely by selling government securities in the open market.
• AD shifts to the left.
• It also triggers the multiplier effect. (in reverse)
Monetary Policy in an Overheated Economy•The Fed conducts a “tight money” policy.
▫raise the required reserve ratio▫raise the discount rate▫sell government securities in the open
market•All decrease money supply, decrease
lending, and raise interest rates•Total spending decreases.
Figure 12-4. Monetary Policy for an Overheated Economy
employment
infla
tion
full-employment
left side:underperformingeconomy
right side:overheatedeconomy
1the economyis here at thestart
2Fed sellssecurities
3multipliereffect
4inflation decreasesand unemploymentrises to full-employ-ment level
AD2
AD1
Supply-Side Policy2 ways to interpret
1. (Production)This is more of a long-run policy, designed to increase the capability and incentive of the nation to produce. Our level of income affects our consumption which affects the supply.
2. (Tax rates) Term also used to describe marginal tax rates. Supply siders believe lower marginal rates induce work ethic, more productivity, and more efficient use of resources.
Favorable Supply-Side Policy
•Lowering production costs and other business costs and increasing productivity will initiate this policy.
•Unemployment will fall, inflation will decrease, and economic growth will increase, a “triple good”.
Figure 12-5. Supply-Side Policy
employment
infla
tion
lower costs orincreased productivity shifts AS to the right.inflation and unemployment bothdecrease.
full employment
AD
AS1
AS2
The Case For Lower Tax Rates
•Taxes are a punishment for earning, a disincentive to produce.▫Higher taxes lead to decreased production.▫Lower taxes lead to increased production.
•Lowering tax rates allows producers to keep more of their income which is an incentive to earn more by producing more. The opposite is true when tax rates are raised.
The Case For Lower Tax Rates
•Critics of lowering tax rates assert that doing so will cause huge budget deficits.▫True in the short run; false in the long run.▫Short-run: pay less tax on current income.▫Long-run: respond to the powerful
incentive to earn more and produce more. Pay more taxes on higher income.
▫This is the J-Curve effect.