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
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