Seventh Edition - The Addison-Wesley Series in Economics Phần 10 doc

648 PART VI Monetary Theory in interest rates and by rapid financial innovation that made the correct measurement of money far more difficult (see Chapter 3). In their view, this period was an aberration, and the close correspondence of money and infla- tion is sure to reassert itself. However, this has not yet occurred. What is the underlying cause of the increased rate of money growth that we see occurring from 1960 to 1980? We have identified two possible sources of inflationary monetary policy: government adherence to a high employment target and budget deficits. Let’s see if budget deficits can explain the move to an inflationary monetary policy by plotting the ratio of govern- ment debt to GDP in Figure 9. This ratio provides a reasonable measure of whether government budget deficits put upward pressure on interest rates. Only if this ratio is rising might there be a tendency for budget deficits to raise interest rates because the public is then being asked to hold more gov- ernment bonds relative to their capacity to buy them. Surprisingly, over the course of the 20-year period from 1960 to 1980, this ratio was falling, not rising. Thus U.S. budget deficits in this period did not raise interest rates and so could not have encouraged the Fed to expand the money supply by buy- ing bonds. Therefore, Figure 9 tells us that we can rule out budget deficits as a source of the rise in inflation in this period. Because politicians were frequently bemoaning the budget deficits in this period, why did deficits not lead to an increase in the debt–GDP ratio? The reason is that in this period, U.S. budget deficits were sufficiently small that the increase in the stock of government debt was still slower than the growth in nominal GDP, and the ratio of debt to GDP declined. You can see that interpreting budget deficit numbers is a tricky business. 6 We have ruled out budget deficits as the instigator; what else could be the underlying cause of the higher rate of money growth and more rapid inflation in the 1960s and 1970s? Figure 10, which compares the actual unemployment rate to the natural rate of unemployment, shows that the economy was experiencing unemployment below the natural rate in all but one year between 1965 and 1973. This suggests that in 1965–1973, the American economy was experiencing the demand-pull inflation described in Figure 6. Policymakers apparently pursued policies that continually shifted the aggregate demand curve to the right in trying to achieve an output target that was too high, thus causing the continual rise in the price level outlined in Figure 6. This occurred because policymakers, economists, and politicians had become committed in the mid-1960s to a target unemployment rate of 4%, the level of unemployment they thought was consistent with price sta- bility. In hindsight, most economists today agree that the natural rate of unemployment was substantially higher in this period, on the order of 5 to 6%, as shown in Figure 10. The result of the inappropriate 4% unemployment 6 Another way of understanding the decline in the debt–GDP ratio is to recognize that a rise in the price level reduces the value of the outstanding government debt in real terms—that is, in terms of the goods and services it can buy. So even though budget deficits did lead to a somewhat higher nominal amount of debt in this period, the continually rising price level (inflation) produced a lower real value of the government debt. The decline in the real amount of debt at the same time that real GDP was rising in this period then resulted in the decline in the debt–GDP ratio. For a fascinating discussion of how tricky it is to interpret deficit numbers, see Robert Eisner and Paul J. Pieper, “A New View of the Federal Debt and Budget Deficits,” American Economic Review 74 (1984): 11–29. http://w3.access.gpo.gov /usbudget/ The Economic Report of the President reports debt levels and gross domestic product, along with many other economic statistics. CHAPTER 27 Money and Inflation 649 FIGURE 9 Government Debt-to-GDP Ratio, 1960–2002 Source: Economic Report of the President. 1960 1965 1970 1975 1980 1985 1990 1995 20052000 0 20 30 40 50 60 Debt (% of GDP) FIGURE 10 Unemployment and the Natural Rate of Unemployment, 1960–2002 Sources: Economic Report of the President and Congressional Budget Office. 3 4 5 6 7 8 9 10 1960 1965 1970 1975 1980 1985 1990 1995 2000 Unemployment Rate Natural Rate of Unemployment Unemployment Rate (%) 0 Activist/Nonactivist Policy Debate All economists have similar policy goals—they want to promote high employment and price stability—and yet they often have very different views on how policy should be conducted. Activists regard the self-correcting mechanism through wage and price adjustment (see Chapter 25) as very slow and hence see the need for the government to pursue active, accommodating, discretionary policy to eliminate high unemploy- ment whenever it develops. Nonactivists, by contrast, believe that the performance of the economy would be improved if the government avoided active policy to eliminate unemployment. We will explore the activist/nonactivist policy debate by first looking at what the policy responses might be when the economy experiences high unem- ployment. Suppose that policymakers confront an economy that has moved to point 1Ј in Figure 11. At this point, aggregate output Y 1Ј is lower than the natural rate level, and the economy is suffering from high unemployment. Policymakers have two viable choices: If they are nonactivists and do nothing, the aggregate supply curve will even- tually shift rightward over time, driving the economy from point 1Ј to point 1, where full employment is restored. The accommodating, activist alternative is to try to elim- inate the high unemployment by attempting to shift the aggregate demand curve rightward to AD 2 by pursuing expansionary policy (an increase in the money supply, increase in government spending, or lowering of taxes). If policymakers could shift the aggregate demand curve to AD 2 instantaneously, the economy would immediately move to point 2, where there is full employment. However, several types of lags pre- vent this immediate movement from occurring. 1. The data lag is the time it takes for policymakers to obtain the data that tell them what is happening in the economy. Accurate data on GDP, for example, are not available until several months after a given quarter is over. 2. The recognition lag is the time it takes for policymakers to be sure of what the data are signaling about the future course of the economy. For example, to minimize errors, the National Bureau of Economic Research (the organization that officially Responses to High Unemployment 650 PART VI Monetary Theory target was the beginning of the most sustained inflationary episode in American history. After 1975, the unemployment rate was regularly above the natural rate of unemployment, yet inflation continued. It appears that we have the phe- nomenon of a cost-push inflation described in Figure 5 (the impetus for which was the earlier demand-pull inflation). The persistence of inflation can be explained by the public’s knowledge that government policy continued to be concerned with achieving high employment. With a higher rate of expected inflation arising initially from the demand-pull inflation, the aggre- gate supply curve in Figure 5 continued to shift leftward, causing a rise in unemployment that policymakers would try to eliminate by shifting the aggregate demand curve to the right. The result was a continuation of the inflation that had started in the 1960s. dates business cycles) will not declare the economy to be in recession until at least six months after it has determined that one has begun. 3. The legislative lag represents the time it takes to pass legislation to implement a particular policy. The legislative lag does not exist for most monetary policy actions such as open market operations. It can, however, be quite important for the imple- mentation of fiscal policy, when it can sometimes take six months to a year to get leg- islation passed to change taxes or government spending. 4. The implementation lag is the time it takes for policymakers to change policy instruments once they have decided on the new policy. Again, this lag is unimportant for the conduct of open market operations because the Fed’s trading desk can pur- chase or sell bonds almost immediately upon being told to do so by the Federal Open Market Committee. Actually implementing fiscal policy may take time, however; for example, getting government agencies to change their spending habits takes time, as does changing tax tables. 5. The effectiveness lag is the time it takes for the policy actually to have an impact on the economy. An important element of the monetarist viewpoint is that the effec- tiveness lag for changes in the money supply is long and variable (from several months to several years). Keynesians usually view fiscal policy as having a shorter effectiveness lag than monetary policy (fiscal policy takes approximately a year until its full effect is felt), but there is substantial uncertainty about how long this lag is. Now that we understand the considerations that affect decisions by policymakers on whether to pursue an activist or nonactivist policy, we can examine when each of these policies would be preferable. Activist and Nonactivist Positions CHAPTER 27 Money and Inflation 651 FIGURE 11 The Choice Between Activist and Nonactivist Policy When the economy has moved to point 1Ј, the policymaker has two choices of policy: the nonactivist policy of doing nothing and letting the economy return to point 1 or the activist policy of shifting the aggregate demand curve to AD 2 to move the economy to point 2. Aggregate Price Level, P P 1Ј P 1 Y 1Ј Y n Aggregate Output, Y P 2 P 2Ј Y 2Ј 2Ј AD 1 AD 2 AS 1 1 AS 2 1Ј 2 Case for an Activist Policy. Activists, such as the Keynesians, view the wage and price adjustment process as extremely slow. They consider a nonactivist policy costly, because the slow movement of the economy back to full employment results in a large loss of output. However, even though the five lags described result in delay of a year or two before the aggregate demand curve shifts to AD 2 , the aggregate supply curve likewise moves very little during this time. The appropriate path for policymakers to pursue is thus an activist policy of moving the economy to point 2 in Figure 11. Case for a Nonactivist Policy. Nonactivists, such as the monetarists, view the wage and price adjustment process as more rapid than activists do and consider nonactivist pol- icy less costly because output is soon back at the natural rate level. They suggest that an activist, accommodating policy of shifting the aggregate demand curve to AD 2 is costly, because it produces more volatility in both the price level and output. The rea- son for this volatility is that the time it takes to shift the aggregate demand curve to AD 2 is substantial, whereas the wage and price adjustment process is more rapid. Hence before the aggregate demand curve shifts to the right, the aggregate supply curve will have shifted rightward to AS 2 , and the economy will have moved from point 1Ј to point 1, where it has returned to the natural rate level of output Y n . After adjustment to the AS 2 curve is complete, the shift of the aggregate demand curve to AD 2 finally takes effect, leading the economy to point 2Ј at the intersection of AD 2 and AS 2 . Aggregate output at Y 2Ј is now greater than the natural rate level (Y 2Ј > Y n ), so the aggregate supply curve will now shift leftward back to AS 1 , moving the economy to point 2, where output is again at the natural rate level. Although the activist policy eventually moves the economy to point 2 as policy- makers intended, it leads to a sequence of equilibrium points—1Ј, 1, 2Ј, and 2—at which both output and the price level have been highly variable: Output overshoots its target level of Y n , and the price level falls from P 1Ј to P 1 and then rises to P 2Ј and even- tually to P 2 . Because this variability is undesirable, policymakers would be better off pursuing the nonactivist policy, which moved the economy to point 1 and left it there. Our analysis of inflation in the 1970s demonstrated that expectations about policy can be an important element in the inflation process. Allowing for expectations about policy to affect how wages are set (the wage-setting process) provides an additional reason for pursuing a nonactivist policy. Do Expectations Favor a Nonactivist Approach? Does the possibility that expectations about policy matter to the wage-setting process strengthen the case for a nonactivist policy? The case for an activist policy states that with slow wage and price adjustment, the activist policy returns the economy to full employment at point 2 far more quickly than it takes to get to full employment at point 1 under nonactivist policy. However, the activist argument does not allow for the possibility (1) that expectations about policy matter to the wage-setting process and (2) that the economy might initially have moved from point 1 to point 1Ј because an attempt by workers to raise their wages or a negative supply shock shifted the aggregate supply curve from AS 2 to AS 1 . We must therefore ask the following question about activist policy: Will the aggregate supply curve continue to shift to the left after the economy has reached point 2, lead- ing to cost-push inflation? The answer to this question is yes if expectations about policy matter. Our dis- cussion of cost-push inflation in Figure 5 suggested that if workers know that policy will be accommodating in the future, they will continue to push their wages up, and Expectations and the Activist/ Nonactivist Debate 652 PART VI Monetary Theory the aggregate supply curve will keep on shifting leftward. As a result, policymakers are forced to accommodate the cost push by continuing to shift the aggregate demand curve to the right to eliminate the unemployment that develops. The accommodating, activist policy with its high employment target has the hidden cost or disadvantage that it may well lead to inflation. 7 The main advantage of a nonaccommodating, nonactivist policy, in which poli- cymakers do not try to shift the aggregate demand curve in response to the cost push, is that it will prevent inflation. As depicted in Figure 4, the result of an upward push on wages in the face of a nonaccommodating, nonactivist policy will be a period of unemployment above the natural rate level, which will eventually shift the aggregate supply curve and the price level back to their initial positions. The main criticism of this nonactivist policy is that the economy will suffer protracted periods of unem- ployment when the aggregate supply curve shifts leftward. Workers, however, would probably not push for higher wages to begin with if they knew that policy would be nonaccommodating, because their wage gains will lead to a protracted period of unemployment. A nonaccommodating, nonactivist policy may have not only the advantage of preventing inflation but also the hidden benefit of discouraging leftward shifts in the aggregate supply curve that lead to excessive unemployment. In conclusion, if workers’ opinions about whether policy is accommodating or nonaccommodating matter to the wage-setting process, the case for a nonactivist policy is much stronger. Do Expectations About Policy Matter to the Wage-Setting Process? The answer to this question is crucial to deciding whether activist or nonactivist policy is preferred and so has become a major topic of current research for economists, but the evidence is not yet conclusive. We can ask, however, whether expectations about policy do affect people’s behavior in other contexts. This information will help us know if expecta- tions regarding whether policy is accommodating are important to the wage-setting process. As any good negotiator knows, convincing your opponent that you will be non- accommodating is crucial to getting a good deal. If you are bargaining with a car dealer over price, for example, you must convince him that you can just as easily walk away from the deal and buy a car from a dealer on the other side of town. This prin- ciple also applies to conducting foreign policy—it is to your advantage to convince your opponent that you will go to war (be nonaccommodating) if your demands are not met. Similarly, if your opponent thinks that you will be accommodating, he will almost certainly take advantage of you (for an example, see Box 1). Finally, anyone who has dealt with a two-year-old child knows that the more you give in (pursue an accommodating policy), the more demanding the child becomes. People’s expecta- tions about policy do affect their behavior. Consequently, it is quite plausible that expectations about policy also affect the wage-setting process. 8 CHAPTER 27 Money and Inflation 653 7 The issue that is being described here is the time-consistency problem described in Chapter 21. 8 A recent development in monetary theory, new classical macroeconomics, strongly suggests that expectations about policy are crucial to the wage-setting process and the movements of the aggregate supply curve. We will explore why new classical macroeconomics comes to this conclusion in Chapter 28, when we discuss the impli- cations of the rational expectations hypothesis, which states that expectations are formed using all available infor- mation, including expectations about policy. The following conclusions can be generated from our analysis: Activists believe in the use of discretionary policy to eliminate excessive unemployment whenever it devel- ops, because they view the wage and price adjustment process as sluggish and unre- sponsive to expectations about policy. Nonactivists, by contrast, believe that a discretionary policy that reacts to excessive unemployment is counter-productive, because wage and price adjustment is rapid and because expectations about policy can matter to the wage-setting process. Nonactivists thus advocate the use of a policy rule to keep the aggregate demand curve from fluctuating away from the trend rate of growth of the natural rate level of output. Monetarists, who adhere to the nonactivist position and who also see money as the sole source of fluctuations in the aggregate demand curve, in the past advocated a policy rule whereby the Federal Reserve keeps the money supply growing at a constant rate. This monetarist rule is referred to as a constant-money-growth-rate rule. Because of the misbehavior of velocity of M1 and M2, monetarists such as Bennett McCallum and Alan Meltzer of Carnegie-Mellon University have advocated a rule for the growth of the monetary base that is adjusted for past velocity changes. As our analysis indicates, an important element for the success of a nonaccom- modating policy rule is that it be credible: The public must believe that policymakers will be tough and not accede to a cost push by shifting the aggregate demand curve to the right to eliminate unemployment. In other words, government policymakers need credibility as inflation-fighters in the eyes of the public. Otherwise, workers will be more likely to push for higher wages, which will shift the aggregate supply curve leftward after the economy reaches full employment at a point such as point 2 in Figure 11 and will lead to unemployment or inflation (or both). Alternatively, a cred- ible, nonaccommodating policy rule has the benefit that it makes a cost push less likely and thus helps prevent inflation and potential increases in unemployment. The following application suggests that recent historical experience is consistent with the importance of credibility to successful policymaking. Rules Versus Discretion: Conclusions 654 PART VI Monetary Theory Box 1 Perils of Accommodating Policy The Terrorism Dilemma. A major dilemma con- fronting our foreign policy in recent years is whether to cave in to the demands of terrorists when they are hold- ing American hostages. Because our hearts go out to the hostages and their families, we might be tempted to pursue an accommodating policy of giving in to the ter- rorists to bring the hostages safely back home. However, pursuing this accommodating policy is likely to encourage terrorists to take hostages in the future. The terrorism dilemma illustrates the principle that opponents are more likely to take advantage of you in the future if you accommodate them now. Recognition of this principle, which demonstrates the perils of accommodating policy, explains why gov- ernments in countries such as the United States and Israel have been reluctant to give in to terrorist demands even though it has sometimes resulted in the death of hostages. CHAPTER 27 Money and Inflation 655 Importance of Credibility to Volcker’s Victory over Inflation Application In the period from 1965 through the 1970s, policymakers had little credibil- ity as inflation-fighters—a well-deserved reputation, as they pursued an accommodating policy to achieve high employment. As we have seen, the outcome was not a happy one. Inflation soared to double-digit levels, while the unemployment rate remained high. To wring inflation out of the system, the Federal Reserve under Chairman Paul Volcker put the economy through two back-to-back recessions in 1980 and 1981–1982 (see Chapter 18). (The data on inflation, money growth, and unemployment in this period are shown in Figures 8 and 10.) Only after the 1981–1982 recession—the most severe in the postwar period, with unemployment above the 10% level—did Volcker establish credibility for the Fed’s anti-inflation policy. By the end of 1982, inflation was running at a rate of less than 5%. One indication of Volcker’s credibility came in 1983 when the money growth rate accelerated dramatically and yet inflation did not rise. Workers and firms were convinced that if inflation reared its head, Volcker would pur- sue a nonaccommodating policy of quashing it. They did not raise wages and prices, which would have shifted the aggregate supply curve leftward and would have led to both inflation and unemployment. The success of Volcker’s anti-inflation policy continued throughout the rest of his term as chairman, which ended in 1987; unemployment fell steadily, while the inflation rate remained below 5%. Volcker’s triumph over inflation was achieved because he obtained credibility the hard way—he earned it. Summary 1. Milton Friedman’s famous proposition that “inflation is always and everywhere a monetary phenomenon” is supported by the following evidence: Every country that has experienced a sustained, high inflation has also experienced a high rate of money growth. 2. Aggregate demand and supply analysis shows that Keynesian and monetarist views of the inflation process are not very different. Both believe that high inflation can occur only if there is a high rate of money growth. As long as we recognize that by inflation we mean a rapid and continuing increase in the price level, almost all economists agree with Friedman’s proposition. 3. Although high inflation is “always and everywhere a monetary phenomenon” in the sense that it cannot occur without a high rate of money growth, there are reasons why inflationary monetary policy comes about. The two underlying reasons are the adherence of policymakers to a high employment target and the presence of persistent government budget deficits. 4. Activists believe in the use of discretionary policy to eliminate excessive unemployment whenever it occurs because they view wage and price adjustment as sluggish and unresponsive to expectations about policy. Nonactivists take the opposite view and believe that discretionary policy is counterproductive. In addition, they regard the credibility of a nonaccommodating (nonactivist) anti-inflation policy as crucial to its success. 656 PART VI Monetary Theory Key Terms accommodating policy, p. 640 constant-money-growth-rate rule, p. 654 cost-push inflation, p. 639 demand-pull inflation, p. 639 government budget constraint, p. 643 monetizing the debt, p. 644 printing money, p. 644 Ricardian equivalence, p. 645 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. “There are frequently years when the inflation rate is high and yet money growth is quite low. Therefore, the statement that inflation is a monetary phenome- non cannot be correct.” Comment. *2. Why do economists focus on historical episodes of hyperinflation to decide whether inflation is a mone- tary phenomenon? 3. “Since increases in government spending raise the aggregate demand curve in Keynesian analysis, fiscal policy by itself can be the source of inflation.” Is this statement true, false, or uncertain? Explain your answer. *4. “A cost-push inflation occurs as a result of workers’ attempts to push up their wages. Therefore, inflation does not have to be a monetary phenomenon.” Is this statement true, false, or uncertain? Explain your answer. 5. “Because government policymakers do not consider inflation desirable, their policies cannot be the source of inflation.” Is this statement true, false, or uncertain? Explain your answer. *6. “A budget deficit that is only temporary cannot be the source of inflation.” Is this statement true, false, or uncertain? Explain your answer. 7. How can the Fed’s desire to prevent high interest rates lead to inflation? *8. “If the data and recognition lags could be reduced, activist policy would more likely be beneficial to the economy.” Is this statement true, false, or uncertain? Explain your answer. 9. “The more sluggish wage and price adjustment is, the more variable output and the price level are when an activist policy is pursued.” Is this statement true, false, or uncertain? Explain your answer. *10. “If the public believes that the monetary authorities will pursue an accommodating policy, a cost-push inflation is more likely to develop.” Is this statement true, false, or uncertain? Explain your answer. 11. Why are activist policies to eliminate unemployment more likely to lead to inflation than nonactivist policies? *12. “The less important expectations about policy are to movements of the aggregate supply curve, the stronger the case is for activist policy to eliminate unemploy- ment.” Is this statement true, false, or uncertain? Explain your answer. 13. If the economy’s self-correcting mechanism works slowly, should the government necessarily pursue an activist policy to eliminate unemployment? *14. “To prevent inflation, the Fed should follow Teddy Roosevelt’s advice: ‘Speak softly and carry a big stick.’” What would the Fed’s “big stick” be? What is the state- ment trying to say? 15. In a speech early in the Iraq-Kuwait crisis in 1990, President George Bush stated that although his heart went out to the hostages held by Saddam Hussein, he would not let this hostage-taking deter the United States from insisting on the withdrawal of Iraq from Kuwait. Do you think that Bush’s position made sense? Explain why or why not. QUIZ CHAPTER 27 Money and Inflation 657 Web Exercises 1. Figure 8 reports the inflation rate from 1960 to 2002. As this chapter states, inflation continues to be a major a factor in economic policy. Go to ftp://ftp.bls .gov/pub/special.requests/cpi/cpiai.txt . Move data into Excel using the method described at the end of Chapter 1. Delete all but the first and last column (date and annual CPI). Graph this data and compare it to Figure 8. a. Has inflation increased or decreased since the end of 2002? b. When was inflation at its highest? c. When was inflation at its lowest? d. Have we ever had a period of deflation? If so, when? e. Have we ever had a period of hyperinflation? If so, when? 2. It can be an interesting exercise to compare the pur- chasing power of the dollar over different periods in history. Go to www .bls.gov/cpi/ and scroll down to the link to the “inflation calculator.” Use this calculator to compute the following: a. If a new home cost $125,000 in 2002, what would it have cost in 1950? b. The average household income in 2002 was about $37,000. How much would this have been in 1945? c. An average new car cost about $18,000 in 2002. What would this have cost in 1945? d. Using the results you found in Questions b and c, does a car consume more or less of average house- hold income in 2002 than in 1945? [...]... Explaining Low Japanese Interest Rates, p 103 Reading the Wall Street Journal “Credit Markets” Column, p 103 Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply, p 108 Money and Interest Rates, p 112 The Enron Bankruptcy and the Baa-Aaa Spread, p 124 Effects of the Bush Tax Cut on Bond Interest Rates, p 127 Interpreting Yield Curves, 1980–2003, p 137 Monetary... 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The result of the inappropriate 4% unemployment 6 Another way of understanding the decline in the debt–GDP ratio. higher nominal amount of debt in this period, the continually rising price level (inflation) produced a lower real value of the government debt. The decline in the real amount of debt at the same. higher rate of expected inflation arising initially from the demand-pull inflation, the aggre- gate supply curve in Figure 5 continued to shift leftward, causing a rise in unemployment that policymakers