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Chapter 36 - Current issues in macro theory and policy. In this chapter, you will learn to: Describe alternative perspectives on the causes of macroeconomic instability, including the views of mainstream economists, monetarists, real-business-cycle advocates, and proponents of coordination failures; explain what the equation of exchange is and how it relates to monetarism; discuss why new classical economists believe the economy will self-correct from aggregate demand and aggregate supply shocks;...
Chapter 36 Current Issues in Macro Theory and Policy McGrawHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.Allrightsreserved Chapter Objectives Alternative perspectives on macroeconomic instability Equation of exchange and monetarism • New classical economists and self-correction • Rules vs discretion in conducting stabilization policy 36-2 Causes of Macro Instability • Mainstream view – Held by most economists • Price stickiness • Unexpected demand shocks – Variable investment spending • Unexpected supply shocks 36-3 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 36-4 Causes of Macro Instability • Real-business-cycle view – Shifts in long-run aggregate supply Price Level ASLR2 ASLR1 P1 AD1 AD2 Q2 Q1 Real Domestic Output 36-5 Causes of Macro Instability • Coordination failures – Fourth modern view • Limited information • Expectations and self-fulfilling prophecy • Unemployment equilibrium • Inflation equilibrium 36-6 Self-Correction • New classical view – Rational expectations theory – Monetarists • Automatic correction will occur • Speed of adjustment • Unanticipated price-level changes • Fully anticipated price-level changes 36-7 Self-Correction New Classical View of Self-Correction Price Level ASLR AS2 AS1 c P3 b P2 a P1 AD2 AD1 Q1 Q2 Real Domestic Output 36-8 Self-Correction New Classical View of Self-Correction ASLR Price Level AS1 AS3 P1 P4 f a d P5 e AD1 AD3 Q4 Q Q1 Real Domestic Output 36-9 Self-Correction • Mainstream view • Downward wage inflexibility • Efficiency wage theory – Greater work effort – Lower supervision costs – Reduced job turnover • Insider-outsider relationships 36-10 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 36-11 Rationale for Monetary Rule Price Level ASLR1 ASLR2 P1 AD2 P2 AD1 Q1 Q2 Real Domestic Output, GDP 36-12 Rules or Discretion? • In defense of discretionary stabilization policy • Discretionary monetary policy – Velocity is not stable • Discretionary fiscal policy – Useful during recession • Increased macro stability 36-13 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 – Use the interest rate • Fed explains deviations from the rule • Increase Fed credibility and reduce uncertainty 36-14 Key Terms • • • • • • • • monetarism equation of exchange velocity real-business-cycle theory coordination failures rational expectations theory new classical economics Taylor rule • price-level surprises • efficiency wage • insider-outsider theory • monetary rule • inflation targeting 36-15 Next Chapter Preview… International Trade 36-16 ... monetary policy 3 6- 4 Causes of Macro Instability • Real-business-cycle view – Shifts in long-run aggregate supply Price Level ASLR2 ASLR1 P1 AD1 AD2 Q2 Q1 Real Domestic Output 3 6- 5 Causes of Macro... price-level changes • Fully anticipated price-level changes 3 6- 7 Self-Correction New Classical View of Self-Correction Price Level ASLR AS2 AS1 c P3 b P2 a P1 AD2 AD1 Q1 Q2 Real Domestic Output 3 6- 8... economics Taylor rule • price-level surprises • efficiency wage • insider-outsider theory • monetary rule • inflation targeting 3 6- 15 Next Chapter Preview… International Trade 3 6- 16