Chapter 36: Current Issues in Macro Theory and Policy

• What causes macro instability?   * Mainstream view - The prevailing macroeconomic perspective of the majority of economists     * Economic instability arises from price stickiness + unexpected shocks to aggregate demand or supply     * Down-sloping aggregate demand curve     * Significant increases in investment can produce demand-pull inflation     * Declines in aggregate supply can destabilize the economy   * Monetarism - (1) focuses on the money supply, (2) holds that markets are highly competitive, and (3) says that a competitive market system gives the economy a high degree of macroeconomic stability     * The government has promoted downward wage inflexibility     * Equation of exchange - Supply of monetary times the velocity of money equals the price level times the physical volume of all goods and services produced     * Velocity in the equation of exchange is relatively stable     * Velocity is expected to change from year to year     * There is a predictable relationship between the money supply and nominal GDP     * Inappropriate monetary policy is the single most important cause of macroeconomic instability     * A decrease in the money supply reduces aggregate demand   * Mainstream economists view instability of investment as the cause of economic instability, but monetarists view changes in the money supply as the cause
• Real-business-cycle theory - Business fluctuations result from significant changes in technology and resource availability   * Changes in the supply of money respond to changes in the demand for money   * A large increase in aggregate supply would shift the long-run aggregate supply curve right

      * Macro instability arises on the aggregate supply side of the economy, not on the aggregate demand side

• Coordination failures - Occur when people fail to reach a mutually beneficial equilibrium because they lack a way to coordinate their actions   * If a reduction of aggregate demand is expected, both firms and households will cut back their investment spending   * If all producers and households would agree to increase their investment and consumption spending simultaneously, then aggregate demand would rise, and real output and real income would increase   * This outcome does not occur because there is no mechanism for firms and households to agree on such a joint spending increase
• Does the economy self-correct?   * Rational expectations theory - Businesses, consumers, and workers expect changes in policies or circumstances to have certain effects on the economy and, in pursuing their own self-interest, take actions to make sure those changes affect them as little as possible   * New classical economics - When the economy occasionally diverges from its full-employment output, internal mechanisms within the economy will automatically move it back to that output     * Monetarists believe that shifts in short-run aggregate supply may not occur for 2 or 3 years or even longer     * Other new classical economists believe that adjustments of nominal wages are very quick or even instantaneous   * Price-level surprises - Unanticipated changes in the price level     * Because firms incorrectly anticipate declines in profit and cut production, real output in the economy falls     * Once firms see what is really happening—that all prices and wages are dropping—they increase their output to prior levels, symbolizing the self-correcting of the economy   * Fully-anticipated price level changes do not change real output
• Mainstream view of self-correction   * Believe that it may take years for the economy to move from recession back to full-employment output, unless it gets help from fiscal and monetary policy   * Efficiency wage - A wage that minimizes the firm’s labor cost per unit of output     * Where the cost of supervising workers is high or where worker turnover is great, firms may discover that paying a wage that is higher than the market wage will lower their wage cost per unit of output     * How can a higher wage result in greater efficiency?       * Greater work effort       * Lower supervision costs       * Reduced job turnover   * Insider-outsider theory - Outsiders may not be able to underbid existing wages because employers may view the nonwage cost of hiring them to be prohibitive     * Implies that wages will be inflexible downward when aggregate demand declines
• In support of policy rules   * Monetarists and other new classical economists believe policy rules would reduce instability in the economy   * Monetarists argue that a monetary rule would tie increases in the money supply to the typical rightward shift of long-run aggregate supply   * Inflation targeting - The Fed would be required to announce a targeted band of inflation rates for some future period     * Would focus the Fed’s attention nearly exclusively on controlling inflation and deflation, rather than on counteracting business fluctuations   * Monetarists are particularly strong in their opposition to expansionary fiscal policy
• In defense of discretionary stabilization policy   * Mainstream economists oppose both a strict monetary rule and a balanced-budget requirement   * While there is indeed a close relationship between the money supply and nominal GDP over long periods, in shorter periods this relationship breaks down   * Mainstream economists support the use of fiscal policy to keep recessions from deepening or to keep mild inflation from becoming severe inflation   * Because politicians can abuse fiscal policy, most economists feel that it should be held in reserve for situations where monetary policy appears to be ineffective or working too slowly

\