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

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