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