Problems in the Macroeconomy: Inflation and Unemployment

Problems in the Macroeconomy:Inflation and Unemployment Chapter 11 and Chapter 12

Problems • When the economy is overheated, inflation is the problem. • When the economy is under performing, unemployment is the problem.

The Historical Record of U.S. Economic Growth Source: U.S. Department of Commerce.

National Business Activity, 1880 to the Present Sources: American Business Activity from 1790 to Today, 67th ed., AmeriTrust Co., January 1996, plus author’s estimates.

Revised

Why does growth matter? • Allows wages and incomes to rise. • Standard of living increases • Takes the pressure of scarce resources… (why?)

Macroeconomic Problems • High inflation rate • High unemployment rate • High interest rates • Low economic growth or stagnation

Is there relationship between unemployment and inflation • From 1940- to 1960’s – economists insisted yes. • From 1960 forward, economists acknowledge short-run relationship majority of times. • Theory was discredited in 1980’s, but some economists still use the relationship as a given.

The Phillips Curve • Shows the short-run trade-off between unemployment and inflation. • unemployment rate increases? inflation rate falls. • unemployment rate decreases? inflation rate rises.

The Phillips Curve • Its position is determined by the capability and the incentive of the economy to produce. • PC relates annual rates of inflation and annual rates of unemployment (December figures.) • There is an inverse relationship.

Figure 11-1. The Phillips Curve inflation PC unemployment

Movement Along the Phillips Curve • In the short run, assume no change in the capability or the incentive of the economy to produce. • Increased total spending causes a movement upward and to the left on the Phillips Curve. • inflation rate increases • unemployment rate decreases

Figure 11-2. Movement Along the Phillips Curve movement due to increased spending inflation inflation increases and unemployment decreases unemployment

Reminders: • When wages and prices are flexible, increase in prices (general level of prices – PL) will stimulate the economy – businesses hire, people leave unemployed, wages increase (nominally.) • When prices decrease – businesses do not hire, income is not earned, unemployment rises.

Movement Along the Phillips Curve • In the short run, assume no change in the capability or the incentive of the economy to produce. • Increased total spending causes a movement upward and to the left on the Phillips Curve. • inflation rate increases • unemployment rate decreases

Figure 11-2. Movement Along the Phillips Curve movement due to increased spending inflation inflation increases and unemployment decreases unemployment

Movement Along the Phillips Curve • In the short run, assume no change in the capability or the incentive of the economy to produce. • Decreased total spending causes a movement downward and to the right on the Phillips Curve. • inflation rate decreases • unemployment rate increases

Figure 11-3. Movement Along the Phillips Curve movement due to decreased spending inflation inflation decreases and unemployment increases unemployment

Shifting the Phillips Curve • The Phillips Curve shifts leftward and downward toward the origin if: • production costs are lowered • productivity is increased • the incentive to work more or harder is increased • Both the unemployment rate and the inflation rate will decrease.

Figure 11-4. Shifting the Phillips Curve Left PC1 PC2 lower costs or increased productivity shifts the PC to the left. inflation and unemployment both decrease inflation unemployment

Shifting the Phillips Curve • The Phillips Curve shifts rightward and upward away from the origin if: • production costs are increased • productivity is decreased • the incentive to work more or harder is decreased • Both the unemployment rate and the inflation rate will increase.

Figure 11-5. Shifting the Phillips Curve Right PC2 PC1 higher costs or decreased productivity shifts the PC to the right. inflation and unemployment both increase inflation unemployment

More Than a Century of Unemployment Source: U.S. Department of Labor, Bureau of Labor Statistics

Inflation and Deflation in U.S. History Source: U.S. Department of Labor, Bureau of Labor Statistics

The Macroeconomic Goal • Full-employment • operate on the institutional PPC • zero cyclical unemployment • Also called: • the “Natural Rate” of unemployment • the “Non-Accelerating Inflation Rate of Unemployment”

Figure 11-13. Full-Employment and the Phillips Curve inflation right side: underperforming economy left side: overheated economy PC unemployment full-employment

What’s Next? • We know that the economy will begin to self-correct from either of the two economic problems: • high unemployment in an underperforming economy • high inflation in an overheated economy • We know that self-correction takes a long time and we are impatient. • Next: We study how the government can form a policy to “fix” the economy more rapidly.

Macroeconomic PoliciesGovernment uses to fix economy Three policy options are available: Fiscal policy – in which the President and Congress manipulate Federal spending and tax laws. Monetary policy – in which the Federal Reserve manipulates the money supply and interest rates. Supply-side policy – in which the President and Congress manipulate government regulations, incentive programs, and tax laws.

Fiscal Policy Fiscal Policy = taxing and spending by government (federal = Congress.) The budget consists of government spending (G) and tax revenues (T). Fiscal policy can increase G or decrease T to cause an increase in total spending. Fiscal policy can decrease G or increase T to cause a decrease in total spending.

Budget Deficit A budget deficit occurs when G > T, that is, spending exceeds tax receipts. The government must borrow to pay the bills. Added borrowing increases the already huge national debt. If the government increases borrowing, there are fewer available funds for the private sector to borrow. This is “crowding out”.

Fiscal Policy for an Underperforming Economy Unemployment is one of the main problems. Solution: Jumpstart the economy by either increasing G or decreasing T, or both. AD shifts to the right. It also triggers the multiplier effect. This action will increase the budget deficit.

Figure 12-1. Fiscal Policy for an Underperforming Economy AS left side: underperforming economy right side: overheated economy AD2 inflation 4 2 unemployment falls but inflation increases AD1 “jumpstart” 3 multiplier effect 1 the economy is here to begin with. employment full-employment

Fiscal Policy for an Overheated Economy Inflation is the other major problem. Solution: Jumpstart the economy by either decreasing G or increasing T, or both. AD shifts to the left. It also triggers the multiplier effect. This action will decrease the budget deficit.

Figure 12-2. Fiscal Policy for an Overheated Economy right side: overheated economy left side: underperforming economy 1 the economy is here at the start 2 “jumpstart” 4 inflation inflation decreases and unemployment rises to full-employment level AD1 3 multiplier effect AD2 employment full-employment

Problems with Fiscal Policy There are several time lags in devising and implementing the policy. Politics will cause arguments on how to implement. Those who favor big government will want to increase G to fight unemployment and increase T to fight inflation. Those who think government is already too big will want to decrease T to fight unemployment and decrease G to fight inflation.

Automatic Stabilizers Fiscal action that does work right away are the two automatic stabilizers: Income tax withholding law. Unemployment compensation law. As a recession begins, layoffs reduce taxes withheld and generate applicants for unemployment compensation. So T decreases and G increases, counteracting the downturn. The opposite occurs in recovery.

Monetary Policy for an Underperforming Economy Unemployment is the main problem. Solution: Jumpstart the economy by implementing an “easy money” policy, most likely by buying government securities in the open market. AD shifts to the right. It also triggers the multiplier effect.

Monetary Policy in an Underperforming Economy • The Fed conducts an “easy money” policy. • lower the required reserve ratio • lower the discount rate • buy government securities in the open market • All increase money supply, increase lending, and lower interest rates • Total spending increases.

Figure 12-3. Monetary Policy for an Underperforming Economy AS left side: underperforming economy right side: overheated economy AD2 inflation 4 2 unemployment falls but inflation increases AD1 Fed buys securities 3 multiplier effect 1 the economy is here to begin with. employment full-employment

Monetary Policy for an Overheated Economy Inflation is the main problem. Solution: Jumpstart the economy by implementing an “tight money” policy, most likely by selling government securities in the open market. AD shifts to the left. It also triggers the multiplier effect. (in reverse)

Monetary Policy in an Overheated Economy • The Fed conducts a “tight money” policy. • raise the required reserve ratio • raise the discount rate • sell government securities in the open market • All decrease money supply, decrease lending, and raise interest rates • Total spending decreases.

Figure 12-4. Monetary Policy for an Overheated Economy right side: overheated economy left side: underperforming economy 1 the economy is here at the start 2 Fed sells securities 4 inflation inflation decreases and unemployment rises to full-employment level AD1 3 multiplier effect AD2 employment full-employment

Supply-Side Policy2 ways to interpret (Production)This is more of a long-run policy, designed to increase the capability and incentive of the nation to produce. Our level of income affects our consumption which affects the supply. (Tax rates) Term also used to describe marginal tax rates. Supply siders believe lower marginal rates induce work ethic, more productivity, and more efficient use of resources.

Favorable Supply-Side Policy Lowering production costs and other business costs and increasing productivity will initiate this policy. Unemployment will fall, inflation will decrease, and economic growth will increase, a “triple good”.

Figure 12-5. Supply-Side Policy AS1 AS2 inflation AD lower costs or increased productivity shifts AS to the right. inflation and unemployment both decrease. full employment employment

The Case For Lower Tax Rates Taxes are a punishment for earning, a disincentive to produce. Higher taxes lead to decreased production. Lower taxes lead to increased production. Lowering tax rates allows producers to keep more of their income which is an incentive to earn more by producing more. The opposite is true when tax rates are raised.

The Case For Lower Tax Rates Critics of lowering tax rates assert that doing so will cause huge budget deficits. True in the short run; false in the long run. Short-run: pay less tax on current income. Long-run: respond to the powerful incentive to earn more and produce more. Pay more taxes on higher income. This is the J-Curve effect.

Problems in the Macroeconomy: Inflation and Unemployment