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Chapter 15. Stabilization Policy, Output, and Employment. 1. Economic Fluctuations —The Historical Record. Economic Fluctuation – The Historical Record. Historically, the United States has experienced substantial swings in real output.
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Chapter 15 Stabilization Policy, Output, and Employment
Economic Fluctuation – The Historical Record • Historically, the United States has experienced substantial swings in real output. • Prior to the Second World War, year-to-year changes in real GDP of 5 percent to 10 percent were experienced on several occasions. • During the last five decades, the fluctuations of real output have been more moderate.
First WorldWar boom Second WorldWar boom Annual % Change(in real GDP) 16 14 12 10 8 1937–1938Recession 6 4 2 GreatDepression 0 1920–1921Recession –2 –4 –6 –8 –10 –12 –14 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Sources: Historical Statistics of the United States, p. 224; and Economic Report of the President (1999). Post-Second World War Decline in Economic Instability • Prior to the conclusion of the WWII, the U.S. experienced double-digit increases in real GDP (in 1918, 1922, 1935-1936, and 1941-1943). • In contrast, real output fell by 5% or greater in 1920-1921, 1930-1932, 1938, and 1946. • As illustrated here, fluctuations in real GDP have moderated during the last four decades due, most economist agree, to more appropriate macro policy (particularly monetary policy).
2. Promoting Economic Stability – Activist and Non-activist Views
Promoting Economic Stability-- Activist and Non-activist Views • Goals of Stabilization Policy: • A stable growth of real GDP, • A relatively stable level of prices, • A high level of employment (low unemployment). • Activists' Views of Stabilization Policy: • The self corrective mechanism works slowly if at all, • Policy-makers will be able to alter macro-policy, injecting stimulus to help pull the economy out of recession and implementing restraint to help control inflation, • According to the activist s view, policy-makers are more likely to keep the economy on track when they are free to apply stimulus or restraint based on forecasting devices and current economic indicators.
Promoting Economic Stability-- Activist and Non-activist Views • Non-activists' Views of Stabilization Policy: • The self-corrective mechanism of markets works pretty well, • Greater stability would result if stable, predictable policies based on predetermined rules were followed, • Non-activists argue that the problems of proper timing and political considerations undermine the effectiveness of discretionary macro policy as a stabilization tool.
Composite Index of Leading Indicators(1987 = 100) a 18 15 9 8 11 • The index incorrectly forecasted recession on five occasions ( ). * 11 30 5 100 90 80 70 60 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 1998 Source: Conference Board, Business Cycle Indicators. Index of Leading Indicators • Index of Leading Indicators: • Is a composite statistic based on 10 key variables that generally turn down prior to a recession and turn up before the beginning of a business expansion. • The index can forecast the future and help policy makers, but it is an imperfect forecasting device. • The index forecast the last 8 recessions (the arrows below show how far ahead the index predicted recession)with variable advanced notice. * * * * *
The Application of Discretionary Stabilization Policy • Forecasting Models: • Highly complex statistical models used to improve the accuracy of macro forecasts that use past data from economic relationships to forecast future outcomes and behaviors. • To date, the record of econometric forecasting models has been mixed. • They are accurate when conditions are relatively stable but miss target when things are otherwise. • They also fail when major structural changes occur which change the relationships that their data is based upon.
The Application of Discretionary Stabilization Policy • Market Signals and Discretionary Monetary Policy: • Some economists believe that information supplied by certain economic markets can also provide early warning of the need to change policies. • Commodity prices, exchange rates, and other market signals are best used as supplements, rather than substitutes for, other economic indicators and forecasting devices.
Practical Problems With Discretionary Macro Policy • Lags and the Problem of Timing: • After a change in policy has been undertaken, there will be a time lag before it exerts a major impact. • This means policy makers need to forecast economic conditions several months in the future in order to institute policy changes effectively. • Politics and Timing of Policy Changes: • Policy changes may be driven by political considerations rather than stabilization.
Real GDP Non-activists believe poor Long-termGrowth Rate timing of discretionary policy will result in destabilizing effects. Path if macro policy is timed improperly E F D Time A C B Time Lags and the Effects of Discretionary Policy • Beginning with pt A we illustrate the hypothetical business cycle. • If a forthcoming recession can be recognized quickly and more expansionary policy instituted at pt B . . . expansionary policy may add stimulus at pt C and help minimize the magnitude of the downturn. Activists believe that discretionary policy may achieve this outcome. • However, if delays result in the adoption of the expansionary policy at C and if it does not exert its major impact until pt D . . . the demand stimulus will exacerbate the inflationary boom (as non-activists fear). • In turn, an anti-inflationary strategy instituted at pt E may exert its primary impact at pt F . . . resulting in a deepening of the recession that follows.
1. What is the index of leading indicators? Why is it useful to macro policy makers? Questions for Thought: 2. Why is proper timing of changes in macroeconomic policy crucially important? What are some of the practical problems that limit the effectiveness of discretionary monetary and fiscal policy as stabilization tools?
How are Expectations Formed?-- Two Theories • Adaptive Expectations:-- individuals form their expectations about the future on the basis of data from the recent past. • Rational Expectations:-- Assumes that people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future.
Actual Rateof Inflation(percent) 12.0 Actual rate of inflation 8.0 4.0 0 Expected Rateof Inflation(percent) Corresponding expected rate of inflation in next period 12.0 8.0 4.0 Time Period 0 1 2 3 4 5 Adaptive Expectations Hypothesis Actual Rateof Inflation(percent) Expected Rateof Inflation(percent) • According to the adaptive expectations hypothesis, what actually occurs during the most recent period (or set of periods) determines people’s future expectations. • Thus, the expected future rate of inflation lags behind the actual rate by one period as expectations are altered over time.
6. How Macro Policy Works-- The Implications of Adaptive and Rational Expectations
How Macro Policy Works – The Implications of Adaptive and Rational Expectations • With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment. • With rational expectations, expansionary policy will not generate a systematic change in output. • Both expectations theories indicate that sustained expansionary policies will lead to inflation without permanently increasing output and employment.
Price level SRAS1 LRAS e2 P P 1 2 E1 AD2 AD1 Goods &Services(real GDP) Y Y Y 2 F F Expectations and the Short-run Effects of Demand Stimulus • Under adaptive expectations, anticipation of inflation will lag behind its actual occurrence. • Thus, a shift to a more expansionary policy would increase aggregate demand (from AD1 to AD2) and lead to a temporary increase in GDP(from YF to Y2) accompanied by a modest increase in prices (from P1 to P2).
Price level SRAS2 SRAS1 LRAS E2 P P 1 2 E1 AD2 AD1 Goods &Services(real GDP) Y Y Y F F F Expectations and the Short-run Effects of Demand Stimulus • In contrast, under rational expectations, decision makers will quickly anticipate the inflationary impact of a demand-stimulus policy. • Thus, while a shift to a more expansionary policy would increase aggregate demand (from AD1 to AD2), resource prices and production costs would rise just as rapidly (thereby shifting SRAS to SRAS2). • The net effect of demand-stimulus in the rational expectations model is an increase in prices without altering real output -- even in the short run.
The Emerging Consensus View • Monetary policy consistent with approximate price stability is the key ingredient of effective stabilization policy. • Sound policy avoids wide policy swings. • Responding to minor economic ups and downs is a mistake.
The Recent Stability of the U.S. Economy • The objectives of stabilization policy have been less ambitious in recent years. Rather than trying to control output and employment, the focus has shifted to the achievement of price stability. • Movement toward price stability has led to a reduction in economic fluctuations.
35 32.8 30 25 22.8 20 15 10 4.2 5 0 Sources: R.E. Lipsey and D. Preston, Source Book of Statistics Relating to Construction (1966); & New York: National Bureau of Economic Research Reduction in the Incidence of Recession 1910–1959 1960–1982 1983–1998 • The U.S. economy was in recession 32.8% of the time during the 1910-1959 period and 22.8% of the time between 1960-1982. • Since that time, the economy has become even more stable, entering into recession only 4.2% of the time from 1983-1998.
1. State the adaptive-expectations hypothesis in your own words. How does the theory of rational expectations differ from that of adaptive expectations? Questions for Thought: 2. Why do you think there has been less economic instability during the last 16 years that any time in American history?
