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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.

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Presentation Transcript
problems
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
The Historical Record of U.S. Economic Growth

Source: U.S. Department of Commerce.

national business activity 1880 to the present
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.

why does growth matter
Why does growth matter?
  • Allows wages and incomes to rise.
  • Standard of living increases
  • Takes the pressure of scarce resources… (why?)
macroeconomic problems
Macroeconomic Problems
  • High inflation rate
  • High unemployment rate
  • High interest rates
  • Low economic growth or stagnation
is there relationship between unemployment and inflation
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
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 curve1
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
Figure 11-1. The Phillips Curve

inflation

PC

unemployment

movement along the phillips curve
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
Figure 11-2. Movement Along the Phillips Curve

movement due to

increased spending

inflation

inflation increases

and unemployment

decreases

unemployment

reminders
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 curve1
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 curve1
Figure 11-2. Movement Along the Phillips Curve

movement due to

increased spending

inflation

inflation increases

and unemployment

decreases

unemployment

movement along the phillips curve2
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
Figure 11-3. Movement Along the Phillips Curve

movement due to

decreased spending

inflation

inflation decreases

and unemployment

increases

unemployment

shifting the phillips curve
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
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 curve1
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
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
More Than a Century of Unemployment

Source: U.S. Department of Labor, Bureau of Labor Statistics

inflation and deflation in u s history
Inflation and Deflation in U.S. History

Source: U.S. Department of Labor, Bureau of Labor Statistics

the macroeconomic goal
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
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
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 policies government uses to fix economy
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

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
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
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
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

“jump-

start”

3

multiplier

effect

1

the economy

is here to begin with.

employment

full-employment

fiscal policy for an overheated economy
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
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

“jump-

start”

4

inflation

inflation decreases

and unemployment

rises to full-employ-

ment level

AD1

3

multiplier

effect

AD2

employment

full-employment

problems with fiscal policy
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
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
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
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
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
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
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
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-employ-

ment level

AD1

3

multiplier

effect

AD2

employment

full-employment

supply side policy 2 ways to interpret
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
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
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
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 rates1
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.