Chapter 15 Debates on Macroeconomic Policy Day One

Chapter 15 Debates on Macroeconomic Policy

Day One

Main Focus § Inflation and Unemployment § The Phillips Curve § Wages and Price Policies § The Debate Over wage and Price Policies

Inflation and Unemployment Relationship between inflation and unemployment is inverse § · AD PL and O Inflation Unemployment § 1. There is an increase in Aggregate Demand (AD) during an economic expansion (people consume, invest more) § 2. b/c of AD ↑ there is a higher equilibrium price level and output. § · A price level ↑ leads to inflation § · An output ↑ leads to lower unemployment § 3. because the AD has pushed up the price level, the resulting INFLATION is demand pull inflation § Demand-pull inflation – inflation that occurs as increased aggregate demand pulls up prices

Demand- Pull Inflation

The Phillips Curve expresses the inverse relationship of unemployment and inflation. - aggregate demand - ª� unemployment - « � inflation - ª� - aggregate demand - « � unemployment - ª� inflation - « � - on Fig. 15. 2, the inverse relationship is shown. **The curve is rarely straight - also used by governments as a policy menu. Expansionary fiscal or monetary policies would move an economy up the curve, contractionary policies would cause a move down. - the effect to which the curve is applicable can be shown in 3 different time periods.

The Phillips Curve

From 1960 to 1972 • There was generally higher inflation with lower unemployment (thus there was demand pull inflation). Since the points fell in a broad band a Phillips Curve could be drawn and used to predict how stabilization policies would affect the economy

Shifts in the Philips Curve

From 1973 to 1982 • Generally inflation and unemployment were both higher %. Their relationship was sometimes direct: a rise in inflation would accompany a rise or nonmovement in unemployment. This caused stagflation

Cost Push Inflation

From 1983 to 1993 • Unemployment rates remained generally high, but inflation rates generally lower. Because of an inconsistent relationship, the Phillips curve could not be drawn for this period. • Inflation was lower because oil prices dropped, reducing cost-push inflation, and because of an economic recession.

Wages and Price Policies

Wages and Price Policies § In the 70’s and 80’s, gov’ts were looking for solutions to stagflation § They tried -Wage and Price Controls and Guidelines.

§ Wage and Price Controls: § - When gov’ts impose restrictions on wage and price increases. (ex. Minimum wage can increase by only a certain % a year). § Wage and Price Guidelines: § - Voluntary restrictions on wage and prices increases

1969 - 1975 § Guidelines didn’t work because businesses wouldn’t cooperate. § A Prices and Incomes Commission was created to work with businesses but nobody listened to them § Inflation actually rose from 5% in 1969 to 10% in 1975.

1976 - 1978 § Controls were then tried: § - In ‘ 76 to ’ 78, a maximum % that wages and salaries could increase was imposed § Businesses could only increase prices to cover increased costs.

The result… § Inflation did subside (10% - 7. 5%) during the time the controls were in place § Economists thought the price and wage controls weren’t the cause, but rather the lower food prices. § After the controls were lifted, inflation rose again.

1982 – 1984 “Six and Five” Rule § In this time the gov’t tried controls again, but only on things the federal government directly controlled. § They increased wages and prices by 6% in ’ 82 -’ 83, then 5% in ‘ 83 -’ 84. § The government encouraged provincial gov’ts to follow their controls.

The Result… § A dramatic fall in inflation between 1982 and 1984, but once again this was contributed to outside factors: - The current economic recession - The contractionary policies put in place by the Bank of Canada at the time

The Debate Over Wage and Price Policies

Is It Effective? § Guidelines are only voluntary in the private sector, and have very little success because most businesses do not follow them § Wage & Price controls may reduce inflation in the short run, but after the controls are removed, inflation almost instantaneously rises.

How Fair Is It? § Larger businesses have to deal with stricter rules from the government whereas smaller businesses find it easier to increase wages. § Not all businesses operate within these restrictions, with some ‘under-the-table’ incentives on top of the legal price to encourage more sales

How Efficient Is It? § Wage & Price restrictions inhibit functions of free markets. § Wage restrictions break the link between productivity & income, thus giving the workers limited incentive to maximize work efforts and output. § Changes in Demand & Supply do not affect price, so resources me be inefficiently distributed

Brief Review § 1. Inflation and unemployment have often had an inverse relationship. In periods of expansion, the result is demand-pull inflation § 2. The Phillips curve represents the Keynesian assumption of an inverse and predictable relationship between inflation and unemployment. While the Phillips curve applied to Canada in the period form 1960 to 1972, it has been less relevant since.

Brief Review § 3. Since the 1970 s, inflation and unemployment in Canada have frequently had a direct relationship. Stagflation has been caused largely by decreases in aggregate supply due to price increase of inputs. The result is cost –push inflation § 4. Overall inflation and unemployment rates in Canada increased in the period from 1973 to 1982, shifting the Phillips curve to the right. From 1983 to 1993, unemployment continued to be high but inflation lowered.

Brief Review § 5. Various types of wage and price restrictions have been applied in Canada since 1969. Critics suggest that these program show little success, while fostering inequalities and inefficiency.

End of Day One

Day Two

Main Focus § § § Monetarism The Velocity of Money The Equation of Exchange The Quantity of Money Inflation Rates and Monetary Growth Monetarist Policies

Monetarism: It is an economic perspective that emphasizes the influence of money on the economy & the ability of private markets to accommodate change Monetarists VS Keynesians -Referred to the economist Keynesians, fiscal and monetary policies perform a beneficial role by smoothing the ups and downs of the business cycle - Keynesians tend to see fiscal policy as more powerful - Believes that private markets are unsteady, and occasional government intervention is necessary.

continue § Monetarism: monetarism is a recent extension of theories that dominated macroeconomics § Monetarists believe that the economy is able to adjust to fluctuations without government intervention § argues that, misguided government intervention just makes economic fluctuation worse. Why? * Because they stress the importance of money, monetarists blame unwise use of monetary policies in particular.

The Velocity of Money Concept Central to Monetarism known as Velocity of Money : the number of times, on average, the money is spent on final goods and services during given year is the velocity of money Nominal GDP § Velocity of Money (V) = Money Supply (M) § Nominal GDP: total dollar value of final goods and services produced in economy § Money supply (M) = M 1 (publicly held currency and publicly held deposits, excluding cash reserves)

Activity Exercise!!!!! § Write the equation to calculate VELOCITY OF MONEY § Now Calculate the velocity of money if Canada’s nominal GDP is $800 billion and the money supply (M) is $50 billion

ANSWER!!! 1) § Velocity of Money (V) = 2) $800 billion 16 = $ 50 billion Nominal GDP Money Supply (M)

The Equation of Exchange - the money supply multiplied by the velocity of money equals price level multiplied by real output. Given: Nominal GDP = P x Q 800 billion = 2. 0 x 400 billion § We can find the equation of exchange! Money Supplied (M) x Velocity of Money (V) = price level (P) x real output (Q)

The Quantity of Money – a theory stating that the velocity of money and real output are relatively stable over short periods. § V only displays gradual change because changes are primarily due to long run factors (like a move to credit and debit cards) § Real output – varies only slightly from its potential level because there is quick adjustment to any changes in prices or unemployment. § Therefore: according to the quantity of money theory, both V and Real Output are constant § SO, given M x V = P x Q , changes in price level must be due to changes in money supply. For example: Inflation (↑ P) is due to too much money chasing the products available for purchase in the economy (↑M)

The Velocity of Money

Inflation Rate and Monetary Growth • The quantity theory shows a close relationship between inflation and growth in money supply • If M 1 were to increase by 10%, so would P • change in P = inflation. V and Q are very constant • equality between M and P is evident, but sometimes rough.

Monetarist Policies § Money is the key factor in the economy, unlike Keynesians who believe it is only one of many factors § Fiscal policy has little influence due to “crowding out effect” Crowding - Out - Effect: The effect of more government borrowing raising interest rates, which reduces or “crowds out” private investment spending § Even monetary policy cannot change output from its potential level § Only way to stabilize economy is minimizing harmful effects of inflation, when bank of Canada minimizes rate of growth of money supply

Comparing the Two Keynesians § Treat money as only one element that determines output and inflation levels § See the process through which money influences the economy is a lengthy one (an expansion in the money supply must first reduce interest rates, then boost investment spending, resulting in an increase in AD) § Regard fiscal policy as a powerful stabilization tool Monetarists § Consider variations in the money supply the most significant factor in the economy § See the impact of monetary changes as being more straightforward and predictable (assuming stable velocity of money, adjustments in the money supply translate immediately into higher nominal GDP and increased prices) § Argue that fiscal policy has little influence because of the crowding out effect

Monetary Rule The Monetary Rule § The monetary rule forces central banks to increase the money supply by a constant rate each year § Recommended at 3% based on real long -term growth in economy

Brief Review for Day Two § 1. In contrast to Keynesians, monetarists believe that the economy has an ability to adjust itself, that governments intervention can harm rather than help the economy, and that the money supply is of ventral importance to the economy. § 2. The equation of exchange states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by the real output (Q) or nominal GDP.

Brief Review for Day Two § 3. According to the quantity theory of money, both the velocity of money and real output are relatively stable over short periods. A certain percentage change in the money supply causes about the same rate of inflation. § 4. Keynesians see the influence of money as indirect and fragile, and fiscal policy as an important stabilization tool. In contrast, monetarist see the influence of money as direct, fiscal policy as ineffective but easily misused. § 5. Monetarists recommend a monetary rule, whereby the money supply is raised by a set annual rate based on the economy’s real growth.

End of Day Two

Day Three

Main Focus § § § Supply- Side Economics Reduction in Incentives Focus on Aggregate Supply The Laffer Curve The Influence of Supply Side Theories

Supply Side Economics § Most economists stress how fiscal and monetary policies influence the economy through shifts in aggregate demand, this follows from their view that any effects on aggregate supply are minor § However, some economists subscribe to a viewpoint known as supply-side economics § They believe that the aggregate supply is the most critical element of government activity and, because the effects are gradual and often hidden, they are usually ignored by policy-makers § The supply-side economists own a large debt to theories of early classical economists, such as Adam Smith and Davis Ricardo, who concentrated on the influence of production costs on price and incomes

Reduction in Incentives § Supply-side economists believe increased government intervention in recent decades has dampened productive economic activity § According to the supply-siders, the government activity can affect aggregate supply by reducing incentives to engage in productive activity § Personal Income and Business Taxes § Anytime marginal tax rates on personal income and business profits increase, the disposable incomes of income earners fall, making it less worthwhile for them to engage in income generating pursuits

Sales Taxes § Hikes in sales taxes also discourage productive activity by reducing the amount of product that can be bought with a given income Transfers and Subsidies § Supply-siders criticize more generous transfer payment programs, such as Unemployment Insurance and welfare, as well as subsidy programs such as farm subsidies. According to the economists, such programs diminish incentives to generate private income.

Regulation § Government has also played a greater role in regulating private businesses. Controls associates with environmental concerns, worker safety, product standards, and workplace equity have all raised business costs and reduced incentives to invest

Aggregate Supply § Monetarists = Gov’t policies affect aggregate demand seriously § Keynesians = Gov’t policies affect aggregate demand seriously § Supply-Siders = Gov’t policies have little effect on aggregate demand a huge effect on aggregate supply.

Focus on Aggregates Supply § Supply-side economists contend that increases in taxes and government regulation means a decrease in aggregate supply. § This shifts the AS curve from AS 0 to AS 1. Therefore, the economy is pushed to a higher price level (P ) and lower real output (Q ) (from point ‘b’ to point ‘a’) § Cost-push inflation then occurs: increased production costs due to taxes and gov’t regulation, decrease aggregate supply, which pushes up prices

Effect of Government Intervention

Supply-Siders’ Views § They say high taxes and increased government regulation create cost-push inflation § Therefore they feel the stagflation of the 1970’s was caused by the government unintentionally because the government over-intervened. § Tax cuts and reduced regulation should right the economy, increasing aggregate supply

Reaganomics § In the early 80’s, supply-siders had many proposals legislated (such as reduction in personal and business taxes), and came to be associated with the Reagan presidency in the United States. § Supply-siders suggested that reducing tax rates would actually lead to an increase in total tax revenues. § The economy underwent a wave of deregulation.

The Laffer Curve § Laffer curve is a curve that expresses the assumed relationship between tax rates and tax revenues § According to the supply- side economics, tax increases at lower tax rates increase tax revenues (from points a to b). However, at higher tax rates (point b to d), tax increases reduce tax revenues as there is little incentive to produce more, make higher incomes, and be taxed more. As a result, a cut in the tax rate from 40% to 20% (from point c to point b) increases tax revenues (read pg. 461) § Tax rates and tax revenues have a direct relationship at low tax rates (a positive slope at lower tax rates) § Tax rates and tax revenues have a direct relationship at high tax rates (a negative slope at higher tax rates) Applying the Laffer Curve § According to the supply-siders, the economies of countries such as Canada and the United States had already reached or surpassed the tax rate at which revenues are maximized. Therefore, cutting tax rates as from 40% to 20% would lead to an increase in revenues

The Laffer Curve

The Influence of Supply. Side Theories • Reaganomic tax cuts were an expensive mistake for the U. S. • mainstream economists said the government deficit acted as an expansionary fiscal policy, raising aggregate demand causing the boom in the U. S. ' economy. • most economists believe stabilization policies effect aggregate demand more than aggregate supply.

Brief Review For Day Three § 1. Supply- side economists focus on the effect of changes in aggregate supply on the economy. They contend that increased government intervention- in the form of higher taxes, greater regulation, and so on – reduces the incentive to engage in productive activity, and so decreases aggregate supply. § 2. Supply-side economists argue that tax hikes and added regulation were the main cause of the stagflation of the 1970 s.

Brief Review For Day Three § 3. The Laffer curve represents the supply -side economic belief that, if tax rates are high enough, tax hikes lead to reduced tax revenues. § 4. Supply- side theories were not borne out by their application in the United States during the Reagon Administration.

End of Day Three

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