Econ 212

1
Econ 212

• Review, Mid-term 3
• April 30, 2007

2
Trade-off between inflation and unemployment

• Phillips curve Policymakers can choose the
  combination of unemployment and inflation they
  most desired
• Expectations-augmented Phillips curve
• p pe - h(u - u)
• Higher expected inflation implies a higher
  Phillips curve
• A higher natural rate of unemployment implies a
  higher Phillips curve
• Adverse supply shocks shift the Phillips curve up
  and to the right

3
Macroeconomic policy and the Phillips curve

• Can the Phillips curve be exploited by
  policymakers? Can they choose the optimal
  combination of unemployment and inflation?
• Classical model NO, due to quick adjustment
• Keynesian model YES, in the short run

4
The long-run Phillips curve

• Long run u u for both Keynesians and
  classicals
• Changes in the level or growth rate of money
  supply have no long-run real effects
• Even though expansionary policy may reduce
  unemployment only temporarily, policymakers may
  want to do so, do to electoral objectives

5
Unemployment

• Costs
• Loss in output from idle resources
• Personal or psychological cost to workers and
  their families
• Policies to reduce the natural rate of
  unemployment
• Government support for job training and worker
  relocation
• Increased labor market flexibility
• Unemployment insurance reform

6
Costs of inflation

• Minimal costs of perfectly anticipated inflation
• With unanticipated inflation, realized real
  returns differ from expected real returns, which
  results in transfer of wealth
• So people want to avoid risk of unanticipated
  inflation, since they spend resources to forecast
  inflation

7
Fighting inflation The role of inflationary
expectations

• Disinflation may lead to recessions
• The costs of disinflation could be reduced if
  expected inflation fell at the same time actual
  inflation fell
• Rapid versus gradual disinflation
• Keynesians
• Classicals
• Options to fight inflation expectations
• Wage and price controls
• Credibility and reputation

8
Three groups affect the money supply

• The central bank is responsible for monetary
  policy
• Depository institutions (banks) accept deposits
  and make loans
• The public (people and firms) holds money as
  currency and coin or as bank deposits

9
Determination of money supply

• Money Supply Money Base x Multiplier
• Formula for the multiplier (1 cu)/(cu res)
• The currency-deposit ratio (CU/DEP, or cu) is
  determined by the public
• The reserve-deposit ratio (RES/DEP, or res) is
  determined by banks
• The multiplier decreases when either cu or res
  rises

10
Means of controlling the money supply

• Open-market operations
• To increase the monetary base, the central bank
  prints money and uses it to buy assets in the
  market this is an open-market purchase
• Reserve requirements
• An increase in reserve requirements reduces the
  money multiplier
• Discount window lending
• Increases in the discount rate discourage
  borrowing and reduce the monetary base

11
Intermediate targets

• The Fed uses intermediate targets to guide policy
  as a step between its tools or instruments (such
  as open-market purchases) and its goals or
  ultimate targets of price stability and stable
  economic growth
• Intermediate targets are variables the Fed can't
  directly control, but can influence and are
  related to the Fed's goals
• Most frequently used are monetary aggregates such
  as M1 and M2, and short-term interest rates

12
Monetary Policy Rules (classical)

• Rules make monetary policy automatic
• The rule should be
• simple
• specify something under the central bank's
  control
• allow the central bank to respond to the state of
  the economy
• Recall Friedman's four main propositions

13
Discretion (Keynesian)

• Discretion means the central bank looks at all
  the information about the economy and uses its
  judgment as to the best course of policy
• Discretion gives the central bank the freedom to
  stimulate or contract the economy when needed it
  is thus called activist

14
Rules and central bank credibility

• How does a central bank gain credibility?
• by building a reputation for following through,
• outside enforcement
• Credibility can be achieved by switching to
  inflation targeting
• Advantage more transparent to the public
• Disadvantage policy becomes non-credible if
  target is missed
• Other ways to achieve central bank credibility
• Appointing a "tough" central banker
• Increasing central bank independence

15
Government budget

• Categories of government expenditures
• Government purchases (G)
• Transfer payments (TR)
• Net interest payments (INT)
• Categories of taxes
• Personal taxes
• Contributions for social security
• Indirect business taxes
• Corporate taxes

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Deficits and Surpluses

• When outlays exceed revenues, there is a deficit
  when revenues exceed outlays, there is a surplus
• Total deficit G TR INT T
• Primary deficit G TR T
• The current deficit equals the deficit minus
  government investment
• The primary current deficit equals the primary
  deficit minus government investment

17
Fiscal policy and automatic stabilizers

• A rise in government purchases increases
  aggregate demand
• The effect of tax changes depends on the economic
  model (Keynesian vs. classical)
• Automatic stabilizers cause fiscal policy to be
  countercyclical by changing government spending
  or taxes automatically
• Because of automatic stabilizers, the budget
  deficit rises in recessions and falls in booms

18
Tax induced distortions and smoothing

• The difference between the number of hours a
  worker would work without taxes and the number of
  hours he or she actually works when there is a
  tax reflects the tax distortion
• Keeping a constant tax rate over time (tax rate
  smoothing) reduces the distortions

19
Government Deficits and Debt

• The growth of the government debt
• The deficit is the difference between
  expenditures and revenues in any fiscal year
• The debt is the total value of outstanding
  government bonds on a given date
• The Debt-GDP Ratio

20
Burden of the government debt

• Future generations will have to pay back the debt
  
• Future taxes may create distortions
• Government deficits reduce national saving
  leading to lower capital accumulation and output

21
Budget deficits and national saving

• When will a government deficit reduce national
  saving?
• It almost certainly does when government spending
  rises
• But it may not for a cut in taxes or increase in
  transfers, due to Ricardian equivalence
• Why could the Ricardian equivalence fail?
• Borrowing constraints
• Shortsightedness
• Failure to leave inheritance
• Distortionary taxes