Expectations and Macroeconomic Stabilization Policies

1
Expectations and Macroeconomic Stabilization
Policies

• Adaptive and Rational Expectations

2
Adaptive Expectations

• Adaptive Expectations
• Expectations depend on past experience only.
• Expectations are a weighted average of past
  experiences.
• Expectations change slowly over time.

3
Rational Expectations

• Expectations that are based on all available
  information past and present as well as on a
  basic understanding of how the economy works.
• The theory of rational expectations states that
  expectations will not differ from optimal
  forecasts using all available information.

4
Rational Expectations

• Rational expectations mean that expectations will
  be identical to optimal forecasts (the best guess
  of the future) using all available information,
  but..
• It should be noted that even though a rational
  expectation equals the optimal forecast using all
  available information, a prediction based on it
  may not always be perfectly accurate.

5
Non-rational Expectations

• There are two reasons why an expectation may fail
  to be rational
• People might be aware of all available
  information but find it takes too much effort to
  make their expectation the best guess possible.
• People might be unaware of some available
  relevant information so their best guess of the
  future will not be accurate.

6
Rational Expectations Implications

• If there is a change in the way a variable moves,
  there will be a change in the way expectations of
  this variable are formed.
• Therefore, the forecast errors of expectations
  will be random with a mean of zero, unrelated to
  those made in previous periods, revealing no
  discernable pattern, and have the lowest variance
  compared to other forecasting methods.

7
The New Classical vs. New Keynesian Debate
8
The Fooling Model

• Components
• Aggregate Supply
• Production function
• Determines the relationship between employed
  factors of production and total output.
• Labor Market
• Determines employment of labor and the real wage.
• Aggregate Demand

9
The Fooling Model

• The distinctive features of this model are
• All markets clear.
• The adjustment process of market clearing is
  the essence of the model.
• The market is cleared when it is in equilibrium.
• Equilibrium is a state of rest where there are
  no forces causing change or there are equal
  opposing forces.
• Business cycles can occur only if workers have
  imperfect information about prices and as a
  result inaccurately perceive price level changes.

10
Equilibrium
LAS
P
SAS0(Pe0)
At point E0, the model is in long- run and
short-run equilibrium. AD SAS LAS The
equilibrium price level is P0 and the full
employment equilibrium output is YN
E0
P0
AD0
0
YN
Y
11
Employment

• Assumptions
• Labor demand is determined by the real wage.
• When the actual price level changes, workers
  price expectations do not change.
• Labor supply is determined by the expected real
  wage that is, the nominal wage divided by the
  price level expected by the workers.

12
The Fooling Model
LAS
SAS0(Pe0)
W/P
P
Ls(W/Pe)
W1/P0
D
W0/P0
E0
C
P1
C
AD1
W1/P1
E0
P0
AD0
Ld(W/P)
0
0
L0 L1
L
Y
YN Y1
Employment
Real GDP
13
AD-AS Model

• The initial equilibrium exists at E0.
• At E0, Y equals YN and P equals P0.
• The increase in aggregate demand shifts the
  aggregate demand curve from AD0 to AD1.
• The price level rises from P0 to P1, causing the
  real wage to fall from W1/P0 to W1/P1.
• Output increases from YN to Y1.
• The new equilibrium exists at C.
• At C, Y equals Y1 and P equals P1.

14
Employment

• The increase in aggregate demand raises the
  actual price level and reduces the actual real
  wage, encouraging firms to hire more workers.
• The workers do not realize that the real wage has
  fallen. As a result, they work more.
• At L1, the real wage equals W1/P1 while the
  nominal wage paid to the workers is W1/P0.
• The workers supply L1 labor, moving up the labor
  supply curve to point D.

15
The Fooling Model
LAS
SAS0(Pe0)
W/P
P
Ls(W/Pe)
W1/P0
D
W0/P0
E0
C
P1
C
AD1
W1/P1
E0
P0
AD0
Ld(W/P)
0
0
L0 L1
L
Y
YN Y1
Employment
Real GDP
16
Fooling Model Long Run Adjustment
SAS(Ls(W/P1))
P
SAS(Ls(W/P0))
When workers realize that the real wage has
fallen, they demand a higher nominal wage. The
increase in the nominal wage causes the SAS to
shift left. A new equilibrium is established at
D.
P2
D
P1 P0
C
B
AD1
AD0
0
YN Y1
Y
17
Fooling Model Long Run Adjustment
SAS(Ls(W/P3))
P
SAS(Ls(W/P1))
SAS(Ls(W/P0))
At point D, the real wage has fallen again,
causing workers to demand a higher nominal
wage. As nominal wages increase, the SAS shifts
left.
E3
P3
P2
D
P1 P0
C
E0
AD1
AD0
0
YN Y1
Y
18
Fooling Model Long Run Adjustment
SAS(Ls(W/P3))
P
SAS(Ls(W/P1))
SAS(Ls(W/P0))
Long-run equilibrium is restored at point E3. At
this point, the nominal wage has risen such that
W3/P3 W0/P0.
E3
P3
P2
D
P1 P0
C
E0
AD1
AD0
0
YN Y1
Y
19
Long Run Aggregate Supply

• The long-run aggregate supply curve is a vertical
  line drawn at the natural level of real GDP.
• It shows that in the long-run expectations are
  accurate.
• It shows that long run equilibrium in the labor
  market can be achieved at many different price
  levels but only a single level of output.
• Long-run equilibrium occurs when labor input is
  the amount voluntarily supplied and demanded at
  the equilibrium real wage.

20
Fooling Model Summary

• Business cycles are explained in this model by
  permitting the actual price level to differ from
  the price level expected by the workers.
• However, when the workers learn they have been
  fooled, their price expectations rise and they
  demand a wage sufficient to regain the original
  real wage.
• The SAS curve shifts up and to the left until
  output has returned to YN.
• The model demonstrates that in the long run
  shifts in aggregate demand have no long-run
  effect on real GDP.

21
Rationale Behind the Fooling Model

• Friedman claims that firms have more accurate
  information than workers because they need to
  know only a small number of prices of particular
  products and can monitor them continuously.
• Workers, however, are interested in a wide
  variety of prices and have insufficient time to
  keep careful track of them.

22
Criticisms of the Fooling Model

• It is unlikely that workers would be fooled for
  long because
• Workers buy many goods and would notice quickly
  when their prices rose.
• Expectational errors would be corrected quickly
  because information about price level changes are
  readily available from the government and the
  media.
• If a periods of high real GDP were always
  accompanied by an increase in the price level,
  workers would learn to predict rising prices when
  production was high and jobs were plentiful.

23
Friedman-Lucas Model

• Assumptions
• Markets clear
• Information is imperfect
• Expectations are rational
• Expectations that are based on all available
  information past and present as well as on a
  basic understanding of how the economy works.

24
Friedman-Lucas Model

• The Model
• Each firm in the economy produces in very
  competitive markets.
• The firm has no pricing power.
• Each firm knows the price of what it produces,
  but does not know about the prices of other
  products.
• This imperfect information leads to confusion
  about changes in the overall price level and
  changes in relative prices that affect the slope
  of the short-run supply curve.

25
Friedman-Lucas Model

• The Model
• The amount of output a supplier chooses to
  produce depends on relative prices.
• If the price of his output is high compared to
  other prices, he is motivated to work hard and
  produce more.
• If the price of his output is low compared to
  other prices, he prefers more leisure.
• When the supplier makes his decision about how
  much to produce, he knows the price of his output
  and forms his expectations about prices of the
  other goods available using rational expectations.

26
Friedman-Lucas Model

• Let all prices rise.
• If past movements in the firms price have always
  been accompanied by similar movements in the
  prices of other firms, the owner will expect
  relative prices to remain unchanged and will not
  produce more.
• If the firms price has experienced unique price
  movements compared to other firms, the owner may
  conclude that relative prices have changed, and
  may produce more or less.

27
Friedman-Lucas Model

• Produce More
• If the supplier determines that his price rose by
  more than other prices, he produces more.
• Produce Less
• If the supplier determines that his price rose by
  less than other prices, he produces less.
• The short-run aggregate supply curve can be
  written as
• Y YN h(P - Pe)

28
Output and Price Expectations

• Y YN h(P - Pe)
• P gt Pe,
• If P gt Pe, the supplier works harder, Y rises.
• P lt Pe
• If P lt Pe, the supplier works less, Y falls.
• P Pe
• If P Pe, there is no change so Y YN

29
Friedman-Lucas Model
P
The Friedman-Lucas supply curve is fixed in
position by the price expectations of
workers. Real GDP can rise above YN in the blue
area only when the actual price level rises above
the expected price level. An increase in the
expected price level shifts the curve up from
SAS1 to SAS 2.
LAS
SAS2(Pe1)
P1
SAS1(Pe0)
P0
Y
0
YN
30
Implications of the Model

• The major contribution of Lucass model is the
  conclusion that the supply response will be high
  for firms that have previously experienced unique
  price movements and low for firms that have
  experienced price movements that mirror the
  aggregate economy.

31
Implications of the Model Business Cycle

• Lucas also concluded that the supply response
  would be higher in countries like the USA where
  inflation had been relatively stable, making
  unique price movements in individual prices
  easier to discern.
• This means that smaller changes in the price
  level lead to larger changes in output and as a
  result a bigger cyclical response.
• The SAS in the USA is more elastic or flatter
  than the SAS in other countries.

32
Implications of the Model Macro Stabilization

• According to the rational expectations
  hypothesis, monetary policy actions that
  individuals and firms anticipate have no effect
  on real variables such as output and employment.
• This is known as the policy ineffectiveness
  proposition.
• Only unanticipated policy actions that people
  cannot predict in advance can influence real GDP
  and employment.

33
Policy Ineffectiveness Proposition

• Let expectations of the price level, Pexp, depend
  in part on their expectation of how the
  government will change macroeconomic policy.
• Also assume that people can anticipate government
  policy with a great deal of accuracy ie. they
  know the policy rule.

34
Policy Ineffectiveness Proposition

• Expansionary monetary policy actions cause an
  increase in aggregate demand.
• If people correctly forecast those policy
  actions, then they fully anticipate the change in
  the price level that the actions will induce.
• As price expectations change, wage demands
  change, causing an offsetting change in aggregate
  supply.

35
Policy Ineffectiveness Proposition
AS1
AS2
P
Rational expectations cause offsetting changes in
AD and AS. P rises but Y remains constant.
P2
P1
AD2
AD1
0
Y1 Y
Anticipated Policy Changes
36
Unanticipated Policy Changes

• If people do not correctly forecast the
  governments policy actions, then they do not
  correctly forecast the change in the price level
  induced by the policy change.
• In this case, as the price level rises output
  increases along the aggregate supply curve.

37
Unanticipated Policy Actions

• Expansionary monetary policy actions cause a
  rightward shift in the aggregate demand curve.
• If people do not correctly forecast those policy
  actions, then they do not correctly forecast the
  change in the price level induced by the policy
  change.
• As the price level rises, output increases along
  the SRAS.

38
Unanticipated Policy Actions
AS1
P
Only unanticipated policy changes result in a
change in output. In this case, both the
price level and output rise.
P2
P1
AD2
AD1
0
Y1 Y2 Y
Unanticipated Policy Changes
39
Summary

• The new classical analysis suggests that
• An unanticipated increase in the money supply
  raises the price level and has no effect on real
  output and employment
• Only unanticipated monetary surprises can affect
  real variables in the short run.

40
Policy Ineffectiveness Conclusions

• The development of rational expectations ignited
  a major controversy among economists because the
  model yielded an implication of policy
  ineffectiveness that directly challenged the
  mainstream view that active fiscal and monetary
  policies are needed to moderate the inherent
  instability of a market economy.

41
Policy Ineffectiveness Conclusions

• The research on expectations that followed the
  introduction of rational expectations
  increasingly supported the rapid expectations
  adjustment implied by rational expectations over
  the sluggish adjustment of adaptive expectations.
• This suggested that price misperceptions would
  disappear so quickly that there was no time for
  countercyclical policies to be implemented.
• Later work, however, found evidence that
  suggested that both unanticipated and anticipated
  monetary policy affected output and employment.

42
Policy Ineffectiveness Conclusions

• Ultimately, a consensus was reached that the key
  issue is not how price expectations are formed,
  but whether changing expectations are really the
  only important source of output fluctuations.
• New approaches rely on underlying sources of
  friction in the market clearing process to
  explain business cycles.

43
Rational Expectations and the Sacrifice Ratio

• The amount of output lost during disinflation is
  known as the sacrifice ratio.
• The size of the sacrifice ratio depends in part
  on how fast price expectations adjust.
• If they adjust slowly, the sacrifice ratio will
  be large, but if they adjust quickly, the ratio
  will be smaller.

44
Rational Expectations and the Sacrifice Ratio

• The responsiveness of expectations depends on the
  credibility and reputation of the monetary
  authority or the Federal Reserve.
• The new classical approach argues that announced
  changes in monetary policy will have no effect on
  output and employment if the policy is credible.
• If the policy announcements lack credibility,
  inflationary expectations will not fall
  sufficiently to prevent the economy from
  experiencing output-employment costs.

45
Real Business Cycle Model

• The real business cycle model explains business
  cycles in output and employment as being caused
  by real shocks.
• The origins of the business cycle lie in real
  shocks rather than monetary shocks.
• This suggests that changes in the SAS curve and
  the IS curve, but not the LM curve, explain
  cycles.
• Real business cycle theorists give the largest
  role to production function shocks or supply
  shocks.

46
Real Business Cycle Shocks

• Supply shocks include the following
• New production techniques and/or new products
• New management techniques
• Changes in the quality of capital or labor
• Changes in the availability of raw materials
• Price changes in raw materials
• Demand shocks include the following
• Changes in spending and saving decisions
• Changes in real government spending
• These shocks are assumed to be persistent,
  tending to fade away smoothly after several years.

47
Real Business Cycle Features

• General Features
• Agents try to maximize their utility or profits,
  given prevailing resource constraints.
• Agents form expectations rationally and do not
  suffer informational asymmetries. Agents may
  have difficulty determining whether a shock is
  temporary or permanent, but information
  concerning the path of the general price level is
  publicly available.
• Price flexibility ensures continuous market
  clearing so that equilibrium always prevails.

48
Real Business Cycle Features

• General Features
• Fluctuations in aggregate output and employment
  are driven by large random changes in the
  available production technology.
• Fluctuations in employment reflect voluntary
  changes in the number of hours people want to
  work.
• Monetary policy is irrelevant and has no
  influence on real variables.
• There is no distinction between the short-run and
  the long-run.

49
Real Business Cycle Model

• In real business cycle models, people are assumed
  to supply more labor when the real wage is high
  and less labor when the real wage is low.
• This propensity to supply more labor during
  periods of high real wages and less labor during
  periods of low wages is called intertemporal
  substitution.

50
Real Business Cycle Model

• As a result of intertemporal substitution, real
  business cycle models explain unemployment as the
  voluntary decision of workers to reduce their
  labor supply in response to temporary declines in
  their real wage.
• This means there is no need for government policy
  intervention to reduce unemployment associated
  with recession.

51
Y
Y
Y1F(L)
1
Y1
Y2F(L)
2
Y2
L
Y
0
0
P
w/P
AS2
LS
AS1
1
w1/P1
2
P2
2
w1/P2
1
P1
AD
LD1
LD2
0
L1
L2
Y2
0
Y1
Y
L
52
Real Business Cycle Model Adverse Shock

• Adverse shocks decrease productivity
• The production function shifts down.
• The labor demand curve shifts to the left.
• The decrease in demand for labor decreases the
  real wage, causing a voluntary decrease in labor
  supply along the labor supply curve.
• Aggregate supply decreases, causing an increase
  in the price level given a fixed aggregate
  demand.
• At the new equilibrium the price level rises to
  P2, and output falls to Y2.

53
Full Employment IS-LM Model
At E1, the economy is at full employment at the
interest rate r1 and output YN. An adverse
supply shock reduces full employment output from
YN to Y2, causing the FE line to shift to the
left and the price level to rise. Given a fixed
nominal money supply, the real money supply
decreases, causing the LM curve to shift to the
left to LM2. At the new equilibrium, output
equal Y2 and the interest rate is r2. Full
employment exists at a lower level of Y
FE2
FE1
LM1
LM2
r
r2
E2
E1
r1
IS
YN Y
0
Y2
54
Adverse Supply Shock Conclusions

• An adverse supply shock lowers the equilibrium
  values of the real wage and employment.
• At the new equilibrium level of output, the
  supply shock causes output to fall and interest
  rates to rise.
• The supply shock raises the price level, causing
  a temporary burst of inflation.
• Because interest rates are higher in the new
  equilibrium, other things remaining the same,
  saving increases, consumption decreases, and
  investment decreases.

55
Real Business Cycles Facts

• Real business cycle theory (RBC) is consistent
  with many of the basic business cycle facts.
• Under the assumption that the economy is
  continuously buffeted by productivity shocks, the
  RBC approach predicts recurrent fluctuations in
  aggregate output, which actually occur.
• The RBC theory correctly predicts that employment
  will move procyclically with output.
• The theory predicts that real wages will be
  higher during booms than in recessions, which
  also occurs.

56
Real Business Cycles Facts

• According to RBC theory, average labor
  productivity is procyclical that is, output per
  worker is higher during booms than during
  recessions.
• This fact is consistent with the RBC theorists
  assumption that booms are periods of beneficial
  productivity shocks, which tend to raise
  productivity while recessions are the result of
  adverse shocks which lower productivity.

57
Real Business Cycles Facts

• With no productivity shocks and a stable
  production function, the expansion of employment
  that occurs during booms would tend to reduce
  average labor productivity because of the
  principle of diminishing marginal productivity of
  labor.
• Similarly, without productivity shocks,
  recessions would be periods of relatively higher
  labor productivity, instead of lower productivity
  as observed.
• RBC theorists argue that the procyclical nature
  of average labor productivity provides strong
  evidence of their approach.

58
Real Business Cycles Facts

• A business cycle fact that is not consistent with
  the RBC theory is that inflation tends to slow
  during or immediately after a recession.
• RBC theory predicts that an adverse productivity
  shock will both cause a recession and inflation,
  contrary to business cycle fact.

59
Real Business Cycle Criticisms

• It is hard to measure certain types of real
  shocks (such as the annual rate of technological
  change in computer software.)
• Since many real shocks are not readily
  observable, one can explain any change in output
  as the result of some unobserved real shock
• It is hard to believe that the unemployment that
  occurred during the Great Depression and similar
  downturns was voluntary.

60
Real Business Cycle Criticisms

• Labor supply of individual workers does not
  appear to be sufficiently responsive to
  intertemporal wage differences to explain the
  bulk of variation in the use of labor over the
  business cycle.
• If shocks are technological in nature, they are
  likely to be both industry specific and to
  average out in the aggregate economy.

61
Real Business Cycle Defense

• Some real shocks such as those due to natural
  disasters are observable.
• Even if it is hard to measure the precise state
  of technology, we know that there are shocks to
  technology, even if we cant measure precisely
  their size and frequency.
• Although one could explain all macroeconomic
  fluctuations by assuming enough shocks of the
  right form, the question is whether one can
  explain a good deal of the variation over time in
  macro variables based on a limited and plausible
  set of shocks.

62
Real Business Cycle Defense

• Much of he blame for the Great Depression may be
  placed on the banking panics of the early 1930s,
  the failure of large numbers of banks, the
  collapse of credit, and the subsequent closing of
  many business. These events could be viewed as a
  type of aggregate productivity shock leading to
  very low real wages.

63
Real Business Cycle Defense

• The reason that workers dont alter their hours
  of work in response to changes in their real
  wages as much as the simple real business cycle
  models predict is that their employers find it
  more profitable to require each worker to work
  full-time.
• Therefore, firms lay off workers in downturns
  rater than permit those they dont lay off to
  work less than full time. These layoffs explain
  the unemployment experienced in recessions.
• Industry specific shocks may be correlated and,
  thereby, produce an aggregate shock.

64
Efficiency Wage Theory Overview

• The efficiency wage theory explains slow
  adjustment of wages relative to prices or by
  stressing the reasons why firms would not want to
  cut the wage they pay relative to the wage paid
  by other firms.
• According to this theory, a firm believes that
  the productivity of its workers will increase if
  the firm pays a higher wage.
• Higher wages lead to greater productivity, less
  shirking, lower turnover as well as attracts
  higher quality workers and improves morale.

65
Efficiency Wage Model

• Assumptions
• Firms operate in a very competitive environment.
• Labor input is multiplied by an efficiency factor
  that is a measure of effort and depends on the
  wage rate paid relative to that paid by other
  firms.
• Raising the nominal wage raises labor costs, but
  also reduces labor cost per unit of output by
  making workers more efficient.
• Firms choose their wages to minimize the wage
  bill and then choose employment to maximize
  profit.

66
Wage Rate and Worker Efficiency
e
W/e
Effort Curve
0
0
W
W
W
W
Worker efficiency increases faster than the
relative wage up to point W and more slowly
thereafter. As a result, labor cost per unit of
efficiency (W/e) reaches a minimum at W.
67
Deriving the Short Run Aggregate Supply Curve
Efficiency Wages

• Assumptions
• Nominal wages are fixed by whatever technological
  and institutional factors that determine the
  efficiency function.
• Firms choose their wages to minimize the wage
  bill and then choose employment to maximize
  profit.
• Consequently, the firms reaction to any change
  in demand for its product is to cut employment
  while maintaining the nominal wage rate.

68
YF(L)
Y
Y
Y1
0
L
Y
0
L1
Y1
w/P
P
LS
U
w1/P1
P1
LD
0
Y
L1
0
Y1
LS
L
69
Deriving the Modern Aggregate Supply Curve
Efficiency Wages

• We begin at the price level P1 where w1/P1 is
  the efficiency wage.
• At w1/P1, the level of unemployment is at the
  natural rate of U.
• L1 people are employed and LS minus L1 are
  unemployed.
• Output equals Y1 at the price level P1.

70
YF(L)
Y
Y
Y2 Y1
0
L
Y
0
L1 L2
Y1 Y2
w/P
P
SAS
LS
U
w1/P1
P2 P1
U
w1/P2
LD
0
Y
L1 L2
0
L
Y1 Y2
71
Deriving the Modern Aggregate Supply Curve
Efficiency Wages

• Let the price level increase to P2 .
• Since nominal wages do not change, the real wage
  falls to w1/P2.
• Firms try to hire more workers while households
  send fewer workers to the labor market.
• Unemployment falls below U.
• Output rises to Y2 at the price level P2.

72
YF(L)
Y
Y
Y2 Y1 Y3
0
L
Y
0
L3 L1 L2
Y3 Y1 Y2
w/P
P
U
SAS
LS
w1/P3
U
w1/P1
P2 P1 P3
U
w1/P2
LD
0
Y
L3 L1 L2
0
L
Y3 Y1 Y2
73
Deriving the Modern Aggregate Supply Curve
Efficiency Wages

• Let the price level decrease to P3 .
• Since nominal wages do not change, the real wage
  rises to w1/P3.
• Firms reduce employment while households send
  more workers to the labor market.
• Unemployment rises above U.
• Output falls to Y3 at the price level P3.

74
The Modern Aggregate Supply Curve Efficiency
Wages

• Summary
• When nominal wages are sticky, a rise in the
  price level results in higher levels of output,
  and a fall in the price level results in lower
  levels of output.
• When we plot the price level/output combinations,
  we get an upward sloping aggregate supply curve.
• Nominal wage is constant on any given aggregate
  supply curve.

75
The Modern Aggregate Supply Curve Efficiency
Wages

• Summary
• When the real wage equals the efficiency wage,
  unemployment is equal to its natural rate, and
  the quantity of output produced is called the
  natural rate of output.

76
Economic Policy

• Unlike the new classical model according to
  new-Keynesian theory, the labor market may not
  always be in equilibrium.
• When nominal wages are sticky, labor demand can
  be less than labor supply.
• As a result, the economy can experience extended
  periods when markets do not clear.
• Consequently, it is possible for macroeconomic
  stabilization policies to change the level of
  output in the short run.

77
Y
Y
YF(L)
0
L
Y
0
LAS
w/P
P
SAS
LS
U
w1/P1
P1
AD1
LD
0
Y
0
L1 L
Y1 Y
L
78
The Efficiency Wage Model

• We begin at the price level P1 where w1/P1 is
  the efficiency wage.
• At w1/P1, the level of unemployment is at the
  natural rate of U.
• L1 people are employed and Ls minus L1 are
  unemployed.
• Output equals Y1 at the price level P1.

79
Y
Y
YF(L)
0
L
Y
0
LRAS
LRAS
w/P
P
SRAS
LS
2
w1/P1
P2
w1/P2
P1
AD2
1
AD1
LD
0
Y

0
L1 L2 L
L
Y1 Y2 Y
80
The Efficiency Wage Model Aggregate Demand
Increase

• Let the money supply increase, causing the
  aggregate demand curve to shift to the right.
• The price level rises to P2, and the real wage
  falls to w1/P2.
• Labor demand rises to L2 while labor supply
  responds with a lag.
• Unemployment falls below the natural rate.
• Output rises to Y2.

81
Y
Y
YF(L)
0
L
Y
0
LRAS
LRAS
w/P
P
SRAS
LS
w1/P2
w1/P1
P1
1
P2
2
AD1
LD
AD2
0
Y
L2
0
L1
L
Y2 Y1 Y
L
82
The Efficiency Wage Model Aggregate Demand
Decrease

• Let the money supply contract, causing the
  aggregate demand curve to shift to the left.
• The price level falls to P2, and the real wage
  rises to w1/P2.
• Labor demand falls to L2while labor supply rises.
• Unemployment rises above the natural rate.
• Output falls to Y2.

83
The Efficiency Wage Model The Non-Neutrality of
Money

• A change in the money supply does not cause all
  the variables to change in proportion because the
  nominal wage is slow to adjust.
• Rather, the change in the money supply causes a
  change in production and employment as well as a
  change in prices.
• In this model, the economy adjusts through
  changes in real variables as well as prices.

84
Implications

• The efficiency wage approach predicts the widely
  observed phenomenon that workers line up for high
  paying jobs but firms hire only a few of them,
  maintaining the high wage in order to be able to
  pick and choose rather that reduce the wage rate
  in the face of abundant supply of workers.
• The theory also predicts that less productive
  workers, those whose labor cost per efficiency
  unit is high, will suffer higher unemployment
  rates than more productive groups.

85
Implications

• The model explains why we do not use work sharing
  in the form of fewer hours per week in periods of
  low demand. Such wage reductions would raise
  labor cost by cutting the wage income and hence
  the efficiency of the most productive workers.
• Finally, the model explains why a firm may find
  it profitable to keep wages above the level that
  balances demand and supply, causing a lower rate
  of job finding and higher unemployment.

86
Supply Side Fiscal Policy
87
Supply Side Economics

• Supply side economics predicts that a reduction
  in marginal income tax rates will create an
  increase in the supply of output, that is, in
  natural GDP.

88
Fiscal Policy Supply Side Transmission Mechanism
Inflation Falls
Unemployment Falls
After-tax Wage Higher
Increase in Labor Supply
Aggregate Supply Rises
Lower Personal Tax Rates
Productivity Rises
Interest Rates Fall
Savings Rise
After-tax ROR Rises
Investment Rises
Lower Business Tax Rates
89
Fiscal Policy Supply Side

• Expansionary Fiscal Policy
• The federal government decreases taxes.
• People work more People save more Firms invest
  more.
• Aggregate supply increases, unemployment falls,
  inflation falls.

90
Tax Cuts Labor Supply

• The decrease in marginal income tax rates
  encourages people to work more.
• People are willing to work more because they now
  keep more of their wages.
• More specifically, they get to keep more of the
  last dollar earned.
• Therefore, the increased labor supply increases
  output without putting upward pressure on wages.

91
Tax Cuts Saving and Investment

• Business tax cuts increase business profits.
• Higher profits encourage investment in new
  capital.
• Individual tax cuts stimulate household savings.
• Increased savings contribute to lower interest
  rates and increased investment in new capital.
• New capital increases productivity, thus,
  lowering costs and inflationary pressures.

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Supply-Side Fiscal Policy Problems

• Small Magnitude of the Supply-side Effects.
• Savings do not appear to respond to tax
  incentives.
• Demand Side Effects.
• People respond to tax cuts by spending more.
  They may or may not respond by working more.
• Timing Problems
• The impact of increases in investment spending
  occur much later as industrial capacity increases.

93
Supply-Side Fiscal Policy Problems

• Effect on Income Distribution
• Supply-side tax cuts favor the wealthy.
• Tax Cuts Increase the Budget Deficit
• But, so do demand-side tax cuts.

94
Criticisms of Supply Side Economics

• Most economists agree with the basic ideas behind
  supply-side economics, but question the magnitude
  of the changes that occur as a result of marginal
  tax decreases.
• In particular, the response of labor supply to
  the decreases in taxes was quite small.