Lecture Economics (18th edition): Chapter 36 - McConnell, Brue, Flynn''s

Chapter 36
Current Issues in
Macro Theory
and Policy

McGraw­Hill/Irwin

        Copyright © 2009 by The McGraw­Hill Companies, Inc. All rights reserved.


Chapter Objectives
• Alternative perspectives on
macroeconomic instability
• Equation of exchange and
monetarism
• New classical economists and
self-correction
• Rules vs. discretion in
conducting stabilization policy
36-2


Causes of Macro Instability
• Mainstream view
– Held by most economists

• Price stickiness
• Unexpected demand shocks
– Variable investment spending

• Unexpected supply shocks

36-3


Causes of Macro Instability
• Monetarist view
• Government interference is the
problem
• Equation of exchange MV = PQ
• Stable velocity
• Monetary causes of instability
– Inappropriate monetary policy
36-4


Causes of Macro Instability
• Real-business-cycle view
– Shifts in long-run aggregate supply
Price Level

ASLR2 ASLR1

P1

AD1
AD2
Q2

Q1

Real Domestic Output

36-5


Causes of Macro Instability
• Coordination failures
– Fourth modern view

• Limited information
• Expectations and self-fulfilling
prophecy
• Unemployment equilibrium
• Inflation equilibrium
36-6


Self-Correction
• New classical view

– Rational expectations theory
– Monetarists

• Automatic correction will occur
• Speed of adjustment
• Unanticipated price-level
changes
• Fully anticipated price-level
changes
36-7

Self-Correction
New Classical View of Self-Correction

Price Level

ASLR

AS2
AS1

c

P3

b

P2
a

P1

AD2
AD1

Q1

Q2

Real Domestic Output

36-8


Self-Correction
New Classical View of Self-Correction
ASLR

Price Level

AS1
AS3

P1
P4

f

a
d

P5

e

AD1
AD3

Q4 Q 3 Q1

Real Domestic Output

36-9


Self-Correction
• Mainstream view
• Downward wage inflexibility
• Efficiency wage theory
– Greater work effort
– Lower supervision costs
– Reduced job turnover

• Insider-outsider relationships
36-10


Rules or Discretion?
• In support of policy rules
• Reduce macro instability
• Monetary rule
– Shift AD to keep up with AS
– Price stability achieved

• Inflation targeting
• Balanced budget
36-11


Rationale for Monetary Rule

Price Level

ASLR1

ASLR2

P1

AD2
P2
AD1
Q1

Q2

Real Domestic Output, GDP

36-12


Rules or Discretion?
• In defense of discretionary
stabilization policy
• Discretionary monetary policy
– Velocity is not stable

• Discretionary fiscal policy
– Useful during recession

• Increased macro stability
36-13

The Taylor Rule
•
•
•
•

Rules: passive monetary policy
Discretion: active monetary policy
Hybrid policy rule to dictate Fed actions
Policy responds to changes in real GDP
and inflation
– Use the interest rate

• Fed explains deviations from the rule
• Increase Fed credibility and reduce
uncertainty
36-14


Key Terms
•
•
•
•
•
•
•
•

monetarism
equation of exchange
velocity
real-business-cycle
theory
coordination failures
rational expectations
theory
new classical
economics
Taylor rule

• price-level surprises
• efficiency wage
• insider-outsider
theory
• monetary rule
• inflation targeting

36-15


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International Trade

36-16