Economics: The Matchup of the Century - Unemployment vs. Inflation

One of the ten main principles of economics is that society faces a short run trade off between unemployment and inflation. In other words, society has to have one or the other no matter what in the short run.

Here, we define the Phillips Curve, a downward sloping curve with inflation rate on the y-axis and unemployment on the x-axis. There is a negative correlation between inflation and unemployment.

We can explain the Phillips curve using the AG demand and shot run AG supply graph. When AG demand is high, the equilibrium is at a higher output and thus lower unemployment. However, the equilibrium is at a higher price level (aka more inflation). The opposite holds true for the converse.

In the long run, the Phillips Curve is actually vertical. Classical theory states nominal changes like inflation do not affect real variables like output and unemployment. This line is located at the natural rate of unemployment. This curve also shows how monetary policies do not affect unemployment in the long run, no matter what the Fed does.

The meaning of "natural" in the natural rate of unemployment is where the economy gravitates to in the long run. This does not mean it is socially desirable, it is just spontaneous. Government policies like removing unions would then be able to shift this vertical line, in this example it would move left (less unemployment with no unions since lower wages).

Unemployment rate = Natural rate of unemployment - a (actual inflation - expected inflation)
where the variable 'a' measures how unemployment responds to unexpected inflation.

Using the above equation, we can put together the short run and long run Phillips curves. Inflation and unemployment starts at the intersection of both. When inflation rises, in the short run the equilibrium moves off the long run curve and moves along the short run Phillips curve to a point with less unemployment. Then as people expect higher inflation, the short run Phillips curve shifts right so that at the same inflation rate the two curves once more intersect.

If a supply shock happens (i.e. a shift of AG short run supply curve), the Phillips curve shifts. In the case of a negative supply shock, the Phillips curve shifts rightward, giving policymakers a worse deal between unemployment and inflation.

To reduce inflation, it comes with a cost. According to the Sacrifice Ratio, and the graph with both long run and short run Phillips curves, reducing inflation temporarily increases unemployment until in the long run inflation is reduced and output returns back to normal. The estimated sacrifice ratio is 5, i.e. 5% annual output must be sacrificed for every reduction of 1% in inflation.

Another theory disagrees. According to other economists, there is something called rational expectations. If the government makes it clear to the people that they will reduce inflation and people believe, their expectations of inflation will reduce, immediately shifting the short run Phillips Curve to put inflation lower without having to increase unemployment temporarily.

Unemployment and inflation managed to be both very low in the 1990s in the U.S. because of declining commodity prices (like the fall of OPEC, recessions in Asian countries, etc. leading to a favorable supply shock), labor-market changes (the baby-boom is theorized to reduce the natural rate of unemployment since older people tend to hold stabler jobs), and technological advance (favorable supply shock).

Economics: What in the World is Monetary and Fiscal Policy?

This chapter really goes hand in hand with the previous chapter. I don't know why Mankiw separated them like this.

Recall the wealth effect, interest rate effect, and exchange rate effect that explains why the aggregate demand curve slopes downward. These 3 effects occur simultaneously to increase quantity demanded when price level falls and decrease quantity when price level rises. The interest rate effect is most important for the U.S.

Now we will define the theory of liquidity preference. We will make another graph. In this graph, money supply is vertical, since the supply is set and controlled by the Fed. The money demand slopes downward explained in the theory of liquidity preference by interest rate. If interest rate is high, one holds less money and saves it, thus reducing money quantity demanded. If interest rate is low, one holds more money (discourages saving) so increases money quantity demanded. So the interest rate goes on the y-axis and the quantity of money goes on the x-axis. The intersection of the money supply and money demand is the equilibrium interest rate.

An example of using the theory of liquidity preference: if price level increases, the quantity of goods demanded decreases. Money demanded increases to counteract the rising prices which then reduces interest rates.

If money supply increases, equilibrium interest rate decreases. This encourages investment and shifts the aggregate demand curve.

So when the Fed wants to change the economy by changing aggregate demand, the monetary policies they make can be described as changing interest rates or changing the money supply.

Then what is fiscal policy and how does that affect the economy? Certain policies that the government decides upon that affect long run economic growth are considered fiscal.

One fiscal policy is changing government purchases. If the government spends $20 billion domestically on fighter planes, the aggregate demand curve will shift right. This shift may not necessarily be exactly 20 billion. Because of the multiplier effect, the impact could be even greater. The multiplier effect happens because increased demand causes increases in wages and profits which encourage more and more spending in different rounds.

The MPC (marginal propensity to consume) is the fraction of extra income people decide to save. If the MPC is 3/4, then an increase of 20 billion yields 20 billion / (1 - 3/4) = 80 billion total impact. This 1/(1-x) formula comes from the infinite sum of a geometric series.

The multiplier effect extends to more than government purchases. It includes recessions and stock market booms and more.

Another side effect is the crowding out effect. This occurs because an increase in demand also increases spending and reduces saving. As saving reduces, interest rates rise and investment is discouraged. This effect makes shifts in aggregate demand less.

Another fiscal policy is tax changes. Tax cuts shift the demand right and tax raises shift the demand left. This includes investment tax credit too.

Should the government use policy to stabilize the economy? Currently, the U.S. government does, according to the Employment Act of 1946. It states that government should avoid being the cause of fluctuations and also respond to changes in the economy to stabilize aggregate demand.

Keynes argues that aggregate demand fluctuates from waves of optimism and pessimism. He says that government should always counteract these waves with economic policy.

Others argue against active stabilization of economy. The primary argument is that changes in policy usually come to late, and instead cause more fluctuation. These lags happen because fiscal policies must be confirmed by legislature and the president and monetary policy takes at least six months to have effects on employment or output.

Some policies act as automatic stabilizers. For example, the tax system is an automatic stabilizer. You pay less tax if you spend/earn less and pay more tax if you spend/earn more. Government spending on welfare and other income supports also acts as an automatic stabilizer. When in recession, spending increases on these supports which increases aggregate demand and counteracts the recession.

Although these automatic stabilizers are not strong enough to stop recessions completely, they have reduced the volatility of output and employment greatly. This is why many people argue against a balanced budget for the government that would eliminate the automatic stabilizers we have already.

Economics: Unpredictable Fluctuations and Why They Happen

A recession is a mild period of falling incomes and rising unemployment, and more severe is a depression.

There are 3 key facts for economic fluctuation:

• Economic fluctuations are irregular and unpredictable
• Most macroeconomic quantities fluctuate together (real GDP, personal income, corporate profits, etc.)
• As output falls, unemployment rises

Earlier we talked about classical economics and classical dichotomy and money neutrality. If the nominal variables changed, real variables still wouldn't be changed. A doubling in prices would make everything cost twice as much but wouldn't affect employment, etc. 

However, in the short-run, classical theory does not apply. It always takes time for all prices to adjust. Thus, we build the model of aggregate demand and aggregate supply. On the x-axis is the real GDP, the quantity of output. On the y-axis is the CPI/GDP deflator, the average level of prices. Remember that this is not simply another supply and demand chart, this is macroeconomics. 

The aggregate demand curve slopes downward, but why? Recall that Y = C + I + G + NX. 

• The price level and consumption (wealth effect): a decrease in price level raises the dollar value making consumers wealthier and more willing to spend, increasing quantity demanded.
• The price level and investment (interest rate effect): a decrease in price level decreases interest rate (since households save more as their money is worth more), and causes more investment and thus causes greater quantity of goods/services demanded.
• The price level and net exports (exchange rate effect): a decrease in price level makes the dollar depreciate and increases net exports, thus making the quantity of goods and services demanded increase.

Why might the aggregate demand curve shift?

• changes in consumption (concerns about saving vs. spending)
• changes in investment
• changes in government purchases (e.g. if the government wants to build more highways, it shifts right)
• changes in NX

Now we talk about the aggregate supply curve. In the long run, the aggregate supply curve is vertical because it represents a country's real GDP and depends on its supplies of labor, capital, and natural resources and on its available technology. This agrees with money neutrality (when price level changes, real GDP doesn't change).

The long run aggregate supply curve could shift from:

• changes in labor
• changes in capital
• changes in natural resources
• changes in technological knowledge

Note that short run fluctuations in output and price level should only be viewed as deviations from continuing long term trends of output growth and inflation.

Why does the short term aggregate supply curve slope upwards?

• sticky wage theory: wages are sticky (if prices are low, it is less profitable with the high cost of labor so firms cut workers and production in the short term)
• sticky price theory: prices take time to adjust since there are menu costs
• misperceptions theory: when overall price level drops, an individual could misperceive relative prices dropping and act accordingly. (e.g. farmers noticing wheat prices dropping before other product prices and responding by producing less wheat)

The short term aggregate supply curve shifts from changes in the expected price level. A rise in the expected price level reduces the quantity of goods and services supplied and shifts short tun aggregate supply curve to the left, and this statement works conversely as well.

If the aggregate demand curve shifts, for example to the left, output falls in the short run in order to maintain equilibrium with the short run aggregate supply. Since price level has dropped below expectations, eventually the short term aggregate supply curve shifts to the right, bringing output back to where the graph started at the long run aggregate supply curve. Policy makers could shorten the recession period by trying to increase aggregate demand curve by increasing government spending for example.

If the short run aggregate supply curve shifts, output temporarily decreases and price level increases. (This phenomenon is called stagflation: inflation and reduced output, stagnation). A wage-price spiral could occur, where workers demand more wages as prices increase. This causes an increase in firms' costs and makes the supply curve shift even further to the left. However, this eventually stops when the lower level of output and increased employment finally make wages decrease. The shift eventually then reverses to come back to equilibrium where output is back at the start at the long run aggregate supply curve. Policymakers could potentially mitigate the impact of the aggregate supply curve shift by increasing the aggregate demand so that equilibrium remains at the natural rate of output (called accommodating shift). This still causes an increase in price level though.