36 Current Issues in Macro Theory and Policy

36 Current Issues in Macro Theory and Policy Mc. Graw-Hill/Irwin Copyright © 2012 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Causes of Macro Instability • Mainstream view • Held by most economists • Price stickiness • Unexpected demand shocks • Variable investment spending • Unexpected supply shocks LO 1 36 —

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 LO 1 36 —

Causes of Macro Instability • Coordination failures • Fail to reach equilibrium because of lack of coordination mechanism • Limited information • Expectations and self-fulfilling prophecy • Unemployment equilibrium • Inflation equilibrium LO 1 36 —

Does the Economy Self Correct? • New classical view • Rational expectations theory • Monetarists • Automatic correction will occur • Speed of adjustment • Unanticipated price-level changes • Fully anticipated price-level changes LO 2 36 —

• New Classical View of Self-Correction AD 2 AD 1 AS 2 AS LRP ric e L e v e l P 1 P 2 P 3 Real Domestic Output Q 1 Q 2 a bc. Does the Economy Self Correct? LO 3 36 —

• New Classical View of Self-Correction AD 3 AD 1 AS 1 AS 3 AS LRP ric e L e v e l P 1 P 4 P 5 Real Domestic Output Q 1 Q 4 Q 3 a edf. Does the Economy Self Correct? LO 3 36 —

Does the Economy Self Correct? • Mainstream view • Downward wage inflexibility • Efficiency wage theory • Greater work effort • Lower supervision costs • Reduced job turnover • Insider-outsider relationships LO 3 36 —

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 LO 4 36 —

Rules or Discretion? • Defense of discretionary stabilization policy • Discretionary monetary policy • Velocity is not stable • Discretionary fiscal policy • Useful during recession • Policy successes LO 4 36 —

Rules or Discretion? LO 4 36 —