Congress says that the Fed should focus on what? But now what are they saying?
High employment and stable prices. Just to focus on inflation (cause it can cause instability in the economy if you keep messing with the money supply)
Time-inconsistency Problem
When policy makers have an incentive to announce on policy in order to influence expectations but then pursue a different policy once those expectations have been formed and acted on
A fully anticipated expansionary policy______if the economy is already producing its potential
Has no effect on output or employment, not even in the short run
A unanticipated expansionary policy ______if the economy is already producing its potential
Can temporarily push output beyond its potential and lead to temporary increase in output and employment. However, there is inflation in the long term and credibility loss of the Fed
European Central Bank only has one objective. Name that objective.
Price stability
Velocity of Money
The average number of times annually each dollar is used to purchase final goods and services
Quantity Theory of Money
If the velocity of money is stable, or at least predictable, changes in the money supply have predictable effects on nominal GDP
Money supply is...
A residual
Phillips curve is the _____of SRAS
Mirror image. So when you move up the SRAS then you are moving up the Phillips curve
Active Approach
1) Economy is relatively unstable and unable to recover from shocks when they
2) Economic fluctuations arise primarily from the private sector, particularly investment, and natural market forces may not help much or may be too slow once the economy gets o
Passive Approach
1) Economy is relatively stable and able to recover from shocks, and if economy derails natural market forces and automatic stabilizers will get it back on track
2) Active discretionary policy is unnecessary and potentially harmful and may contribute to t
According to the passive approach, how is the economy self-correcting?
1) Wages and prices are flexible enough to adjust within a reasonable period to labor shortages or surpluses
2) NATURAL MARKET FORCES
3) AUTOMATIC STABILIZERS- already build into taxes, transfers, and gov't purchases
According to the active approach, why are discretionary/monetary policies necessary?
1) Wages/prices are not that flexible, esp in the downward direction
2) Adverse supply shocks/sagging demand push unemployment above natural rate and market forces are too slow to respond
3) High cost of passive approach b/c the longer market forces take
When closing a recessionary gap, describe the shift in the graph in reaction to 1) passive approach 2) active approach
1) SRAS curve shifts to the right. High unemployment causes real wages to fall, reducing production costs
2) AD curve shifts right (gov't tries to stimulate demand)
Describe the passive approach's reasoning on why an expansionary gap would be eliminated through natural market forces
1) Firms/businesses will negotiate higher wages, which increase nominal production costs and through a decrease of the SRAS there is a shifting of the curve to the left
What are the problems with active policy?
1) Identifying the economy's potential output and natural rate of unemployment is hard to do
2) An effective policy needs a detailed knowledge of current and future economic conditions. Policy makers need to forecast AD and AS
3) Must be able to predict e
Recognition Lag. Give an example
1) Time needed to identify a macroeconomic problem and assess its seriousness
2) Data is revised so many times.
3) Ex. the gov't releases an advanced estimate, a preliminary estimate, and a final estimate more than a month apart, and often these are revis
Why is it hard to identify a recession during a recession?
1) Not usually identified until > 6 mo after it begins
2) Average recession is about 11 mo
3) Average lag b/w recession's end and official announcement that it has ended is about 15 mo
Decision-making lag. Who has the advantage?
1) Discretionary fiscal policy- Congress and prez must agree, take months/year(s) to develop/approve
2) shorter for monetary policy than fiscal policy (Fed doesn't have to wait for meetings)
Implementation Lag. Who has the advantage?
1) Time needed to introduce a change in monetary or fiscal policy
2) Monetary policy has the advantage over fiscal policy, since Fed can immediately buy/sell bonds to change bank reserves and therefore federal funds rate
3) Fiscal policy can take more tha
Effectiveness Lag
1) Time needed for changes in monetary or fiscal policy to affect the economy
2)
Inflationary Pressure. What are the 2 kinds and describe them.
1) Demand/supply-side pressures that can cause a rise in the general price level
2) Demand-pull inflationary pressure- When total demand for goods and services exceeds total
3) Cost-push inflationary pressure- when firms increase prices to maintain or pro
Effectiveness Lag. Why would this cause some policies to be ineffective/not necessary?
1) Time needed for changes in monetary or fiscal policy to affect the economy
2) For monetary policy- lag b/w change in federal funds rate and AD and output ranges from months to >1 year
3) For fiscal policy- usually takes 3-6 mos to take effect and 9-18
How do lags support the passive approach?
These lags show that an active stabilization policy imposes troubling fluctuations in the price level and real GDP b/c it often takes hold only after market forces already have returned the economy back to its potential output level
During troubled times, what type of policy is more favored by voters? Passive or Active?
Active
Rational expectations. Explain how this would affect aggregate supply?
1) School of thought that argues people form expectations based on all available info, including likely future actions of gov't policy makers
2) Aggregate supply depends on what sort of macroeconomic course policy makers are expected to pursue
3)
Time-inconsistency problem
When policy makers have an incentive to announce on policy to influence expectations but then pursue a different policy once those expectations have been formed and acted on
Talk about the public's distrust in the Fed/gov't
So if policy makers say they are going to implement one policy, but then end up changing the policy, this makes it less likely for the Fed's announcement to influence the public's expectations and the public will learn to distrust future Fed announcements
What would the Fed probably do if the public expects expansionary monetary policy but they announced they want to keep price levels stable?
1) Probably pursue an expansionary monetary policy even if it means increasing inflation
2) Workers and firms will negotiate higher wages, and if the Fed keeps price levels the same, then output would be less than the potential output. If the Fed pursues
Which is more harmful according to rational expectations if the economy is already producing its potential: a fully anticipated expansionary policy, or an unanticipated expansionary policy?
1) Unanticipated- can temporarily push output beyond its potential
2) Anticipated- has no effect on output or employment
Cold Turkey
The announcement and execution of tough measures to reduce high inflation
Complete this statement: For the Fed to pursue a policy consistent with a constant price level, its announcements must somehow be ___________
credible
What is the determining factor of the Fed's pronouncement, execution, and result of their policies in whether their policies will work or not?
CREDIBILITY
By law, the Fed must_____________________
Promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates
How is the Fed independent but still tied to the U.S. gov't?
1) Doesn't rely on congressional appropriations (Congress doesn't give them money)
2) Fed earns its money from interest from securities and fees from bank services
3) U.S. prez appoints Board of Governors and Senate must approve appointments
4) 14 year te
What (at least used to be) the two main focuses of the Fed?
Price stability and potential output. But now it is leaning towards just the inflation rate.
Describe the relationship between the independence of banks and inflation.
It seems the more independent a (central) bank is, the lower the inflation rate. Inverse relationship. More independence=lower interest rate.
Inflation Target. What do their supporters say, and what do their criticizers say?
1) Commitment of central bankers to keep inflation below a certain rate for the next year or two
2) Supporters- encourage workers, firms, and investors to plan on a low and stable inflation rate
3) Opponents- Fed would pay less attention to jobs and econo
What, in place of discretionary policy, do supporters of the passive approach recommend?
1) Predetermined rules to guide policy makers
2) Fiscal policy- automatic stabilizers (unemployment insurance, transfer payments, progressive income tax)
2) Monetary policy-Ex. allow money supply to grow at a predetermined rate to maintain interest rates
Describe (more in detail) the reasoning behind the the passive approach in not doing anything (in terms of discretionary policy)
1) The economy is so complex and economic aggregates interact in such obscure ways and with such varied lags that policy makers can't comprehend what's going on well enough to pursue an active monetary/fiscal policy
2) It's INCREDIBLY difficult to read th
How are proponents of the rational expectations approach similar to to the proponents of the passive approach, and how are they different?
1) Same result- Fed should follow a predictable monetary rule instead of discretionary policy
2) Difference underlying belief- People have a good idea of how the economy works and what to expect from gov't policy makers
3) Overall, economic forecasters ar
Why are central bankers reluctant to adhere to the proponents of the rational expectations approach and follow predictable rules?
1) Some believe that although theoretically, it would make the Fed's job easier and could result in reduced uncertainty, no such rule exists b/c the economy is complex and is constantly changing
2) Some believe that it just won't work
What does the active stabilization policy focus on?
Shifts of the aggregate demand curve
What does the passive stabilization policy focus/rely on?
Natural shifts of the short-run aggregate supply curve
Phillips Curve
A curve showing possible combinations of the inflation rate and the unemployment rate
What type of relationship is the phillips curve?
Inverse relationship
Finish this statement: The phillips curve shows that the _____of reducing ______ was _______, and the ______ of reducing ________ was ___________.
1. opportunity cost
2. unemployment
3. higher inflation
4. opportunity cost
5. inflation
What are 2 inconsistencies with the Phillips Curve?
1) Stagflation- Adverse supply shocks can cause both high inflation and unemployment
2) Expansionary gap- When the gap closes by a leftward shift of SRAS, greater and inflation and unemployment occurs
The Phillips curve was based on _________________
an era when inflation was low and the primary disturbances in the economy were shocks to aggregate demand
According to Phillips curve, describe the relationship between aggregate demand and price level and unemployment
1) If aggregate demand increases, price level increases but unemployment falls
2) If aggregate demand decreases, the price level falls but unemployment rises
Short-run Phillips Curve
1) Based on an expected inflation rate, a curve that reflects an inverse relationship b/w the inflation rate and unemployment rate
2) Based on labor contracts that reflect a given expected price level, which implies a given expected rate of inflation
Long-run Phillips Curve
A vertical line drawn at the economy's natural rate of unemployment that traces equilibrium points that can occur when workers and employers have the time to adjust fully to any unexpected change in aggregate demand
When the economy produces its potential __________
unemployment is at its natural rate
If the expected inflation rate is 3%, what happens to the short-run Phillips curve if the inflation rate is 5%? 1%? What if it's just 3% as expected?
1) 5%- unemployment in the short run falls below natural rate
2) 3%- Unemployment is at its natural rate
3) 1%- Unemployment in the short run exceeds its natural rate
Long-run Phillips curve
1) Vertical line drawn at the economy's natural rate of unemployment that traces equilibrium points that can occur when workers and employers have the time to adjust fully to any unexpected change in aggregate demand
2) Points on the Long-run Phillips cur
Finish this statement: "As long as prices and wages are __________ enough, the ___________, in the _________ run, is ____________ of the ____________." What is the effect of this?
1) flexible
2) rate of unemployment
3) long
4) independent
5) rate of inflation
6) The effect of this, is that policy makers can't, in the long run, choose between unemployment and inflation. they can choose only among alternative rates of inflation
Natural Rate Hypothesis. When does it occur? What kind of policy does it imply?
1) The natural rate of unemployment is largely independent of the (aggregate demand) stimulus provided by monetary or fiscal policy
2) In the long run, the economy tends toward the natural rate of unemployment
3) Policy makers can only push output beyond
What is the main difference between short-run Phillips curve and the long-run Phillips curve?
1) If there's a trade off between inflation and unemployment, it's only in the short run
2) Expansionary fiscal/monetary policies may stimulate output and employment in the short run, but if the economy was already at/or near its potential output, these p