Lecture 13: Policy I – Controlling Business Cycles with Monetary and Fiscal Policy

So far, we have said little about how government decisions influence our economy. We are now going to remedy that deficiency by considering a couple of hypothetical economies, facing hypothetical problems. Since these countries are similar to the United States, it is not surprising that they face similar problems: how do you deal with problems of inflation, unemployment, and tax and spending policies. By considering these problems in the context of these hypothetical economies, we will be able to take each issue up separately. This gives us a luxury not faced in a real economy, where the government must often deal simultaneously with many problems.

This lecture and the next will focus on short-term policies; a subsequent lecture turns to longer-term issues.

The Basic Model

We begin by quickly reviewing our basic model, depicted in Figure 13-1. As you will recall there are four basic parts of the model:

· The labor market, with the demand and supply of labor;

· The production function, determining the output;

· Money market where the Equation of Exchange gives us the price level; and

· The capital market, equating the demand and supply of loans.

Because the demand and supply of loans are equal if and only if aggregate supply and demand are equal, we can also rewrite our basic model as shown in Figure 13-2.

The Lake Pleasant Meetings

Once a year, the famous Lake Pleasant Resort is host to economists from all over the world. Representatives from a variety of countries discuss their particular economic problems and get advice from the audience, of eminent economists from around the world. This year, representatives from Upper, Middle, and Lower Bedrock are making the presentations. At one time, the three countries were actually one, but split for reasons we need not go into. Because of their common history, the countries are quite similar and indeed similar to the United States.

The Economist General also attends and manages to make a number of comments during the discussion.

Figure 13-1
Our Basic Model

This figure summarizes the basic macroeconomic model. Starting with the upper left-hand panel and moving counterclockwise, the demand and supply of labor determines the number of people working. In turn, the number of people working determines the total level of GDP. The demand and supply of loans determines the real interest rate, and hence the division of output between consumption and saving. Finally, the equation of exchange determines the price level.

Figure 13-2
Our Basic Model – Slightly Restated

This figure summarizes a slightly different way of stating the basic model. The difference here is that the requirement that the supply and demand for loans be in balance is replaced with the requirement that aggregate supply and aggregate demand be in balance. There is both a short run aggregate supply curve and a long run aggregate supply curve. They intersect at the expected price level. As drawn here, aggregate demand also intersects short run aggregate supply at the expected price level, though it does not necessarily have to.

Upper Bedrock

Upper Bedrock's real Gross Domestic Product (GDP) has been growing at about 3 percent a year for some time. Unemployment equals the natural rate. Alas, the money supply has been growing at 15% a year. As the quantity theory predicts, the inflation rate is:

%Growth in Prices »
%Growth in the Money Supply - %Growth in Real GDP =
15% - 3% = 12%

The government wants to bring the inflation rate down, essentially to zero, but it wants to keep the unemployment rate at the natural rate. Economists from the Central Bank and the Ministry of Finance have assembled to discuss their options.

American economists recognize the Central Bank of Upper Bedrock as roughly corresponding to the United States Federal Reserve System. The United States splits the responsibilities of the Finance Ministry among the United States Department of the Treasury, the Office of Management and Budget and the Council of Economic Advisors.

Why Worry

At this point, someone in the audience wondered why Upper Bedrock should worry about inflation. He recalled Fisher's Law, which states that

r_N @ r^e_R + p_e

where

· r_N = The Nominal Interest Rate

· r^e_R = Expected Real Rate

· p_e = The expected inflation rate

Thanks to its workings, people are unaffected by expected inflation. When inflation was unexpected, a gainer matched each loser. Given that, why go to the trouble of eliminating inflation, particularly when the data from other countries indicated that stopping inflation could be a painful task?

The Economist General himself answered this fundamental question. Recall the basic equation:

%Growth in Prices »
%Growth in the Money Supply - %Growth in Real GDP

A more precise restatement would be

%Growth in Prices =
%Growth in the Money Supply - %Growth in Real GDP
+ ε

The last term represents the uncertainty of inflation, which tends to grow with the inflation rate. As we know from models incorporating imperfect information the more imperfect the information, the harder it is to make correct decisions. Thus the greater the rate of inflation, the greater is the uncertainty in the economy. By eliminating inflation, we eliminate a source of uncertainty. That is our real objective. (The Economist General noted some qualifications we need not go into here.)

The Dilemma

The mechanics of ending inflation is not such a big deal. Every beginning economics student knows the basic equation for inflation:

%Growth in Prices »
%Growth in the Money Supply - %Growth in Real GDP

and everybody knows that Upper Bedrock had gotten in this predicament by allowing the money supply to grow at 15% per year. To get an inflation rate of zero, all the Central Bank of Upper Bedrock need do is to cut the rate of growth of the money supply from 15 percent a year to three percent a year.

The aggregate supply and demand curves drawn in Figure 13-3 show the dilemma. The inflation rate has been 12 percent a year for so long that people are clearly expecting a 12 percent inflation rate next year. The aggregate demand curve and the short run aggregate supply curve will intersect the long run aggregate supply curve where the price level is 112 (or 112 percent of this year's price level.). If the Central Bank only allows the money supply to grow by three percent, the aggregate demand curve will shift down by 12%.

	Figure 13-3 Equilibrium in Upper Bedrock
P 112	Y AS^LR ASSR AD
	This graph shows the situation people are expecting next year in Upper Bedrock.

The concern is how people will react to the cut in the money supply growth rate. There are two possibilities.

· If people believe the government is serious about cutting the rate of growth of the money supply the short run aggregate supply curve will also shift down by 12%. The aggregate demand curve and the short run aggregate supply curve will intersect along the long aggregate supply curve, but with a price level of 100, the same as last years. Figure 13-4 shows this case.

· If people do not believe the government is serious about cutting the rate of growth of the money supply the short run aggregate supply curve will not shift down, and the intersection will occur below long run aggregate supply. In short, there will be a recession. Figure 13-5 shows this case.

Figure 13-4
Equilibrium in Upper Bedrock
with lower growth in the money supply if
the government is credible

100

P

112

AS_SR

AD'

Y

AS^LR

AS_SR

AD

If the government cuts the rate of growth of the money supply from 15 percent a year to 3 percent a year, the aggregate demand curve will shift down by 12% to AD'. If people believe the government is serious about cutting the inflation rate, the short run aggregate supply curve will also drop by 12%. The new intersection will be at a price level of 100, but still at long run aggregate supply. In short, prices will be stable and there will be full employment.

Figure 13-5
Equilibrium in Upper Bedrock
with lower growth in the money supply if
the government is not credible

100

P

112

AD'

Y

AS^LR

AS_SR

AD

If the government cuts the rate of growth of the money supply but has no credibility with the public, the short run aggregate supply curve will not shift. The initial effect will be an intersection of aggregate supply and aggregate demand below long run aggregate supply. Thus, there will be a recession. Of course, with time, Lincoln's Law works and the economy will move back to full employment. However, the recession can be brutal.

Expectations in Upper Bedrock

The panel then discussed expectations in Upper Bedrock. The head of the Central Bank is relatively new at his job. There were several unsuccessful attempts to control inflation in the past under his predecessors. As each of these programs began, the head of the Central Bank went on all the TV talk shows, looked the camera in the eye, and promised faithfully that he was serious about stopping inflation. However, every time he announced a program to control inflation there were great fears of a recession, and he ultimately backed away from the policy. By the end of their terms, cartoonists were comparing the head of the Central Bank to Lucy, with her annual ritual of faithfully promising Charlie Brown each fall that this time she would positively hold the football. The panel also pointed out that while Charlie Brown was a true blockhead and thus always believed Lucy, the public in Upper Bedrock was not so stupid and had lost confidence.

In short, the new head of the central bank had a problem: credibility. No one believes he is serious about reducing inflation. The public’s expectation of inflation will not change merely because he says that inflation will come down. The short-run aggregate supply curve will stay put, and there will be a reduction in the level of output.

In plain English, a cut in the inflation rate from 12 percent to zero percent a year meant a recession.

Analogies to Other Countries

Others wondered whether a cut in the money supply must bring on a recession, and whether the only way to get credibility is to weather a recession. There are examples where this turned out to be the case.

· In 1981, Paul Volker (every bit as impressive as Alan Greenspan) became Chairman of the Board of Governors of the Federal Reserve System at a time of 13% inflation. He announced that he was going to cut the rate of monetary growth and bring inflation under control, just as his predecessors had promised. People did not believe him. When he persisted in his policies, there was a massive recession as people changed their inflationary expectations.

· In 1979, Margaret Thatcher became Prime Minister of Great Britain, and similarly promised a cut in the inflation rate. She succeeded, but at the cost of a major recession. Why? Given the history of British governments in the 1970's, Thatcher was not credible. Like Volker she stuck to her guns and achieved the desired result of a cut in the inflation rate, but there was a recession.

However, there are cases where inflation ended without a recession.

· In 1923-24, Germany suffered from a massive hyperinflation, when prices rose by a factor of a trillion (1,000,000,000,000) in about 18 months. The hyperinflation abruptly ended when the German Government reformed its monetary policies, and made the Bundesbank (the German equivalent of the Federal Reserve System) independent of the government. The government also resumed the gold standard. These measures had credibility. Inflation halted almost overnight, and there were few effects on unemployment and GDP.

In sum, credibility matters.

Summary

What then should Upper Bedrock do? The panel saw three choices.

Upper Bedrock could continue to accept the high inflation rate

If it did, its economy would suffer long-term damage.

It could accept the recession as the price of bringing price stability.

Perhaps this was necessary, but it would be a dreadful price. For a year or two, millions of people would lose their job and GDP would decline significantly. The cost of this policy would be in the billions of dollars.

It could figure out some magical way of restoring their credibility.

Surely, it would not do for the new head to simply make the round of the TV shows. Suggestions that he make some pledge such as "I wont accept my pay unless I stick to this policy" had an empty ring. In the United States, former members of the Board of Governors of the Federal Reserve System had accepted positions with private corporations with magnificent salaries. While giving up a salary of $100,000 a year might seem like a significant penalty, $1,000,000 a year salaries on Wall Street were not uncommon.

The German experience suggested an option. Germany had adopted a credible policy. While the precise policy that Germany had followed would not work here – the Central Bank of Upper Bedrock was already independent, and resuming the gold standard was impractical – it showed the importance of a credible policy.

Recent Argentinean experience suggested the credible policy. Several years ago, Argentina was suffering from significantly higher inflation. It had learned that the gold standard was not a realistic option. However, the Argentinean government did something similar. It pegged the exchange rate of the Argentinean peso at one P = one $. It then promised to maintain that rate. It would only print new pesos when dollars were deposited at the Argentinean Central Bank. It offered to exchange dollars for pesos whenever anyone wanted to switch from pesos to dollars. Price stability came quickly. Perhaps Upper Bedrock should consider the same step.