Chapter 15
Stabilization Policy, Output, and Employment
OUTLINE
I. Economic Fluctuations The Historical Record
A. Historically, the United States has experienced substantial swings in real output.
B. Prior to the Second World War, year-to-year changes in real GDP of 5 percent to 10
percent were experienced on several occasions.
C. During the last five decades, the fluctuations of real output have been more moderate.
II. Can Discretionary Policy Promote Economic Stability?
A. Goals of Stabilization Policy
1. Economists of almost all persuasions favor the following goals:
2. But there is disagreement about how these goals can be achieved.
B. Activist and Non-Activist Views
1. If monetary and fiscal policies could inject stimulus during economic slowdowns
and apply restraint during inflationary booms, this would help reduce the ups and
downs of the business cycle.
a. Activists believe that policy-makers can respond to changing economic
2. Both activists and non-activists recognize that conducting macro policy in a
stabilizing manner is not an easy task..
B. Practical Problems with Timing
1. The time lag problem: It takes time to identify when a policy change
2. The forecasting problem: Because of the time lag problem, policy makers need to
know what economic conditions will be like 12 to 24 months in the future. But, our
3. The political problem: Policy changes may be driven by political considerations
rather than stabilization needs
150 Chapter 15/Stabilization Policy, Output, and Employment
III. Forecasting Tools and Macro Policy
A. Index of Leading Indicators
1. Composite statistic based on 10 key variables that generally turn down prior to a
recession and turn up before the beginning of a business expansion.
2. Can forecast future and help policy makers, but it is an imperfect forecasting
devise.
B. Forecasting Models
C. Other Forecasting Information
D. Is Accurate Forecasting Feasible?
IV. How Are Expectations Formed?
A. Adaptive Expectations: individuals form their expectations about the future on the
basis of data from the recent past.
V. Macro Implications of Adaptive and Rational Expectations
A. With adaptive expectations, an unanticipated shift to a more expansionary policy will
temporarily stimulate output and employment.
inflation without permanently increasing output and employment.
VI. The Phillips Curve: The View of the 1960s versus Today
A. The Phillips Curve outlines the relationship between inflation and unemployment.
B. In the 1960s, it was widely believed that higher rates of inflation could be used to
reduce the unemployment rate.
1. This view provided the foundation for the expansionary policies and inflation of
the 1970s.
C. Once expectations are integrated into macro analysis, it is clear that this early view of
the Phillips Curve is fallacious.
VII. What Have We Learned About Macro Policy
A. Areas of Agreement
2. Expansionary policies that generate strong demand and inflation will not reduce the
rate of unemployment below the natural rate at least not for long.
B. Areas of Continued Debate
1. Does fiscal policy exert much impact on AD?
2. During a severe recession, will an increase in government spending be more
effective than a reduction in taxes to promote recovery?
3. Is economic instability the result of the natural tendencies of a market economy or
the errors of policy-makers?
C. Current Policy and Implications for the Future
1. Macroeconomic policy in the Aftermath of the Crisis of 2008
a. Fiscal policy was highly expansionary during 2008-2011:
(1) budget deficits were approximately 9 percent of GDP during 2009-2011, the
largest since WWII.
2. Impact of the 2008-2011 Expansionary Policy
1. Comparison of the recessions of 1981-1982 and 2008-2009 provide insight on this
issue.
a. These recessions were the most severe of the post WWII era
b. In both cases, unemployment soared above 10%
c. Policy response was dramatically different:
(1) government spending was reduced as a share of the economy and monetary
d. How did the Strength of the Two Recoveries Compare?
(1) -82 recession and to
D. Why Has the Fiscal and Monetary Stimulus Failed to Promote a Stronger Recovery?
1.
a. The fiscal stimulus spending was largely temporary.
(1) Programs of this type exert less impact on aggregate demand and output
b. Politically directed spending will result in counterproductive programs (e.g.
ethanol subsidies, wind and solar energy, and high-speed rail).
c. Expansionary fiscal policy and the accompanying large budget deficits drove
the federal debt to dangerously high and unsustainable levels generating
2. Why has the monetary
a. Huge increases in bank reserves led to fear and uncertainty about future inflation.
b. Household
OBJECTIVES
This chapter focuses on a major area of current controversy among economists: what policy strategy
is most likely to minimize economic instability? Activists believe that discretionary changes in
macroeconomic policy in response to economic indicators and forecasting tools will moderate
economic instability. In contrast, nonactivists believe that it is a mistake for policy makers to change
course in response to current economic conditions. The nonactivists argue rigid rules and guidelines
requiring policy makers to follow a stable economic course, independent of current economic
conditions, are most likely to minimize instability. This chapter also gives students both a historical
perspective of the Phillips curve as well as the modern view of the Phillips curve. It concludes with
a discussion of what we have learned about macro policy.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Exhibit 1 provides historical perspective on fluctuations in real GDP. Of course, we continue
2. The index of leading indicators is an important forecasting device available to policy makers.
3. Many laypersons believe that training in economics permits one to forecast the future
accurately. Economists, particularly those marketing forecasting services, have also promoted
4. Critical Analysis question 1 provides a project suitable for assignment as a short paper. Critical
5. There are several useful analogies to the problem facing policy activists in their attempt to
reduce macroeconomic instability. One of the best is to that of an ocean liner captain. Ocean
liners turn only with a lag, so to pilot it well you need to know how long the lag is and how
6. It can sometimes be helpful to talk about why forecasting models are reasonably accurate in
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
3. According to the adaptive expectations hypotheses, individuals base their expectations on the
immediate past. Thus, expectations in the short run lag behind actual events, and decision
makers will systematically make errors. The rational expectations hypothesis assumes that
6. With adaptive expectations, an unanticipated shift to a more expansionary policy will
temporarily stimulate output and employment. In contrast, with rational expectations,
7. Here are three practical problems that limit the effectiveness of discretionary macro policy as
12. The tendency of the self-corrective mechanism to restore full employment can be offset by