Prof. Bryan Caplan

Econ 311

Fall, 1999

Week 11: Aggregate Demand Policy and Expectations

  1. LRAS, the Natural Rate of Unemployment, and AD Policy
    1. AD policy could be used to simply offset market fluctuations, OR it could be used to take advantage of the SRAS curve.
    2. Think of the unemployment rate along the LRAS curve as the "natural rate" of unemployment. When the level of output is greater than the level of the LRAS, unemployment is also below its "natural rate" (i.e., employment is above its natural rate).
    3. Central banks (CBs) have often tried to take advantage of the SRAS curve to push unemployment below its natural rate.
    4. Why? They think the natural rate is too high, whether because of government policy, money illusion, or menu costs.
    5. In general, such efforts have not been successful overall. Even if they had temporary successes, average unemployment rates rarely fell over a long time period. Indeed, they often seemed to increase.
  2. Expectations
    1. Why didn't these efforts to "take advantage of the SRAS"/"push unemployment below its natural rate" succeed?
    2. Main answer: the public's expectations adjust. People eventually catch on to what you are doing - "you can't fool all of the people all of the time."
    3. If you change the rules, you change people's expectations. When you try to take advantage of their expectations, people start to expect different things.
      1. Landsburg's football example.
    4. Economic theorists formalized this with the notion of rational expectations. Admittedly, people make mistakes, but you shouldn't expect them to make the same mistake all of the time.
    5. More formally: Error=Actual Value-Expected Value. If you underestimate inflation, that is a positive error; if you overestimate it, that is a negative error. The rational expectations assumption is that the average error=0.
    6. Ex: If people underestimate inflation sometimes (positive errors), they will overestimate it other times (negative errors). RE says this balances out on average.
    7. As RE predicts, when governments use AD policy to increase output and push unemployment below the natural rate, people start to expect this, and adjust their price and wage-setting behavior accordingly.
    8. Interesting tendency: Empirically, RE about inflation often fails in low-inflation regimes, but works well in high-inflation regimes. Lesson: A CB has the greatest ability to push unemployment below the natural rate when they don't actually try. The more they try, the less their ability to succeed.
  3. Time Consistency
    1. Governments often try to overcome this problem by trying to stay one step ahead of the public's expectations. But when this happens, people start changing their expectations more rapidly.
    2. One reflection of this: Policy-makers quickly switched their attention from levels to rates of growth. Early Keynesian policy involved raising the price level; later Keynesian policy switched to raising the inflation rate; in more serious cases, there was a switch to increasing the rate of change of the inflation rate!
    3. High inflation is typically the outgrowth of this "race" between the government's policy and the public's expectations.
    4. How can the government break out of this trap? It often has to drastically change policy to convince people it has sincerely changed its ways. This usually means tolerating an extended period of output below the LRAS and unemployment above the natural rate.
    5. For this reason, the SRAS's upward slope may create a "self-control" problem for CBs rather than an opportunity to improve the world.
    6. This self-control problem is often called the problem of time consistency. Why? Because whatever plans its makes, a CB may want to alter them IF the public believed them in the first place.
    7. Ex: If the CB says it will do nothing to increase AD, and people believe them, the CB then faces a temptation to increase AD anyway. But if people know this, they won't believe the CB in the first place.
  4. Credibility
    1. The time consistency problem is one of the reasons CBs often place a high value on "credibility." If they say what they mean and mean what they say, the public will believe them. Otherwise it won't.
    2. Before 1914, the U.S. and other governments were on the "gold standard." This provided CBs with a high level of credibility, because preserving a fixed dollar price of gold was the first priority of policy.
    3. The link between the dollar and gold weakened repeatedly during the following decades. In the early 70's, Nixon cut all remaining ties, as did most other economically influential countries.
    4. In the following decade, most of these countries had high inflation, and the credibility of CBs was low. Without the discipline imposed by the gold standard, they seemed to repeatedly give into the temptation to promise monetary restraint while practicing the opposite.
    5. How did the Fed regain its credibility? The sharp recession in the early 80's played a key role. People didn't believe that the Fed had changed its ways, so the SRAS curve kept shifting back until unemployment was around 10%.
    6. When the Fed made little effort to solve the problem for two years, this gradually convinced people that policy had changed course.
    7. The Fed's restored reputation has since remained more or less intact, so far...
  5. The Simple versus the Expectations-Augmented Phillips Curve
    1. A good example of pre-RE thinking: the simple Phillips curve, showing a negative relation between inflation and unemployment.
    2. Why? Just think of the Fed choosing different rates of monetary growth. The higher the monetary growth, the more AD increases. The more AD increases, the further up the SRAS you move.
    3. This worked well until the Fed tried to take advantage of it. After about a decade of this, it seemed to fall apart. (See graph).
    4. Explanation: Simple Phillips curve assumes expectations are constant. They aren't!
    5. When inflation increases, people start to expect inflation.
    6. As expectations change, the inflation/unemployment trade-off worsens.
    7. You can thus get more of both, as the U.S. did in the late 70's. This combination of high unemployment AND high inflation was labeled "stagflation."
  6. Application: COLAs
    1. COLA stands for "cost-of-living allowance." In other words, it is an automatic adjustment for inflation.
    2. When inflation was high in the U.S. - and today in countries where inflation is high - workers and employers start to adds such COLAs to their contracts.
    3. The worse the inflation gets, the more refined COLAs get. They may start out with flat adjustments negotiated every few years, but eventually get tied explicitly to the monthly CPI.