Fundamental Questions

1. Is there a tradeoff between inflation and the unemployment rate?

2. How does the tradeoff between inflation and the unemployment rate vary from the short to the long run?

3. What is the relationship between unexpected inflation and the unemployment rate?

4. How are macroeconomic expectations formed?

5. What makes government policies credible?

6. Are business cycles related to political elections?

7. How do real shocks to the economy affect business cycles?

8. How is inflationary monetary policy related to government fiscal policy?

Teaching Objectives

The primary purpose of this chapter is to present several issues in macroeconomic policy. These include the inflation-unemployment tradeoff, the formation of adaptive and rational expectations, credibility in macroeconomic policy, and the relationship between monetary policy and fiscal policy.

The unique feature of this chapter is the explanation of the long-run and short-run Phillips curve and the short-run tradeoff between inflation and unemployment. The chapter also deals with the implications of adaptive versus rational expectations. Another important feature of the chapter is its discussion of credibility and time inconsistency.

Special attention should be paid to how unexpected price changes lead to changes in output and unemployment. You should also make certain that your students understand that rational expectations are formed by using an informal, experience-based model to predict the course of a variable. This chapter is a companion to Chapter 16 on perspectives in macroeconomic theory and policy.

Key Term Review

Phillips curve
reservation wage
adaptive expectations
rational expectations
time inconsistent
shock
monetary reform

Lecture Outline and Teaching Strategies

1. The Phillips Curve

The Phillips curve shows the inverse relationship between inflation and unemployment.

1.a. An inflation-unemployment tradeoff? The inflation-unemployment tradeoff is a short-run phenomenon.

1.b. Short-run versus long-run tradeoffs

1.b.1. In the short run: When aggregate demand increases and thereby pushes output above the natural rate, unemployment falls and inflation increases. This moves the economy up along the short-run Phillips curve.

1.b.2. In the long run: When price expectations adjust upward, the aggregate supply curve shifts to the left and the Phillips curve shifts to the right.

2. The Role of Expectations

Teaching Strategy: Be sure to work through the long- and short-run Phillips curves carefully. This material tends to be difficult for students.

2.a. Expected versus unexpected inflation

2.a.1. Wage expectations and unemployment: When wage offers are unexpectedly high, workers shorten their job searches; hence, the unemployment rate falls.

2.a.2. Inventory fluctuations and unemployment: When aggregate demand is greater than expected, inventories fall below desired levels, producers increase output to restore inventory levels, and unemployment falls.

2.a.3. Wage contracts and unemployment: Contracts create nominal wage stickiness, which establishes a short-run tradeoff between inflation and unemployment.

2.b. Forming expectations

2.b.1. Adaptive expectations: People form adaptive expectations by using past information about a variable.

2.b.2. Rational expectations: When people use all available information efficiently, they form rational expectations. In its simplest form the rational expectations hypothesis states that people learn from their mistakes, making no systematic forecasting errors.

3. Credibility and Time Inconsistency

When the Fed adjusts its policies to new economic conditions, it may pursue policies that are time inconsistent.

3.a. The policymaker's problem: If policymakers announce a policy and conditions change so that the policy becomes inappropriate, the policymakers are left with the choice of continuing an inappropriate policy or adjusting policy and losing credibility.

3.b. Credibility: By maintaining a reputation for following through on announced policy, the Fed can earn public confidence.

4. Sources of Business Cycles

4.a. The political business cycle: Politicians may generate a business cycle by exploiting the short-run tradeoff between inflation and unemployment.

4.b. Real business cycles: Real shocks to aggregate supply may account for the business cycle.

Teaching Strategy: Point out that a randomly generated series of numbers can appear to be a trend and a business cycle. So, even though data such as GDP may appear to follow a cycle, it might be generated by a series of random shocks.

5. The Link between Monetary and Fiscal Policies

Monetary and fiscal policy are interdependent.

5.a. The government budget constraint: Government spending can be financed only through taxes, borrowing, or money creation.

5.b. Monetary reforms: In many developing countries money creation has been the only avenue for financing persistent deficits.