Chapter 15 --

Economic Policy
This chapter -- looks at Economic
Policy, overt intervention taken to
improve a economy currently operating
with problems.

Economic Policy -- medicine given to
cure a sick economy.
Emphasizes Fluctuations Strategy,
Get Y* closer to a given Y
F
.
Diagnosing the Economy --
A Quick Review
Y < Y
F
-- sluggish economy
Y > Y
F
-- economy with
accelerating inflation
Y = Y
F
-- economy with constant
inflation rate (desired
state)
Strategies for (Fluctuations)
Economic Policy
Expansionary Policy -- Policy
designed to address a sluggish
economy (Y* < Y
F
).
Contractionary Policy -- Policy
designed to address an
overstimulated, or accelerated
inflation economy (Y* > Y
F
).

Types of
Economic Policy
Monetary Policy -- The Federal Reserve
changing the supply of financial capital
to promote investment (and possibly
durable goods consumption).
Fiscal Policy The Federal
Government changing the government
budget position (G-T).
Trade Policy -- Trying to managing the
economy though changing exports (X)
and imports (M).

The Intent and Method
of Economic Policy
Intent -- to move Y* closer to Y
F
.
Expansionary Policy (policy for
Y* < Y
F
), seeks to increase spending on
goods and services, or shift the AD
curve rightward.
Contractionary Policy (policy for
Y* > Y
F
), seeks to decrease spending
on goods and services, or shift the AD
curve leftward.
Challenges to Using
Economic Policy
(1) Can the economy cure itself
instead?
(2) Avoiding excessive expansion
and the wage-price spiral.
(3) Reacting to adverse supply
shocks.
Challenge #1 -- Can The
Economy Cure Itself?
Short-Run Perspective (equilibrium in
AD-AS model): Y* does not necessarily
equal Y
F
due to market failure in the
labor market. Therefore, the economy
needs policy (interventionist position).
Long-Run Perspective (equilibrium in
AD-LAS model): Y* = Y
F
because the
nice assumptions are satisfied and
the economy is at GCE. Therefore, it
can cure itself and there is no need for
policy (non-interventionist position).
The Long-Run:
A Graphical Description
Lets return to the Labor Market --
the demand and supply for labor
employment.
In this case, lets consider the
Aggregate Labor Market, or the
total demand and supply for labor.

Labor Market Equilibrium
and the Economy
Labor Market Equilibrium (N*) --
where labor demand equals labor
supply across the economy.
At N*, there is no demand-
deficient unemployment.
So at N*, Y* = Y
F
and u = u
N
.

The Economy Curing Itself
in the The Long-Run
Example 1 -- sluggishness
(Y < Y
F
), and correspondingly,
demand-deficient unemployment.
Problem -- wage rate (W) is too
high.
Solution -- allow W to decrease,
until N = N*. When that occurs,
simultaneously Y* = Y
F
.
The Economy Curing Itself
in the The Long-Run
Example 2 -- accelerating inflation
(Y > Y
F
), and correspondingly,
having u < u
N
.
Problem -- wage rate (W) is too
low.
Solution -- allow W to increase,
until N = N*. When that occurs,
simultaneously Y* = Y
F
.
The Economy in the The
Short-Run (Market Failure)
Example 1 -- sluggishness
(Y* < Y
F
), and correspondingly,
demand-deficient unemployment.
Problem -- W is too high.
Key -- W does not decrease due to
market failure (e.g. labor contracts).
Therefore, Y* stays less than Y
F
.
Problem persists without policy.
The Economy in the The
Short-Run (Market Failure)
Example 2 overstimulated,
accelerating inflation economy
(Y* > Y
F
).
Problem -- W is too low.
Key -- W does not increase due to
market failure (e.g. labor contracts).
Therefore, Y* stays greater than Y
F
.
Problem persists without overt policy.
Why Do We Call For Policy?
The Relevant Short-Run
John Maynard Keynes
famous quote.
The Great Depression and the
Employment Act of 1946.
The 1992 election -- (George H.W.)
Bush versus Clinton.
Policy successes --
Volcker (1980s) and Greenspan
(1991-2000).
Challenge #2 -- Avoiding the
Wage-Price Spiral
US -- Late 1960s-Early 1970s.
Excessive demand policy -- shifts
the AD curve rightward too far,
Y* > Y
F
, accelerates inflation,
increases inflation expectations.
Labor seeks above-normal
increases in nominal wage rates
(W) to protect themselves, AS
curve shifts leftward.
The Wage-Price
Spiral, Continued
As a result, Y* returns to previous
level, call for further expansionary
policy.
Process keeps repeating itself.
Avoiding the
Wage-Price Spiral
Use expansionary policy judiciously.
Be careful of overshooting where Y*
exceeds Y
F
, dont arouse inflation
fears.
Be watchful for nominal wage rate
increases when deciding to use policy.
Refrain from expansionary policy if
nominal wage increases are larger than
normal.
Challenge #3 -- Reacting to
Adverse Supply Shocks
Most dramatic US Experiences -- 1973
and 1978.
Adverse supply shock -- large increase
in the price of energy (P
E
), shifts AS
curve leftward.
As a result, Y* decreases and P*
increases.
Both represent problems in the
economy.
Reacting to Adverse Supply
Shocks -- Lessons Learned.
Dont react -- standard policy will
not help the situation.
Calls for alternative strategy, such
as energy policy.
Or wait it out inherent instability
of cartels.

Examining the Different
Types of Economic Policy
Monetary Policy -- Chapter 16.
Fiscal Policy -- Chapter 17.
Trade Policy -- Chapter 18.