Active vs. Passive Policy Making
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Setting
the Alarm Clock from a Rational Expectations Perspective |
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Active vs. Passive Policy Making
The Supply-Side Squeeze Leading to Stagflation
Dr. Carl B Montano,
The analogy often used to illustrate demand-pull inflation with the aid of a (Keynesian) GDP Tank Model is water overflowing from one's bath tub at home. A corresponding analogy for cost-push inflation with the same GDP Tank Model is generally impractical to do.
A creative alternative is suggested here using an ordinary can of soft drink, such as e.g. Dr.Pepper. First, explain that stagflation is the simultaneous occurrence of high unemployment, or a recession, and high inflation. Then open the can of Dr. Pepper and take a few sips to reduce the liquid content. Tell students that the can represents an economy's production capacity or GDP Tank. Show the partly empty can to some students seated in the front row, telling them that the vacant space in the can represents unemployment. Ask them, "How is it possible for a real-world economy to have so much production slack, or unemployment, and yet have high inflation?" Point to the can and say, "How could this can, representing the GDP Tank, be partly empty, yet overflowing at the same time?" Answer your query by saying that stagflation occurs because the economy's aggregate supply, represented by the can's capacity, has decreased.
Gripping the can in the middle section, hold it up before the class (Note: Be sure to put a garbage can lined with a plastic bag underneath!) and squeeze hard, compressing the can until the liquid content overflows. Say that the supply-side squeeze on the economy caused the inflation (overflow) in spite of the fact that there was high unemployment (vacant space in the can).
The Phillips Curve and a Seesaw
Ki Hoon Kim,
As an economy approaches full employment, certain sectors within the economy face shortage and the price begins to rise. This is what economists call premature inflation. If the aggregate demand continues to increase and surpasses full employment, we will have pure inflation.
The Phillips curve shows the relationship between the price level (on the vertical axis) and the unemployment rate (on the horizontal axis). In other words, there is a tradeoff between these two variables which are inversely related. Hence, we can see the relationship on a seesaw diagram:
Figure 17-1
If unemployment is reduced, the price level goes up, and vice versa.
Figure 17-2
INFLATION ILLUSION, RELATIVE PRICES, AND PHILLIPS CURVES
Visually, at least, the Phillips Curve is a useful concept when discussing inflation and unemployment. While at first glance the inflation/unemployment tradeoff seems plausible enough, however, students often become confused when the instructor attempts to distinguish the short‑run negatively‑sloped Phillips Curve from its long‑run vertical counterpart, especially when this distinction is couched in terms of general as opposed to specific price movements. Specifically, students are perplexed about the crucial role that absolute and perceived relative prices play in the dynamic response of the economy to an increase in the actual inflation rate.
Here is a pedagogical technique that I use in my principles classes to visually demonstrate how, because of individual "price myopia" and the inertia which characterizes the dissemination of relative price knowledge, a sudden inflation can cause market participants (e.g., employers and employees) to become confused about relative versus absolute price changes. The demonstration provides students with keen insights into: 1) why, at least temporarily, a rise in the inflation rate can result in reduced unemployment, and, 2) how microeconomic behavior fits into the macroeconomic concept of the Phillips Curve.
First you might want to review what relative and absolute prices are and how resource allocations respond to perceived movements in relative prices, but not in absolute prices alone. Now assemble several pencils between the palms and fingers of your hands (ten or so‑‑assorted colors would be best). Be sure the pencils are in line and vertical to the ceiling. Explain that the height of each pencil above your hands represents the absolute (i.e., dollar) price of products and labor inputs. In order to reflect the existence of a relative price structure in the economy, the pencils should be arranged at slightly different heights, as if determined by individual supply and demand conditions in each market. Now, as the students watch the pencils, begin to raise you hands toward the ceiling, simultaneously explaining that this, in effect, is what a general inflation does; assuming that the inflation is "even," it raises all absolute prices proportionately. After you stop elevating your hands point our that the relative heights of the pencils are still the same; the economy‑wide inflation has not changed one price relative to another and, therefore, should not alter how resources are allocated.
Now comes the hard part. Lower your hands once again and ask each student to fix his/her vision on just one pencil, ignoring the others. Begin to raise your hands again slowly toward the ceiling, reminding the class that all other pencil heights are perceived to be stationary. When your hands come to a stop ask if the pencil each student was watching has risen relative to the others. There should be a general consensus among the students that each individuals "own" pencil has risen relative to the others as he/she perceives it. Now point out that the perceived higher pencil heights really represent higher perceived relative prices received for various commodities and labor services and that resources will be allocated accordingly. For example, an employer will believe the price of his product has risen relative to input costs (other pencil heights) and will be prompted, via the profit motive, to supply more. Likewise, an employee will believe the price of his/her labor services (the wage rate) to have risen relative to the prices paid for commodities (other pencil heights) and will be inclined to trade leisure time for labor hours worked.
Continuing your demonstration with your hands still elevated, ask the class to once again train their vision on all pencils simultaneously and ask if relative pencil heights (i.e., relative prices) have, in fact, really changed. Of course, since you have not allowed relative pencil heights to change, there should be general agreement to this effect. Quickly follow with this question: "If the relative height of (your) pencil didn't really change, why did you respond as if it did?" Each student will say, "I thought it did because (you) told me other pencils weren't going up also." The class should now get the message you wish to convey: a general inflation which, in fact, raises all prices by the same amount, initially creates the illusion that the price (wage) of a particular commodity or resource input is rising relative to other prices when, in fact, it is not. Point out that this is how a spurt in the inflation rate can temporarily cause the marketplace to suffer from "price narrow‑mindedness"‑‑a tendency to concentrate just on the price or wage particularly relevant to them without regard for other price movements in the economy. Tell the class that you artificially created this narrow‑mindedness when you asked them to concentrate on the movement of just one pencil, and that you removed the resulting relative/absolute price illusion when you asked them to once again visualize the (elevated) heights of all pencils simultaneously. Be sure to explain that knowledge about the "true" relative price structure is not provided this quickly in the real world, however, because information lags characterize an individual's awareness about one price relative to another.
You can close your demonstration by relating the relative - absolute price illusion phenomenon to the short‑ and long‑run Phillips Curves, alluding to how inflationary expectations can lag actual inflation as long as this illusion exists.
The Search Model and the Mating Game
Herbert M. Bernstein,
In macroeconomics I often utilize a simple search model that incorporates time into the employment situation:
Figure 17-3
With time on the horizontal axis and MC, MB on the vertical axis with MC representing the rising marginal or opportunity cost of not working and MB representing the declining marginal benefit of additional job information, I indicate that there is an optimal time for the worker to remain unemployed. If he utilizes less time than optimal, then there is still much job information to be gotten while incurring minimal opportunity cost; if more time than optimal, then the opportunity cost exceeds the meager additional job information to be had. I use the analogy of mating. You do not marry the first person you date nor do you seek information on every possible candidate. There will be an optimal amount of time expended for the search!
Simulating A Natural Rate Of Unemployment
The following demonstration with students effectively illustrates the concept of search unemployment in an economy where aggregate demand for labor equals aggregate supply, and where the labor market is decentralized. First, determine the number of students in the room. Then list on the board several job sites‑‑A, B, C, D. At each site, s, post a notice of vacancies such that the number of vacancies summed over all sites equals the number of students in the room. Explain that all jobs are identical. Then, ask each student to write down on a slip of paper a single site which (s)he selects to apply for a job.
Collect the responses and compare the distribution of responses to the distribution of posted vacancies. You can then point out that since there are always new entrants to the labor market and deaths and retirements create a new distribution of vacancies, search unemployment may be a steady state phenomenon even when the number of job searchers is always identical to the number of available jobs. The demonstration should get students to think about why there is not a central labor exchange and the problem of achieving coordination in the absence of perfect communication or idealized central direction.
Inflationary Acceleration And The Phillips Curve
William S. Franklin and
I have found the following analogy useful in conveying to students the idea of the accelerationist view of the Phillips Curve in the short run and long run.
I ask students to compare a policymaker attempting to manage aggregate demand to cure unemployment with a doctor using chemotherapy to fight cancer in a patient. Our doctor administers a cancer‑killing drug that is effective in reducing the size of the cancer, but this treatment has unpleasant side effects (loss of appetite, hair loss, nausea). Similarly, our policymaker will discover that inflation results from "treatment" of unemployment.
The doctor must make a choice as to whether to press on with the treatment in order to reduce the size of the cancer, or decrease treatment to lessen the side effects. Thus, doctors face trade‑offs between cancer reduction and side effects just as policymakers must choose between inflation or unemployment.
In the long run the doctor discovers that the cancer has become resistant to the drug, and must prescribe even larger doses in order to secure the same degree of remission as before, causing the patient to endure even more side effects. This is similar to the policymaker who discovers that reducing the unemployment rate once the economy has adapted to inflation requires accelerated inflation.
At some point the patient may decide that the side effects are more painful than the disease. But if the doctor ceases using the drug, the cancer will worsen, i.e., if policymakers reverse course in order to fight inflation, the likely result is a rise in unemployment.
The doctor has two choices: administer an additional drug to offset the side effects of the original treatment, or explore alternative treatments of the problem. Similarly, policymakers have the options of, e.g., imposing incomes policies in order to cure the inflation caused by the original treatment, or, perhaps, optimistically adopting supply side policies.
Setting the Alarm Clock from a Rational Expectations Perspective
Carlos Ulibarri,
I
begin by stipulating
From these examples the concept of how rational expectations work seems to become understandable and applicable.
Rational Expectations, Behavior and Credibility
Arthur J. Raymond,
To impress upon students the idea that behavior depends upon expectations try the following instructive, although somewhat underhanded exercise.
Choose a relevant day in the semester and announce that because of an important personal commitment, class will only last fifteen minutes. At the fifteen-minute mark there will be noticeable fidgeting. Continue to lecture for another fifteen minutes despite rising anxiety levels. Plan to let class out earlier than the official time but a good fifteen minutes after the announced end of class.
You have dramatically demonstrated that changes in behavior are motivated not by actual events, but by deviations of actual events from expected events. After all, disappointment occurred despite dismissing class early. The anxiety occurred because class was held longer than expected.
At this point the role of credibility can be introduced. Discuss class behavior if you announced a fifteen-minute class every day and held it for thirty minutes. Eventually this new information would become part of expectations and the rational students would expect the class to last 30 minutes. Disappointment would not occur after 15 minutes as was the initial case.
After this demonstration it is easier to introduce a number of models in which expectations are important, e.g., expectations-augmented Phillips Curves and money supply "surprises."
Tuition Increases and the Role of Expectations
Janet M. Thomas,
At the principles level, it is sometimes difficult to explain something as intangible as the role of expectations in the macroeconomy. One semester, the timing of this part of the course followed a recent outbreak of rumors on campus of an impending tuition hike. Typically, many students anticipated a tuition increase that turned out to be highly exaggerated.
The temporary impact of mistaken expectations in the macroeconomy was more readily understood when discussion was opened in the classroom to instances of student reaction based on their own erroneous anticipations about the tuition increase. During the interim period when many believed the worst about the following year's tuition expense, some students began to seek extra work hours during the semester or a more lucrative summer job. Others investigated the possibility of transferring to a less expensive institution, etc. These actions reportedly waned once the official announcement of the true tuition expense was given.
The students readily understood the importance of information in decision-making behavior. They recognized that their immediate reactions based on mistaken expectations were temporary and that responses were minimal once these expectations adjusted over time. The transition of these ideas to the macroeconomy and the important discussion of speed of adjustment followed with relative ease.
Michael B. McElroy,
The distinction between one-shot price level changes and the continuing changes that constitute inflation is often neglected by students, politicians, and the media who then fall into the trap of seeing inflation lurking in virtually any event that expands demand or contracts supply.
An effective way to make the point that inflation must be a sequence of events is to characterize it as a story, with beginning, middle, and end. The beginning can be associated with any event that alters the price level. By itself, however, this is a one-shot event and cannot result in continued excess demand. The inflation story proceeds only if the initial event continues or is followed by other ongoing events, e.g., continually growing deficits, continually worsening supply shocks, or, logically and empirically most likely, continued monetary expansion for accommodative purposes, such as a tax or to achieve an ill-advised interest rate or other targets. The relatively minor characters (events) from the beginning disappear or are transformed into either scapegoats or red herrings by the middle of the story. The end of inflation can occur only when the more potent characters or sequences of events, from the middle section are eliminated.
Economics of Information and the Job Search
Dennis Sebrecht,
To drive home the point that information is a scarce resource
and that one should economize on the use of it, I use the example of job search
in my principles of economics courses. Since most of the students in the class
are freshmen and sophomores, I begin by asking the class what things they would
do if they were seniors looking for a job. Invariably, the students will
respond that they would prepare a resume, search through job openings lists in
their fields, set up interviews, and the like. I then point out that these
things they have mentioned refer to the costs of the job search for the
potential employee. Then I ask the class if they would have perfect information
on all jobs and job characteristics throughout the
Peter Pan And The Phillips Curve
Paul Cantor, University of California-Davis
A humorous handout that supplements the typical textbook discussion of the Phillips curve has been popular with my students. The handout is titled The Story Behind the Phillips Curve. The story takes place in Never-Never land (NNL) in three successive years. The civilian labor force in NNL is 10,000 in each year. Every week 100 people quit or are fired from their jobs so the number of people unemployed at any one moment is determined by the average length of time spent looking for work. A typical job seeker in the handout is always represented by a fictional character. In year 1 the rate of inflation and expected rate of inflation are 0%. Captain Hook is made to walk the plank, i.e., is fired. He had been earning $10,000 a year as a stevedore. So he searches for a new $10,000 a year job. It takes him five weeks to find what he is looking for Vice President Bush hires him to pirate a new idea for his presidential campaign. In year 2, a year in which the rate of inflation is 20% and the expected rate of inflation 0%, Hook is fired again. He is fired for suggesting Bush hire a voodoo witch doctor as an economic advisor. This time, however, it takes him only three weeks to find and accept a $10,000 a year job. He takes the job because he mistakenly believes it pays him a wage equivalent in real terms to what he was earning before. In year 3 the rate of inflation is still 20% but workers are aware of it, understand its effect on their purchasing power, and expect it to continue. Therefore, when Peter fires Tinkerbell from her $100,000 a year job she searches until she gets a $120,000 a year offer. It takes her five weeks to find and accept such an offer. The offer comes from the National Aeronautics and Space Administration.
Peter Pan and the Phillips Curve, Part II
Paul Cantor, University of California-Davis
Figure 17-4
_____________________________
* P is the rate of inflation. Pe is the expected rate of inflation. LRPC is an acronym for "long run Phillips curve". The curves labeled Pe = 20% and Pe = 0% are, respectively, the Phillips curve when the expected rate of inflation is 20% and the Phillips curve when the expected rate of inflation is 0%.
Every week 100 people quit or are fired from their jobs. On the average it takes each person five weeks to find a job. Therefore, there are always 500 people looking for work at any one moment. They are in between jobs and together they constitute NATURAL or FRACTIONAL unemployment. The natural rate of unemployment in percentage terms is, therefore, 500/10,000 x 100 or 5%.
YEAR: 1989
PLACE: NNL
CLF: 10,000
INFLATION RATE: 20%
EXPECTED RATE OF INFLATION: 0%
LOCATION ON THE PHILLIPS CURVE: POINT A
Captain Hook is fired again. This time, however, it takes him only three weeks in the pipeline between jobs before he gets and accepts a new $10,000 a year offer. He accepts this offer because he does not understand that his real wage has gone down though his nominal wage remains unchanged. Had he insisted on receiving the same real wage that he received before, he would have continued to search until he was offered a $12,000 a year.
Workers have no idea that inflation is eroding the purchasing power of their wages because they lack brains or information or both. Every week the quits and layoffs continue and 100 new job seekers begin their search for jobs. But now there is inflation and the job seekers are unaware of it or unaware of how it is cutting into their purchasing power. Bosses, however, know they can offer workers 20% more and still make the same (real) profits because the prices they receive for their products are 20% higher. So bosses jack up their wage offers something less than 20% and workers find that from the moment they begin wage offers than they expected. If we assume it now takes workers only three weeks to find and accept a job which pays them a nominal wage equal to what they were earning before, then at any one moment there are only 300 people looking for work. Therefore, the unemployment rate is 3% (300/10,000 x 100) or two percentage points less than the natural rate of unemployment.
YEAR: 1990
PLACE: NNL
CLF: 10,000
INFLATION RATE: 20%
EXPECTED RATE OF INFLATION : 20%
LOCATION: POINT N' ON A NEW PHILLIPS CURVE.
Peter gives Tinkerbell the ax. Tinkerbell earned $100,000 in 1989. So she searches for a job that will pay her enough to buy what $100,000 would buy in 1989. She searches, in other words, until she finds a job offer of $120,000 a year. It takes her five weeks to find and accept such and offer.
Workers have seen the light. They are aware of inflation, understand its effect on their purchasing power, and expect it to continue. Every week 100 people continue to be laid off or quit but now they aren't tricked by higher nominal wage offers. They expect to get, and they hold out for, nominal wages 20% higher than the wages they earned before they lost or left their former jobs. They hold out for higher nominal wages in order to be able to maintain their former standard of living. So once again, as in every period when workers are aware of the rate of inflation, i.e., do not suffer from money illusion, it takes each worker on the average five weeks to find a wage offer she or he will accept, i.e., which is equivalent in real terms to the wage he or she earned before.
NOTE: The Phillips Curve shifts whenever workers' expectations of inflation change.
Key Concepts: Nominal Wage, Real Wage, Money Illusion, Natural Rate Of Unemployment.
1988 1989 1990
Civilian Labor Force 10,000 10,000 10,000
Quit + Fired Each Week 100 100 100
CPI (1987=100) 100 120 144
Rate Of Inflation (P) 0 20% 20%
Expected P 0 0 500
Daily # Of Job Seekers 500 300 500
Unemployment Rate 5% 3% 5%
Table 17-1
The Illusion of High Interest Rates
Robert J. Tokle,
When explaining the difference between nominal and real interest rates, it can be helpful to think about a person investing in instruments such as Treasury bills or CDs in the 1980s. Nominal interests rates on 6-month Treasury bills, the inflation rate, and the resulting real interest rate are shown in the table. (More correctly, the nominal interest rate is equal to the real interest rate plus the expected rate of inflation. Since the expected inflation rate is difficult to measure, the actual inflation rate is frequently substituted as proxy measure of it, as is done here.)
Average Interest Rates on
6-Month
Nominal Inflation Real Interest
Interest Rate Rate Rate
1981 13.8% 10.3% 3.5%
1986 6.0% 1.9% 4.1%
Source: Economic Report of the President, 1991.
Table 17-2
Many
investors felt that they were "doing very well" by earning, say 13.8%
on a 6-month Treasury bill in 1981.
However, by 1986, when this interest rate fell to 6.0%, they felt
disappointed in their investments. But,
we know that nominal interest rates fell in the 1980s because inflation rates
fell. After adjusting for inflation, the
real interest rate on 6-month Treasury bills rose from 3.5% in 1981 to 4.1% in
1986. Some economists attributed this
increase in the real interest rate mainly to the large increase in