IntroductiontoMacroeconomicsMScInductionSimon.ppt

Y0 P0 SRAS Classical or Monetarist SRAS AD Price Level 0 Real GDP Y0 P0 SRAS General Case AD Price Level 0 Real GDP Lessons of the 1970s and 1980s Inflation is persistent Expected inflation rises, so workers demand higher wage increases (wage-price spiral). If inflation is high, employees demand high wage rises. Firms then raise prices to maintain margins. Inflation expectations are important. Unemployment is persistent The long-term unemployed become less attractive to employers. Hence wage inflation tends to increase even when unemployment relatively high. What About The Money Supply? Monetarists argued that “inflation is always and everywhere a monetary phenomenon”, so if you can control the money supply, you can control inflation. But although money is involved in every transaction, it is seldom the cause of the transaction. The relationship between money and inflation is not stable, so it is not a reliable means of controlling inflation. Furthermore, in a modern economy, the money supply (largely in the form of bank accounts) is hard to control, or even measure. Evolution of macro-economic policymaking Classical (1776 - 1930s) Free markets with no government interference Keynesian (1930s – 1970s) Discretionary demand management used to regulate economy Monetarist (1970s – 1980s) Control money supply to control inflation Supply-side measures to help markets move to equilibrium Markets should then clear to achieve full employment Instead the economy entered deep recession in early 1980s. Monetarist theory discredited. Current pragmatic system Inflation expectations are important, so objectives must be clear and credible Independent central bank avoids political motives Stabilisation Policies Fiscal policy Budget deficit boosts demand But cyclical adjustment is needed to be sure Substantial lags: obtaining data, implementation and impact of policy shift. Hence net effect could be destabilising. Monetary policy Interest rates affect investment and consumer spe