Chapter 15
Debates on
Macroeconomic
Policy
Day One
Main Focus
 Inflation and Unemployment
 The Phillips Curve
 Wages and Price Policies
 The Debate Over wage and Price
Policies
Inflation and
Unemployment
Relationship between inflation and unemployment is inverse
 · AD  PL and O  Inflation  Unemployment
 1. There is an increase in Aggregate Demand (AD) during an
economic expansion (people consume, invest more)
 2. b/c of AD ↑ there is a higher equilibrium price level and
output.
 ·
A price level ↑ leads to inflation
 ·
An output ↑ leads to lower unemployment
 3. because the AD has pushed up the price level, the
resulting INFLATION is demand pull inflation
 Demand-pull inflation – inflation that occurs as increased
aggregate demand pulls up prices
Demand- Pull Inflation
The Phillips Curve
The Phillips Curve expresses the inverse relationship of
unemployment and inflation.
- aggregate demand - •
ª unemployment « inflation - •
•
ª
- aggregate demand - •
« unemployment ª
•
inflation - •
«
- on Fig. 15.2, the inverse relationship is shown.
**The curve is rarely straight
- also used by governments as a policy menu.
Expansionary fiscal or monetary policies would move
an economy up the curve, contractionary policies
would cause a move down.
- the effect to which the curve is applicable can be
shown in 3 different time periods.
The Phillips Curve
From 1960 to 1972
• There was generally higher inflation with
lower unemployment (thus there was
demand pull inflation). Since the points
fell in a broad band a Phillips Curve
could be drawn and used to predict how
stabilization policies would affect the
economy
Shifts in the Philips Curve
From 1973 to 1982
• Generally inflation and unemployment
were both higher %. Their relationship
was sometimes direct: a rise in inflation
would accompany a rise or nonmovement in unemployment. This
caused stagflation
Cost Push Inflation
From 1983 to 1993
• Unemployment rates remained generally
high, but inflation rates generally lower.
Because of an inconsistent relationship,
the Phillips curve could not be drawn for
this period.
•
Inflation was lower because oil prices
dropped, reducing cost-push inflation,
and because of an economic recession.
Wages and
Price Policies
Wages and Price Policies
 In the 70’s and 80’s, gov’ts were looking
for solutions to stagflation
 They tried -Wage and Price Controls and
Guidelines.
 Wage and Price Controls:
 - When gov’ts impose restrictions on
wage and price increases. (ex.
Minimum wage can increase by only a
certain % a year).
 Wage and Price Guidelines:
 - Voluntary restrictions on wage and
prices increases
1969 - 1975
 Guidelines didn’t work because
businesses wouldn’t cooperate.
 A Prices and Incomes Commission was
created to work with businesses but
nobody listened to them
 Inflation actually rose from 5% in 1969 to
10% in 1975.
1976 - 1978
 Controls were then tried:
 - In ‘76 to ’78, a maximum % that wages
and salaries could increase was imposed
 Businesses could only increase prices to
cover increased costs.
The result…
 Inflation did subside (10% - 7.5%) during
the time the controls were in place
 Economists thought the price and wage
controls weren’t the cause, but rather the
lower food prices.
 After the controls were lifted, inflation
rose again.
1982 – 1984 “Six and Five” Rule
 In this time the gov’t tried controls again,
but only on things the federal government
directly controlled.
 They increased wages and prices by 6%
in ’82-’83, then 5% in ‘83-’84.
 The government encouraged provincial
gov’ts to follow their controls.
The Result…
 A dramatic fall in inflation between 1982
and 1984, but once again this was
contributed to outside factors:
- The current economic recession
- The contractionary policies put in place
by the Bank of Canada at the time
The Debate Over
Wage and Price
Policies
Is It Effective?
 Guidelines are only voluntary in the
private sector, and have very little
success because most businesses
do not follow them
 Wage & Price controls may reduce
inflation in the short run, but after the
controls are removed, inflation almost
instantaneously rises.
How Fair Is It?
 Larger businesses have to deal with stricter
rules from the government whereas smaller
businesses find it easier to increase wages.
 Not all businesses operate within these
restrictions, with some ‘under-the-table’
incentives on top of the legal price to
encourage more sales
How Efficient Is It?
 Wage & Price restrictions inhibit functions of
free markets.
 Wage restrictions break the link between
productivity & income, thus giving the workers
limited incentive to maximize work efforts and
output.
 Changes in Demand & Supply do not affect
price, so resources me be inefficiently
distributed
Brief Review
 1. Inflation and unemployment have often had
an inverse relationship. In periods of
expansion, the result is demand-pull inflation
 2. The Phillips curve represents the Keynesian
assumption of an inverse and predictable
relationship between inflation and
unemployment. While the Phillips curve applied
to Canada in the period form 1960 to 1972, it
has been less relevant since.
Brief Review
 3. Since the 1970s, inflation and unemployment in
Canada have frequently had a direct relationship.
Stagflation has been caused largely by decreases
in aggregate supply due to price increase of
inputs. The result is cost –push inflation
 4. Overall inflation and unemployment rates in
Canada increased in the period from 1973 to 1982,
shifting the Phillips curve to the right. From 1983 to
1993, unemployment continued to be high but
inflation lowered.
Brief Review
 5. Various types of wage and price
restrictions have been applied in Canada
since 1969. Critics suggest that these
program show little success, while
fostering inequalities and inefficiency.
End of Day
One
Day Two
Main Focus
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Monetarism
The Velocity of Money
The Equation of Exchange
The Quantity of Money
Inflation Rates and Monetary Growth
Monetarist Policies
Monetarism
Monetarism: It is an economic perspective that
emphasizes the influence of money on the economy &
the ability of private markets to accommodate change
Monetarists VS Keynesians
-Referred to the economist Keynesians, fiscal and
monetary policies perform a beneficial role by
smoothing the ups and downs of the business cycle
- Keynesians tend to see fiscal policy as more
powerful
- Believes that private markets are unsteady, and
occasional government intervention is necessary.
continue
 Monetarism: monetarism is a recent extension of the
theories that dominated macroeconomics
 Monetarists believe that the economy is able to adjust
to fluctuations without government intervention
 argues that, misguided government intervention just
makes economic fluctuation worse.
Why?
* Because they stress the importance of money,
monetarists blame unwise use of monetary policies in
particular.
The Velocity of Money
Concept Central to Monetarism known as
Velocity of Money : the number of times, on average, the
money is spent on final goods and services during
given year is the velocity of money
Nominal GDP
 Velocity of Money (V) = Money Supply (M)
 Nominal GDP: total dollar value of final goods and
services produced in economy
 Money supply (M) = M1 (publicly held currency and
publicly held deposits, excluding cash reserves)
Activity Exercise!!!!!


Write the equation to calculate
VELOCITY OF MONEY
Now Calculate the velocity of money if
Canada’s nominal GDP is $800 billion
and the money supply (M) is $50 billion
ANSWER!!!
1)
 Velocity of Money (V) =
2)
$800 billion
16 = $ 50 billion
Nominal GDP
Money Supply (M)
The Equation of Exchange
Equation of Exchange - the money supply
multiplied by the velocity of money equals price
level multiplied by real output.
Given:
Nominal GDP = P x Q
800 billion = 2.0 x 400 billion
 We can find the equation of exchange!
Money Supplied (M) x Velocity of Money (V)
= price level (P) x real output (Q)
The Quantity of Money
The Quantity of Money – a theory stating that the
velocity of money and real output are relatively stable
over short periods.
 V only displays gradual change because changes are primarily
due to long run factors (like a move to credit and debit cards)
 Real output – varies only slightly from its potential level
because there is quick adjustment to any changes in prices or
unemployment.
 Therefore: according to the quantity of money theory, both V
and Real Output are constant
 SO, given M x V = P x Q , changes in price level must be due
to changes in money supply. For example: Inflation (↑ P) is due
to too much money chasing the products available for
purchase in the economy (↑M)
The Velocity of Money
Inflation Rate and
Monetary Growth
• The quantity theory shows a close relationship
between inflation and growth in money supply
• If M1 were to increase by 10%, so would P
• change in P = inflation. V and Q are very
constant
• equality between M and P is evident, but
sometimes rough.
Monetarist Policies
 Money is the key factor in the economy, unlike
Keynesians who believe it is only one of many factors
 Fiscal policy has little influence due to “crowding out
effect”
Crowding - Out - Effect: The effect of more government
borrowing raising interest rates, which reduces or “crowds out”
private investment spending
 Even monetary policy cannot change output from its
potential level
 Only way to stabilize economy is minimizing harmful
effects of inflation, when bank of Canada minimizes
rate of growth of money supply
Comparing the Two
Keynesians



Treat money as only one element that determines output and inflation
levels
See the process through which money influences the economy is a
lengthy one (an expansion in the money supply must first reduce interest
rates, then boost investment spending, resulting in an increase in AD)
Regard fiscal policy as a powerful stabilization tool
Monetarists

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Consider variations in the money supply the most significant factor in the
economy
See the impact of monetary changes as being more straightforward and
predictable (assuming stable velocity of money, adjustments in the money
supply translate immediately into higher nominal GDP and increased
prices)
Argue that fiscal policy has little influence because of the crowding out
effect
Monetary Rule
The Monetary Rule
 The monetary rule forces central
banks to increase the money supply
by a constant rate each year
 Recommended at 3% based on real
long-term growth in economy
Brief Review for Day Two
 1. In contrast to Keynesians, monetarists believe that
the economy has an ability to adjust itself, that
governments intervention can harm rather than help
the economy, and that the money supply is of ventral
importance to the economy.
 2. The equation of exchange states that the money
supply (M) multiplied by the velocity of money (V)
equals the price level (P) multiplied by the real output
(Q) or nominal GDP.
Brief Review for Day Two
 3. According to the quantity theory of money, both the
velocity of money and real output are relatively stable
over short periods. A certain percentage change in the
money supply causes about the same rate of inflation.
 4. Keynesians see the influence of money as indirect
and fragile, and fiscal policy as an important
stabilization tool. In contrast, monetarist see the
influence of money as direct, fiscal policy as ineffective
but easily misused.
 5. Monetarists recommend a monetary rule, whereby
the money supply is raised by a set annual rate based
on the economy’s real growth.
End of Day
Two
Day Three
Main Focus
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Supply- Side Economics
Reduction in Incentives
Focus on Aggregate Supply
The Laffer Curve
The Influence of Supply Side Theories
Supply Side Economics
 Most economists stress how fiscal and monetary policies influence
the economy through shifts in aggregate demand, this follows from
their view that any effects on aggregate supply are minor
 However, some economists subscribe to a viewpoint known as
supply-side economics
 They believe that the aggregate supply is the most critical element
of government activity and, because the effects are gradual and
often hidden, they are usually ignored by policy-makers
 The supply-side economists own a large debt to the theories of
early classical economists, such as Adam Smith and Davis
Ricardo, who concentrated on the influence of production costs on
price and incomes
Reduction in Incentives
 Reduction in Incentives
 Supply-side economists believe increased government
intervention in recent decades has dampened
productive economic activity
 According to the supply-siders, the government activity
can affect aggregate supply by reducing incentives to
engage in productive activity
 Personal Income and Business Taxes
 Anytime marginal tax rates on personal income and
business profits increase, the disposable incomes of
income earners fall, making it less worthwhile for them
to engage in income generating pursuits
Sales Taxes
 Hikes in sales taxes also discourage
productive activity by reducing the amount of
product that can be bought with a given income
Transfers and Subsidies
 Supply-siders criticize more generous transfer
payment programs, such as Unemployment
Insurance and welfare, as well as subsidy
programs such as farm subsidies. According to
the economists, such programs diminish
incentives to generate private income.
Regulation
 Government has also played a greater
role in regulating private businesses.
Controls associates with environmental
concerns, worker safety, product
standards, and workplace equity have all
raised business costs and reduced
incentives to invest
Aggregate Supply
 Monetarists = Gov’t policies affect aggregate
demand seriously
 Keynesians = Gov’t policies affect aggregate
demand seriously
 Supply-Siders = Gov’t policies have little effect
on aggregate demand and a huge effect on
aggregate supply.
Focus on Aggregates Supply
 Supply-side economists contend that increases in
taxes and government regulation means a decrease in
aggregate supply.
 This shifts the AS curve from AS0 to AS1. Therefore,
the economy is pushed to a higher price level (P ) and
lower real output (Q ) (from point ‘b’ to point ‘a’)
 Cost-push inflation then occurs: increased production
costs due to taxes and gov’t regulation, decrease
aggregate supply, which pushes up prices
Effect of Government
Intervention
Supply-Siders’ Views
 They say high taxes and increased government
regulation create cost-push inflation
 Therefore they feel the stagflation of the 1970’s
was caused by the government unintentionally
because the government over-intervened.
 Tax cuts and reduced regulation should right the
economy, increasing aggregate supply
Reaganomics
 In the early 80’s, supply-siders had many proposals
legislated (such as reduction in personal and business
taxes), and came to be associated with the Reagan
presidency in the United States.
 Supply-siders suggested that reducing tax rates would
actually lead to an increase in total tax revenues.
 The economy underwent a wave of deregulation.
The Laffer Curve

Laffer curve is a curve that expresses the assumed relationship between
tax rates and tax revenues
 According to the supply- side economics, tax increases at lower tax rates
increase tax revenues (from points a to b). However, at higher tax rates
(point b to d), tax increases reduce tax revenues as there is little incentive
to produce more, make higher incomes, and be taxed more. As a result, a
cut in the tax rate from 40% to 20% (from point c to point b) increases tax
revenues (read pg.461)
 Tax rates and tax revenues have a direct relationship at low tax rates (a
positive slope at lower tax rates)
 Tax rates and tax revenues have a direct relationship at high tax rates (a
negative slope at higher tax rates)
Applying the Laffer Curve
 According to the supply-siders, the economies of countries such as
Canada and the United States had already reached or surpassed the tax
rate at which revenues are maximized. Therefore, cutting tax rates as
from 40% to 20% would lead to an increase in revenues
The Laffer Curve
The Influence of SupplySide Theories
• Reaganomic tax cuts were an expensive
mistake for the U.S.
• mainstream economists said the government
deficit acted as an expansionary fiscal policy,
raising aggregate demand causing the boom in
the U.S.' economy.
• most economists believe stabilization policies
effect aggregate demand more than aggregate
supply.
Brief Review For Day
Three
 1. Supply- side economists focus on the effect
of changes in aggregate supply on the
economy. They contend that increased
government intervention- in the form of higher
taxes, greater regulation, and so on – reduces
the incentive to engage in productive activity,
and so decreases aggregate supply.
 2. Supply-side economists argue that tax hikes
and added regulation were the main cause of
the stagflation of the 1970s.
Brief Review For Day
Three
 3. The Laffer curve represents the
supply-side economic belief that, if tax
rates are high enough, tax hikes lead to
reduced tax revenues.
 4. Supply- side theories were not borne
out by their application in the United
States during the Reagon Administration.
End of Day
Three
Not sure if needed part of
the article on page456
and 457