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9-5 Stabilization Policy

Fluctuations in the economy as a whole come from changes in aggregate supply or aggregate demand. Economists call exogenous events that shift these curves shocks to the economy. A shock that shifts the aggregate demand curve is called a demand shock, and a shock that shifts the aggregate supply curve is called a supply shock. These shocks disrupt the economy by pushing output and employment away from their natural levels. One goal of the model of aggregate supply and aggregate demand is to show how shocks cause economic fluctuations.

Another goal of the model is to evaluate how macroeconomic policy can respond to these shocks. Economists use the term stabilization policy to refer to policy actions aimed at reducing the severity of short-run economic fluctuations. Because output and employment fluctuate around their long-run natural levels, stabilization policy dampens the business cycle by keeping output and employment as close to their natural levels as possible.

In the coming chapters, we examine in detail how stabilization policy works and what practical problems arise in its use. Here we begin our analysis of

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stabilization policy using our simplified version of the model of aggregate demand and aggregate supply. In particular, we examine how monetary policy might respond to shocks. Monetary policy is an important component of stabilization policy because, as we have seen, the money supply has a powerful impact on aggregate demand.

Shocks to Aggregate Demand

Consider an example of a demand shock: the introduction and expanded availability of credit cards. Because credit cards are often a more convenient way to make purchases than using cash, they reduce the quantity of money that people choose to hold. This reduction in money demand is equivalent to an increase in the velocity of money. When each person holds less money, the money demand parameter k falls. This means that each dollar of money moves from hand to hand more quickly, so velocity V (= 1/k) rises.

If the money supply is held constant, the increase in velocity causes nominal spending to rise and the aggregate demand curve to shift outward, as in Figure 9-13. In the short run, the increase in demand raises the output of the economy—it causes an economic boom. At the old prices, firms now sell more output. Therefore, they hire more workers, ask their existing workers to work longer hours, and make greater use of their factories and equipment.

Over time, the high level of aggregate demand pulls up wages and prices. As the price level rises, the quantity of output demanded declines, and the economy gradually approaches the natural level of production. But during the transition to the higher price level, the economy’s output is higher than its natural level.

YIncome, output, Y

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supply, the economy goes immediately from point A to point C. In this case, the Fed is said to accommodate the supply shock. The drawback of this option, of course, is that the price level is permanently higher. There is no way to adjust aggregate demand to maintain full employment and keep the price level stable.

In 1986 oil prices fell by nearly half. This favorable supply shock led to one of the lowest inflation rates experienced in recent U.S. history and to falling unemployment.

More recently, OPEC has not been a major cause of economic fluctuations. Conservation efforts and technological changes have made the U.S. economy less susceptible to oil shocks. The economy today is more service-based and less manufacturing-based, and services typically require less energy to produce than do manufactured goods. Because the amount of oil consumed per unit of real GDP has fallen by more than half over the previous three decades, it takes a much larger oil-price change to have the impact on the economy that we observed in the 1970s and 1980s. Thus, when oil prices rose precipitously in 2007 and the first half of 2008 (before retreating in the second half of 2008), these price changes had a smaller macroeconomic impact than they would have had in the past.5 ■

9-6 Conclusion

This chapter introduced a framework to study economic fluctuations: the model of aggregate supply and aggregate demand. The model is built on the assumption that prices are sticky in the short run and flexible in the long run. It shows how shocks to the economy cause output to deviate temporarily from the level implied by the classical model.

The model also highlights the role of monetary policy. On the one hand, poor monetary policy can be a source of destabilizing shocks to the economy. On the other hand, a well-run monetary policy can respond to shocks and stabilize the economy.

5 Some economists have suggested that changes in oil prices played a major role in economic fluctuations even before the 1970s. See James D. Hamilton, “Oil and the Macroeconomy Since World War II,’’ Journal of Political Economy 91 (April 1983): 228–248.

Q U E S T I O N S F O R R E V I E W

P R O B L E M S A N D A P P L I C A T I O N S

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C H A P T E R 10

Aggregate Demand I:

Building the IS–LM Model

I shall argue that the postulates of the classical theory are applicable to a special

case only and not to the general case. . . . Moreover, the characteristics of the

special case assumed by the classical theory happen not to be those of the

economic society in which we actually live, with the result that its teaching is

misleading and disastrous if we attempt to apply it to the facts of experience.

—John Maynard Keynes, The General Theory

Of all the economic fluctuations in world history, the one that stands out as particularly large, painful, and intellectually significant is the Great Depression of the 1930s. During this time, the United States and many other countries experienced massive unemployment and greatly reduced

incomes. In the worst year, 1933, one-fourth of the U.S. labor force was unemployed, and real GDP was 30 percent below its 1929 level.

This devastating episode caused many economists to question the validity of classical economic theory—the theory we examined in Chapters 3 through 6. Classical theory seemed incapable of explaining the Depression. According to that theory, national income depends on factor supplies and the available technology, neither of which changed substantially from 1929 to 1933. After the onset of the Depression, many economists believed that a new model was needed to explain such a large and sudden economic downturn and to suggest government policies that might reduce the economic hardship so many people faced.

In 1936 the British economist John Maynard Keynes revolutionized economics with his book The General Theory of Employment, Interest, and Money.

Keynes proposed a new way to analyze the economy, which he presented as an alternative to classical theory. His vision of how the economy works quickly became a center of controversy. Yet, as economists debated The General Theory, a new understanding of economic fluctuations gradually developed.

Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns. He criticized classical theory for assuming that aggregate supply alone—capital, labor, and technology—determines national income. Economists today reconcile

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these two views with the model of aggregate demand and aggregate supply introduced in Chapter 9. In the long run, prices are flexible, and aggregate supply determines income. But in the short run, prices are sticky, so changes in aggregate demand influence income. In 2008 and 2009, as the United States and Europe descended into a recession, the Keynesian theory of the business cycle was often in the news. Policymakers around the world debated how best to increase aggregate demand and put their economies on the road to recovery.

In this chapter and the next, we continue our study of economic fluctuations by looking more closely at aggregate demand. Our goal is to identify the variables that shift the aggregate demand curve, causing fluctuations in national income. We also examine more fully the tools policymakers can use to influence aggregate demand. In Chapter 9 we derived the aggregate demand curve from the quantity theory of money, and we showed that monetary policy can shift the aggregate demand curve. In this chapter we see that the government can influence aggregate demand with both monetary and fiscal policy.

The model of aggregate demand developed in this chapter, called the IS–LM model, is the leading interpretation of Keynes’s theory. The goal of the model is to show what determines national income for a given price level. There are two ways to interpret this exercise. We can view the IS –LM model as showing what causes income to change in the short run when the price level is fixed because all prices are sticky. Or we can view the model as showing what causes the aggregate demand curve to shift. These two interpretations of the model are equivalent: as Figure 10-1 shows, in the short run when the price level is fixed, shifts in the aggregate demand curve lead to changes in the equilibrium level of national income.