Can policymakers improve short-run macroeconomic performance?
If so, how?
Fighting inflation requires the central bank to hold the line on
AD, even in the face of a leftward shift in the AS curve that
causes a recession (Y* < Ynrl). The question is,
How much will fighting inflation “cost” the economy in terms of
lost output? According to the pre-Lucas AS-AD model, about 4
percent per year for each 1 percent shaved from inflation! The new
classical macroeconomic model, by contrast, is much more
optimistic. If the public knows and believes that the central
bank will fight inflation, output won’t fall at all because both
the AD and the AS curves will stay put. Workers won’t fight for
higher wages because they expect P* will stay the same. An
unanticipated anti-inflation stance, by contrast, will cause a
recession. The moral of the story told by the new classical
macroeconomic model appears to be that the central bank should be
very transparent about fighting inflation but opaque about
EMP!
The new Keynesian model also concludes that an unanticipated
anti-inflation policy is worse than an anticipated and credible
one, though it suggests that some drop in Y* should be expected due
to stickiness. A possible solution to that problem is to slowly
ease money supply growth rather than slamming the brakes on. If the
slowing is expected and credible (in other words, if economic
agents know the slowing is coming and fully expect it to continue
until inflation is history), the AS curve can be “destickyfied” to
some degree. Maybe contracts indexed to inflation will expire and
not be renewed, new contracts will build in no or at least lower
inflation expectations, or perhaps contracts (for materials or
labor) will become shorter term. If that is the case, when money
supply growth finally stops, something akin to the unsticky world
of the new classical macroeconomic model will hold; the AS curve
won’t shift much, if at all; and inflation will cease without a
major drop in output.
How can central bankers increase their credibility? One way is
to make their central banks more independent. Another is not to
repeatedly announce A but do B. A third is to induce the government
to decrease or eliminate budget deficits.
Figure 26.3 summarizes the differences
between the pre-Lucas AS-AD model, the new classical macroeconomic
model, and the New Keynesian model.
Stop and Think Box
In Bolivia in the first half of 1985,
prices rose by 20,000 percent. Within one month, inflation was
almost eliminated at the loss of only 5 percent of gross domestic
product (GDP). How did the Bolivians manage that? Which theory does
the Bolivian case support?
A new Bolivian government came in and
announced that it would end inflation. It made the announcement
credible by reducing the government’s deficit, the main driver of
money expansion, in a very credible way, by balancing its
budget every single day! This instance, which is not atypical
of countries that end hyperinflation, supports the two rational
expectation-based models over the pre-Lucas AS-AD model, which
predicts 4 percent losses in GDP for every 1 percent decrease in
the inflation rate. The fact that output did decline somewhat may
mean that the policy was not credible at first or it may mean that
the new Keynesian model has it right and the AS curve was a little
bit sticky.
key takeaways
Whether policymakers can improve short-term macroeconomic
performance depends on the degree of wage and price stickiness,
that is, how much more realistic the new Keynesian model is than
the new classical macroeconomic model.
If the latter is correct, any attempts at EMP and EFP that are
anticipated by economic actors will fail to raise Y* and, in fact,
can reduce Y* if the stimulus is less than the public expected. The
only hope is to implement unanticipated policies, but that is
difficult to do because central bankers can never be absolutely
sure what expectations are at the time of policy
implementation.
On the other hand, inflation can be squelched relatively easily
by simply announcing the policy and taking steps to ensure its
credibility.
If the new Keynesian model is correct, Y* can be increased over
Ynrl (in the short term only, of course) because,
regardless of expectations, wages and prices cannot rise due to
multiyear contractual commitments like labor union contracts and
other sources of stickiness.
Inflation can also be successfully fought by announcing a
credible policy, but due to wage and price stickiness, it will take
a little time to take hold and output will dip below
Ynrl, though by much less than the pre-Lucas AS-AD model
predicts.