Monetary Policy and The Phillips Curve Analysis - Essay Example

Critically assess the policy implications, for the role of conduct of stabilization policy of the expectations-augmented Phillips curve analysis. Monetary policy research commonly takes it as "given" that, along with price stability, stabilization policy-the minimization of squared deviations of output around potential-is an appropriate policy objective (Yellen and Akerlof 2004, p.1). According to Yellen and Akerlof, despite Robert Lucas' (1987, 2003) conclusion that stabilization policy should not be a macroeconomic priority1, it has long been an explicit or implicit objective of monetary policy in most industrial countries, even including those countries with inflation targets (2005, p.1). Standard macroeconomic analysis additionally assumes that inflation is determined by an expectations-augmented Phillips curve of the form: t = te - f(ut - u*) + t where te is the expected inflation rate at time t (with expectations formed at t-1), and t captures supply shocks to the Phillips curve at t. Reflecting the inflationary effects of tighter labour markets, f' is positive; reflecting the definition of u*, the natural rate of unemployment, as the rate of unemployment where actual and expected inflation match, f(0) is equal to zero. In this formulation u* is the unique unemployment rate where inflation is stable. This Phillips curve has the property that inflation rises (the price level accelerates) when u is below u*: since actual inflation exceeds expected inflation, with adaptive expectations, inflation expectations rise over time and are factored into wage and price setting. In contrast, when unemployment exceeds the natural rate, actual inflation falls short of expected inflation, so inflation declines over time as expectations adjust downward toward reality. With chronic high unemployment, deflation is inevitable (Yellen and Akerlof 2005, p.2). According to Yellen and Akerlof, stabilization policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilisation of labour and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level. In their survey, Yellen and Akerlof conclude that there is a solid case for stabilization policy and that there are especially strong reasons for central banks to accord it priority in the current era of low inflation. With a nonlinear short-run Phillips curve, stabilization policy reduces average levels of joblessness and raises average output by a nontrivial amount. A nonlinear relationship between unemployment and social welfare may reflect the increasing incidence of long-duration unemployment spells as aggregate unemployment rises, the diminishing benefits associated with additional job creation as unemployment falls (2004, p.31). On Charles Bean's discussion of stabilization policy, Stanley Fischer comments the following on Bean's analysis the implications of the nonlinearity of the Phillips curve: a one percentage point reduction in an already low unemployment rate will push up inflation more than a one percentage point increase in a higher unemployment rate will reduce inflation. How should this affect policy Fischer cites that Bean's analysis shows that in the presence of a nonlinear tradeoff, the authorities should aim for a higher unemployment rate than the natural rate, because a positive shock that reduces unemployment will have a larger effect on inflation than a negative shock of the same size. Yellen and Akerlof go on that a Phillips curve that is not always accelerationist provides a further, important reason for central banks to pursue stabilization as an objective. The traditional accelerationist Phillips curve captures the following truth on inflation: when product and labour markets are tight, as typically occurs when unemployment is low, prices and wages both tend to increase. This corresponds to the simplest notion of supply and demand: if unemployment is sufficiently low, the demand for labour exceeds supply, and it would be highly surprising if wages did not rise to close the gap. Higher inflationary expectations should similarly raise labour demand and reduce labour supply, pushing wage and price inflation higher. However, accelerationist Phillips curve is much more specific and goes further, stating that the impact of inflationary expectations on inflation is exactly point-for-point at all times and in all phases of the business cycle. Such a conclusion would be justified theoretically if all parties affected by wage and price decisions thought exactly like economists. Finally, since the gains from stabilization policy depend largely on the nature of the inflation process-whether it is linear or nonlinear [and whether it is accelerationist or not] Yellen and Akerlof suggest that policymakers should be cautious about embracing inflation forecasts derived from theoretical models embodying overly strong priors. A cautious approach is also dictated by the fact that the fit of the Phillips curve for many countries and time periods is extremely loose considered in their study (2004, p.33). However, Minford in his Monetary Policy in the Light of Rational Expectations also cautions that though it may seem attractive to allow the central bank to exercise discretion in its attempts to stabilize the economy, the potential benefits of stabilization may be lost through the failure to carry out announced policies. As an example, he cites an example on the announcement of a tough anti-inflation policy, which causes people to expect low inflation in the future and so to sign moderate wage contracts today. Once the private sector is committed to moderate wage growth, the government will be tempted to expand the money supply to achieve higher output growth as well as not quite so low inflation. Unfortunately this tactic cannot be repeated indefinitely: people come to realize in advance that the government will renege, and so they expect high money growth and high inflation. The government then finds that it has to deliver exactly this amount of money growth and that attempts to increase output will result only in higher inflation. Hence, the scope for backsliding is greater when stabilization responses are permissible. It is minimized when rules, which in practice should be simple and fixed rules, are enforced by some higher authority such as a constitutional court. Critically assess the role of supply-side management policies within a macroeconomic strategy. Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side potential of an economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth of real national output. Most governments now accept that an improved supply-side performance is the key to achieving sustained economic growth without a rise in inflation. But supply-side reform on its own is not enough to achieve this growth. There must also be a high enough level of aggregate demand so that the productive capacity of an economy is actually brought into play (tutor2uTM 2004, p.2). De-regulation or liberalisation means the opening up of markets to greater competition. The aim of this is to increase market supply (driving prices down) and widen the range of choice available to consumers. The discipline of competition should also lead to greater cost efficiency from producers -who are keen to hold onto their existing market share. Supply-side economics holds that increased taxation steadily reduces economic trade between economic participants within a nation and that it discourages investment. The idea is that lowering the tax rate on production, work, investment, and risk-taking will spur more of these activities and thereby will often lead to more tax revenue collections for the government rather than less (Hawthorne 2005). Taxes are seen to be trade barriers that cause economic participants to revert to less efficient means of satisfying their needs. As such, higher taxation leads to lower levels of specialization and lower economic efficiency. Lowering these "trade barriers" provides the domestic economy the advantages that the international economy obtained from lowered tariff barriers. Essential to the operation of supply-side theory is the expansion of free trade and free movement of capital. It is argued that free capital movement, in addition to the classical reasoning of comparative advantage, frequently allows an economic expansion. Supply-side economists believe in the dynamic effects of greater competition and that competition forces business to become more efficient in the way in which they use scarce resources. This reduces costs which can be passed down to consumers in the form of lower prices. A tougher competition policy regime includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses of a dominant market position - in other words - intervention to curb some of the market failure that can come from monopoly power. Governments of all political persuasion argue that they want to promote an entrepreneurial culture and to increase the rate of new business start-ups. The proliferation of small businesses of today can often become the cluster of larger businesses of tomorrow, adding to national output, employing more workers and contributing to innovative behaviour that can have positive spill-over effects in other industries. Supply side policies that encourage "entrepreneurial culture" include loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the country, as well as advice for new firms in untapped industries. As for the supply-side labour market economic policies, these are designed to enhance the quality and quantity of the supply of labour available to the economy. They seek to make the labour market in a country more flexible so that it is better able to match the labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of structural unemployment. An expansion in the country's total labour supply is then seen to raise the productive potential of an economy. Investment and spending in education and training have the potential to raise the skills within the work force and improve the employment prospects of unemployed workers. Government spending on education and training improves workers' human capital. Improved training should improve the occupational mobility of workers in the economy. This should help reduce the problem of structural unemployment. A well-educated workforce also acts as an attraction for foreign investment in the economy. Economists who support supply-side policies also believe that lower rates of income tax provide a short-term enhance to demand, and thus improve incentives for people to work longer hours or take a new job because they get to keep a higher percentage of the money they earn. Attention has focused in recent years on lower income households. Cutting tax rates for lower paid workers may help to reduce the extent of the 'unemployment trap' - where people calculate that they may be no better off from working than if they stay outside the labour force. Reference List 'Fiscal Policy Theory' in Supply-Side Economics (25 April 2006), Wikimedia Foundation. Retrieved 27 April 2006 from http://en.wikipedia.org/wiki/Supply-side_economics#_ref-4. Fischer, S ______, Commentary: the Role of Demand Management Policies in Reducing Unemployment, The Federal Reserve Bank of Kansas City. Retrieved 25 April 2006 from http://www.kc.frb.org /PUBLICAT/SYMPOS/1994/s94fisch.pdf Hawthorne, D 2005, Economics 101: Never Underestimate the Incentive Power of Marginal Tax Cuts (4 July 2005), Anchor Rising, United States of America. Retrieved 26 April 2006 from http://www.anchorrising.com /barnacles/002106.html. Minford, P ______, Monetary Policy in Light of Rational Expectations, CEPR Discussion Paper No. 104, Centre for Economic Policy Research, London. Retrieved 26 April 2006 from http://www.cepr.org/Pubs/bulletin/014/MINFORD.HTM. Tutor2uTM 2004, AS Economics Supply Side Economic Policies. Retrieved 25 April 2006 from http://www.tutor2u.net/economics/revision_focus_2004/AS_Supply_Side_Economic_Policies.pdf#search='supplyside%20economic%20policies'. Yellen, J and Akerlof, G 2004, Stabilization Policy: A Reconsideration (July 1, 2004), University of California at Berkeley, United States of America. Retrieved 25 April 2006 from http://www.frbsf.org/news/speeches/2004/040701.pdf#search='stabilization%20policy%20in%20the%20expectationsaugmented%20phillips%20curve'. Read More