Unit 5 Macroeconomic policy: Inflation and unemployment
5.3 Fiscal and monetary policy responses to demand shocks
- supply shock, supply-side shock
- An unexpected or exogenous change in supply. In macroeconomics a supply shock means a change on the supply side of the economy, such as a rise or fall in oil prices or an improvement in technology. In microeconomics it refers to an exogenous shift in the supply curve for a particular good. See also: demand shock, exogenous shock.
We first consider how policymakers can respond to demand shocks. Later sections will show that supply shocks raise more difficult problems.
The initial equilibrium: The macroeconomic policymaker’s ‘sweet spot’
To simplify the analysis, we assume that, before the shock hits, the economy is in supply-side equilibrium, illustrated in the three panels of Figure 5.3:
- Employment and wages are at point A in the top panel. The WS and PS curves intersect, which means that the real wage paid by firms is equal to the wage their HR department needs to set to recruit and motivate sufficient workers.
- The inflation rate is equal to the central bank’s target rate, assumed to be 2%.
- Using the assumption we made in Unit 4 about how expectations of inflation are formed, workers and firms also expect inflation to be 2%, so the Phillips curve in the middle panel starts out at point A, where employment is at its supply-side equilibrium level.
- The bottom panel shows that aggregate demand is also initially at the level which maintains output and employment consistent with the top two panels.
Figure 5.3 A fall in investment and AD: the need for stabilization.
Therefore, the economy starts out in what might be described as a ‘sweet spot’ of the macroeconomic policymaker. The equilibrium is sustainable in the sense that it is compatible with all the actors doing the best they can given what everyone else is doing. Given their objectives and the constraints they face, policymakers, workers, employers, and owners of firms would not change their behaviour. There will be involuntary unemployment but, as discussed in previous units, this is inevitable. Its level depends on supply-side policies.
This equilibrium is a Nash equilibrium. For an introduction to this concept, read Section 1.5 and Section 4.4.
In practice, it is unlikely that all of the sweet-spot characteristics will arise at exactly the same moment. But, for reasons that we shall go into later in the unit, we do have reason to expect that these conditions are likely to be satisfied—at least on average. So it is helpful to consider what happens when a shock moves the economy away from this initial position.
A negative demand shock
Suppose that from this initial position, there is a negative shock to aggregate demand—for example, due to a fall in business confidence about the growth of markets.
In principle, the demand shock might arise from a fall in any of the autonomous components of aggregate demand, as analysed in Unit 3.
Figure 5.3 shows the impact of the negative aggregate demand shock. According to Unit 3, in the absence of any policy response this will produce an initial fall in output and employment, which will be amplified by the multiplier process, shifting the economy to point B in the bottom panel. There is no mechanism in the model through which private-sector aggregate demand (consumption and investment) would automatically rise to offset the impact of the fall in business confidence. From the Phillips curve model of inflation in Unit 4, in the central panel, inflation will also fall to point B. It falls by one percentage point, which is the size of the (negative) bargaining gap between the WS and PS curves (in the upper panel).
How might our two policymakers respond?
- From the central bank’s perspective, inflation has now fallen below its target. Its job description therefore tells it that it should relax monetary policy: that is, reduce interest rates, with the objective of stimulating aggregate demand enough to bring inflation back up towards target.
- The government may also wish to use fiscal policy to directly add to aggregate demand and counteract the impact of the shock, on the assumption that doing so will be pushing output and employment back towards supply-side equilibrium.
In both cases, the incentive to act is strengthened by the risk that, if lower inflation persists, and as a result inflation expectations adjust downward, then the Phillips curve will shift down, possibly introducing the risk of deflation.
So in the face of this shock, both fiscal and monetary policy objectives point in the same direction. While the central bank will definitely wish to relax monetary policy, the same objective could be achieved by fiscal policy or by some combination of the two.
Figure 5.4 shows how the economy can be restored to the supply-side equilibrium using monetary policy. The central bank cuts the policy rate, investment rises again, and the new AD curve goes through point A.
Figure 5.4 A fall in investment: stabilization via monetary policy.
Alternatively, the government could intervene to return the economy to equilibrium by raising a component of aggregate demand under its control. In Figure 5.5 we assume that fiscal policy is implemented by an increase in forms of government spending that directly replace the fall in aggregate demand due to the lower investment. But the same effect on AD could be achieved by an increase in transfers, or indeed a cut in taxes. Recalling the multiplier model from Unit 3, a change in G is simple to show because it is just a shift in the intercept of the AD curve. A change in the tax rate, for example, alters the size of the multiplier and changes the slope of the AD curve.
In Figure 5.5, the lower level of investment spending is offset by higher government spending. When intervening, the government will hope that once confidence returns, and firms restore their previous level of investment, the government can reverse its higher spending and the economy will remain at point A.
Figure 5.5 A fall in investment and AD: stabilization via fiscal policy.
