5.7: The Role of Macroeconomic Policy

In Chapter 4, performance of the economy was evaluated based on the standard of living, measured as the real GDP per capita, it provided. Recessionary gaps reduce the standard of living in the economy by reducing employment, real GDP, and per capita real GDP.

Inflationary gaps reduce standards of living in more subtle ways. They push up the price level, raising the cost of living. But the rise in the cost of living affects different people in different ways. Those on fixed money incomes suffer a reduction in their standards of living. People holding their wealth in fixed price financial assets like bank deposits and bonds suffer a loss in their real wealth. On the other hand, inflation reduces the real value of debt, whether it is mortgage debt used to finance the purchase of a house, or a student loan used to finance education. The money repaid in the future has a lower purchasing power than the money borrowed. In these and other ways, the costs of inflation are distributed unevenly in the economy, making decisions about employment, household expenditure, and investment more difficult.

Using Figure 5.10, we have described the self-adjusting mechanism within the AD/AS model that might eliminate output gaps and move the economy to equilibrium at potential output. We have also seen, in Figure 5.7, that output gaps have been persistent in the Canadian economy despite the possibility that flexible wages and prices might automatically eliminate gaps. These observations raise two questions:

1. Why are output gaps, especially recessionary gaps, persistent?
2. Can government policy work to eliminate output gaps?

To answer the first question, we need to think about two issues. The first is the flexibility or rigidity of wages and prices both up and down. The second is strong possibility of asymmetry between adjustment effects of absolute increases and absolute decreases in wages and prices.

In any case the economy’s reaction to output gaps takes time, because wage rates and prices are sticky and slow to adjust to changed economic circumstances. But, there is reason to doubt that absolute reductions in money wage rates and prices would help to eliminate a recessionary gap in an economy with fixed nominal financial contracts.

In the modern economy, wage rates for labour are often fixed by contract or custom for finite periods of time. Labour contracts often set wage rates for periods of several years. Even without explicit contracts, employers are unlikely to change the wages they pay on an hour-by-hour or day-to-day basis. Custom may suggest an annual adjustment. Minimum wage laws prevent cuts in the lowest wage rates. These institutional arrangements mean that the money wage rates paid to labour adjust slowly to changes in economic conditions. Cuts to money wage rates are particularly difficult and controversial, although they have occurred in particular industries, like the airline industry and the auto industry under very difficult market conditions. The macroeconomic adjustment process calls for a change in the average money wage rate across the entire economy. That is a more complex process and uncertain.

Contracts and custom also affect the speed of price adjustment to economic conditions. Producers in many cases have supply contracts with their customers that fix prices for a finite time period. Sellers may be reluctant to change prices frequently, in part because they are uncertain about how their competitors will react to their price changes, and in part to avoid alienating their customers. Retailers often issue catalogues in which prices are fixed for a specified period. The result is slow price adjustment to changing economic conditions in many parts of the economy.

Nevertheless, if the economy experiences a persistent output gap, that gap will lead eventually to changes in factor prices, costs, and market prices for goods and services. Indeed, the adjustment to inflationary gaps may come more quickly than to recessionary gaps because it is easier to raise money wage rates than to cut them. The important policy question is: When wages and prices are sticky, should government wait for the self-adjustment process to work, accepting the costs of high unemployment or rising inflation that it produces? This was a very serious and widely debated question since 2008 in the face of growing international recessions as a consequence of serious sovereign debt problems and continued international financial market uncertainty.

Government has policies it can use to reduce or eliminate output gaps. In Chapter 7 we will examine fiscal policy, the government expenditures and tax policy that establish the government’s budget and its effect on aggregate demand. Government can use its fiscal policy to change the AD curve and eliminate an output gap without waiting for the economy to adjust itself. Chapters 9 and 10 discuss monetary policy, actions by the monetary authorities designed to change aggregate demand and eliminate output gaps by changing interest rates, money supply, and the availability of credit. Both fiscal and monetary policy work to change aggregate demand and eliminate output gaps, which reduce the standard of living the national economy provides for its citizens.

Fiscal policy: government expenditure and tax changes designed to influence AD.

Monetary policy: changes in interest rates and money supply designed to influence AD.