Abstract
By the early 1980s, the macroeconomic landscape had changed significantly for the United States and several other Western European economies. Once, successful Keynesian discretionary demand-side stabilization policies appeared to be ineffective. The output-inflation tradeoff seemed to be no longer in evidence—expansionary fiscal and monetary stimuli only yielded additional inflation with no accompanying increase in GDP growth or employment. The Phillips curve, for all intents and purposes, appeared to be dead.
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Notes
- 1.
In this chapter and the remainder of this book, rational expectationists and supply-siders will be used interchangeably. Technically, in the context of this chapter, rational expectationists were the theoretical macroeconomists who constructed fundamental mathematical models that validated the paradigm shift. Their supply-sider colleagues then prescribed real-world macroeconomic policies consistent with this new rational expectations model.
- 2.
The model presented here is a synthesis of the Joanna Gray/Phelps class of asymmetric information models that were key in the early development of the paradigm shift. Once again, in keeping with the policy-driven focus of this book, the theoretical aspects are de-emphasized to make way for expositional convenience and intuition.
- 3.
The numbers used for P1 and W1 are purely for discussion. The point is that increases in nominal wages do not match increases in prices, and this disparity leads to an erosion of the real wage.
- 4.
This AS is also called the adaptive expectations AS curve.
- 5.
The asymmetric information theory for a positively sloped AS is only one of several theories. Another explanation is the rigidity in long-term nominal wage adjustments caused by long-term wage contracts. According to this theory, unexpected increases in inflation in a labor market characterized by fairly rigid long-term contracts will have the same effect as in our model. Once again, nominal wage increases will not match increases in inflation, resulting in a positively sloped AS.
- 6.
This is the view propounded by the expectationists. Later, in this chapter, the Keynesian explanation of the “so-called” paradigm shift will be discussed.
- 7.
Paradigms, in the context of this chapter, are basically differentiated by their AS curves. ISLM space and the AD curve are identical for both Keynesian as well as RE-AS models. It is only the AS curves derived from crucial assumptions in their respective labor markets that separate the two major paradigms.
- 8.
Both oil shocks have been combined into one “composite” shock as shown in the diagram.
- 9.
US macroeconomic statistics during the stagflationary bouts in the 1970s were indeed bleak, and included double-digit inflation and unemployment. Relate stagflation to the earlier discussion on cost-push inflation, where similar countercyclical movements in prices and GDP were discussed.
- 10.
The AD shifts are independent of the AS curve, and hence are identical in Fig. 10.9a, b.
- 11.
The problem exists primarily in developing economies because these economies are almost certainly Keynesian. Developing economies are characterized by excess labor supply and the inability of this excess labor supply to enforce and influence nominal wage contracts. Information is imperfect and asymmetric, and there is an absence of efficient bond-markets that signal expected inflation. All these characteristics point to Keynesian models as “default” paradigms for emerging and even for newly industrialized economies.
- 12.
Mainstream macroeconomics texts by authors such as Michael Parkin and Richard Froyen also propose short-term and long-term AS and Phillips curves.
- 13.
In the example where prices went from 2–5 while wages only went from 12–15. Here workers did not “see” the increase in price—they only “saw” their nominal wage increases from 12–15 in the short-run, and responded by supplying more labor. Thus, output increased with increases in price, resulting in a positively sloped AS.
- 14.
In this section, we deliberately shy away from specific definitions of short- and long-run. The point is that information asymmetry can exist only for so long. Eventually, workers will know all pieces of information. And besides, this process may be of different duration in different economies. An economy with a more sophisticated labor market will go from short- to long-run far more quickly than one with a less-developed economy possessing a less sophisticated labor market.
- 15.
Robert E. Lucas Jr., of the University of Chicago, was the recipient of the Nobel Prize for Economics in 1995.
- 16.
This assumes that all other macroeconomic factors—tax rates, government spending, confidence, foreign GDP—remain constant and dormant. This is a purely linear, simplified causality from interest rate announcements to typical long-bond and stock market behavior, immediately following the Fed’s announcement.
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Langdana, F.K. (2016). The Supply-Side Model and the New Economy. In: Macroeconomic Policy. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-319-32854-6_10
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