Summary of the Wolfers’s Article
This assignment will first summarize the article published by Wolfers (2016) in the New York Times, about policymakers’ possible response to an economic slowdown.
Wolfers (2016) begins his article referring to an employment report that suggests job growth is slowing down. He brings up the possibility that the economy may suffer a significant slump, maybe even a recession. Wolfers (2016) suggests that the recent economic recovery may have come to an end. Worse, it is hard to think of a time in recent history when policy makers were so unprepared to answer to the challenge (Wolfers, 2016).
If the economy shows unmistakable signs of a recession, the Federal Reserve may resort to quantitative easing, but Wolfers (2016) thinks it is unlikely because of the proximity of presidential elections. Moreover, the Federal Reserve is likely worried that movements such as “Audit the Fed” pick up strength and wants to protect its reputation as a conservative central bank.
My Opinion about Wolfers’s Article
Wolfers (2016) is right to be worried about the Federal Reserve and other policy makers. They have been wrong in the past, as in the Great Depression, where the policy makers failed to give a proper answer to stimulate the economy back to normal. More recently, simplification of home loans requirements and the activist monetary policy of stimulus in the early 2000s created a housing bubble. When this bubble burst, the economy came crashing down, and the Federal Reserve took its sweet time to answer correctly, after the blunder of the Lehman Brothers failure. The very existence of an “Audit the Fed” movement is indicative that the policy makers may be discordant with reality, and need to have their job watched over.
However, it is wrong to think that more stimulus will help the economy in the long-run. If the economy is not in general equilibrium, economic forces will attempt to restore it, as one can see in both AD-AS and IS-LM models (Wood, 2016). Monetary policy usually has a temporary effect, affecting only the short-run, not the long-run. This sentence will be explained in the next section.
Explanation of Monetary Policy using the IS-LM and AD-AS models
Mankiw (2010, p. 324) tells us that the IS-LM model should be utilized in the short-run, for a fixed price level. However, the AD-AS model is useful both in the short and in the long-run. The next graph indicates that the AD-AS model has curves for both periods, the Short-Run Aggregate Supply (SRAS) and the Long-Run Aggregate Supply (LRAS). Aggregate Demand is AD.
Source: Wood (2016)
One can see that the equivalent IS-LM graph does not show anything about long or short-run, on the right:
Source: Wood (2016)
If the Federal Reserves decided for an activist monetary policy and lowered the basic interest rates, these would move from r0 (in the graph above) to a lower position without shifting the LM curve or its IS sister. In this lower step of interests, the economy would heat up, and output would be above Y0. The economy would be above full employment. On the AD-AS model, the SRAS would shift downwards, and there would be a new equilibrium at a higher output where it crossed the AD curve. However, there would not be a shift in the LRAS, and that is essential to understand the limits of monetary policy.
Soon enough, prices and wages would increase, because neither the FE – Full Employment – curve has shifted, nor the LRAS. There was no increase in productivity to make either curve shift. All the Federal Reserve did was artificially decrease interest rate levels. As prices rise (demand is up) and workers are laid-off (their wages are too expensive), the economy falls back to the original equilibrium: interest rates adjust back to r0, and the SRAS0 shifts back up. Initial equilibrium is restored, although in the short-run it was temporarily and artificially inflated.
References
Mankiw, N. G. (2010). Macroeconomics (7th ed.). New York, NY: Worth.
Wolfers, J. (2016, June 04). If the Economy Is Sinking, Policy Makers Are Far From
Prepared. Retrieved July 02, 2016, from
http://www.nytimes.com/2016/06/05/upshot/if-the-economy-is-slowing-policy-makers-are-far-from-prepared.html
Wood, S. A. (2016), Lecture on The IS-LM/AD-AS Model: A General Framework for
Macroeconomic Analysis, Part 3. Personal Collection of S. A. Wood, University of
California Berkeley, Berkeley CA.
