Economics Basics — Economic Stability Policy Debate and Inflation

Part 10. Theory of Economic Stabilization Policy

Debates Surrounding Economic Stabilization Policy

1. Macroeconomic School Development Genealogy (Must-Memorize for Exams)

School	Formation Background / Core Theory	Government vs. Market Perspective
Classical (Marshall, Pigou)	Say’s Law / Price Flexibility	Market is complete, no involuntary unemployment exists
Keynesian (Keynes)	1930s Great Depression / Insufficient Effective Demand	Market is incomplete, fiscal policy is essential
Monetarist (Friedman)	New Quantity Theory of Money / K% Rule	Criticizes policy lag errors, emphasizes rules
New Classical (Lucas)	Rational Expectations Theory / Real Business Cycle	Anticipated policy = Zero real effect
New Keynesian (Mankiw)	Menu Cost / Efficiency Wage Theory	Accepts rational expectations + Micro-justification of price stickiness

2. Phillips Curve and Stagflation

The Phillips curve shows the short-run trade-off between the inflation rate and the unemployment rate.

• Demand Shock (Expansionary Policy): Movement along the downward-sloping short-run Phillips curve → Price level↑, Unemployment rate↓
• Supply Shock (Oil shock, etc.): Upward-rightward shift of the short-run Phillips curve itself → Price level↑, Unemployment rate↑ = Stagflation

3. Natural Rate of Unemployment Hypothesis and the Long-Run Phillips Curve (Friedman)

In the long run, the unemployment rate returns to the “natural rate” level → The long-run Phillips curve is a vertical line.

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Part 11. Unemployment and Inflation

Theory of Unemployment

1. Four Types of Unemployment

Type	Cause	Character
Cyclical Unemployment	Economic slump/recession (deflationary gap)	Involuntary, targeted by Keynes for eradication
Structural Unemployment	Rapid industrial restructuring, technological innovation	Involuntary, requires long-term training
Seasonal Unemployment	Seasonal factors in agriculture, construction, etc.	Involuntary, predictable
Frictional Unemployment	Search period during job turnover/transition	Voluntary, part of natural unemployment

2. New Keynesian Basis for ‘Downward Wage Rigidity’

• Efficiency Wage Theory: The idea that wages determine the marginal productivity of labor. Firms voluntarily pay an “efficiency wage” higher than the equilibrium wage to maximize profits.
  • Purpose: Prevention of moral hazard, prevention of departure of top talent (adverse selection), reduction of turnover costs.
  • Result: Even with excess labor supply (= involuntary unemployment), market wages do not fall.

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Spillover Effects of Inflation

1. Demand-Pull vs. Cost-Push Inflation

Classification	Demand-Pull	Cost-Push
Main Causes	Excessive money supply, explosive fiscal spending	Wage disputes, soaring raw material prices (oil prices)
AD-AS Change	AD curve shifts right	SRAS curve shifts left
National Income Pattern	Price level↑, National income↑ (accompanied by boom)	Price level↑, National income↓ (accompanied by stagflation)
Government Prescription	Aggregate demand suppression policy effective	Difficult to resolve. Structural improvement / exchange rate stabilization urgent

2. Anticipated vs. Unanticipated Inflation Costs

Costs incurred by anticipated inflation:

• Shoe-leather cost: The trouble cost of frequent visits to the bank to reduce held cash.
• Menu cost: Physical costs of having to update continuous price change notifications.

Unanticipated inflation → Forced redistribution of wealth:

Gainer Groups	Loser Groups
Debtors (debt burden eased)	Creditors (collapse of currency value)
Real estate / real asset holders	Fixed-income / pension recipients
Government (real tax revenue increases)	Salaried workers (real wages decline)