Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Key Concepts
Concepts…
Business
B
i
C
Cycles
l
Econ 402
Professor Yamin Ahmad
 The relationship between Aggregate Supply and the
Phillips Curve
 The short-run tradeoff between inflation and
unemployment
 Incorporating
p
g expectations:
p
 Adaptive Expectations
 Rational Expectations
 Sargent and Wallace (1977) Policy Ineffectiveness
Proposition
Lecture 5: Phillips Curve and
E
Economic
i P
Policy
li
 The Phillips Curve
 The Role of Expectations
 Barro – Gordon Model
 Barro – Gordon Model
 Monetary Policy
 Active versus Passive Policy
 Rules versus Discretion
 Time Inconsistency Problem and Some Solutions
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Okun’s
Okun
s Law
Inflation Unemployment,
Inflation,
Unemployment and the Phillips Curve
Percentage
change in real 10
GDP
 Governments (and society in general) care
about
b t inflation
i fl ti  and
d unemployment,
l
t u, nott
prices, P and output, Y.
8
• Okun’s
O u s Law:
a
the negative
relationship
between GDP
and
unemployment.
 To go from prices to inflation is fairly
straightforward!
 To go from output to inflation, we need Okun’s
6 1984
2003
4
1987
2
0
1975
2001
-2
1991 1982
-4
-3
Law
Note: These lecture notes are incomplete without having attended lectures
Y
 3.5  2 u
u
Y
1951 1966
-2
-1
0
1
2
3
4
Change in unemployment rate
2
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Inflation, Unemployment,
Inflation
Unemployment and the Phillips Curve
 Aggregate Supply: Y  Y    P  P e 
t
t
t
t
 Yt    Pt 1 1   t   Pt 1 1   te  
 Yt    t   te 
The Phillips
Th
Philli curve states that
h  depends
d
d on
 expected inflation,  e.
 cyclical
li l unemployment:
l
t the
th deviation
d i ti off th
the actual
t l
rate of unemployment from the natural rate
1
 Okun’s Law :    u  u n     Y  Y 
 supply shocks
shocks,  (Greek letter “nu”)
nu ).
  
 Phillips Curve:  t     ut  utn
e
t
 with
ith shock:
h k
t  
e
t


   u  u  
t
n
t
   e   (u  u n )  
t
 So the Phillips Curve is just an alternative way of
where  > 0 is an exogenous constant.
describing the Aggregate Supply Curve
Curve.
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Professor Yamin Ahmad, Business Cycles – ECON 402
Phillips curve:
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Professor Yamin Ahmad, Business Cycles – ECON 402
The Phillips Curve and SRAS
SRAS:
Inflation, Unemployment, and the Phillips
Curve
Graphing the Phillips curve
In the short
run, policymakers
face a tradeoff
between  and u.
u
Y  Y   (P  P )
e
   e   (u  u n )  
 SRAS curve:
p is related to unexpected
p
movements in
Output
the price level.

   e   (u  u n )  

1
The short-run
Phillips curve
e 
 Phillips curve:
Unemployment is related to unexpected
movements in the inflation rate.
Note: These lecture notes are incomplete without having attended lectures
un
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Note: These lecture notes are incomplete without having attended lectures
u
7
Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Shifting the Phillips curve
People
p adjust
j
their
expectations
o er time
over
time,
so the tradeoff
y holds in
only
the short run.

Two causes of rising & falling inflation
   e   (u  u n )  
   e   (u  u n )  
 cost-push
t
h inflation:
i fl ti
i fl ti resulting
inflation
lti ffrom supply
l
shocks
Adverse supply shocks typically raise production costs
and induce firms to raise prices, “pushing” inflation up.
 2e  
 1e  
 demand-pull inflation: inflation resulting from demand
E g an increase
E.g.,
in e shifts the
short-run P.C.
upward.
un
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u
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Professor Yamin Ahmad, Business Cycles – ECON 402
shocks
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which “pulls”
pulls the inflation rate up
up.
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Adaptive expectations
Key Question: How are Expectations
F
Formed?
d?
Phillips curve:
   e   (u  u n )  
 Adaptive
p
expectations:
p
an approach
pp
that
assumes people form their expectations of
future inflation based on recently observed
inflation.
 A simple
p example:
p
We will look at two types:
Expected inflation = last year’s actual inflation
 e   1
• Then,
Th
the
th P
P.C.
C b
becomes
   1   (u  u n )  
• Adaptive Expectations
• Rational Expectations
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
The Sacrifice Ratio
Inflation Inertia
n
   1   (u  u )  
 To reduce inflation,, policymakers
p y
can contract
Aggregate Demand, causing unemployment to rise
above the natural rate.
In this form, the Phillips curve implies that
inflation has inertia:
 In the absence of supply shocks or cyclical
 The sacrifice ratio measures the percentage of a
unemployment, inflation will continue indefinitely at
it currentt rate.
its
t
year’s real GDP that must be foregone to reduce
inflation by 1 percentage point
point.
 A typical estimate of the ratio is 5 in the US
US.
 Past
P t inflation
i fl ti iinfluences
fl
expectations
t ti
off currentt
inflation, which in turn influences the wages &
prices that p
p
people
p set.
 [[For UK,, a 1% reduction in output
p for one year
y
lowers
inflation by about ¼% point.]
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
The Sacrifice Ratio
Rational Expectations
 Example: To reduce inflation from 6 to 2 percent, must
sacrifice
ifi 20 percentt off one year’s
’ GDP
GDP:
Ways of modeling the formation of expectations:
 Adaptive expectations:
GDP loss = (inflation reduction) x (sacrifice ratio)
=
4
x
5
People base their expectations of future inflation
on recently observed inflation.
 Rational expectations:
 This loss could be incurred in one year or spread over
several years, e.g., 5% loss for each of four years.
People base their expectations on all available
g information about current
information, including
and prospective future policies.
 The cost of disinflation is lost GDP.
One could use Okun’s law to translate this cost into
unemployment.
Note: These lecture notes are incomplete without having attended lectures
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Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Painless disinflation?
Rational Expectations
 Proponents of rational expectations believe
 Rational Expectations (Muth): People use available information
that the sacrifice ratio may be very small:
efficiently, including how the economy works.
 In practice this boils down to assuming agents use the same model
of the economy as the researcher (“model-consistent” expectations).
 Suppose u = u n and  = e = 6%,
and suppose the Fed announces that it will do whatever is
necessary to reduce inflation from 6 to 2 percent as soon as
p
possible.
 People can make mistakes, but they do not make systematic
forecasting errors.
 If the announcement is credible, then e will fall, perhaps by the full
4 points.
 With rational expectations disinflation is painless: (credible)
announcement  e
 Then,  can fall without an increase in u.
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Professor Yamin Ahmad, Business Cycles – ECON 402
u
9 5%
9.5%
9.5
74
7.4
7.1
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Professor Yamin Ahmad, Business Cycles – ECON 402
Calculating
g the sacrifice ratio for the
Volcker disinflation
 1981:  = 9.7%
Total disinflation = 6.7%
1985:  = 3.0%
year
1982
1983
1984
1985
Note: These lecture notes are incomplete without having attended lectures
un
uu n
6.0%
6
0%
6.0
60
6.0
6.0
3.5%
3
5%
3.5
14
1.4
1.1
Calculating
g the sacrifice ratio for the
Volcker disinflation
 From previous slide: Inflation fell by 6.7%,
t t l cyclical
total
li l unemployment
l
t was 9
9.5%.
5%
 Okun
Okun’s
s law:
1% of unemployment = 2% of lost output.
 So, 9.5% cyclical unemployment
= 19.0% of a year’s real GDP.
 Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 p
percentage
g p
points of GDP were lost for each 1
percentage point reduction in inflation.
Total 9.5%
Note: These lecture notes are incomplete without having attended lectures
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Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Policy Ineffectiveness Proposition
Anticipated versus Unanticipated Shocks
LRAS
P
 Rational Expectations + “Surprise”
Surprise supply function + Market
Clearing + Symmetric Information 
C
Price Level
P
Policy Ineffectiveness Proposition (Lucas, Sargent-Wallace):
Only unanticipated policy matters  no role for stabilization
policy.
Anticipated
Demand
Shock
Unanticipated
Demand
Shock
B
A
AD2
 To get a role for policy either:
AD1
(i) the government must have superior information; or
(ii) agents must be locked into old contracts as in non-market
clearing models
models.
Y
Y
Income and Output
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Stabilization Policy: Active or Passive?
No Price/Wage Adjustment?
 Under the Neoclassical (and Real Business Cycle)
Why might wages/prices not adjust?
view, fluctuations are the efficient response of the
view
economy to shocks (subject to whatever information
agents have); no role for active policy.
1. “Menu” costs of changing prices;
2. Staggering of wage and price changes;
 With wage and/or price rigidities theoretical case for
intervention is stronger.
 With wage/price rigidities, economic policy can have short
3. Co-ordination failure and multiple equilibria.
run effects
ff t ( - multipliers
lti li
are non zero in
i the
th short
h t run))
All of these explanations require some form of market
imperfection.
 But is this enough? …
Note: These lecture notes are incomplete without having attended lectures
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Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
Problems of Activist Policy
Stabilization Policy: Rules vs.
vs Discretion
 Lags in implementing (inside lag) and between
 Government’s incentives may not align what is best
policy and target variables (outside lag) may be long
and variable.
 Hence, forecasts are needed, but these are often inaccurate.
 An announced policy may be “incredible” (or “time
 “Lucas
Lucas Critique
Critique” suggests that many of the
inconsistent”) because the policy maker
subsequently has an incentive to deviate (renege)
from the policy even in the absence of new
information.
relationships in econometric models will shift with
policy (e.g. = e – (u-un) with e= -1).
 Encourages
g caution in the use of p
policy.
y
Note: These lecture notes are incomplete without having attended lectures
for economy: they may use economic policy to
influence their chances of reelection, not necessarily
to the ultimate benefit of the economy (political
business cycle).
 Examples…
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Professor Yamin Ahmad, Business Cycles – ECON 402
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Professor Yamin Ahmad, Business Cycles – ECON 402
Barro Gordon Model (1983)
Barro-Gordon Model: Time Inconsistency
 Robert Barro (left) and David
 Phillips Curve: u – un = -( - e)
Gordon (right) highlighted the time
inconsistency issue within the
monetary policy literature
(1)
 Private Sector sets e, then government sets .
 Government minimizes loss function:
 In their model, the government cares about inflation
L = u +  2 = un - ( - e) +  2
and
d unemployment
l
t
 The government would like both inflation and unemployment
(2)
dL/d = -  + 2   = 0   
to be as low as possible.
 Under Rational Expectations: e = 
 However, are their policy announcements time
 Substituting into (1) yields: u = un
 Loss under discretion: Ld = un + 
consistent?
Note: These lecture notes are incomplete without having attended lectures
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Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Professor Yamin Ahmad, Business Cycles – ECON 402
The Inflation Unemployment Tradeoff
Is Zero Inflation Possible?
Inflation
 Suppose
pp
that the g
government tries to set inflation to
zero (and more importantly, people believe them!)
 Loss with zero inflation

 = = 0 and u =
un
 Plugging into Phillips Curve (1) yields: Lr = un < Ld
policy(Lr):
e
 However, this optimal policy is not credible!
C
A
B
0
 Why?...
Note: These lecture notes are incomplete without having attended lectures
PC1(e = 
PC2(e = 
I2
un
I1
Unemployment
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Professor Yamin Ahmad, Business Cycles – ECON 402
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Professor Yamin Ahmad, Business Cycles – ECON 402
What Rule for Monetary Policy?
Resol ing the Time Inconsistency
Resolving
Inconsistenc Issue
Iss e
 Constant money growth (Friedman)
 Constitutional rule
 Problematic if velocity of money is unstable.
 But a fixed rule is very inflexible. Will limit the use of
monetary policy to address shocks that hit the economy.
 Nominal GNP target (Meade, Tobin)
 equivalent to a “velocity
velocity corrected
corrected” money target.
 Reputation
 Price level/inflation target (Bundesbank, UK govt., ECB)
 Government will have an incentive to carryy through
g optimal
p
 Same
S
as nominal
i l GNP ttargett for
f AD shocks,
h k b
butt ttoo
monetary policy if it cares enough about its reputation.
contractionary in face of adverse supply shocks (e.g. OPEC).
 Interest rate rule, e.g. Taylor rule
 Delegation to an independent authority with different
preferences/incentives
 Example: An independent central bank who will focus only
 Note: All of these are rules for a nominal variable.
variable
on inflation, like the ECB.
Note: These lecture notes are incomplete without having attended lectures
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Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
What Rule for Monetary Policy?
Further Reading:
 Robert E. Lucas, J.r., 1976, “Econometric Policy Evaluation: A Critique”.
In Karl Brunner and Allan Meltzer (Eds.), The Phillips Curve and Labor
Markets, Carnegie-Rochester Conference on Public Policy, 1,
Amsterdam: North Holland
Holland, pp
pp. 19 – 46.
46
 Kydland, F. and E. Prescott, 1977, “Rules Rather Than Discretion: The
Inconsistency of Optimal Plans”, Journal of Political Economy, 85:3,
June pp
June,
pp. 473 – 492
 Barro, R. and D. Gordon, 1983, “A Positive Theory of Monetary Policy
in a Natural Rate Model”, Journal of Political Economy, 91:4, August,
pp 589 – 610.
pp.
610
 Ben S. Bernanke and Frederic S. Mishkin (1997), “Inflation Targeting: A
New Framework for Monetary Policy?”, Journal of Economic
Perspectives 11,
Perspectives,
11 (Spring),
(Spring) pp
pp. 97 – 116.
116
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