Projekt :
„Odpowiedź na wyzwania gospodarki opartej na
wiedzy: nowy program nauczania na WSHiP”.
Projekt współfinansowany ze środków Unii
Europejskiej w ramach Europejskiego Funduszu
Społecznego.
Medium run approach
Designing a disinflation path
What is a disinflation?
Disinflation is a decrease in the inflation rate.
It is actually the Central Bank policy to decrease the
inflation rate, if needed.
There are at least two questions that arise while
making a disinflation policy:
1. What tools and how should be used to achieve a
given disinflation goal?
2. Considering the Philips curve, one can ask if
decreasing inflation can make any harm to the
economy, like increasing unemployment rate?
Generally, one can ask what are the effects of
such a policy for wider economic environment?
Referring to the questions:
To engineer disinflation we need:
1. Okun’s law
2. The Philips curve relation
3. The AD relation slightly
transformed
Okun’s law:
Okun’s law shows how the deviation of output
growth leads to a change in the unemployment
rate:
u t  u t 1

   g


yt
 g
y



What are ”the roots” of the Okun’s law?
”Roots” of Okun’s law:


Empirical evidences (see figure 9-2 in Blanchard’s
textbook)
The following reasoning:
If we assume that Y=N and L (labour force) is constant,
then 1% increase in output leads to 1% point increase in
employment and 1% decrease in unemployment,
therefore:
u t  u t 1   g yt
In other words the change in the unemployment
rate should be equal to the negative one of the
change of output growth rate.
”Roots” of Okun’s law:
Now if we assume that there is such a level of the ouput
growth that prevents the unemployment rate from rising,
in other words that maintains a constant unemployment
rate, so called normal growth rate :

gy
and we assume that unemployment rate change
can react with certain kind of sensitivity with
respect to output growth changes, say equal to β
We can finally write down:
If we tried to estimate Okun’s law
relation for different countries
then we would obtain different values of β
coefficient and we will have to find-out what
is a normal growth rate for the analysed
country.
For the US:
u t  u t 1   0 . 4  g yt  3 % 
The Philips curve relation…
is well known to you:
 t   t 1   u t  u n 
We will also assume (as in the Okun’s law case)
that α coefficient serves as a ”sensitivity” measure
of inflation rate change with respect to
unemployment rate change. Therefore, we can also
expect that α probably differs among the countries.
The AD relation slightly
transformed:
Let’s use the AD relation considering time indexes:
Yt 



 M t
f 
, G
 Pt


t
, Tt





We can focus on relation between the real
money stock and output:
Yt  
M
Pt
t
The AD relation slightly
transformed:
If we turn the equation into logarithmic one
(assuming for the simplicity that γ =1), we
will obtain:
ln Yt  ln M t  ln Pt
And this allows us to treat this equation in the ”rate”
terms:
g yt  g mt   t
It shows us how the difference between nominal money
growth and inflation affects output growth.
We can use all three equations
to design the disinflation path:
u t  u t 1



    g yt  g y 


 t   t 1   u t  u n 
g yt  g mt   t
Our case study
ASSUMPTIONS:
The CB wants to decrease a current inflation
rate, which is equal to 16% over 4 years to
the level of 4%.
normal growth rate = 3%
natural unemployment rate = 4%
α = 1 β =0.3
nominal money growth rate = 19%
Solution:
%
T0
T1
T2
T3
T4
inflation rate
16
13
10
7
4
unemployment rate
4
7
7
7
7
output growth rate
3
-2
3
3
3
nominal money growth rate 19
11
13
10
7
Step by step:
1.
2.
3.
From the Philips curve relation you are able
to derive the unemployment rate path
From the Okun’s law you are able to derive
the output path
From the AD relation knowing both
unemployment and output path you are able
to design the nominal money growth
The Lucas critique:
The former approach is based on assumption that the wage
setters keep their inflation expectations on the previous
inflation level, in fact the wage setters knowing the CB plans,
for example disinflation plan, they may also lower their
expectations, if so then this would reduce current inflation,
without necessarily any change in the unemployment, as:
 t     u t  u n 
e
t
if
t 
e
t

0    u t  u n 
The Lucas critique:
Lucas & Sargent in fact did not believe that
disinflation could take place without some
increase in unemployment, but there are
some empirical evidences that the end of
several high inflations was accompanied only
by small unemployment increases.
Decreases in nominal money growth can be
neutral in the long run, i.e. disinflation doesn’t
have to cause recession if monetary policy is
trustful/credible.
Fischer’s contrary view:


Due to nominal rigidities (many wages and prices
are set in nominal terms for some time) the wages
do not readjust when there are some changes in
policy.
Even the CB fully convinced the workers and firms
than nominal money growth would be lower, the
wages set before the policy change, still would be
reflecting former higher expectations, therefore too
rapid decrease in nominal money growth would lead
to higher unemployment.
Taylor’s one step further


Wage contracts are not signed at the same time,
therefore, it causes staggering of wage decisions.
This should be considered while designing nominal
money change. If there is a rapid decrease in the
nominal money growth, then there is no big
decrease in inflation as wages are the result of
decisions made before the policy change and the
result will be a decrease in real money and
recession. So the best for the CB is to proceed
slowly at the beginning while announcing it will
proceed faster in future. This leads to new wage
agreements taking the new policy into account.
Projekt :
„Odpowiedź na wyzwania gospodarki opartej na
wiedzy: nowy program nauczania na WSHiP”.
Projekt współfinansowany ze środków Unii
Europejskiej w ramach Europejskiego Funduszu
Społecznego.