Chapter 33

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Overview-ch.16: Pdot and U rate
Pdot = %∆P
u = U/LF
The Phillips curve relates u and Pdot.
Shifts in the Phillips curve - the role of
expectations. P and PE>>Pdot and PdotE
Shifts in the Phillips curve - the role of
supply shocks.
The cost of reducing inflation.
Pdot and u
How are inflation and unemployment
related in the short run? In the long run?
What factors alter this relationship?
What is the short-run cost of reducing
inflation? LR?
How does this relate to AD and AS?
Conclusion
In the long run, inflation & unemployment are
unrelated:
Neutrality
– The inflation rate depends mainly on growth in
the money supply.
– Unemployment (the “natural rate”) depends
on the minimum wage, the market power of
unions, efficiency wages, and the process of
job search.
– SRPC is related to cycles.—AD and SRAS.
How much Inflation? Rule of 70
Inflation and Unemployment
The Natural Rate of Unemployment
–
–
–
depends on various features of the labour market,
(e.g. minimum-wage laws, the market power of
unions, the role of efficiency wages, and
effectiveness of job search).
The Inflation Rate.
depends primarily on growth in the quantity of
money, controlled by the
B of C.
Inflation and Unemployment
Macroeconomics focuses on three primary
areas of our economy - output, prices, and
unemployment.
–
–
If policy-makers expand aggregate demand, they
can lower unemployment, in the short-run, but only
at the cost of higher inflation.
If they contract aggregate demand, they can lower
inflation, but at the cost of higher unemployment.
The Phillips Curve
Illustrates the tradeoff between inflation and
unemployment -- a short-run relationship.
The Phillips Curve relates inflation and
unemployment in the short-run as shifts in the
aggregate demand curve move the economy
along the short-run aggregate supply curve.
1958: A.W. Phillips showed that
nominal wage growth (Wdot) was negatively
correlated with unemployment in the U.K.
Deriving the Phillips Curve
Suppose P = 100 this year.
The following graphs show two possible
outcomes for next year:
A. aggregate demand low,
small increase in P (i.e., low inflation-P goes
to 102), low output, high unemployment.
B. aggregate demand high,
big increase in P (i.e., high inflation-P to
106), high output, low unemployment.
Phillips Curve and AD-SRAS
The Phillips Curve in the 1950s and
1960s
9
8
Rate of Inflation
7
6
1966
1967
5
4
1956
3
2
1968
1965
1964
1957
1
1963 1959
1958
1960
1962
1961
0
0
2
4
Unemployment Rate
6
8
The Phillips Curve, Aggregate
Demand and Aggregate Supply
The greater the aggregate demand for goods
and services, the greater is the economy’s
output and the higher the overall price level.
A higher level of output results in a lower level
of unemployment.
Monetary and fiscal policy can shift the
aggregate demand curve along SRAS , thus
moving the economy along the SR Phillips
curve.
Inflation
Rate
Phillips Curve
B
6%
A
2%
0
4%
7%
Unemployment
Rate
The Tradeoff Between Inflation and
Unemployment
Policy-makers face a tradeoff between
inflation and unemployment, and the
Phillips Curve illustrates that tradeoff.
–
–
Okun’s law (PAST DATA) tells us that greater
output means a lower rate of unemployment
but the Phillips Curve says this is at a higher
overall price level.
SR Relationship
Shifts in the Phillips Curve
It has been suggested that the Phillips
curve offers policy-makers a “menu of
possible economic outcomes.” Choices
Historical events have shown that the
Phillips Curve can shift due to:
–
–
Expectations
Supply Shocks
Shifts in the Phillips Curve
The concept of a stable Phillips Curve broke
down in the 1970s and 1980s. During the 70s
and 80s the economy experienced high
inflation and high unemployment
simultaneously.
Economists determined that monetary policy
was effective in the short-run in picking a
combination of inflation and unemployment, but
not in the long-run.
The Breakdown of the Phillips
Curve
9
1973
8
Rate of Inflation
7
6
1970
1969
1966
1967
5
4
1956
3
2
1968
1965
1964
1957
1
1972
1971
1963 1959
1958
1960
1962
1961
0
0
2
4
Unemployment Rate
6
8
Phillips curve data--US
LRPC and LRAS
Natural-rate hypothesis: the theory that
unemployment eventually returns to its
normal or “natural” rate, regardless of the
inflation rate.
Based on the classical dichotomy
(neutrality) and the
vertical LRAS curve.
LRAS and LRPC: In LR faster
money growth just causes Pdot
Reconciling theory and data
Evidence (from ’60s):
PC slopes downward.
Theory:
PC is vertical in the long run.
To bridge the gap between theory and
evidence, Friedman and Phelps
introduced a new variable: expected
inflation – a measure of how much people
expect the price level to change.
The Phillips Curve Equation
U rate = Natural U – a (Actual inflation-expected
inflation) Like the SRAS equation
Short run
BofC can reduce u-rate below the natural u-rate
by making inflation greater than expected.
Long run
Expectations catch up to reality, u-rate goes
back to natural u-rate whether inflation is high or
low.
The Role of Expectations
In the long-run, expected inflation adjusts to
changes in actual inflation, and the short-run
Phillips Curve shifts.
–
–
Once people anticipate inflation, the only way to get
unemployment below the natural rate is for actual
inflation to be above the anticipated rate.
As a result, the long-run Phillips Curve is vertical at
the natural rate of unemployment.
The Role of Expectations
In the long-run, with a vertical Phillips Curve at
the natural rate of unemployment, the actual
rate of inflation and unemployment will depend
upon aggregate supply factors and the fiscal
and monetary policies pursued by the
government.
The Role of Expectations
The view that unemployment eventually
returns to its natural rate, regardless of the
rate of inflation is called the natural-rate
hypothesis.
Expected Inflation Shifts the SRPC
Exam
Same format as December
Monday April 18---9AM
Next week-chapter 17
Last class Tuesday April 5—Review
+discuss exam
Office hours after term ends:
April 11: 3-4:30 and
April 13 and April 14 from 9:30-11
How Expected Inflation Shifts
the PC
At A, expected &
actual inflation = 3%,
unemployment =
natural rate (6%).
BOC makes inflation
2% higher than expected,
u-rate falls to 4% at B.
In the long run, expected
inflation increases, PC shifts
upward, unemployment
returns to natural rate at C.
Phillips curve
Unstable in LR because Pedot changes.
SR: MS↑, AD ↑,Y ↑,u↓--Pdot ↑ on SRAS
but sticky W&P so that Pdot> Pedot
Firms increase output but wages and other
costs are sticky
Workers supply more labour but greater
Pdot means real wages are lower.
When Pdot becomes fully expected, the
SR changes are reversed as SRPC shifts
Shifts in the Phillips Curve:
The Role of Supply Shocks
The short-run Phillips Curve also shifts
because of shocks to aggregate supply.
An adverse supply shock, such as an increase
in world oil prices, gives policy-makers a less
favourable trade-off between inflation and
unemployment.
Example: 1974 OPEC price increases +2011
The Role of Supply Shocks
Example: OPEC in the 1970s
(1) cut output and (2) raised prices. This shifts
SRAS up so P ↑ and Y ↓ . As Y ↓ , u ↑ .
The tradeoff in this situation resulted in two
choices:
Fight the unemployment battle with monetary
expansion (and accelerate inflation).
Stand firm against inflation (but endure even
higher unemployment).
Adverse supply shock and SRPC
The 1970s Oil Price Shocks
Oil $ per barrel
1973: $3.50
1974: $10.10
1979: $14.85
1980: $32.50
1981: $38.00
The BOC chose to
accommodate the first
shock in 1973 with
faster money growth.
Result: Higher
expected inflation, which
further shifted PC.
1979-81: Oil prices
surged again,
worsening the BOC
tradeoff.
Real and nominal oil prices
The 1970s Oil Price Shocks
The Cost of Reducing Inflation
To reduce inflation, the B of C has to pursue
contractionary monetary policy (e.g.
Contractionary OMO, raising interest rates).
When the B of C slows the rate of money
growth:
– It contracts aggregate demand (AD), which
reduces the quantity of output that firms
produce, which leads to a fall in employment.
Long run: output & unemployment return to
their natural rates.
Disinflation: MP and AD
The Cost of Reducing Inflation
Given the actions of the B of C in
combating inflation, the economy moves
along (downward) the short-run Phillips
Curve, resulting in lower inflation but
higher unemployment.
If an economy is to reduce inflation it must
endure a period of high unemployment
and low output.
Zero inflation target
Some economists believe that if the central bank
makes a credible statement of its intention to
deflate, that lower rates of inflation can be
obtained at smaller cost. PE adjusts faster.
In 1988, the Bank of Canada announced its
zero-inflation target, and in 1989 monetary
contraction began
The target was reached in 1994, by which time
the unemployment rate exceeded 10 percent.
Inflation fell from 4.5% to 1.1%.
The Cost of Reducing Inflation
The sacrifice ratio is the number of percentage
points of one year’s output that is lost in the
process of reducing inflation by one percentage
point.
A typical estimate of the sacrifice ratio is between
2 and 5 percentage points.
We can also express the sacrifice ratio in terms of
unemployment. Reducing inflation by 1
percentage point requires a sacrifice of between 1
and 2.5 percentage points of unemployment.
The Cost of Reducing Inflation
In some years (e.g. 1979) the sacrifice ratio
was very large indicating a high level of
unemployment was to be experienced in order
to reduce inflation to acceptable levels.
Rational Expectations
The theory of rational expectations suggested
that the time and therefore the sacrifice-ratio,
could be shorter and lower than estimated.
The theory of rational expectations suggests
that people optimally use all the information
they have, including information about
government policies, when forecasting the
future.
Rational Expectations (RE)
Expected inflation is an important variable that
explains why there is a tradeoff between
inflation and unemployment in the short-run,
but not in the long-run.
How quickly the short-run tradeoff disappears
depends on how quickly expectations adjust.
RE says they adjust quickly, making U costs
smaller –less sacrifice.
The Cost of Reducing Inflation
The Zero Inflation Target
The B of C in the 1980s, asserted that the
sole goal of the B of C would thereafter be
to achieve and maintain a stable price
level and close to zero inflation.
The Bank’s target was reached by 1992 by
which time the unemployment rate had
increased to over 11 percent.
Disinflation in the 80s and 90s
INFLATION SINCE 1960s
Low in 1960s
Upward spike through 70s into 1980s
“Disinflation”-positive but declining in
the 1980s
Low and stable since.
Bank of Canada
Central banks wish to avoid future inflation
episodes.
Analysis of 1970s indicated
Pdot = f (Mdot).
Since late 1980s, central banks have been
“credibly committed” to price stability.
Implies low Pedot
Why so much inflation?
Mistakes by central banks—did not
recognize that M growth would cause so
much inflation.
Bad theory—inflation will “buy” lower U.--PC
Political pressures to inflate (instead of
taxes to pay for spending).
Policy now—B of C
Current M growth targets are designed to
limit M growth if:
GDP approaches potential. >>Yfe
Prices start to increase by more than 2%.
Conclusion
Our understanding of the tradeoffs
between inflation and unemployment has
changed dramatically over the past forty
years.
New evidence, new experiences, and
additional analysis have led to more
agreement about this phenomena than in
the past. Particularly for the LR-Mankiw’s
rules.
Summary
The Phillips curve describes a negative
relationship between inflation and
unemployment.
By expanding aggregate demand, policymakers
can choose a point on the Phillips curve with
higher inflation and lower unemployment.
By contracting aggregate demand, policymakers
can choose a point on the Phillips curve with
lower inflation and higher unemployment.
Summary
The tradeoff between inflation and
unemployment described by the Phillips curve
holds only in the short run.
The long-run Phillips curve is vertical at the
natural rate of unemployment.
The short-run Phillips curve also shifts because
of shocks to aggregate supply.
An adverse supply shock gives policymakers a
less favorable tradeoff between inflation and
unemployment.
Summary
When the Bank of Canada contracts
growth in the money supply to reduce
inflation, it moves the economy along the
short-run Phillips curve.
This results in temporarily high
unemployment.
The cost of disinflation depends on how
quickly expectations of inflation fall. RE
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