Macroeconomics
Chamberlin and Yueh
Chapter 10
Lecture slides
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
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Unemployment, Inflation and
Monetary Policy
• The Phillips Curve: the unemploymentinflation trade-off
• Theories of Unemployment
• Costs and Benefits of Inflation
• Policy Choices: preferences between
unemployment and inflation
• Expectations Augmented Phillips Curve
• NAIRU: Policy Implications
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Learning Objectives
• Understand the theory of the Phillips curve, which shows
that there is a trade-off between unemployment and
inflation.
• Recognise that the trade-off is different in the short run and
the long run, and the transition between short and long run
is governed by the way expectations are formed and the
degree of flexibility in wages and prices.
• Analyse the policy choices while considering the costs of
unemployment and inflation.
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Learning Objectives
• Explain how monetary policy can be used to control the rate
of inflation, and how the Phillips Curve framework is used
to formulate monetary policy.
• Recognise how the importance of monetary policy has
grown as policy makers place an increasing emphasis on the
control of inflation.
• Investigate the reasons behind the recent trend for making
central banks independent and analyse the time
inconsistency problem
• Cover the concepts of seignorage and hyper-inflation
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Unemployment and Inflation
• The control of unemployment and inflation has been a
longstanding preoccupation of macroeconomists.
• This takes on an added degree of fascination, as the theory
of the Phillips curve argues that there is a trade-off between
the two.
• Therefore, policy makers are faced with a conundrum: if
either unemployment or inflation can only be controlled at
the expense of the other, then which combination is the best
choice?
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Unemployment and Inflation
• To shed some light on this question, two sets of issues need
to be discussed.
• Firstly, what are the relative costs of unemployment and
inflation? Secondly, what is the nature of the trade-off
between the two?
• The nature of the trade-off is where economic theory has a
lot to contribute. There is ample evidence to suggest that
the trade-off is different in the short run and the long run,
and the transition between short and long run is governed
by the way expectations are formed and the degree of
flexibility in wages and prices.
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Monetary policy
• Monetary policy refers to the control of either the quantity
or the price of money. The importance of monetary policy
has grown as policy makers place a growing emphasis on
the control of inflation.
• The traditional goal of full employment has been supplanted
by target of economic stability, and as a result, the tools the
government uses to control the economy have shifted away
from fiscal (demand management) to monetary policy.
• The theory of the Phillips curve is very useful here, as it can
explain how monetary policy could be used to control the
rate of inflation.
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The Phillips Curve: the
unemployment-inflation trade-off
• The level of inflation refers to the rate at which prices are changing:
P

P
• The definition of unemployment varies, but the accepted International
Labour Organisation (ILO) measure describes it as those who are
without a job, and are both looking and are available for work.
• A proposed link between unemployment and inflation is described by
the Phillips curve.
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The Phillips Curve: U.S. 1960s
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The Phillips Curve
• The Phillips curve has been at the centre of economic
policy making for over 40 years. It originated from a
simple empirical relationship discovered by A.W.H. Phillips
(who was actually an engineer and also invented the
Phillips machine highlighted in chapter 1), which showed
an inverse relationship between unemployment and
inflation. As unemployment falls, inflation would be
expected to rise, and vice versa.
• Following the empirical evidence, economists developed
the theory behind the trade-off relationship. The basic
rationale accounting for the Phillips curve is taken to be a
disequilibrium relationship in the labour market.
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Theories of Unemployment
• There are two important concepts of labour market
equilibrium, but both share similar foundations, that is,
wages will move in the same direction as the difference
between demand and supply pressures in the labour market.
• The natural rate of unemployment is essentially the level
of unemployment that results when the labour market is in
equilibrium.
• Under competitive conditions, the labour market is in
equilibrium when the demand and supply of labour are
equal to each other.
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Competitive labour market
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Natural rate of unemployment
• The price of labour is the real wage. The demand for labour
is downward sloping, meaning that as the real wage falls,
firms demand more labour. The supply of labour is upward
sloping – as the real wage increases, more workers are
prepared to swap leisure for work, so supply increases.
• If there are people in the labour market, then this will
consist of employed (N) and unemployed (U) workers, so.
If is the level of employment in a labour market in
equilibrium, then the corresponding equilibrium level of
unemployment is: U*=L-N*.
• The natural rate of unemployment is: unr  U  L
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Disequilibrium in competitive labour
markets
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Natural rate of unemployment
• The nature of the labour market suggests that the change in
wages is related to the size of the disequilibrium in the
labour market.
• When there is a large degree of excess demand, the rate of
wage increase will be much higher than at levels of low
excess demand.
• Likewise, the downward rate of wage inflation (wage
deflation) will be greater when there is higher excess
supply.
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Natural rate of unemployment
• Therefore, the change in wages can be written as a negative
function of the level of unemployment:
W
  Nd  NS
W


• More specifically, the relationship between demand and
supply in the labour market will be related to the difference
between the actual and equilibrium level of unemployment:

N d  N s   U U

• The change in wages is a function of the difference between
unemployment and its equilibrium level.
W
 f u  unr 
W
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The Phillips Curve
• When prices are set equal to marginal costs – price inflation is equal to
wage inflation, so the Phillips curve can be written as:
P
 
  unr  u 
P
• The natural rate of unemployment is the traditional concept of
unemployment in the labour market.
• The Phillips curve implies that inflation will be negatively related to the
difference between unemployment and the natural rate.
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The Phillips Curve
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Non-Accelerating Inflation Rate of
Unemployment (NAIRU)
• The NAIRU is defined as the level of unemployment where
there is no pressure on prices to change. The natural rate
and the NAIRU differ in their theoretical foundations.
• The natural rate theory refers to the disequilibrium
adjustments in competitive markets.
• The NAIRU comes out of an imperfect competition model.
Here the equilibrium level of unemployment and wages are
the result of bargaining between firms and labour (unions).
Both the unions and firms have some power to determine
wages and prices, so the price level is not competitively
determined.
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NAIRU
• In this set up, unions set wages and firms set prices.
• The wage-setting relationship, described as the Bargained Real Wage
(BRW), implies those nominal wages demands are positively related to
expected prices, negatively related to unemployment, and are also
determined by a set of factors Z, which accounts for things such as trade
union power and the replacement ratio of unemployment benefits to
wages, etc.:
W  P Z  u 
e
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NAIRU
• The bargained real wage is downward sloping with respect
to unemployment, implying that unions will moderate wage
demands when unemployment is high, but in times of a
tight labour market, will be more ambitious about what can
be achieved.
• The price-setting relationship, also known as the Feasible
Real Wage (FRW), describes the way that firms set prices.
Essentially, these are just a mark up over costs, which are in
turn defined by the ratio of wages to labour productivity
(LP):
W
P  1   
LP
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NAIRU
• In terms of the real wage, the FRW is unrelated to the level
of unemployment and is just determined by product market
conditions (mark up) and productivity.
• The NAIRU is found at the intersection of the price-setting
(FRW) and wage-setting (BRW) schedules.
• Again, prices will change as a result of disequilibrium. If
unemployment is below the NAIRU, then the BRW is
above the FRW. Consequently, high wage demands by
workers will lead to higher prices. Correspondingly, when
unemployment is above the NAIRU, moderating wage
demands will put downward pressure on prices. Again, the
rate at which prices change is assumed to be proportionally
related to the size of the disequilibrium.
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NAIRU
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Phillips curve
• As the change in nominal wages reflects the
difference between unemployment and the
NAIRU, then we can once again generate a
Phillips curve type relationship:
W
 g u  un 
W
   u  un 
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Natural rate or NAIRU?
• Both the natural rate of unemployment and the NAIRU reflect an
equilibrium position in the labour market.
• Any movement of actual unemployment away from this position
generates a change in wages proportional to the disequilibrium.
• Because prices are just a mark up on wages, wage inflation feeds
directly into price inflation:
 
P W

P
W
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Empirical Evidence
• In general, wage inflation
lies above price inflation,
although both clearly
follow similar trends.
• The difference is mainly
accounted for by a positive
growth in productivity,
which allows the real wage
to grow over time in line
with living standards.
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Natural rate or NAIRU?
• Many economists use the concepts of the natural rate and
the NAIRU interchangeably. Although the two measures
are similar – strictly speaking, they are not the same. The
main difference concerns the existence of involuntary
unemployment. In the natural rate definition, there is no
involuntary unemployment.
• The difference can then largely be summed up by the size of
the mark up in the price-setting (FRW) schedule. In
competitive markets, prices are equal to marginal costs, so
μ=0. In imperfectly competitive industries, prices exceed
marginal costs so that μ>0. The consequence is that there is
now a wedge between the price levels of the imperfectly
and perfectly competitive markets, and the natural rate is
below the NAIRU.
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NAIRU falls with a declining mark up
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Natural rate or NAIRU?
• Unemployment rises with the size of because increasing
prices reduce aggregate demand. As the NAIRU lies above
the natural rate of unemployment, inflation will be higher at
every level of unemployment, so the presence of market
imperfections will create an inflation wedge.
• This the main difference between the natural rate and the
NAIRU.
• We will concentrate on the NAIRU, as most policy makers
through the world do. The reason is not just because of
some empirical justification, but also because the imperfect
competition model provides a useful model for analysing
structural factors in the labour market.
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Inflation
• Although the trade-off between unemployment and inflation
started out as an empirical observation, the Phillips curve
has played a central role in policy making for more than 30
years. The Phillips curve was seen as a trade-off frontier
for policy makers. Lower unemployment can be bought
with higher inflation and vice versa. The role of economic
policy is to choose the preferred point on this frontier.
• In making these policy choices, the government is
effectively trying to reach the lowest level of misery –
neither inflation nor unemployment is desirable. The theory
of choice is therefore not about utility maximisation but the
minimisation of disutility.
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Costs of Unemployment
• The costs associated with unemployment can be divided
into two sorts: social and economic.
• Social Costs: Poverty, crime, social/personal esteem.
• Economic Costs: There are two main economic costs
associated with unemployment.
– Efficiency
– Budgetary
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Is zero unemployment a sensible
policy? (Full employment)
• Recognising that unemployment is costly, governments
might optimally pursue a policy of zero unemployment. In
fact, full employment was the goal of policy makers for
many decades.
• However, are full employment and zero unemployment the
same thing? Would it be possible for an optimal choice to
have a positive amount of unemployment?
• Frictional unemployment: people who are between jobs.
The presence of this could be optimal, as the process of job
matching is not an immediate occurrence. However, this
does not discount the usefulness of policies that reduce
frictional unemployment by increasing the speed of efficient
job matching.
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Costs of Inflation
• The costs associated with rising prices can be split,
depending on whether inflation is anticipated or
unanticipated.
• Anticipated: Menu and shoe leather costs
• Unanticipated:
– Redistribution
– Instability: Probably, the main concern for
maintaining low and stable inflation is that it
creates conditions which are amenable for long
term investment.
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Benefits of Inflation
• If there are costs to inflation, should policy makers
aim to achieve zero inflation? In fact, should we
go further and actually target a negative rate of
inflation? This would imply falling prices known
as deflation.
• The answers to these questions are:
– Policy makers tend to prefer a low positive rate
of inflation rather than zero inflation.
– Deflation is regarded as being just as bad, if not
worse, than high inflation.
• Global Applications 10.2 Japan
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Policy Choices: preferences between
unemployment and inflation
• If the Phillips curve acts as a constraint on policy making,
then it is just left to policy makers to choose their most
preferred combination on this frontier. The rational choice
would be that which maximises utility, or in this case
minimises disutility.
• The policy choice will depend on the preferences of the
policy maker, which are represented in a utility function:
U  U  , u
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Policy Choices
• An indifference curve plots the combinations of inflation
and unemployment that give the same level of (dis)utility.
• Each level of (dis)utility will be synonymous with a
different indifference curve.
• As both inflation and unemployment are ‘bads,’ the lower
the indifference curve, the better.
• The policy maker is made better off as he moves from
I1 I2  I3.
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Policy Choices
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Policy Choices
• The indifference curves are concave to the origin, which
implies that policy makers prefer averages to extremes.
This suggests that if unemployment is high, the policy
maker would be preferred to trade off a higher increase in
inflation to reduce unemployment than if unemployment
were low. The same would apply to inflation. The policy
maker will act to minimise the total amount of disutility that
is suffered.
• The Phillips curve represents the menu of inflationunemployment outcomes from which the policy maker can
choose. The rational choice is the lowest indifference curve
that is consistent with a position on the Phillips curve. This
is where the two curves are tangential to each other.
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Optimal unemployment-inflation
combination
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Policy Choices
• In this framework, the combination of unemployment and
inflation that the economy ends up with will reflect the
preferences of the policy maker.
• If the policy maker is very adverse to high unemployment,
then he is now more willing to trade off higher inflation for
lower unemployment, the indifference curves are skewed
towards verticality.
• If the policy maker is highly adverse to inflation, then he
would be prepare to trade off higher levels of
unemployment for lower inflation. The indifferences
curves reflecting these preferences are flatter and the
economy ends up in a position where unemployment is
higher and inflation is lower.
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Unemployment averse policy maker
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Inflation averse policy maker
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Stagflation: The death of the Phillips
cure
• This simple model is a good reflection of macroeconomic
policy before the 1970s.
• It was believed that the Phillips curve was a stable frontier
on which the economy could move along in accordance
with the decrees of governments.
• This view, though, ended spectacularly in the 1970s when
unemployment and inflation rose simultaneously – an
outcome which is completely at odds with the Phillips curve
as a trade-off constraint.
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The Phillips Curve, 1970s, 1980s
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Expectations Augmented Phillips
Curve
• If the Phillips curve was to maintain its place at the
heart of macroeconomic analysis, it would have to
offer an explanation for these events.
• The solution was the expectations augmented
Phillips curve.
• The typical Phillips curve equation:
   un  u 
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Expectations Augmented Phillips
Curve
• What effect, though, would an increase in inflationary
expectations have on the level of inflation and the NAIRU?
• From the wage-setting curve, higher expectations of
inflation will lead to higher nominal wage growth as
workers aim to maintain the value of the real wage.
• The change in the bargained real wage is related to the
change in price expectations in the following way:
W  Pe Z  u 
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Expectations Augmented Phillips
Curve
• Therefore, the rate of wage inflation equals:
W P e
 e
W
P
• The price-setting relationship then describes
how this would feed into price inflation:
W , P W
W ,

P


P  1   
LP
• Therefore:
LP
P
W
P e W P


e
P
W
P
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Expectations Augmented Phillips
Curve
• A persistent increase in the rate of expected inflation will
lead to a persistent increase in the actual level of inflation,
but what would be the impact on the NAIRU?
• The answer is nothing. As the rate of wage and price
inflation is the same, the real wage will remain constant. A
10% increase in the wage level will have no effect on the
real wage if the price level also increases by 10%. As a
result, a change in inflation expectations produces a change
in the inflation rate in the economy, but doest not affect the
NAIRU.
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Expectations Augmented Phillips
Curve
• This means that different rates of inflation are possible at
the same rate of unemployment depending on prevailing
inflation expectations. This gives rise to the expectations
augmented Phillips curve:
e
   un  u   
• The actual rate of inflation is now the product of the
disequilibrium in the labour market, and also the expected
level of inflation. Therefore, the Phillips curve will shift
vertically with changes in the expected level of inflation.
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Expectations Augmented Phillips
Curve
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Long run Phillips Curve
• The expectations augmented Phillips curve posits that
inflation is the product of two factors: (1) the disequilibrium
between the rate of unemployment and the NAIRU, and (2)
the degree of inflation expectations.
• The disequilibrium story gives rise to the traditional Phillips
curve. This is known as the short run Phillips curve, as
disequilibria are not expected to persist in the long run.
• In the long run, the economy will rest at its NAIRU, but
there are many different rates of inflation that are consistent
with this depending on the rate of inflation expectations.
This gives rise to a long run Phillips curve, which is
vertical at the NAIRU.
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Processes of Expectations Formation
• Adaptive Expectations
• Under adaptive expectations, inflation expectations are a
weighted average of last period’s actual and expected rates
of inflation:
te  te1  1   t 1
• This backward –looking approach has clear implications for
how the economy will react to shocks and policies.
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Adaptive Expectations
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Adaptive Expectations
• Suppose the economy starts of with unemployment at the
natural rate, and actual and expected inflation equal to one
another at point a.
• The government, however, decides that the current rate of
unemployment is too high and unleashes an expansionary
policy (fiscal or monetary) with the aim of reducing
unemployment. As the expected price level rises, the
Phillips curve will shift upwards to point b.
• However, because the expected price level lags behind the
actual price level, the expected real wage will still exceed
the equilibrium level. There will be further upward pressure
on prices and the economy moves to point c.
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Adaptive Expectations
• Over time, the expected level of inflation will eventually
catch up with the actual level of inflation and the economy
will return to is long run equilibrium position.
• This exercise demonstrates that under the adaptive
expectations framework, policy changes will only be able to
exploit a short run trade-off between unemployment and
inflation. In the long run, when expectations fully adjust, it
will be the case that policy can have no effect on the level
of unemployment, only on inflation which has risen
permanently to a higher level representing a higher point on
the long run Phillips curve, point d.
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Rational Expectations
• The major criticism levelled at adaptive
expectations is that it only makes use of past
information. Forming expectations using only a
subset of information available is deemed to be
sub-optimal and irrational behaviour.
• Expectations which are formed rationally use all
available information: e
 t  E  It
 
where It represents the set of information available to
the private sector at time t.
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Rational Expectations
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Rational Expectations
• Rational expectations was a revolutionary concept, arguing
that the short run trade-off between unemployment and
inflation no longer existed.
• When expectations are formed rationally, changes in policy
will not influence the level of unemployment at all, not even
in the short run. Agents in the private sector are fully aware
of the consequences of the policy action and will
immediately adjust their expectations of inflation.
Consequentially, wages will stay in tune with prices. If the
real wage does not change, the rate of unemployment will
not deviate from the NAIRU.
• Rational expectations and the vertical long run Phillips
curve are very important in monetary policy.
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Supply Shocks
• Supply side shocks can lead to a change in the equilibrium
level of unemployment. These have been explained
previously and principally fall into two categories.
• First, there are factors which impact upon labour
productivity, which leads to shifts in the price-setting or
feasible real wage schedule.
• Second, anything which affects the bargaining power of
labour will also influence the equilibrium level of
unemployment via movements in the wage-setting or
bargained real wage schedule. These might include labour
market legislation, trade union power, and the replacement
ratio, amongst others.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Supply Shocks
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Policy Neutrality
• The important implication of the NAIRU concept
is that in the long run, the unemployment rate can
only change as a result of a change in the NAIRU.
• This has a strong bearing on policy makers. If
unemployment is to be tackled in the long term,
then policies should concentrate on the supply
rather than the demand side.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Hysteresis
• In the long run, the Phillips curve is vertical at the
equilibrium rate of unemployment, indicating that no tradeoff exists between unemployment and inflation. However,
this does not rule out the possibility that the equilibrium rate
of unemployment is open to change.
• The NAIRU has been found to have changed over time and
the evidence suggests that there is a close relationship
between the NAIRU and the actual rate of unemployment.
• Hysteresis refers to the notion that short run changes in
unemployment can influence the NAIRU. In this case,
short run changes in unemployment can become remarkably
persistent.
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Hysteresis
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Hysteresis
• The concept of hysteresis is of growing importance in
economics. This is due to a new interest in what is defined
as the medium run.
• As the short run can effectively be a considerable period of
time, the medium run is used to describe situations where
there are fairly persistent, but not necessarily permanent,
movements in a series such as unemployment.
• This might be one reason why estimates of the NAIRU tend
to track the actual rate of unemployment.
• One important example of hysteresis is the rise in
unemployment in Europe.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Global Applications 10.4
• Eurosclerosis
• Why is hysteresis
empirically most
applicable to the
economies of
continental Europe?
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© 2006 Cengage Learning
Hysteresis Mechanisms
• How do short run movements in the
unemployment rate become permanent?
• Several different types of hysteresis
mechanisms have been proposed:
– Insider-Outsider Mechanisms
– Long run unemployment
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© 2006 Cengage Learning
Insider-Outsider Mechanisms
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© 2006 Cengage Learning
Long run unemployment
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© 2006 Cengage Learning
NAIRU: Policy Implications
• The NAIRU has become a very important concept in
macroeconomic policy making. It is significant to two main
ways.
• The first is that in the long run, unemployment is
determined by structural factors; therefore, the only way to
reduce unemployment is to reduce the NAIRU. Hysteresis
adds another dimension to this.
• The second area where the NAIRU is undoubtedly
important is in the operation of monetary policy. As the
control of inflation has become the increasing
preoccupation of macroeconomic policy, the NAIRU has
gained importance by association.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Monetary Policy and Inflation
• Controlling inflation has been the predominant aim of
government policy in recent times. This possibly reflects
the changing emphasis of economic policy – away from
direct intervention and maintaining full employment, and
towards creating a stable economic environment in which
private sector firms can prosper.
• As inflation is considered to be a root cause of economic
instability, monetary policy has become increasingly
important for maintaining price stability as much as an
influence on aggregate demand and output.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Monetary Policy and Inflation
• It has been established that in terms of output, monetary
policy is neutral in the long run, and perhaps also in the
short run if expectations are formed rationally.
• Therefore, controlling the money supply appears to be a key
ingredient in controlling inflation. In addition, we have
seen that inflation expectations feed through directly into
inflation, so the management of expectations is also
important.
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© 2006 Cengage Learning
Controlling the money supply
• Recall that the Quantity Theory of Money
suggests the following relationship between
the level of nominal output and the amount
of money in circulation:
• Mv=PY
• M is the money stock
• v is the velocity of circulation
• P is the price level
• Y is the level of real output
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Controlling the money supply
• As v and Y are fixed, then the quantity theory equation can be
rearranged so that:
P  v Y  M
P   v Y  M
• So, P  M
P
M
• The policy prescription suggested by the quantity theory is that
controlling the growth of the money supply is key to controlling
inflation. Inflation is everywhere a result of an excessive growth in the
money supply.
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© 2006 Cengage Learning
Monetary Targeting
• The expectations augmented Phillips curve highlights the
important role that expectations of inflation play in
establishing the actual rate of inflation in an economy.
• If the government considered the current level of inflation
to be too high, it could simply reduce the money supply.
• When expectations are formed adaptively, the level of
output will rise above the natural rate and there will be
downward pressure on prices. Eventually, as expectations
catch up with the actual rate of inflation, the economy will
settle at the equilibrium rate of unemployment, but also at a
lower actual and expected rate of inflation.
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© 2006 Cengage Learning
Monetary Targeting
• However, under rational expectations, the use of monetary policy is far
more successful, in that higher unemployment does not need to be
created in order to reduce the rate of inflation.
• In fact, not even a contraction in the money supply is required – only a
credible announcement of such. Once the government or other
monetary policy authority has made public their intentions to reduce the
money supply, then rational inflation expectations will be immediately
revised downwards. These lower expectations will then feed through
the economy through wage bargains and the lower actual rate of
inflation will arise.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Monetary Targeting
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Inflation targeting
• Continued financial deregulation means that monetary
authorities are unlikely to exert complete control over the
domestic money supply. This was described as trying to
control without controls.
• The policy of targeting the money supply is aimed at
achieving a target inflation rate. The solution to the
problems might be to target the inflation rate directly.
• Inflation is likely to arise when the economy deviates form
the NAIRU. Therefore, maintaining an inflation target
requires the economy to be maintained at this level. As the
interest rate is likely to control domestic activity, it can be
used in keep the economy at its NAIRU.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The credibility of inflation targets
• For monetary or inflation targeting to work, any
announcement has to be seen as credible. That is, the
private sector really must believe that the monetary policy
authority will be prepared to make the contraction in the
money policy it has announced – even if it may create
unemployment.
• A reason why targeting may fail could well be because
these policy announcements just aren’t viewed as being
credible. Once the private sector has doubts over the
government’s resolve to carry out the means necessary to
reduce inflation, it will no longer rationally reduce inflation
expectations downwards on announcement.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Time Inconsistency Problem
and Central Bank Independence
• If agents have rational expectations, then inflation targeting
should prove to be remarkably successful. Whenever a new
target is announced, inflation expectations will
automatically adjust to the new level. No policy needs to be
activated, the private sector is simply aware that if inflation
differs from the target then policy would be forthcoming.
Therefore, changing expectations will simply pre-empt any
need for policy implementation.
• However, when a target is announced should the
government be believed?
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Time Inconsistency Problem
and Central Bank Independence
• Looking at the Phillips curve relationship, it is clear that in
the long run there is no trade-off between unemployment
and inflation. Accepting this, the government would
probably have a preferred level of inflation towards the
bottom of the vertical line. All that is required is for the
government to choose their favoured position on the long
run Phillips curve and announce it as their inflation target.
• The problem, though, for the government is in making its
announcements credible. Credibility becomes an issue
because of the presence of the short run Phillips curve.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Time Inconsistency Problem
• If the government were to announce a low inflation target
which is adopted into private sector expectations, the
government may then face an incentive to expand the
economy.
• If the public believes this announcement and sets
expectations equal to the target inflation rate, then the short
run Phillips curve with this expectation forms the policy
frontier faced by the government.
• This original inflation announcement is now incredible. It
is clearly the case that the government can move on to a
lower indifference curve by trading off higher inflation for
lower unemployment.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Time Inconsistency Problem
• The public is aware of the government’s preferences and
this inflation announcement is time inconsistent. If the
public were to believe it, the government would then have
the incentive to renege on the target. In fact, the lowest
level of inflation where time inconsistency does not occur is
3.
• If this is the public’s inflation expectation then the
government cannot move to a lower indifference curve by
launching an inflation ‘surprise.’
• At any inflation announcement below this level, the
incentive to cheat would be restored. The public would
therefore not believe any inflation announcement below 3.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Time Inconsistency Problem
• This problem with credibility is known as the time
inconsistency of low inflation monetary policy. Low inflation
announcements cannot be believed because once they are
acted upon, the government has the incentive to change their
target level of inflation.
• The private sector is fully aware of these incentives and will
not allow themselves to be duped. Therefore, their anticipated
level of inflation would be somewhat higher.
• The presence of the opportunity to exploit a short run gain can
actually make the government worse-off in the long run. This
is an important feature of time inconsistency in policy
making. Even if a government is sincere in its proclamations,
it will find it hard to enforce its best outcome.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Time Inconsistency Problem
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Solving the Time Inconsistency
problem in monetary policy
• Delegating Policy to Conservative Central Bankers: One
possible solution would be to delegate monetary policy
making to an agent or an institution that does not share the
same incentives over unemployment and inflation; this is
Rogoff’s famous conservative central banker.
• Monetary policy is set by an independent central bank
which is only interested in achieving the target rate of
inflation. As its objective is independent of the rate of
unemployment, its indifference curves are horizontal.
Inflation announcements are now highly credible.
• This is the logic behind the move to make central banks
independent.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Conservative Central Bankers
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© 2006 Cengage Learning
Global Applications 10.6
• Central Bank
Independence (CBI)
and Inflation
• What is the evidence?
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© 2006 Cengage Learning
Solving the Time Inconsistency
problem in monetary policy
• Optimal Contracts
• Delegation does not necessarily need to be made to
a central banker with very conservative attitudes
towards inflation. All that is required is that the
central bankers are given the incentives to act in
such a way.
• These incentives can be formalised through
performance contracts; these are known as Walsh
contracts after Carl Walsh who proposed the idea.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Solving the Time Inconsistency
problem in monetary policy
• Reputation
• Looking at the time inconsistency problem, it is clear that
the government is made worse-off in the long run. Given
that this is universally known, the government should be
able to find a credible way of maintaining a low inflation
announcement.
• This simply requires the government to care about the
future. If the government has a sufficiently long horizon,
then they may have an incentive to try and build a
reputation on being tough on inflation. The problem with
reputation building is that government terms are finite and
relatively short.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Solving the Time Inconsistency
problem in monetary policy
• Wider considerations:
• Global Applications 10.8 Coordinating
monetary and fiscal policies
• Global Applications 10.9 What Role is
Left for Fiscal Policy?
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Seignorage and Hyper-Inflation
• There are two ways in which a government can finance a
deficit other than restricting fiscal policy.
• The first and conventional way is to borrow by issuing
bonds.
• The second is that the government, usually with the
cooperation of the central bank, can finance its deficit by
printing money. The value of the real resources (real goods
and services) that the government obtains by simply
running the printing presses is known as seignorage
revenue.
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© 2006 Cengage Learning
Seignorage and Hyper-Inflation
• If the change in the money stock is M, and the
price level in the economy is P, then seignorage
revenue S is given as follows:
M
S
P are
• Alternatively, if both sides of this equation
multiplied and divided by M, then
M
S  gM 
P
• Seignorage is equal to the growth in the money
supply gM multiplied by the current real money
stock (M/P).
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Seignorage and Hyper-Inflation
• If the government wished to fund its budget deficit
B from seignorage revenues (so S=B), then the
required growth in the money stock can be found
from rearranging:
M 
gM  B  
P
• If the current budget deficit represents x percent of
the money stock, then this is the required growth
rate of the money stock or so we would think! The
reason why the relationship isn’t as clear cut as this
is because the current money stock might be
influenced by the growth in the money supply.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Seignorage and Hyper-Inflation
• In chapter 5, the amount of money balances that the
public are willing to hold is given by liquidity
preference theory: M
P
 L Y , r 
• where the demand for money balances is positively
related to income Y and negatively related to the
level of interest rates r. The nominal interest rate
represents the opportunity cost of money. It
consists of two parts, the real interest rate and the
expected level of inflation:
r  rno min al  rreal  
e
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Seignorage and Hyper-Inflation
• The growth in the money supply, through the Quantity
Theory of Money, will lead to an increase in the rate of
inflation. As inflation increases, the value of the domestic
money stock falls. Given the reduction in purchasing
power, people move out of money into either financial
assets or real goods and services.
• The current money stock will be determined by the
expected rate of inflation, and hence the expected rate of
money growth:
S  gM  L Y , rreal   e




S  gM  L Y , rreal  gM
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Seignorage and Hyper-Inflation
• The growth in the money supply has two effects on
seignorage revenues. Seignorage can be thought of as an
inflation tax, if gM=.
• Higher gM will increase seignorage revenues gained from
the existing money stock, but it will also have the effect of
reducing the money stock held by the public on which
seignorage revenues can be obtained.
• As the growth in the money stock rises, seignorage
revenues will at first rise but eventually the second order
effect where money demand falls will eventually dominate.
Therefore, the revenue from seignorage will be inverse Ushaped with respect to the growth in the money supply.
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Seignorage revenue
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© 2006 Cengage Learning
Hyper-inflation
• In the short run, an increase in the growth rate of the money
supply may lead to little change in real money balances.
However, over time as prices adjust, the government will
find the same rate of money growth yields lower seignorage
revenue. Therefore, in order to fund persistent deficits, it
will have to continuously increase the growth of its money
supply. If there was no lag between money growth and the
updating of inflation expectations, then the demand for
money would fall immediately when the money growth rate
was increased.
• Therefore, hyper-inflation requires the acceleration in the
growth of money to stay one step ahead of the updating of
expectations. Ever increasing growth in the money stock
will generate an increase in seignorage revenues.
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© 2006 Cengage Learning
Hyper-inflation
• Hyper-inflation usually starts when a government faces a
large budget deficit that requires painful policy measures to
offset. Seignorage is then seen as an easy way out.
• Hyper-inflations do not blow themselves out; inflation will
continue to accelerate and can only be stopped by
intervention:
– A credible commitment to reducing the budget deficit
through tax increases or reductions in government
spending.
– A credible commitment from the monetary authorities to
stop printing money for the purposes of paying the debt.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• The control of unemployment and inflation has been a
longstanding preoccupation of macroeconomists. We
covered the theory of the Phillips curve, which shows that
there is a trade-off between the two.
• We saw that there is ample evidence to suggest that the
trade-off is different in the short run and the long run, and
the transition between short and long run is governed by the
way expectations are formed and the degree of flexibility in
wages and prices.
• Policy makers face a dilemma in trading off unemployment
and inflation. They use policy to make the trade-off based
on their preferences between unemployment and inflation.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• The theory of the Phillips curve is very useful here, as it can
be used to explain how monetary policy can be used to
control the rate of inflation. More than this, it is the
framework that is generally used to formulate monetary
policy.
• The importance of monetary policy has grown as policy
makers place an increasing emphasis on the control of
inflation. Also, the traditional goal of full employment has
been supplanted by target of economic stability, and as a
result, the tools the government uses to control the economy
have shifted away from fiscal (demand management) to
monetary policy.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• The reasons behind the recent trend for making
central banks independent can be described using
the Phillips curve theory. In particular, the time
inconsistency problem can be understood.
• Solving the time inconsistency problem involves
delegation of monetary policy and the creation of
an independent central bank, among others.
• Finally, seignorage and hyper-inflation were
covered as interesting episodes.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning