Part 3 Macroeconomic Analysis of Finance ???????? Chapter 8 Inflation, Deflation and Unemployment ???????????????????

1
Part 3 Macroeconomic Analysis of Finance
????????Chapter 8 Inflation, Deflation and
Unemployment???????????????????
Naotsugu HAYASHI ? ?? Professor of Economics
????? Faculty of Business Administration
???? Hosei University ????
2
1. Aggregate Demand Curve and Aggregate Supply
Curve ???????????

• ? Rise in prices P
• ?decrease in real balance of money M/P
• ? LM curve shifts to the left
• ? decrease in aggregate demand Y
• ? aggregate demand curve D is
  downward-sloping
• ???P???
• ???????M/P???
• ?LM????????
• ????Y???
• ??????D?????

Aggregate demand curve and aggregate supply curve
3
1B. Aggregate Demand Curve and Aggregate
Supply Curve ???????????

• ? Macro production function Y F(N)
• From the condition for profit maximization
• Marginal productivity of labor dY/dN F(N)
• real wages W/P
• ?the first axiom of the classical school
• decreasing marginal productivity of labor
• increasing marginal cost
• ?aggregate supply curve S is upward-sloping
• ? At the intersection, goods market equilibrium
• Simultaneous determination of equilibrium
• income Y and equilibrium prices P
• ????????YF(N)
• ??????????
• ????????dY/dNF(N)????W/P ??????1??
• ???????????????????
• ??????S?????
• ?????????????????Y?????P?????

Aggregate demand curve and aggregate supply curve
4
2.Deamnd-Pull Inflation and Cost-Push
Inflation?????????????

• Classification using Comparative Statics by F.
  Machlup
• ? Inflation of Currency?increases aggregate
  demand
• ? Aggregate demand curve D shifts a right side
  to D
• ? Equilibrium E shifts to E
• ? Income Y increases, prices P rises
• ? Demand-pull Inflation
• ???????????????????(??)
• ??????(inflation)???????
• ??????D??????
• ?????E??E'?
• ???Y???????P???
• ?????????
• (?????????? )

Demand-pull Inflation
5
2B.Deamnd-Pull Inflation and Cost-Push
Inflation?????????????
Demand-pull Inflation

• ?Increase in (Marginal) Cost
• ? Aggregate Supply curve S shifts upward
• ? Equilibrium E shifts to E
• ? Income Y decreases, prices P rises
• ? Cost-push Inflation
• Coexistence of stagnation and inflation
• ? stagflation
• ???(????)???
• ??????S??????
• ?????E??E'?
• ???Y???????P???
• ?????????
• (???????????)
• ????????????
• ??????????(stagflation)

Cost-push Inflation
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3.Lower Prices and Deflation????????
Innovation Lower prices

• ?decrease in costs by innovation
• ?Downward shift of marginal cost curve
• ?Downward shift of aggregate supply curve S
• ? Equilibrium shifts from E to E
• ? Prices P fall, National Income Y increases
• ? Cheaper prices and mass production
• ??????????????
• ?????????????
• ??????S??????
• ?????E??E?
• ???P???????????Y???
• ?????????

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3B.Lower Prices and Deflation????????

• ? Decrease in aggregate demand by depression
• ?Left side shift of aggregate demand curve D
• ? Equilibrium shifts from E to E
• ? Prices P fall, National Income Y decreases
• ? Deflation
• ????????????
• ??????D??????
• ?????E??E?
• ??????Y???????P???
• ????????(deflation)

Deflation
8
4.Speculation and Bubble??????

• ? Stability condition for market equilibrium
• The law of demand When a price rises, the
  demand decreases. When a price falls, the demand
  increases.
• Gross substitutability When a price rises,
  the demand decreases and the demand for its
  substitute increases.
• ?Occurrence of bubble
• If the stability conditions are not
  satisfied
• ? When a price rises, the demand D increases to
  D, the price rises more.
• ? speculation ? equilibrium E shifts to E
• ? Income Y increases a little, but the price
  rises greatly.
• ? Bubble occurs
• ??????????
• ???? ?????????????
• ?????????????
• ???? ????????????????????
• ???????????
• ???????
• ??????????????????

Speculation and Bubble
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4B.Speculation and Bubble??????

• ? Collapse of Bubble
• When a price falls, the demand D decreases
  to D, and
• a further fall in the price causes a further
  decrease in the demand.
• ? speculation collapses
• ? equilibrium E shifts to E
• ? National income Y decreases and the price
  falls
• ? Collapse of bubble
• ???????
• ?????????D??D???????
• ?????????????
• ????????
• ?????E????E?
• ????????????
• ??????

10
5.Inflation Gap and Deflation Gap??????????????
??
Inflationary Gap nominal aggregate demand which
exceeds full employment national income YF ? to
cause inflationary pressure on prices Deflationar
y Gap nominal aggregate demand which is short of
full employment national income YF ? to cause
deflationary pressure on prices ????????YF???????
???? ?????? ?????????(inflationary
gap) ??????????? ???????????? ????????(deflationa
ry gap) ??????????
Inflation Gap Deflation Gap
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6. Voluntary Unemployment and Involuntary
Unemploymant????????????(1)

• ? Classical Equilibrium
• Firms demand labor in order for the marginal
  productivity of labor to be equal to real wages
  ?the first postulate of the classical school
• Workers supply labor in order for the marginal
  disutility of labor to be equal to real wages
  ?the second postulate of the classical school
• At the intersection of the curves of labor
  demand and supply, E
• ? to determine equilibrium employment N and
  equilibrium real wages (w/p)
• ?Classical equilibrium??????
• When real wages are too high, excess supply of
  labor occurs
• ?Voluntary Unemployment ? a fall in w/p restores
  equilibrium E
• ??????
• ?????????????????????????????
• ??1??
• ????????????????????????????????
• ??2??
• ????????????????E
• ??????N????????(w/p)???
• ??????(Classical equilibrium)??????
• ??????????????????
• ??????(voluntary unemployment)

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6. Voluntary Unemployment and Involuntary
Unemployment????????????(2)

• ? Keynesian Equilibrium
• Periodical wage negotiation ? nominal wages have
  downward rigidity
• labor supply curve is horizontal from w to E
  to deny the second postulate
• equilibrium K Underemployment Equilibrium
  Keynesian Equilibrium
• ? Involuntary unemployment from K to E
• Unemployment though he has working intension
  and ability and looked for a job
• ? Expansion of fiscal expenditure, aggregate
  demand, labor demand to ND
• ? Restore full employment equilibrium Effective
  demand policy
• ???????
• ??????????????????w??????(downward rigidity)
• ???????w??E????????2?????
• ?K???????????
• ??????(Keynesian equilibrium)
• ?KE???????(involuntary unemployment)
• ???????w?????????????
• ????????????
• ??????????????????
• ??????????????ND'????
• ???????E?????????????

Keynesian Equilibrium
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7. Inflation and Unemployment???????????????

• ? Phillips curve
• When unemployment rate u rises, the rate of
  increase in money wages ?w/w falls.
  ??w/wf(u)-a(u-u)?f'(u)lt0
• When uu, ?w/w0
• frictional unemployment
• Phillips insisted that the relation ship had been
  stable for 100 years.
• ?????????
• ???u?????????????w/w????
• ??w/wf(u)-a(u-u)?f'(u)lt0
• uu????w/w0
• ?????(frictional unemploymant)
• ???????100????????????

Phillips curve
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7B. Inflation and Unemployment???????????????

• ? Quasi-Phillips curve
• Nominal income PY rate of distribution of
  labor O Wage income W
• ? (PY/N)OW/N ? PyO w, where y Y/N, w W/N
• ? rate of increase in P rate of increase in y
  rate of increase in O rate of increase in w
• If ?y/y ? O / O , ?w/w?p/p 0.
• ??p/p-a(u-u)?f'(u)lt0 Price version of
  Phillips curve Quasi-Phillips curve
• ? it shows the trade-off between inflation and
  unemployment
• ? If monetary policy suppresses inflation,
  unemployment increases. If monetary policy
  accelerates inflation, unemployment increases.
• ??????????
• ??????PY?????O?????W ????? ?(PY/N)OW/N
• PyOw (???????????????)
• ???????????????????????????
• ??????????????????????
• ?w/w?p/p??p/p-a(u-u)?f'(u)lt0
• ????????????????????
• ???????????????
• ??????????????????
• ??????????????????

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8. Natural Rate of Unemployment and Rational
Expectations???????????

• ? Expectations-Augmented Quasi-Phillips Curve
• When expected inflation ?p / p rises, actual
  inflation ?p / p also rises, and the
  quasi-Phillips curve shifts upward. ?p / p ?p /
  p- a (u - u), f '(u) lt0
• Fisherian curve reverse of causal relationship
• u - (1 / a) (?p / p - ?p / p) u
• If ?p / p ?p / p, u u
• When expected inflation actual inflation, u
  natural rate of unemployment
• Friedman, Lucas, Sargent, Barro, New
  Monetarists
• ????????????????
• ????????p/p?????
• ?????????????????
• ?p / p ?p / p- a (u - u), f '(u) lt0
• ??????????????
• u - (1 / a) (?p / p - ?p / p) u
• ? ?p / p ?p / p ???uu
• ?????????????????????u
• ??????
• ???????????????????
• ??? ?????????

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8B. Natural Rate of Unemployment and Rational
Expectations???????????

• ? Rational Expectations
• Expectations which is not systematically
  different from the average of actual observations
• E(?p / p) ?p / p?E(u)u
• ? Phillips curve becomes vertical and the
  natural unemployment rate hypothesis holds.
• ? Monetary policy can control inflation but
  cannot change unemployment rate in the long run.
• Monetary policy is effective only in the
  short run.
• ??????(rational expectations)
• ??????????????????
• ??????(????)
• E(?p / p) ?p / p?E(u)u
• ????????????????????
• ????????????????????
• ??????????
• ?????????

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9. Lucas Supply Function????????

• ? Let denote labor force by LN, actual employment
  by N, natural employment N ,then
  u(LN-N)/LN?u(LN-N)/LN?
• Denote c labor per output, then NcY?NcYF
• ?u1-cY/LN?u1-cYF/LN?
• ?u-u-(c/LN)(Y-YF)
• Substitute it in quasi-Phillips curve to obtain
• ??p/p?pe/peß(Y-YF)?f'(Y)gt0?ßac/LN
• ? Lucas Supply Function
• ??????LN???????N??????????????N?
• u(LN-N)/LN?u(LN-N)/LN?
• ???1??????????c?????
• NcY?NcYF
• ?u1-cY/LN?u1-cYF/LN?
• ?u-u-(c/LN)(Y-YF)
• ??????????????????
• ??p/p?pe/peß(Y-YF)?f'(Y)gt0?
• ßac/LN
• ?????????(Lucas supply function)

Lucas Supply Function
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9B. Lucas Supply Function????????

• ? Under rational expectations,
• E(?p/p)?pe/pe ?p/p,E(u)u
• hold in the long run.
• Lucas supply curve stands vertically, full
  employment is attained.
• New Classical school
• ? Monetary policy can control inflation but
  cannot change full employment level.
• ? Monetary policy is effective only in the short
  run.
• ????????????????
• E(?p/p)?pe/pe?E(u)u
• ???????????????????
• ??????
• ??????????????????
• ???????????????
• ?????????

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10. Proposition of Impotence of Monetary
Policy????????
? From the Quantity Theory of Money, MV PY,
money M velocity V nominal income PY. ? Y
MV/P ? Yalog(M/P)? Y-Y-1a(logM/P-logM-1/P-1
)a(logM/M-1-logP/P-1) Let denote Y-1YF
YYFa(?M/M-?P/P) Inflationary aggregate
demand curve ?p/p?pe/peß(Y-YF)
Inflationary aggregate supply curve Lucas
supply curve ? ????????MVPY????Yalog(M/P)? Y-Y-
1a(logM/P-logM-1/P-1)a(logM/M-1-logP/P-1) Y-1YF
???? YYFa(?M/M-?P/P)????????? ?p/p?pe/peß(Y-Y
F)??????????????????
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10B. Proposition of Impotence of Monetary
Policy????????

• ? Under rational expectations,
• E(?p/p)?pe/pe?E(?M/M)E(?P/P) ?E(Y)YF
• holds in the long run. The expected rate of
  inflation the expectation of actual rate of
  inflation the expectation of actual rate of
  increase in money supply
• the expectation of national income full
  employment national income
• ? Monetary policy-omnipotence proposition
• ? Only disturbance policy that is not expected
  by the public is effective in the short run.
• ? Money illusion based on asymmetry of
  information has policy effect in the short run.
• ????????????????
• E(?p/p)?pe/pe?E(?M/M)E(?P/P) ?E(Y)YF
• ???????????????????????????
• ????????????????
• ??????????????????????(policy-omnipotence
  proposition)
• ??????????????????????????
• ????????????????????????????????????
• ?????(money illusion)???????????????
• ??????????????????????

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11. Proposition of Impotence of Fiscal
Policy????????

• ? In case of financing fiscal deficit by money
  printing ? the same as monetary policy
• ? In case of financing fiscal deficit by issuing
  bonds ? the public buy bonds with savings
• ? the price of national bonds falls ? the
  interest rate rises
• ? to crowd out private investment
• crowding-out effect
• ? to decrease private investment by the same
  amount of increased fiscal expenditure
• ? national income remains unchanged
• ???????????????????????
• ???????????????
• ?????????????????????????
• ????????????
• ????????????(crowding-out effect)
• ??????????????????????????????2

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11B. Proposition of Impotence of Fiscal
Policy????????

• ? Effect of future tax increase
• If tax revenue fiscal expenditure lt 0,
  fiscal deficit. ? to expect future tax increase
• ? to decrease consumption and to increase
  savings
• Ricardian equivalence theorem, Barro's
  overapping generation model
• New Ricardian school
• Under rational expectations, people increase
  savings and legends in order for future
  generations to pay increased future taxes
• ? Deficit fiscal policy becomes omnipotent in
  the long run.
• Debt illusion can be effective in the short
  run.
• ???????
• ??-????lt0???????????????????????????
• ?????????(Ricardian equivalence theorem)
• ???????????(Barro's overapping generation model)
• ???????
• ????????????????????????????????
• ??????????????????????
• ????????????????????????????
• ?????(debt illusion)???????????????

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12. Methods of Monetary Policy Rules or
Discretion?????????????

• Under rational expectations, a consistent policy
  based on rules will be anticipated and
  incorporated into their behavior rationally by
  the public, and thus will not have any effect on
  real economy averagely in the long run.
• ? Keynesian discretionary policy has an effect
  only when it is random. But it becomes mal effect
  , because transmission lags are not anticipated
  correctly.
• ? It abandoned stable money supply and adopted
  discretionary and arbitrary interest rate
  control. ? to cause the bubble
• ? disturb market ? rapid decrease in the money
  supply ? deteriorate the collapse of the bubble
  failure of monetary policy
• ??????????????????????????????????????
• ??????????????????(???????)???????????????????????
  ????????
• ????????????????????????
• ?????????
• ??????????????????????????????
• ????????????????????????????

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12B. Methods of Monetary Policy Rules or
Discretion?????????????

• ? New Monetarists Method based on Rules
• ? stopped discretionary monetary policy and
  adopted stable money supply policy based on rules
• ? achieved price stability and economic
  stability in the late 1970s and the early 1980s
• k rule
• ????????????????
• ?????????????????????????
• ?70????80?????????(?????????)????????
• k???

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13. Methods of Fiscal Policy Rules or
Discretion?????????????

• ?Keynesian Deficit Fiscal Policy
• ?Perpetuates the issuing of deficit
  bonds?discretionary increase in deficits
• ?accumulation of huge amount of fiscal
  deficit(700 trillion yen in 2002 fiscal year)
• ?huge future tax burden
• ?suppress consumption?decrease in sales?decrease
  in profits
• ?decrease in investment?prolong deflation
• Keynes?fiscal deficits in depression should be
  financed by fiscal surplus in boom
• ?????????????
• ????????????????????????
• ??????????(2002???700??)
• ??????????
• ??????????????????
• ???????????????????
• Keynes?????????????????????????????

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13. Methods of Fiscal Policy Rules or
Discretion?????????????

• ?New Monetarists Act of Balancing the Budget
• Enact a rule of multi-year balanced budget as a
  law or constitution
• Single-year balanced budget
• ? Multi-year balanced budget
• American Reagan administration enacted
  GramRadoman Act
• Clinton administration achieved a balanced
  budget
• ?????????????????
• ????????????????????????????????????
• ?????????
• ??????????
• ????????????????????????????