Inflation and the Business Cycle

1
Inflation and the Business Cycle

• Phillips Curve in AD-AS Model
• Conduct of Monetary Policy

2
The Phillips Curve

• Why is the relationship between inflation and
  unemployment interesting?
• (i) Understanding business cycles
• (ii) Monetary Policy Goals
• Low Inflation
• Sustained Economic Growth

3
FOMC Statement May 2000

• The Federal Open Market Committee voted today to
  raise its target for the federal funds rate by
  50 basis points to 6-1/2 percent.
• Increases in demand have remained in excess of
  even the rapid pace of productivity-driven gains
  in potential supply The Committee is concerned
  that this disparity will continue, which could
  foster inflationary imbalances.
• The Committee believes the risks are weighted
  mainly toward conditions that may generate
  heightened inflation pressures in the foreseeable
  future.

4
FOMC Statement January 2001

• The Federal Open Market Committee decided today
  to lower its target for the federal funds rate by
  50 basis points to 6 percent.
• These actions were taken in light of further
  weakening of sales and production, and in the
  context of lower consumer confidence, tight
  conditions in some segments of financial markets
  Moreover, inflation pressures remain contained.
• The Committee continues to believe that the risks
  are weighted mainly toward conditions that may
  generate economic weakness in the foreseeable
  future.

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Monetary Policy 2002 - 2007
6

• The Phillips Curve (PC) is a statistical negative
  relationship (trade-off) between inflation and
  the unemployment rate.
• It can also be expressed as a positive relation
  between inflation and real GDP.

7
Figure 12.1 The Phillips curve and the U.S.
economy during the 1960s
8

• Breakdown since 1970s

9
Figure 12.2 Inflation and unemployment in the
United States, 19702002
10

• Questions
• (i) How can our models explain the PC and its
  breakdown?
• (ii) Can the Federal Reserve use the PC to
  target the unemployment rate (manage the
  inflation-UR tradeoff)?

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Phillips Curve in AD-AS Model

• AD-AS ? AD shock leads to direct relationship
  between P and Y in the short-run.
• Recall Ms shifts AD curve.
• Factors which shift short-run AS Curve An
  increase in
• (i) Full Employment Output ( ) - right
• (ii) Expected Price Level (Pe) left (Classical
  misperceptions theory).
• (iii) Nominal Wage Rate left (Keynesian theory)

12

• CASE I m p pe 10 (anticipated inflation)
• Y , u un
• CASE II m 15 pe 10 (unanticipated
  inflation)
• Short-Run Y gt , u lt un
• p 13 gt pe
• Long-Run pe 15 p
• Y , u un

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• Expectations augmented PC
• h(un - u) (p-pe), h gt 0 constant.
• (i) For a given pe, there is a negative
  trade- off between p and u.
• (ii) IF
• pe gt p ? u gt un
• pe lt p ? u lt un
• pe p ? u un

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• Factors which shift PC
• (i) Inflation expectations (pe)
• (ii) Supply shocks (changes un)
• Why did the PC breakdown since 1970s?
• Negative supply shocks and higher inflation
  expectations.

15
Monetary Policy

• Policy implications Does the PC provide the Fed
  with a stable menu of choices for (p,u)?
• Trade-off is short-run and temporary. The LRPC is
  vertical. But
• Keynesian ? Yes, short-run can persist.
• Classical ? No, trade-off is very short so LR
  consequences outweigh any SR gains.

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Rules Discretion

• The Lucas Critique The impact of economic
  (monetary) policies depends on how those policies
  affect public expectations of economic policy.
• Should the Fed follow Rules or Discretion?
• Drinking Driving
• Hostage Negotiation

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• According to the Classical expectations augmented
  PC, rules establish credibility
• Monetarism ? key to economic stability is a
  monetary policy rule.

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• Time lags involved with policies
• (i) Recognition
• (ii) Implementation
• (iii) Response
• The Titanic!
• Alternative DisInflation Policies
• (i) Gradualism
• (ii) Cold Turkey

19

• Ways for Fed to Commit to Rules
• (i) Tough central banker
• (ii) Tougher consequences for not meeting
  inflation targets.
• (iii) Central bank independence.

20
Central bank independence and inflation
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Senate Testimony of Ben Bernanke (11/15/05)

• the Federal Reserve's success in reducing and
  stabilizing inflation and inflation expectations
  is a major reason for this improved economic
  performance.
• Monetary policy is most effective when it is as
  coherent, consistent, and predictable as
  possible.
• One possible step toward greater transparency
  would be for the FOMC to state explicitly the
  numerical inflation rate or range consistent
  with the goal of long-term price stability