Econ 102 Fall 2006

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Econ 102 Fall 2006

• Lecture 4.4
• Phillips Curve (Part 2)

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Preview

• This lecture is about the history of unemployment
  and inflation in the Post World War II period
• We will apply the theory of the expectations
  augmented Phillips curve to the data

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The History of Inflation 49-69
Inflation 49-59
Inflation 59-69
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The History of Inflation 69-89
Inflation 69-79
Inflation 79-89

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The History of Inflation 1989-2004
Inflation 1989-2004
Inflation has been under control again since 1989
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Inflation History
Oil goes from 4 to 10 a barrel
Oil goes from 17 to 25 a barrel
William Mc C. Martin Jr.
Alan Greenspan
Arthur Burns
Paul Volcker
Price inflation
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The complete model with fixed expectations
Aggregate demand
Aggregate supply
Fixed expectations
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The importance of expectations
The solution
Output is above potential if the money supply
grows faster than expected inflation
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The position of demand and supply curves
The position of the aggregate demand curve
depends on the money supply
Log Price
The position of the aggregate demand curve
depends on the expected price level
mt
ptE
Log Gdp
Potential output
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Inflation
This picture shows what happens in an economy
with steady money growth of 2 per year and
expected inflation of 2 per year
Log Price
Log Gdp
Potential output
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Inflation the 50s
Period 1 money growth is faster than expected
output is above potential
Log Price
Period 2 money growth is lower than expected
output is below potential
On average money growth equals expected inflation
Log Gdp
Potential output
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Inflation the 60s and 70s
During the 60s and 70s output is above potential
Log Price
Money growth starts to increase to pay for the
Vietnam War Inflationary expectations increase
and the supply curve shifts up faster
Accelerating inflation
Money growth must accelerate just to keep up with
expectations
Log Gdp
Potential output
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Why inflation took hold
The government ran a deficit to finance the
Vietnam War
The Fed accommodated the deficit by keeping
interest rates low. This led to excessive money
growth
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Stagflation the 80s
During the 1980s Volcker slows the rate of
growth of the money supply
Log Price
Expectations of inflation are still high
The result is high inflation AND high unemployment
Log Gdp
Potential output
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Greenspan the 90s
Volcker got inflationary expectations under
control
Log Price
Under Greenspan money growth has been modest
The situation is similar again to the 1950s
Log Gdp
Potential output
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Summary of Lecture

• Keeping inflation under control is important
  because once inflation takes hold it is
  difficult to remove
• Inflationary expectations are very persistent
• In the 1970s the Fed kept interest rates low and
  allowed the money supply to grow too fast
• This led to inflation and a decade of output
  below potential as the Fed removed inflation from
  the economy

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Reading

• Chapter 18