Overview-ch.16: Pdot and U rate

1
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 PEgtgtPdot and PdotE
• Shifts in the Phillips curve - the role of supply
  shocks.
• The cost of reducing inflation.

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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?

3
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.

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How much Inflation? Rule of 70
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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.

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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.

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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.

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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.

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Phillips Curve and AD-SRAS
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The Phillips Curve in the 1950s and 1960s
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The Phillips Curve, Aggregate Demand and
Aggregate Supply

• The greater the aggregate demand for goods and
  services, the greater is the economys 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.

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Phillips Curve
Inflation Rate
B
6
A
2
Unemployment Rate
0
4
7
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The Tradeoff Between Inflation and Unemployment

• Policy-makers face a tradeoff between inflation
  and unemployment, and the Phillips Curve
  illustrates that tradeoff.
• Okuns 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

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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

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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.

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The Breakdown of the Phillips Curve
17
Phillips curve data--US
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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.

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LRAS and LRPC In LR faster money growth just
causes Pdot
20
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.

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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.

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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.

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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.

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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.

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Expected Inflation Shifts the SRPC
26
Exam

• Same format as December
• Monday April 18---9AM
• Next week-chapter 17
• Last class Tuesday April 5Review discuss exam
• Office hours after term ends
• April 11 3-430 and
• April 13 and April 14 from 930-11

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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.

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Phillips curve

• Unstable in LR because Pedot changes.
• SR MS?, AD ?,Y ?,u?--Pdot ? on SRAS but sticky
  WP so that Pdotgt 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

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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

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The Role of Supply Shocks

• Major changes in aggregate supply can worsen
  the short-run tradeoff between unemployment and
  inflation.
• Eg higher oil prices shift the SRPC rightward.

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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).

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Adverse supply shock and SRPC
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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 firstshock in
  1973 with faster money growth.
• Result Higher expected inflation, which further
  shifted PC.
• 1979-81 Oil prices surged again, worsening the
  BOC tradeoff.

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Real and nominal oil prices
35
The 1970s Oil Price Shocks
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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.

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Disinflation MP and AD
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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.

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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.

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The Cost of Reducing Inflation

• The sacrifice ratio is the number of percentage
  points of one years 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.

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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.

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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.

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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.

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The Cost of Reducing InflationThe 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 Banks target was reached by 1992 by which
  time the unemployment rate had increased to over
  11 percent.

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Disinflation in the 80s and 90s
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INFLATION SINCE 1960s

• Low in 1960s
• Upward spike through 70s into 1980s
• Disinflation-positive but declining in the
  1980s
• Low and stable since.

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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

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Why so much inflation?

• Mistakes by central banksdid not recognize that
  M growth would cause so much inflation.
• Bad theoryinflation will buy lower U.---PC
• Political pressures to inflate (instead of taxes
  to pay for spending).

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Policy nowB of C

• Current M growth targets are designed to limit M
  growth if
• GDP approaches potential. gtgtYfe
• Prices start to increase by more than 2.

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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-Mankiws rules.

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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.

52
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.

53
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