15 Section Phillips Curve and Aggregate Supply - FALL 2014...

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Unformatted text preview: FALL 2014 ECONOMICS 100B GSI: KRISTYN ABHOLD Section Exercise Answers: The Phillips Curve and Aggregate Supply Section 15 Agenda 1. The Phillips Curve a. b. c. d. The Original Phillips Curve The Expectation-­‐Augmented Phillips Curve Short-­‐Run Expectations-­‐Augmented Phillips Curve with Supply Shocks (Modern PC) Accelerationist Phillips Curve 2. The Long-­‐Run Aggregate Supply Curve 3. The Short-­‐Run Aggregate Supply Curve 1. This Phillips Curve • The Phillips Curve expresses the inverse relationship between unemployment (U) and inflation (π). • The Phillips curve is downward sloping because: o When unemployment is unusually low, the demand for labor will exceed the supply of labor and wages will rise more quickly. o Because wages are a major input into total costs, more rapidly rising wages leads to higher inflation. • It has seen many changes since its inception in the 1960s as the data accumulated and the relationship became clearer. • The Original Phillips Curve o The Phillips curve was originally based on an inverse relationship between nominal wages, W, and unemployment, U. o The first major flaw in the original Phillips curve analysis was that it failed to distinguish between nominal wages, W, and real wages, w. o Labor market incentives for working and hiring are determined by real, not nominal, wages. o If workers and businesses expect inflation to increase, they will also adjust nominal wages higher so that the real wage does not fall. o The second major flaw in the original Phillips curve analysis was that it failed to recognize that in the long-­‐run, when all wages and prices are completely flexible, unemployment would be at the natural rate of unemployment, UN. o This is the unemployment rate consistent with the economy’s long-­‐run steady state. 1 FALL 2014 • ECONOMICS 100B GSI: KRISTYN ABHOLD The Expectations-­‐Augmented Phillips Curve is o Incorporating these two changes, the Phillips Curve becomes the expectations-­‐ augmented Phillips curve, given by: • • π = πe – ω( U – UN ) o i.e., actual inflation is: o Positively related to expected inflation, πe , and o Inversely related to the unemployment gap, U -­‐ UN. o This implies that when U = UN then π = πe o Because in the long-­‐run, U = UN: o There is no long-­‐run trade-­‐off between unemployment and inflation. o This is consistent with the classical dichotomy. Three important conclusions: o There are two types of Phillips curves: § Short-­‐run Phillips curves (SRPC) and § Long-­‐run Phillips curves (LRPC). o There may be a short-­‐run trade-­‐off between unemployment and inflation. o There is no long-­‐run trade-­‐off between unemployment and inflation. The Short-­‐Run Expectations-­‐Augmented Phillips Curve with Supply Shocks (Modern PC) o Adjusted to account for price shocks or supply shocks, ρ. § Price or supply shocks are events that affect inflation directly but are independent of: • Labor market conditions, and/or • Inflationary expectations. π = πe –ω(U–UN)+ρ • • This modern version of the Phillips curve implies that wages and prices are sticky. o The more flexible wages and prices are, the more they and inflation respond to the unemployment gap, i.e., ω is larger. o If wages and prices were completely flexible, then .ω = ∞ and the short-­‐run Phillips curve is vertical and indistinguishable from the long-­‐run Phillips curve. Inflationary expectations are very important in the Phillips curve analysis. o For ease of analysis, assume that inflation expectations are determined in an adaptive (or backward-­‐looking) way, i.e., πet = πt-­‐1 2 FALL 2014 • • • ECONOMICS 100B GSI: KRISTYN ABHOLD The modern short-­‐run Phillips curve can now be written as: πt = πt-­‐1– ω(Ut–UN) + ρt This formulation of the Phillips curve has two significant analytical advantages: o It is in a form that is very convenient to use, and o It provides additional reasons for sticky prices. § Inflation expectations adjust only slowly as past changes in inflation, and § Some wage and price contracts are also likely to depend on past inflation. The Accelerationist Phillips Curve simply reflects rearrangement: Δπt = – ω ( Ut – UN ) + ρt • • • • If Ut < UN, then Δπt > 0, i.e., inflation continues to accelerate. If Ut = UN, then Δπt = 0 and inflation stops accelerating (or changing at all). UN is also referred to as the Non-­‐Accelerating Inflation Rate of Unemployment or the NAIRU. The modern Phillips curve is the basis for deriving the aggregate supply curve. o Because there are both long-­‐run and short-­‐run Phillips curves, there are both long-­‐run and short-­‐ run aggregate supply curves. 2. The Long-­‐Run Aggregate Supply Curve • • • • • The long-­‐run aggregate supply curve, LRAS, is the vertical relationship between: o Inflation, π, and o Potential output, YP. The long-­‐run aggregate supply curve, LRAS, is derived from the long-­‐run Phillips curve by replacing: o The natural rate of unemployment, UN, with o Potential output, YP. Potential output, YP, is the output that is produced at the natural rate of unemployment. The LRAS curve is vertical at potential output because a rise in inflation causes: o No change in the size of the labor force, L, o No change in the size of the capital stock, K, o No change in total factor productivity, A, and o No change in the natural rate of unemployment, UN. The LRAS curve will shift if there is : o A change in the amount of labor, ΔL, and/or o A change in the amount of capital, ΔK, and/or o A change in the total factor productivity, ΔA, and/or o A change in the natural rate of unemployment, ΔUN. 3 FALL 2014 ECONOMICS 100B GSI: KRISTYN ABHOLD 3. The Short-­‐Run Aggregate Supply Curve • • • The short-­‐run aggregate supply curve, SRAS, is the positive relationship between: o Inflation, π, and o The actual output that firms are producing, Y. The short-­‐run aggregate supply curve, SRAS, is derived from the short-­‐run Phillips curve by replacing: o The unemployment gap, U – UN, with the output gap, Y – YP using Okun’s law. Okun’s law describes the relationship between the unemployment gap and the output gap as: U–UN =–β(Y–YP ) o o o • • • • Start with the modern Phillips curve: § πt = πt-­‐1 – ω( Ut – UN ) + ρt and Okun’s law: § U–UN =–β(Y–YP ) Substitute and generalize: § πt = πt-­‐1 + γ( Yt – YP ) + ρt The SRAS curve is the positively sloping because: o As firms expand production they need to hire more workers. o In order to hire more workers, firms need to offer higher wages (increase wages more quickly). o To protect profit margins, firms need to raise prices (in order to compensate for higher wages). Because the short-­‐run Phillips curve embeds sticky wages and prices. o The short-­‐run aggregate supply curve also embeds sticky wages and prices. o The more flexible wages and prices are, the more inflation responds to the output gap, the higher the value of γ and, the steeper the short-­‐run aggregate supply curve. If wages and prices are completely flexible in the short-­‐run, then: o = ∞ and o The short-­‐run aggregate supply curve becomes vertical, and o The short-­‐run aggregate supply curve and the long-­‐run aggregate supply curve are indistinguishable. The SRAS curve will shift if there is: o A change in expected inflation, ∆πe, and/or o A price or supply shock, ρ, and/or o An output gap, Y–Yp ≠ 0. 4 FALL 2014 • ECONOMICS 100B GSI: KRISTYN ABHOLD Combining the short-­‐run and long-­‐run aggregate supply curves with the aggregate demand curve provides a model of short-­‐run fluctuations in: o Economic output, Y, and o Inflation, π. Multiple Choice Questions 1. According to real business cycle theory, wages and prices are completely flexible in the short-­‐ run. If this theory is correct, then a large fiscal expansion would: a. Have no effect on inflation. b. Have no effect on economic output. c. Increase inflation but not change the real interest rate. d. Increase economic output and inflation in the short-­‐run but not in the long-­‐run. Explanation: If they wages and prices are entirely responsive (flexible) to changes in unemployment, then the SRAS would be vertical and we’d see no change in output. 2. According to the Phillips Curve, policymakers may “buy” less unemployment: a. But “pay” for it with a larger output gap in the short run. b. But “pay” for it with higher inflation in the long run. c. But “pay” for it with higher inflation in the short run. d. But “pay” for it with a larger output gap in the long run. Explanation: Unemployment is negatively related to inflation in the short run. Less unemployment means a smaller output gap. 3. Which of the following changes would cause a direct upward shift in the SRAS curve? a. An increase in the labor force. b. An increase in production costs. c. An increase in the money supply. d. An increase in government purchases. Explanation: This is the same effect as a positive price shock (price of inputs increase). This increased cost will be transferred into higher prices for goods – the quality of the goods haven’t changed, but the price has, so the cost has been inflated. 5 FALL 2014 ECONOMICS 100B GSI: KRISTYN ABHOLD 4. In the short-­‐run, if current output remains persistently above potential: a. Inflation will rise, causing a movement along the aggregate supply curve. b. Inflationary expectations will rise, causing an upward shift of the aggregate supply curve. c. The aggregate supply curve will continue to shift upward until output returns to potential. d. All of the above. e. None of the above. Explanation: A persistent output gap will lead to an initial endogenous increase in inflation, which then leads to an increase in expected inflation which further increases actual inflation if Y is persistently above potential, and so on. 5. The flatter the SRAS curve, the _____ the initial effect on inflation and the _____ the initial effect on unemployment for any given change in monetary or fiscal policy. a. larger; larger b. larger; smaller c. smaller; larger d. smaller; smaller Explanation: Flatter SRAS curves mean prices and wages are sticky and do not adjust quickly to increases or decreases in aggregate demand – i.e., adjustments to changes in aggregate demand are smaller for flatter SRAS curves. This leads to Choice C – smaller initial effects on inflation and larger initial effects on unemployment (and output). 6 FALL 2014 ECONOMICS 100B GSI: KRISTYN ABHOLD Analytical Question Answer the following question based on the standard models of analysis developed in class. The information in the various parts of the question is sequential and cumulative. 1. Suppose that the economy is initially in general equilibrium. a. Use PC – AS diagrams to clearly and accurately show the economy’s initial equilibrium. These diagrams should be drawn in BLACK. b. Now suppose that the World Trade Organization concludes an agreement with its member countries to significantly reduce trade barriers, resulting in a sharp increase in globalization. Greater globalization also increases competitive pressures within an economy. As a result of increased competitive pressures, workers have less bargaining power over wages and businesses have less pricing power. On your diagrams above, clearly and accurately show how greater globalization would affect the economy. These changes should be drawn in RED. c. Provide an economic explanation of what you have shown in your diagrams above and explain why these changes take place. The increase in globalization also increases competitive pressures that reduce the bargaining power of workers and the pricing power of businesses. This means that wages and prices will be less responsive to any given unemployment or output gap, i.e., wages and prices have become stickier. As a consequence, both the Phillips Curve and the Aggregate Supply curve will become flatter. 7 ...
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