16 Section Exercise Answers- The Phillips Curve and Aggregate Supply - SPRING 2015 ECONOMICS 100B GSI KRISTYN ABHOLD Section Exercise Answers The

16 Section Exercise Answers- The Phillips Curve and Aggregate Supply

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Unformatted text preview: SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Section Exercise Answers: The Phillips Curve and Aggregate Supply Section 16 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 SPRING 2015 • 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 Expected inflation this year = last year’s actual inflation The modern short-­‐run Phillips curve can now be written as: πt = πt-­‐1– ω(Ut–UN) + ρt 2 SPRING 2015 • • ECONOMICS 100B GSI: KRISTYN ABHOLD 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 SPRING 2015 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 γ = ∞ 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 SPRING 2015 • 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 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 SPRING 2015 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 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Analytical Questions 1. IS—MP—AD—SRAS—LRAS Models (35 points). In 2011, the U.S. economy, which is characterized by sticky wages and prices, had an unemployment rate that was above the natural rate of unemployment. Assume that shifts in the aggregate demand curve have a larger effect on economic output than do shifts in the short-­‐run aggregate supply curve that occur in the same year. a. Use IS—MP—AD—SRAS—LRAS diagrams to clearly and accurately show the U.S.’s economic situation in 2011. These diagrams should be drawn in BLACK. b. In 2012, new legislation is passed that requires commercial banks to hold more reserves – reducing the money supply. On your diagrams above, clearly and accurately show what effects these changes would have on economic output, inflation, and the real interest rate. These changes should be drawn in RED. 7 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD c. Provide an economic explanation of what you have shown in your diagrams above. Be sure to discuss what happens to economic output and inflation and explain why these changes take place. Because the unemployment rate is above the natural rate of unemployment the economy is in short-­‐run equilibrium but no general equilibrium with economic output below its potential, i.e. Y0 < YP, i.e., there is a negative output gap. As a result of the negative output gap, actual inflation is less than expected inflation, i.e. π0 < πe0 = π-­‐ 1. This causes expected inflation to decline from πe0 = π-­‐1 to πe1 = π0 and also causes a decline in actual inflation. The negative output gap also causes a decline in actual inflation. This is represented by a rightward (or downward) shift of the SRAS curve from SRAS0 to SRAS1. Lower inflation causes the real interest rate to decline along the MP curve. A lower real interest rate causes economic output to increase along the IS curve, reducing the size of the negative output gap. Now, new legislation that reduces the money supply – this is represented by a leftward (or upward) shift of the MP curve from MP0 to MP1, increasing the real interest rate for every inflation rate. A higher real interest rate would cause economic output to decline along the IS curve. This is also a negative aggregate demand shock and is represented by a leftward shift of the AD curve from AD0 to AD1. Because the shift in the aggregate demand caused a larger change in economic output than the shift in the short-­‐run aggregate supply curve (by assumption), the net result of these changes is that at the end of 2012 economic output declines from Y0 to Y1, inflation has declined from π0 to π1, and the real interest rate has increased from r0 to r1. d. Now in 2013, reacting to projections of ballooning public debt, government purchases are substantially reduced. On your diagrams above, clearly and accurately show what effects this change would have on economic output, inflation, and the real interest rate. Intermediate steps do not have to be shown. These changes should be drawn in BLUE. e. Provide an economic explanation of what you have shown in your diagrams above. Be sure to discuss what happens to economic output and inflation and explain why these changes take place. Because this is a negative output gap, actual inflation is less than expected inflation, i.e. π1 < πe1 = π0. This causes expected inflation to decline from πe1 = π0 to πe2 = π1 and also causes a decline in actual inflation. The negative output gap also causes a decline in actual inflation. This is represented by a rightward (or downward) shift of the SRAS curve from SRAS1 to SRAS2. Lower inflation causes the real interest rate to decline along the MP curve. A lower real interest rate causes economic output to increase along the IS curve, reducing the size of the negative output gap. Now, government purchases are substantially reduced. This causes economic output at every real interest rate level and is represented by a leftward shift of the IS curve from IS0 to IS2. This is also a negative aggregate demand shock and is represented by a leftward shift of the AD curve from AD1 to AD2. Because the shift in the aggregate demand caused a larger change in economic output than the shift in the short-­‐run supply curve (by assumption), the net result of these changes is that economic output has declined from Y1 to Y2, inflation has declined from π1 to π2, and the real interest rate has declined from r1 to r2. 8 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD At the end of 2013, economic output has fallen to Y2 < Y1 < Y0 < YP, inflation has fallen to π2 < π1 < π0, and the real interest rate has fallen to r2 < r1 (which may be either <, =, or > r0 depending on the size of shifts in the MP and IS curves. 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. 2. 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. 9 ...
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