Chapter 16 Notes

Chapter 16 Notes - Chapter 16 inflation, Unempioyment, and...

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Unformatted text preview: Chapter 16 inflation, Unempioyment, and iiederal Reserve Poiicy The Biscovery of the Short-Run Trade-offhetween Unemployment and inflation A. Explaining the Phiiiips Curve with Aggregate Demand and Aggregate Supply Eurves B. ' There is a Shari-run trademjjr between unemployment and inflation: Higher unemployment is usually accompanied by lower inflation, and lower unemployment is usually accompanied by - higher inflation. , _ ° The Phillips curve is a curve showing the short—run relationship between the unemployment rate _ and the inflation rate. The inverse relationship between unemployment and inflation that Phillips discovered is consistent with the aggregate demand and aggregate supply analysis. 6%5 . new?» ones?- {is eh‘xti‘m so MS & fittecfi is the Phiiiips Curve a Peiicy Meets? * ,Some economists argued during the 19605 that the Phillips curve represented a structural relationship in the economy. A structural relationship depends on the basic behavior of consumers and firms and remains unchanged over long periods. . Structural relationships are useful in formulating economic policy because the relationships will not change as a result of changes in policy. Many economists and policymakers in the 19603 viewed the Phillips curve as a structural relationship and believed it represented a permanent Imde—ojjr between unemployment and inflation. is the Short-Run Phillips Curve Stable? In 1968, in his preéidential address to the American Economic As'sociation, Milton Friedman of the University of Chicago (who would go on to win the Nobel Prize in Economics) argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. TheLong‘Run Phillips Curve At potential real GDP (long—run level), firms will operate at their normal level of capacity, and everyone who Wants a job will have one, except the structurally and frictionally unemployed. Friedman defined the natural rate of unemployment as the unemployment rate that exists when the economy is at potential GDP. The actual unemployment rate will fluctuate in the short run but will always come back to the natural rate in the long run. . If the long-run Phillips curve is a vertical line, no trade—017 exists beta/Veer: unemployment and inflation in the long run - . ' --e r " “ ' LEE“ mesa ~— \‘fl SQ 0L Sh W1 Al) (“GREG /\\ in “1X” CW "m champ QC)th ._ m HQ] new mm m ‘ fame-lg gang to thfi ' “V . {9V ' WW ‘ De] 3 «03 WW 9‘ memo-t mkth The Role of Expectations of Future Inflation A higher inflation rate can lead to lower unemployment if both workers and firms mistakenly expect the inflation rate to be lower than it turns out to be. Expected inflation increases the value of total production and the value of total income by the same amount. . _ If actual inflation is higher than expected inflation, actual real wages in the economy will be lower than expected real wages, and many furns will hire more workers than they had planned to hire,- causing the unemployment rate to fall. _ - An increase- in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is unexpected. I Extra Solved Problem 16-1 Determining Real Wage Growth Determine the real wage and the growth rate in the real wage for the years from 2001 to 2004. Nominal 'wage and price data are given in the table belOw: 2000 14.32 ' 172.2 15.29 179.9 SOLVENG THE PROBLEM; Step I: Review the chapter material. BL 29' m To Mam we a, MU. wage- LZO/CGO w w a + mmmm w 90W» I @pwmw mm "TY w Mn SWM mom—EH ‘ NW z Xme W1 66 H3O WOOD mummy/DO 1: “1:2 0300 Wow a mm W of W00 a W N @9219; \M‘mmm Kb DE, (90/0 {OWL {Mg am] aw ' KOO/o m have mm ESE" (W \[00 paid 3 x1 t: LLOI RCQFWOOMKCJ VOL? , fi {600 9933‘ 'i :2 «x . . Wmdes‘xrd WW“ W6»??? X mo 7 5339“) , Q mm wage We \Dmfiw owe Em th‘\¢%{fmce m f aim CW: (Mum? mm W W8 (ME-PMW mm \mgas cm Com \er ye move WOV w: :7 Qt \‘M<?,m‘mmx 1mg“; This problem is about calculating real wage rates, so you may want to review the section “The Discovery of the Short-Run Trade—off Between Unemployment and Inflation,” which begins on page 974 in the textbook. Step 2: Describe how the real wage is calculated. The real wage is calculated as the nominal wage divided by the price level and multiplied by 100. \lWiwlucyme-ht '1 _ flom a“. Exitwmg’lemgw .. NOW; to Meg Wot mpg. «\3 W JR) 60/0 Step 3: Describe how the growth rate in the real wage rate is calculated. The growth rate (g) in the wage is calculated as: = wag-62004 _- Wage 2003 x 1 wage 2003 The calculated values are: Inflation Percentage rate Percentage change nominal Therefore, while the nominal rate increased an acreage of 3.1% for this time period, the real Wage increased only 0.7% for the same time period. Eittra Scived P'reblem 16-} The Policy Menu View of the Phillips Curve In 1960; Paul Samuelson and Robert Solow wrote the first article to use the Phillips curve model to explain the relationship between unemployment and inflation in the United States. They concluded that: [Plrice stability is seen to involve about 5 1/2 percent unemployment; whereas...3 percent unemployment is seen to involve a price rise of about 4 1/2 percent per annum.‘ We rather expect that the tug of war of politics will end us up in the next few years somewhere in between these selected points. Source: Paul A. Samuelsen and Robert M. Solow, “Analytical Aspects of Anti-InflationPelicy,” American Economic Review, Vol. 50, No. 2 (May 1960), pp. 192—193. - What did Samuelson and Solow them by “price stability”? What does the “tug of war of politics” have to do with what happens to the unemployment and inflation rates? sou/mo THE PROBLEM; Step 1 : Step 2: Step 3: Review the chapter material. ‘ This problem is about how the Phillips curve was understdod in the 19603, so you may want to review the section “Is the Phillips Curve a Policy Menu?” which is on page 976 in the textbook. Explain what is meant by “price stability." When prices are stable, the price level does not change. So, price stability is another term for zero inflation. I Explain how the “tug of war of politics" affects the unemployment end inflation rates. By the “tug of war of politics,” Samuelson and Solow were referring to the policy menu view of the Phillips curve. Some politicians would prefer expansionary policies that would result in very low unemployment at the cost of higher inflation. Others would prefer low inflation at the cost of higher unemployment. Political compromise would result in the economy ending up somewhere in between. The Short-Run and Long-Run Phiilips Curves Shifts in the Short-Run Phillips Curve The relationship between the short—run and long—run Phillips curves has to do with the economy’s equilibrium changes. As the US. economy’s equilibrium moved up the short—run Phillips curve during the 19603, workers and fmns were expecting a 1.5 percent inflation'rate. However, they-experienced an inflation rate of 4.5 percent because of expansionary monetary and fiscal policies that moved the short-run equilibrium up the short-run Phillips curve. The new, higher expected inflation rate can become embedded in the economy, meaning that workers, firms, consumers, and the government all take the inflation rate into account when making decisions. . There is a short-run Phillips curve for every level of expected inflation. Each short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate. B. _... no @03th WDWWW Oh fl ‘ A How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy? By the 19703, economists realized that the common View of the 1960s had been wrong: It was not possible to buy a permanently lower unemployment rate at the cost of a permanently higher inflation rate. I The moral of the vertical long-run Phillips curve is that in the long run there is no trade-off between unemployment and inflation. - . In the long run, the unemployment rate always returns to the natural rate, no matter what the inflation rate is. In other words, in the long run, the Federal Reserve can affect the inflation rate, but not the unemploymentrate. Nonaccelerafing inflation rate of unemployment mAIRU) refers to the unemployment rate at which the inflation rate has no tendency to increase or decrease. “UMP/Written is. a w: one at Mommy hone-g Oh Tl Expectations of the inflation Rate and Monetary A. The economy can remain on the short—run Phillips curve depending on how quickly workers and firms adjust their expectation of future inflation to changes in current inflation. There are three possibilities: 7 1. Low inflation a Sat—PC diets h“; action): fl 2. Moderate, but stable inflation ._ <3 {2 Corgi Lil? C (Rd :50 ETt Q lDUJ l6 3. High and unstable inflation as L QPC {1A N S CbUKXI Expectations formed by using all available information about an economic variable are called rational expectations. ' Margin-t cith new -- aclctptl M to e C. one m- it snow WWW/hi fill-{Cr he , ms»? to to re wipe.th on ON on past obgewoo’iOllS The Eff“ ct of Rational Expectations on Monetary Policy Robert Lucas and Thomas Sargent pointed out an important consequence of rational expectations: An expansionary monetary policy would not work. In other words, there might not be a trade-off between unemployment and inflation, even in the short run. \W [@5an 'm'wwma CiC-COWW ’Y ‘m'fl \NK\\ Yd ROCK V) 6N; M ' WWW pm WW» mammal W WOYQVS? Wm MJUCfi 'Tmixr WWW WOW— \8 UWQQQC-Jfid \M A m 14“ mm W8 ‘\\=-‘\ meflu git/W A WWW m ',.:jzjiii®\/\ Tb \-. man you {2+ ‘ WW0“ WWW» w my mm wag - WM Q vamw? ' lf workers and firms ignore inflation, or if they have adaptive expectations, inflation will rise and unemployment will fall. If workers and firms have rational expectations, an expansionary monetary policy Will cause the short-run equilibrium to move up the long-run Phillips curve. inflation will still rise, but there will be no change in unemployment. ' is the Short-Run Phillips Curve Reaily Vertical? Many economists have remained skeptical of the argument that the short—run Phillips curve is vertical. The two main objections raised are that: 1. Workers and firms actually may not have rational expectations. 2. The rapid adjustment of wages and prices needed for the shortwrun Phillips curve to be vertical will not actually take place. Real Business Cycle Model-s Some economists argued that fluctuations in “real” factors, particularly technology Shocks, explained deviations of real GDP from its potential level. Technology shocks are changes to the economy that make it possible to produce either more output or less output with the same amount of workers, machines, and other inputs. Real business cycle models focus on real rather than monetary explanations of fluctuations in real GDP. Extra Soived Problem 16-3 Stagtlotion and the Short-run Phillips Curve Stagflation is the simultaneous increase in inflation and unemployment (or an increase in inflation and slower economic growth). Given the negative slope of the short—run Phillips curve, how is it possible for the inflation rate and the unemployment rate to increase at the same time? SOLVING THE PROBLEM: Step 1: Review the chapter material. This problem is about the role that changing expectations play in shifting the position of the short-run Phillips curvea so you may want to review the section “Expectations of the Inflation Rate and 'Monetary Policy,” which begins on page 984 in the textbook. Step 2: illustrate the short-run trade-off between the inflation rate and the unemployment rate. _ The short-run Phillips curve shows the short—run trade—off between inflation and unemployment. On any particular short-run Phillips curve, an increase in inflation will be accompanied by a decrease in unemployment. The movement from point A to point B in the graph on the following page shows a decrease in the unemployment and an increase in the inflation rate. inflation Longwn rate Philiips (percent curve per year) Short-run Phillips _ curve 0 _ Unemployment rate (percent) Step 3: Illustrate how an adverse supply shock can cause both the unemployment rate and the inflation rate to increase. _ _ Periods of stagflation are often the result of adverse supply shocks, caused by rapid increase ‘.in the prices of resources, such as oil; An adverse supply shock that shifts the SRAS curve to the left will also shift the short—run Phillips curve up. This is shown in the graph below: Inflation rate (percent per year) Long-run Phiilips curve Short—run Phillips curve (after supply shock} Short-run Phillips curve 0 Unempioymem rate (percent) As the graph shows, a shift in the short-run Phillips curve creates the possibility of a simultaneous increase in inflation and unemployment. Stagflation is shown as a movement from point A to point B in the graph above. How the Fed fights inflation A, The Effect of a Supply Shock on the Phillips Carve ' By the mid—19705, the Fed had to deal with the inflationary impact of the OPEC oil price increases. ' - The Organization of Petroleum Exporting Countries (OPEC) caused the short—run aggregate supply curve to shift to the left. ' As a result, the economy experienced a higher price level and a lower level of real GDP. The inflation rate and unemployment rate both increased. The short—run Phillips curve was shifted up. B. Pan! Volcker and Disinflation The Federal Reserve had gone. through a two~decade period of continually increasing the rate of growth of the money supply. In August 1979, President Jimmy Carter appointed Paul Volcker as chairman of the Board of Governors of the Federal Reserve System. Paul Volcker reduced the annual growth rate of the. money supply to reduce inflation, which raised interest rates, causing a decline in aggregate demand. Under Volcker’s leadership, the Fed had reduced the inflation rate from more than 10 percent to less than 5 percent. ' A significant reduction in the inflation rate is called disinflation; This episode is often referred to as the “Volcker disinflation.” The disinflation had come at a very high price of unemployment. From September 1982 through June 1983, the unemployment rate was above 10 percent. Alan Greenspan and the importance of a Credible Monetary Policy In 1937, President Ronald Reagan appointed Alan Greenspan to succeed Paul Volcker as Fed chairman. Beginning-in the mid-19903 and early 20005, the US. economy: 1. Experienced an increase in the growth of labor productivity. 2. Had a more rapid increase in potential GDP. 3. Experienced low rates of inflation. Der-emphasizing the Money Snppiy Before 1987, the Fed would announce annual targets for how much M1 and M2 would increase during the year. ' In February 1987, the Fed announced that it would no longer set targets for M]. In July 1993, Alan Greenspan announced that the Fed also would no longer set targets for M2. Instead, the Federal Open Market Committee (F OMC) has relied on setting targets for the federal funds rate to meet its goals of price stability and high employment. ' 443’ x; ‘. .4\ "4!“ _\"\ K" i i” 3‘ K3 +3 L/l :‘k‘ ELL/“N UK #2. W # 3}. ( H53 , _. c. n.._.,~.q..m_w,__n__.__mw..w.mwmwma : A _ fiQka-Q 7- / i fiwmfcfifi 3 £3 1 x 1 n‘ %/ ‘- ‘9' "i" ' I“ VL‘ {Fain / :\ \ 1L ‘ “MN 5 3‘0 W: U: HM‘EC 1 gm w/L ~ Kw“, “3&qu c J ,. ":V fi if. { §\/ \R {k LS .‘A. 3‘-:;KJ\LLJK a f; V J ., n u it ‘ r '7' I‘ V “\r r 7 7 ‘r 153.3: {L/i 1 r ‘1 K‘\ \\ [‘7 it. J\J\.J§ Iii :H‘i ‘.- ;' 1'in \ .‘ riV' :3, “,4 .71 f. | J: ,.__ a fig - “5 Hal-‘7‘: H 4%” ‘ W " W“ N if? K‘:i.‘\¥¥\r?1£:’€i:?‘;i ml'x b r h '1. u ‘\ , J ; \__.w\_. v j Egg-,1}. ‘ ix x, 1 1.75:: 3-; A: m? 1 W E i it f i. __ , I j E buny g- 2.1 2 U (\‘kyfl Ear/‘21 UL}; K{_‘{auwfi Qt; QCAJK f0 “ll/KL iflxflq‘v“ VCR? The Importance of lied Credibility The Fed learned an important lesson during the 19703: Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective. Monetary Policy Credibility after Greenspan A rules strategy for monetary policy involves the central bank’s following specific and publicly announced guidelines for policy. Economists and policymakers who oppose the rules strategy support a discretion strategy for monetarypolicy. _ The central bank should adjust monetary policy as it sees fit to achieve its policy goals, such as price stability and high employment. According to the Taylor rule, the Fed should set the target for the federal filnds rate according to an equation that includes the inflation rate, the equilibrium real federal funds rate, the “inflation gap,” and the “output gap.” ' A Failure of Credibility at the Bank of tapan The inflation rate can be too low if inflation becomes deflation, a falling price level. Deflation can contribute to slow growth by raising real interest rates, increasing the real value of debts, and causing consumers to postpone purchases in the hope of experiencing even lower prices in the future. _ By 1999, the Bank of Japan had reduced the target interest rate on overnight bank loans—the equivalent of the U.S. federal fimds rate—to zero. The Bank of Japan’s, policies lacked credibility because firms, workers, and participants in financial markets doubted the Bank of Japan’s willingness to continue an expansionary monetary policy long enough to end the deflation. Federal Reserve Policy and Whirlpool’s “?ricing Power" Whirlpool had managed to impose modest price increases at a time its competitors were cutting prices. Whirlpool has a double exposure to recession because it may lose direct sales to consumers- buying new or replacement appliances and also sales to builders buying appliances to be included in new home construction.- ' Consumer demand remained strong throughout 2004 as low interest rates in the United States helped maintain the momentum of new housing starts. ...
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Chapter 16 Notes - Chapter 16 inflation, Unempioyment, and...

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