Recent_History_Lesson_-_FED_Policy

Recent_History_Lesson_-_FED_Policy - Money, Unemployment,...

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Money, Unemployment, and Inflation Rate of Inflation Unemployment Rate U π 69 62 60 61 63 64 65 68 66 67 Phillips Curve Considering observed combinations of Inflation and Unemployment in the 1960’s, economists entertained the possibility of tradeoff between rates of inflation and unemployment. This tradeoff was labeled the “Phillips Curve” tradeoff, after British economist A.W. Phillips (who had been researching similar empirical patterns in the U.K.). University of Chicago Economist Milton Friedman warned (predominately) “Keynesian” economists of that era that this tradeoff would not be permanent.
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Monetary and Fiscal Policy in the 1960’s Price Level Real Income Y P During this era, Fiscal Policy was Expansionary: - 1964 Tax Cut - Vietnam and Great Society Program in 1966 The FED during this period was targeting interest rates, taking action to keep them from rising. During this decade, the unemployment rate was falling, BUT the rate of inflation was slowly rising as the rate of growth in the money supply increased. AD 0 AS AD 1 Y 0 Y 1 Y 2 Y 3 Y 4 P 2 P 0 P 1 P 3 P 4 AD 2 AD 4 AD 5 AD 3 Y 5 P 5
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Rate of Inflation Unemployment Rate U π 69 62 60 61 63 64 65 68 66 67 Phillips Curve Though Friedman’s argument was scoffed at, the data soon proved him right. In I970 and 1971, observed inflation and unemployment was far off the 60’s Phillips Curve. If there is a tradeoff, it seems to have shifted to a higher level. Through the 70’s and 80’s any tradeoff that may exist shifted frequently. Friedman noted that there may be a short run tradeoff, but in the long run the Phillips Curve is vertical at the Natural Rate of 70 71 73 72
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Monetary Policy in the 1970s – Enter Price Expectations Price Level Real Income Y P Price Expectations were slow to adjust because we had experienced several decades with very low inflation. This changed dramatically as we entered the 1970s. Wage demands increased as we became aware of higher prices. In 1970, the rate of inflation continued to rise, BUT unemployment also rose. The “tradeoff” between inflation and unemployment disappeared. The FED, still determined to keep interest rates from rising, continued to increase the money supply and Aggregate Demand. AD 0 AS AD 1 Y 0 Y 1 Y 2 Y 3 Y 4 P 2 P 0 P 1 P 3 P 4 AD 2 AD 4 AD 5 AD 3 Y 5 P 5 P AD 7
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Monetary Policy in the 1970s – Accelarating Inflation Price Level Real Income Y P Price Expectations continued to rise in the early 1970s, and the FED remained determined to keep interest rates low. As price expectations rose at a faster rate, the FED had to increase the money supply at faster rates. Inflation was accelerating, increasing at faster and faster rates. And then came OPEC…… AD 0 AS 0 AD 1 Y 0 P 2 P 0 P 1 P 3 AD 2 AD 3
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Monetary Policy in the 1970s – OPEC – ADVERSE SUPPLY SHOCK Price Level Real Income Y P The price of crude oil increased significantly in world oil markets. Increased demand for substitutes
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This note was uploaded on 03/18/2011 for the course ECON 415 taught by Professor Holland during the Spring '09 term at Purdue.

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Recent_History_Lesson_-_FED_Policy - Money, Unemployment,...

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