Econ- Chap 16

Econ- Chap 16 - Overview-ch.16: Pdot and U rate...

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Unformatted text preview: Overview-ch.16: Pdot and U rate Overview-ch.16: Pdot = %∆P u = U/LF The Phillips curve relates u and Pdot. Shifts in the Phillips curve - the role of Shifts expectations. P and PE>>Pdot and PdotE expectations. Shifts in the Phillips curve - the role of Shifts supply shocks. supply The cost of reducing inflation. Pdot and u Pdot How are inflation and unemployment How related in the short run? In the long run? What factors alter this relationship? What is the short-run cost of reducing inflation? LR? inflation? How does this relate to AD and AS? Conclusion Conclusion In the long run, inflation & unemployment are In unrelated: Neutrality unrelated: – The inflation rate depends mainly on growth in The the money supply. the – Unemployment (the “natural rate”) depends Unemployment on the minimum wage, the market power of unions, efficiency wages, and the process of job search. job – SRPC is related to cycles.—AD and SRAS. How much Inflation? Rule of 70 How Inflation and Unemployment Inflation The Natural Rate of Unemployment The – – – depends on various features of the labour market, depends (e.g. minimum-wage laws, the market power of unions, the role of efficiency wages, and effectiveness of job search). effectiveness The Inflation Rate. The Inflation depends primarily on growth in the quantity of depends money, controlled by the money, B of C. of Inflation and Unemployment Inflation Macroeconomics focuses on three primary Macroeconomics areas of our economy - output, prices, and unemployment. – – If policy-makers expand aggregate demand, they If expand can lower unemployment, in the short-run, but only at the cost of higher inflation. at If they contract aggregate demand, they can lower If contract inflation, but at the cost of higher unemployment. inflation, The Phillips Curve The Illustrates the tradeoff between inflation and Illustrates tradeoff unemployment -- a short-run relationship. unemployment The Phillips Curve relates inflation and The 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. Deriving the Phillips Curve Deriving Suppose P = 100 this year. Suppose this The following graphs show two possible outcomes for next year: next A. aggregate demand low, aggregate small increase in P (i.e., low inflation-P ., goes to 102), low output, high unemployment. unemployment. B. aggregate demand high, aggregate big increase in P (i.e., high inflation-P ., to 106), high output, low Phillips Curve and AD-SRAS Phillips The Phillips Curve in the 1950s and 1960s 1960s 9 8 Rate of Inflation 7 6 1966 1967 5 4 1956 3 2 1968 1965 1964 1957 1 1963 1959 1962 1958 1960 1961 0 0 2 4 Unemployment Rate 6 8 The Phillips Curve, Aggregate Demand and Aggregate Supply Demand The greater the aggregate demand for goods The and services, the greater is the economy’s output and the higher the overall price level. higher A higher level of output results in a lower level higher of unemployment. of Monetary and fiscal policy can shift the aggregate demand curve along SRAS , thus moving the economy along the SR Phillips curve. curve. Inflation Rate Phillips Curve Phillips B 6% A 2% 0 4% 7% Unemployment Rate The Tradeoff Between Inflation and Unemployment Unemployment Policy-makers face a tradeoff between Policy-makers inflation and unemployment, and the Phillips Curve illustrates that tradeoff. Phillips – – Okun’s law (PAST DATA) tells us that greater Okun’s output means a lower rate of unemployment but the Phillips Curve says this is at a higher overall price level. overall SR Relationship Shifts in the Phillips Curve Shifts It has been suggested that the Phillips It curve offers policy-makers a “menu of possible economic outcomes.” Choices possible Historical events have shown that the Historical Phillips Curve can shift due to: Phillips – – Expectations Supply Shocks 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 and simultaneously. simultaneously. Economists determined that monetary policy Economists was effective in the short-run in picking a short-run combination of inflation and unemployment, but not in the long-run. long-run. The Breakdown of the Phillips Curve Curve 9 1973 8 Rate of Inflation 7 6 1970 1969 1966 1967 5 4 1956 3 2 1968 1965 1964 1957 1 1972 1971 1963 1959 1962 1958 1960 1961 0 0 2 4 Unemployment Rate 6 8 Phillips curve data--US Phillips LRPC and LRAS LRPC Natural-rate hypothesis: the theory that the unemployment eventually returns to its normal or “natural” rate, regardless of the inflation rate. inflation Based on the classical dichotomy Based (neutrality) and the vertical LRAS curve. LRAS LRAS and LRPC: In LR faster money growth just causes Pdot money Reconciling theory and data Reconciling Evidence (from ’60s): Evidence PC slopes downward. PC Theory: Theory: PC is vertical in the long run. PC To bridge the gap between theory and evidence, Friedman and Phelps introduced a new variable: expected inflation – a measure of how much inflation people expect the price level to change. people The Phillips Curve Equation The U rate = Natural U – a (Actual inflation-expected inflation) Like the SRAS equation Short run Short BofC can reduce u-rate below the natural u-rate BofC by making inflation greater than expected. by Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low. The Role of Expectations The In the long-run, expected inflation adjusts to In changes in actual inflation, and the short-run Phillips Curve shifts. Phillips – – Once people anticipate inflation, the only way to get Once unemployment below the natural rate is for actual inflation to be above the anticipated rate. inflation As a result, the long-run Phillips Curve is vertical at As the natural rate of unemployment. the The Role of Expectations The In the long-run, with a vertical Phillips Curve at In 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. government. The Role of Expectations The The view that unemployment eventually The returns to its natural rate, regardless of the rate of inflation is called the natural-rate hypothesis. hypothesis Expected Inflation Shifts the SRPC Expected Exam Exam Same format as December Monday April 18---9AM Next week-chapter 17 Last class Tuesday April 5—Review Last +discuss exam +discuss Office hours after term ends: April 11: 3-4:30 and April April 13 and April 14 from 9:30-11 April How Expected Inflation Shifts the PC PC At A, expected & At actual inflation = 3%, actual unemployment = natural rate (6%). natural BOC makes inflation 2% higher than expected, u-rate falls to 4% at B. In the long run, expected inflation increases, PC shifts PC upward, unemployment returns to natural rate at C. Phillips curve Phillips Unstable in LR because Pedot changes. SR: MS↑, AD ↑,Y ↑,u↓--Pdot ↑ on SRAS SR: but sticky W&P so that Pdot> Pedot but Firms increase output but wages and Firms other costs are sticky other Workers supply more labour but greater Workers Pdot means real wages are lower. Pdot When Pdot becomes fully expected, the When SR changes are reversed as SRPC shifts SR Shifts in the Phillips Curve: The Role of Supply Shocks The short-run Phillips Curve also shifts The 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. unemployment. Example: 1974 OPEC price increases +2011 The Role of Supply Shocks The Major changes in aggregate supply can Major “worsen” the short-run tradeoff between unemployment and inflation. unemployment Eg higher oil prices shift the SRPC Eg rightward. rightward. The Role of Supply Shocks The Example: OPEC in the 1970s (1) cut output and (2) raised prices. This shifts (1) SRAS up so P ↑ and Y ↓ . As Y ↓ , u ↑ . and The tradeoff in this situation resulted in two choices: choices: Fight the unemployment battle with monetary Fight expansion (and accelerate inflation). expansion Stand firm against inflation (but endure even Stand higher unemployment). higher Adverse supply shock and SRPC Adverse The 1970s Oil Price Shocks The Oil $ per barrel 1973: $3.50 1974: $10.10 1979: $14.85 1980: $32.50 1981: $38.00 The BOC chose to The accommodate the first accommodate shock in 1973 with shock faster money growth. faster Result: Higher Result: expected inflation, which further shifted PC. 1979-81: Oil prices surged again, worsening the BOC tradeoff. Real and nominal oil prices Real The 1970s Oil Price Shocks The The Cost of Reducing Inflation The To reduce inflation, the B of C has to pursue To contractionary monetary policy (e.g. Contractionary OMO, raising interest rates). When the B of C slows the rate of money growth: growth: – It contracts aggregate demand (AD), which reduces the quantity of output that firms produce, which leads to a fall in employment. produce, Long run: output & unemployment return to Long their natural rates. their Disinflation: MP and AD Disinflation: The Cost of Reducing Inflation The Given the actions of the B of C in Given combating inflation, the economy moves along (downward) the short-run Phillips Curve, resulting in lower inflation but higher unemployment. higher If an economy is to reduce inflation it must If endure a period of high unemployment and low output. and Zero inflation target Zero Some economists believe that if the central bank Some makes a credible statement of its intention to deflate, that lower rates of inflation can be obtained at smaller cost. PE adjusts faster. obtained In 1988, the Bank of Canada announced its In zero-inflation target, and in 1989 monetary contraction began contraction The target was reached in 1994, by which time The the unemployment rate exceeded 10 percent. the Inflation fell from 4.5% to 1.1%. The Cost of Reducing Inflation The The sacrifice ratio is the number of percentage The points of one year’s 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. and 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. and The Cost of Reducing Inflation The In some years (e.g. 1979) the sacrifice ratio In was very large indicating a high level of unemployment was to be experienced in order to reduce inflation to acceptable levels. to Rational Expectations The theory of rational expectations suggested that the time and therefore the sacrifice-ratio, could be shorter and lower than estimated. could The theory of rational expectations suggests The that people optimally use all the information they have, including information about government policies, when forecasting the future. future. Rational Expectations (RE) Rational Expected inflation is an important variable that Expected explains why there is a tradeoff between inflation and unemployment in the short-run, but not in the long-run. but How quickly the short-run tradeoff disappears How depends on how quickly expectations adjust. depends RE says they adjust quickly, making U costs RE smaller –less sacrifice. smaller The Cost of Reducing Inflation The The Zero Inflation Target The B of C in the 1980s, asserted that the The sole goal of the B of C would thereafter be to achieve and maintain a stable price level and close to zero inflation. level The Bank’s target was reached by 1992 The by which time the unemployment rate had increased to over 11 percent. increased Disinflation in the 80s and 90s Disinflation in the 80s and 90s INFLATION SINCE 1960s INFLATION Low in 1960s Upward spike through 70s into 1980s “Disinflation”-positive but declining in Disinflation”-positive the 1980s the Low and stable since. Bank of Canada Bank Central banks wish to avoid future inflation Central episodes. episodes. Analysis of 1970s indicated Analysis Pdot = f (Mdot). Pdot Since late 1980s, central banks have been Since “credibly committed” to price stability. “credibly Implies low Pedot Why so much inflation? Why Mistakes by central banks—did not recognize that M growth would cause so much inflation. much Bad theory—inflation will “buy” lower Bad U.---PC U.---PC Political pressures to inflate (instead of Political taxes to pay for spending). taxes Policy now—B of C Policy Current M growth targets are designed to Current limit M growth if: limit GDP approaches potential. >>Yfe Prices start to increase by more than 2%. Conclusion Conclusion Our understanding of the tradeoffs Our between inflation and unemployment has changed dramatically over the past forty years. years. New evidence, new experiences, and New additional analysis have led to more agreement about this phenomena than in the past. Particularly for the LR-Mankiw’s rules. rules. Summary Summary The Phillips curve describes a negative The relationship between inflation and unemployment. unemployment. By expanding aggregate demand, policymakers By can choose a point on the Phillips curve with higher inflation and lower unemployment. higher By contracting aggregate demand, policymakers By can choose a point on the Phillips curve with lower inflation and higher unemployment. lower Summary Summary The tradeoff between inflation and The unemployment described by the Phillips curve holds only in the short run. holds The long-run Phillips curve is vertical at the The natural rate of unemployment. natural The short-run Phillips curve also shifts because The of shocks to aggregate supply. of An adverse supply shock gives policymakers a An less favorable tradeoff between inflation and unemployment. unemployment. Summary Summary When the Bank of Canada contracts When growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve. short-run This results in temporarily high This unemployment. unemployment. The cost of disinflation depends on how The quickly expectations of inflation fall. RE quickly ...
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