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Unformatted text preview: CHAPTER 17 (AND APPENDIX TO CHAPTER 10) CHAPTER THE PHILLIPS CURVE, THE THE LONG-RUN AS SCHEDULE AND EXPECTATIONS THEORY EXPECTATIONS Spring, 2011 1 THE PHILLIPS CURVE AND THE THE LONG-RUN AS SCHEDULE LONG-RUN The effectiveness of aggregate demand The policies depends on the shape of the AS schedule schedule Classical view—vertical in long run Keynesian view--short run only Horizontal up to full employment Vertical thereafter No “long-run” view. Monetarist view – Upward sloping ( short-run) Vertical (long-run) 2 THE PHILLIPS CURVE: THE DEPICTS A “TRADE-OFF” BETWEEN UNEMPLOYMENT AND INFLATION UNEMPLOYMENT The Phillips Curve The Named after A.W. Phillips Australian economist 1958 classic article Plotted 1861-1957 data Found remarkably stable and Found inverse relationship between unemployment rates and inflation rates More recent estimation of the Phillips More Curve for the 1960’s documented a stable and negative relationships. See graph next page. 3 THE PHILLIPS CURVE FOR THE U.S. IN THE 1960S, P. 431 IN Figure 27.2 (Macro 17.2) WHAT TYPE OF AS SCHEDULE IS WHAT CONSISTENT WITH THESE PHILLIPS CURVE FINDINGS PHILLIPS 1. IF the AS schedule is stable, a IF fluctuating AD schedule can trace out the shape of the AS schedule. 2. 2. The same approach allows us to trace The out the shape of the Phillips curve. out 3. So, we can establish that the shape of So, the AS schedule determines the shape of the Phillips curve if the AS schedule remains stable. 5 EXAMPLE: SUPPOSE THE AS SCHEDULE IS UPWARD SLOPING BUT NOT VERTICAL BUT P. 430 Figure 27.1 (Macro 17.1) WHAT TYPES OF RELATIONSHIPS WHAT ARE POSSIBLE? ARE If the AS schedule is vertical, the If Phillips curve will be vertical Phillips If the AS schedule is horizontal, the If Phillips Curve will be horizontal up to full employment, and vertical thereafter.. thereafter.. If the AS schedule upward-sloping, If the Phillips curve will be downward sloping. 7 THE PHILLIPS CURVE IF THE AS SCHEDULE IS VERTICAL Page 1 Price Level Long-Run AS Schedule AD3 AD2 AD1 Real GDP 8 THE PHILLIPS CURVE IF AS SCHEDULE IS VERTICAL Page 2 Inflation Rate Phillips Curve Unemployment Rate 9 AD-AS AND THE PHILLIPS CURVE IF AD-AS THE AGGREGATE SUPPLY HORIZONTAL: Page 1 HORIZONTAL: Price Level 3 AD SCHEDULES AD1 AS SCHEDULE AD2 AD3 Real GDP 10 AD-AS AND THE PHILLIPS CURVE IF AD-AS THE AS SCHEDULE IS HORIZONTAL: Page 2 Page Inflation Rate Phillips Curve Unemployment rate at “NATURAL” RATE OF UENPLOYMENT Unemployment Rate 11 RELATIONSHIP BETWEEN AS SCHEDULE AND THE PHILLIPS CURVE AS SCHEDULE IS UPWARD-SLOPING, P. 430 UPWARD-SLOPING, Figure 27.1 (Macro 17.1) POLICY IMPLICATIONS OF THE POLICY SHORT-RUN PHILLIPS CURVE IF the AS schedule is stable and upwardsloping, then: sloping, Increases in AD cause prices to rise Increases and unemployment rates to fall. and Decreases in AD cause prices to fall Decreases and unemployment rates to rise. Macro policy can focus on selecting Macro the “best” (i.e., least-cost) combination of inflation and unemployment. Macro policy can focus on the Macro “tradeoffs” (at the margin) of policies to reduce unemployment or inflation to 13 THE PHILLIPS CURVE FOR THE U.S.INTHE 1960S, P. 431 U.S.INTHE Figure 27.2 (Macro 17.2) MONETARISTS’ CRITICISMS OF THE MONETARISTS’ “SHORT-RUN” PHILLIPS CURVE “SHORT-RUN” 1. There is no long-run tradeoff between There long-run unemployment and inflation. 2. 2. There may be a short-run trade-off There short-run because the AS schedule is upwardbecause sloping in the short-run sloping 3. 3. Because the long-run AS schedule is Because vertical, the long-run Phillips curve will be vertical as well. 4. This is the “natural rate” hypothesis: the economy will self-correct to the self-correct “natural” rate of unemployment” 15 INFLATION AND UNEMPLOYMENT RATAES FOR THE U.S. 1970-1995 RATAES P. 432 Line of “Best Fit? What line best fits these data? Figure 27.3 (Macro 17.3) EXHIBIT A-7, P. 271 (Appendix to Ch. 10) 17 WHAT DETERMINES THE POSITION OF WHAT THE LONG-RUN PHILLIPS CURVE OR THE NATURAL RATE OF UNEMPLOYMENT? NATURAL 1. Composition of the labor force. 1. Composition A. Structural unemployment A. B. Frictional unemployment B. 2. Extent of government regulation of 2. business (e.g, environmental reg.) business 3. Tax rates and tax structure 4. Extent of competitive pressures in 4. product and resource markets. A. Deregulation B. Free trade B. C. Immigration policy 5. Technology 18 HOW ARE EXPECTATIONS ABOUT HOW FUTURE RATES OF INFLATION FORMED? FORMED? Two versions of the natural rate theory: Two Will an increase in AD cause the unemployment rate to fall below the natural rate? natural Adaptive expectations Adaptive Rational expectations Adaptive expectations theory Workers respond to price increases Workers which they have observed and demand wage increases to match demand Based on the belief that people form Based expectations about future inflation on the basis of the past rate of inflation. the 19 THE NATURAL RATE HYPOTHESIS WITH ADAPTIVE EXPECTATIONS Adaptive Expectations: Adaptive (1) Expansionary monetary and fiscal (1) policies may be beneficial in the a short-run, but not in the long-run. (2) After a short run reduction in the (2) unemployment rate, the economy unemployment will “self-correct” to the natural rate of unemployment, but at a higher inflation rate. (3) The short-run AS schedule shifts (3) upward over time as wages adjust upward to price increases 20 Adaptive Expectations: Implications for Discretionary Fiscal Policy and Monetary Policy: P. 272 Policy: Figure 27.6 (Macro 17.6) ADAPTIVE EXPECTATIONS: The Short-Run and Long-Run Phillips Curves, P. 415 Note that as the short-run AS schedule slopes upward, the short-run Phillips curve shifts upward! shifts Figure 27.4 (Macro 17.4) THE NATURAL RATE AND RATIONAL THE EXPECTATIONS THEORY EXPECTATIONS The alternative view: expections about The future inflation rates are formed rationally, not adaptively. rationally not Robert Lucas, University of Chicago, Nobel Laureate Laureate Adaptive expectations model is too Adaptive naive and simple-minded naive People use all available information to People all form expectations about the future form People look at information other than People past price changes in formulating future expectations future 23 RATIONAL EXPECTATIONS THEORY (continued) Workers rationally raise their wage Workers demands as soon as they see AD increasing. This eliminates the “gap” between the This natural unemployment rate and current unemployment rate. current As soon ad the AD schedule shifts to As the right, the AS schedule shifts upward and to the left. The result is that the inflation rate The rises but the economy remains at the natural rate of unemployment. . 24 RATIONAL EXPECTATIONS THEORY (continued) Conclusions: (1) Systematic and predictable (1) expansionary monetary and fiscal policies used to reduce unemployment rates are not only useless, but also harmful because the only result is higher inflation. inflation. (2) Only unannounced (“surprise”) (2) changes in monetary and fiscal policy can produce even a short-run effect on unemployment rates. unemployment 25 RATIONAL EXPECTATIONS: Implications for discretionary fiscal policy and monetary policy, . 440 policy, Figure 27.6 (Macro 17.6) The Short-Run and Long-Run Phillips Curves Figure 27.4 (Macro 17.4) WHERE IS MACROECONONIC WHERE THEORY TODAY? THEORY 1. 1. Classical model 2. Keynesian model Keynesian 3. AD-AS model and the natural rate of unemployment. A. A. B. B. Adaptive expectations Rational expectations 4. Real business cycle theory 4. 28 28 IF THE LONG-RUN AS SCHEDULE IF IS VERTICAL, CHANGES IN AD CANNOT CAUSE BUSINESS CYCLES CYCLES Price Level AS Schedule Changes in AD AD2 AD1 Real GDP 29 29 IF AS SCHEDULE IF VERTICAL,CHANGES IN AS MUST ACCOUNT FOR BUSINESS CYCLES BUSINESS Real business cycle theory studies such Real causes: causes: 1. 1. 2. 3. 3. 4. 4. 5. 5. 6. 7. 7. 8. 8. Changes in technology Innovation Investment The regulatory setting Infrastructure develop. Energy Costs Population growth Expectations 30 30 END OF CHAPTER 17 END LECTURE LECTURE QUESTIONS???????? 31 31 ...
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