Eco 106 W8B Contrasting Views of Inflation and Unemployment Case-Fair Ch 14

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster

Eco 106 W8BContrasting Views of

Inflation and UnemploymentCase-Fair Ch 14

1. Unemployment Types and Flows

2. Classical and Keynesian views of the Labor Market

3. The Phillips Curve1. Inflation expectations2. US supply and demand shocks

4. Okun’s Law

5. The Taylor Rule and the FAIR model

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 29

The Labor Market: Basic Concepts

The labor force (LF) is the number of employed plus unemployed:

LF = E + U

unemployment rate The number of people unemployed as a percentage of the labor force.

Unemployment rate = U/LF

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The Labor Market: Basic Concepts

frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.

structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

cyclical unemployment The increase in unemployment that occurs during recessions and depressions.

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4

Ue Duration

Most spells are short but at any moment in time the

Unemployed population is dominated by longer term

Unemployed. For example suppose:

2 mo. Spells, 60m spells for the year, 10m at any time

1 yr spells, 20m spells, 20m at any time

Average spell= (60/80)2 mo+(20/80)12mo=4.5

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Change in employment status in a typical month

The US labor market has huge “churn” relative to the net change in employment.

Net Change in Employment here is -0.36, that is 1/5th of one percent of the Employed

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Employment Situation

Has both Household and Establishment Data

Household survey has been showing more job growth.

Changes are small in comparison to totals

The Employment Situation from the BLS

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BLS retrieved 10 Jan 2009, http://www.bls.gov/LAU

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9BLS retrieved 10 Jan 2009, http://www.bls.gov/LAU

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Big Numbers

2.4 million jobs lost (reduction in employment) over 2008.

1.9m in last 4 months of year (post panic from Lehman Brothers collapse.)

2.6m long term unemployed (27 weeks or more). (Table A-12, Current Employment Situation, Friday Jan 9 2009)

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2 sources of employment data

household

establishment

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2 Classical vs Keynesian Views of the Labor Market

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The Classical View of the Labor Market

labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate.

labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate.

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Classical economists believe that the labor market always clears. If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1. Anyone who wants a job at W1 will have one.

FIGURE 14.1 The Classical Labor Market

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The Classical Labor Market and the Aggregate Supply Curve

The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical.

When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.

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Sticky Wages vs Market Clearing

With a perfectly functioning

market an adverse supply

shock will lower wages

and employment.

With “sticky wages” that shock

would cause a greater fall

in employment as well as

unemployment rather than

a falling real wage.

S

D

D’

N

W

W

N

S

D

D’

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Keynesian vs Classical View of Ue

K view: shocks to labor demand come from both

the supply side (productivity and oil prices)

and the demand side (C+I+G+X-IM).

sticky wages cause labor demand shocks to

become unemployment rather than lower wages.

C view: shocks to labor demand come essentially

from productivity shocks.

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The Unemployment Rate and the Classical View

The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly.

The measured unemployment rate may sometimes seem high even though the labor market is working well.

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Explaining the Existence of Unemployment

Sticky Wages

sticky wages The downward rigidity of wages as an explanation for the existence of unemployment.

If wages “stick” at W0 instead of falling to the new equilibrium wage of W* following a shift of demand from D0 to D1, the result will be unemployment equal to L0 - L1.

FIGURE 14.2 Sticky Wages

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Sticky Wages

social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages.

Social, or Implicit, Contracts

relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts.

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Sticky Wages

explicit contracts Employment contracts thatstipulate workers’ wages, usually for a period of 1 to 3 years.

Explicit Contracts

cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.

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Sticky Wages

Explicit Contracts

Graduate School Applications in Recessions

Graduate School Offers Relief During Economic Recession

Oklahoma Daily (U. Oklahoma)

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Efficiency Wage Theory

efficiency wage theory An explanation forunemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate.

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Imperfect Information

Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information.

If firms have imperfect or incomplete information, they may set wages wrong—wages that do not clear the labor market.

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Minimum Wage Laws

minimum wage laws Laws that set a floor for wage rates—that is, a minimum hourly rate for any kind of labor.

An Open Question

The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment.

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3 The Phillips Curve

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The Short-Run Relationship Betweenthe Unemployment Rate and Inflation

The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).

FIGURE 14.3 The Aggregate Supply Curve

In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.

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This curve shows a negative relationship between the price level (P) and the unemployment rate (U). As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the price level rises more and more.

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inflation rate The percentage change in the price level.

Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate.

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The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

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During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off.

The Phillips Curve: A Historical Perspective

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In the 1950’s 60’s and 70’s the two political parties were associated with different preferences regarding where the economy should operate on the Phillips curve

32 of 29

Unemployment

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From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

The Phillips Curve: A Historical Perspective

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Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply

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Able and Bernanke Figure 12.01

The Phillips curve and the U.S. economy during the 1960s

In the 1960’s the Phillips curve was viewed as a stable trade off

Between inflation and unemployment. It is a menu, we thought.

Just pick which point you like best.

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USA Phillips Curve Data 1948-1959

-10

-5

0

5

10

15

20

0 1 2 3 4 5 6 7 8

Unemployment

Infl

ati

on

US 1942-68

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Demand Pull then Supply Push

Pi is the inflation rate.

There is a special point on any Phillips curve that shows the natural rate of unemployment and the expected rate of inflation.

Unemployment rate

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Demand Pull then Supply Push

In the late 60’ the economy stayed above expected inflation and so inflation expectations rose.

Unemployment rate

Late 60’s

Phillips Curve of 1960’s

Phillips Curve of 1970’s

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Expectations and the Phillips Curve

Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation.

Price expectations that affect wage contracts eventually affect prices themselves.

Inflationary expectations shift the Phillips Curve up and to the right.

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USA 1970s

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8 9 10

unemployment

infl

ati

on

US 70’s

Late 1960’s Demand Pull Inflation

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Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

FIGURE 14.9 The Price of Imports, 1960 I–2007 IV

The Role of Import Prices

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USA 1980's

0

2

4

6

8

10

12

0 2 4 6 8 10 12

unemployment

infl

ati

on

US 80’s

1979 Oil Shock and After

2nd Oil Shock

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USA 1990-2000

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

0 1 2 3 4 5 6 7 8 9

unemployment

infl

atio

n

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End

60’s

73

79

Early 80’s

Late 90’s

inf

Ue

Why Can’t I Draw?

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Is There a Short-Run Trade-Off between Inflation and Unemployment?

There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves more than simply choosing a point along a nice smooth curve.

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The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment

If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment—that is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output. U* is the natural rate of unemployment.

FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment

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natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment.

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The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

To the left of the NAIRU, the price level is accelerating (positive changes in the inflation rate); to the right of the NAIRU, the price level is decelerating (negative changes in the inflation rate).

Only at the NAIRU is inflation constant.

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4 Okun’s Law

Only mentioned in passing by Fair, useful for your paper!

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Okun’s law

How does unemployment vary with output.

How does unemployment vary in response to the

Growth rate of output?

What is the potential growth rate of the economy?

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Arthur Okun’s Level Law

http://www.amherst.edu/~econ53/Okun.PDF

When real GDP is 2 percentage points below the full-employment level of GDP the unemployment rate will exceed the natural rate of unemployment (The NAIRU) by 1 %.

The level version as an equation:

%GDP gap = 2(u – u natural),

where u is measured in percentage points, i.e., u = 5.5%, not .055.F

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II. The basic idea underlying the growth rate version is that when output grows more slowly than full employment output, unemployment will rise (i.e., the utilization of productive factors will be falling). This version of Okun’s Law is particularly useful for forecasting:For every 2 percentage points that the rate of growth of real GDP exceeds the rate of growth of full-employment GDP over the course of a year, the unemployment rate will fall by one percentage point.The growth rate version as an equation:%Y = 3 - 2u

Okun’s Growth Rate Law

http://www.amherst.edu/~econ53/Okun.PDF

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From Level to Growth Form of Okun’s law (an approximation)

)(%

)(%%

)(%%

)(%%

)(*100*100

)(*100

uY

uYY

uYY

uYY

uY

Y

Y

Y

writecanweionapproximatanasand

YYinitiallythensituation

employmentfullafromstartweif

uuY

YY

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Okun’s law in the United States: 1954-1998

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US Annual Data 1974-95

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

-3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0

X: Change in Percent Unemployment Rate

Y:

GD

P G

row

th R

ate

in P

erce

nt

Y

Predicted Y

From BEA data

In 1974-95 annual data alpha (2.39, 2.86, 3.34) beta (-1.28, -1.84, -1.4)

Okun’s law US Data 1974-1995

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US Data 1980-90

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

-2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5

X: Change in Unemployment rate

Y:

Per

cen

t G

row

th o

f G

DP

Y

Predicted Y

In 1980-90 annual data alpha (2.4, 2.87, 3.32) beta (-2.57, -2.11, -1.7)

Okun’s Law US Data 1980-90

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 57J. Bradford DeLong, 2000 Macroeconomics.

DeLong on Okun’s Law

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Economagic Okun’s Law

11 data points: to 2001

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Krugman: How Fast?

Paul Krugman, ‘How

Fast Can The US

Economy Grow? HBR

July/Aug 1997

2.4% Potential Growth

Rate

)(2%%

)(24.2%

uYY

uYp

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5 The Taylor Rule and Fair Model

60 of 29

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Taylor Rule

Is a “rule” describing rather than prescribing FRB action.

.02.0

.inf

)(5.05.002.0

rateinterestrealtermlongtheis

lationofratetheis

percentingapgdptheisy

yi target

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Interest rate targeting

Fairmodel:

Central bank can

Target only 1:

a) Interest rate

b) Money supply

c) Gov Debt

They target (a)

Able and Bernanke Ch 14

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Figure 14.05 The discount rate and the Fed funds rateThe discount rate and the Fed funds rate

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Fair Model http://fairmodel.econ.yale.edu

FAIR MODEL

We will look at some of the equations in the Faimodel

Which are found in Appendix A (pdf) of the US model.

It contains

Table A.1 the 6 sectors of the model.

Table A.2 the variables in Alphabetical Order

Table A.3 the equations of the model

Table A1-Equations 1-30 then follow

(this ought to be Table A.4)

Table A.5 Sources of raw data

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We will look at Appendix A, Table 3, FairModel’s Equations

1) Spending Behavior equations 1-3 cons/eq 4housing/eq 12 investment

2) Price and Output Behavior eq10 and eq12

3) FRB Behavior eq 30

FAIR MODEL

Then we will look at the Forecast Memo

http://fairmodel.econ.yale.edu/memo/index.htm

After that we will run one experiment with the FairModel

by how much will lower interest rates increase inflation?

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FAIR MODEL

Then we will look at the Forecast Memo

http://fairmodel.econ.yale.edu/memo/index.htm

After that we will run one experiment with the FairModel:

by how much will lower interest rates increase inflation?

Start by naming a data base and copying the base data

http://fairmodel.econ.yale.edu/usmodel/index.htm

Then pick option 2: monetary policy options

allow the interest rate to be exogenous

Pushes us to a screen where we put in a new value for

the interest rate for future quarters. Hit enter and see the

changes on the screen. Then click “commit to changes”.

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FAIR MODEL

Now solve the model (option 8) and examine the results.

Graph 1:

pick graph one per variable

pick the comparison dataset UseBase option

select the 5 main variables from the US variable list:

GDPR, GDPD, RS, M1, UR, SGP

Graph 2:

GDPD percentage change

Graph3:

Y, YS (full employment output by firm sector)

(In Fairmodel Y and YS referr only to the firm sector.)

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Eco 106 W8B Contrasting Views of Inflation and Unemployment Case-Fair Ch 14

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Transcript of Eco 106 W8B Contrasting Views of Inflation and Unemployment Case-Fair Ch 14