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Inflation and the Phillips Curve

The first few months or years of inflation, like the first few

drinks, seem just fine. Everyone has more money to spend and

prices aren’t rising quite as fast as the money that’s available.

The hangover comes when prices start to catch up.

— Milton Friedman

CHAPTER 33

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Inflation and the Phillips Curve 33

Effects of Inflation

• Unexpected inflation redistributes income from lenders to borrowers

• If lenders charge a nominal rate of 5%and expect inflation to be 2%, the expected real rate is 3%

• If inflation is actually 4%, the real rate is only 1%

33-2


Expectations of Inflation

• Rational expectations: predicted by economists’ models

• Adaptive expectations: based on the past

• Extrapolative expectations: expectations that a trend will continue

33-3


Productivity, Inflation, and Wages

• Changes in productivity and changes in wages determine if inflation is coming

• There will be no inflationary pressures if wages and productivity increase at the same rate

• Inflation = Nominal wage increases -Productivity growth

33-4


Nominal Wages, Productivity, and Inflation

• Nominal wage: the wage you get paid/make per year

• $7.50 per hour

• $50,000 per year

McGraw-Hill/Irwin Colander, Economics 5


Nominal Wages, Productivity, and Inflation

• When nominal wages increase by morethan the growth of productivity, the SRAS curve shifts left (decrease), resulting in inflation

• When nominal wages increase by less than the growth of productivity, the SRAS curve shifts right (increase), resulting in deflation



Theories of Inflation

• Theory #1: The quantity theory of inflation emphasizes the connection between money and inflation

• If the money supply rises, the price level rises

• If the money supply does not rise, the price level will not rise

33-7



• Theory #2: The institutional theory emphasizes the relationship between market structure and price-setting institutions and inflation

• It is easier for firms to raise prices than to lower them and they do not take the effect of this into account




• As workers push for higher nominal wages (or a firms raise prices) more people want higher wages (or more firms raise their prices)



The Quantity Theory of Money and Inflation

• The equation of exchange is: MV = PQ

• M = Quantity of money

• V = Velocity of money

• Q = Real GDP

• P = Price level

33-10



• Velocity of money is the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income

• (Side note: Think of it as how well the economy is doing: is money being spent quickly or slowly?)

• (Higher velocity = more inflation)


•Velocity = Nominal GDPMoney Supply



• Three assumptions of the quantity theory:

1. Velocity is constant due to the structure of the economy

2. Real output (Q) is independent of money supply

• Q is autonomous (determined by outside forces in the economy)

33-12



3. Causation goes from money to prices

• The price level varies in response to changes in the quantity of money

• The quantity theory of money is stated as %∆M %∆P

• If the money supply goes up 5% so does the price level



Central Banks and the Money Supply

• If the central bank must buy government bonds to finance a government deficit, the money supply increases and inflation may occur

33-14


Central Banks and the Money Supply

• Central banks have to make a policy choice:

• Bailing out their governments with expansionary monetary policy

OR…

• Do nothing and risk a recession



Institutional Theory of Inflation

• According to the institutionalists, increases in prices force the government to increase the money supply or cause unemployment

• MV PQ

33-16


Institutional Theory of Inflation

• In this theory, inflation is caused by the way in which prices as well as wages are set

• For example: if wages are increasing so is the price level

• At this point, the government must decide whether or not to increase the money supply

–If it increases it, inflation is accepted

–If not, unemployment increasesMcGraw-Hill/Irwin Colander, Economics 17


Demand-Pull Inflation

• Demand-pull inflation: inflation that occurs when the economy is at or above potential output (creates inflationary gap)

• Characterized by shortages of goods and workers

• Associated with the quantity theory of money/inflation

33-18


Cost-Push Inflation

• Cost-push inflation: inflation that occurs when the economy is below potential output

• Usually caused by an increase in input costs of one of the factors of production

• No excess demand but excess supply may exist

• Firms that raise prices may not sell their goods



Cost-Push Inflation

• Example: 1970s when OPEC raised the price of oil

• Associated with the institutional theory of Inflation



Addressing Inflation with Monetary Policy

•Some policymakers believe there is a tradeoff between inflation and unemployment

•Government can:

•Keep output high (AD0; inflationary gap)

• Low unemployment • Higher inflation



Addressing Inflation with Monetary Policy

•Decrease AD ( to AD1)

• Low inflation• Higher unemployment



The Phillips Curve

• This concept can be expressed in a new graph: the Phillips Curve

33-23


The Short-run Phillips Curve

• The short-run Phillips curve is a downward-sloping curve showing the relationship between inflation and unemployment when expectations of inflation are constant



Draw the Graph: Short-run Phillips Curve


Inflation

Unemployment rate

Short-run Phillips curve (SRPC)


The Short-Run Phillips Curve

• Actual inflation depends on both supply and demand forces and on how much inflation people expect

• At all points on the short-run Phillips curve (SRPC), expectations of inflation (the rise in the price level that the average person expects) are fixed

33-26


The Long-Run Phillips Curve

• At all points on the long-run Phillips curve, expectations of inflation are equal to actual inflation

• The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment



Draw the Graph: The Long-run Phillips Curve

Inflation

Unemployment rate

LRPC

33-28

5%


More on the Phillips Curve

• The sustainable combination of inflation and unemployment on the short-run Phillips curve is where it intersects the long-run Phillips curve—this is where the unemployment rate is consistent with the economy's potential income



Draw the Graph: The Short-run and Long-run Phillips Curve

Inflation

Unemployment rate

LRPC

33-30

5%

SRPC

5%A

Point A represents the (long-run equilibrium)


What Shifts the Short-Run Phillips Curve?

• Changes in productivity

• Changes in input prices

• Changes in inflationary expectations



Example #1

• The price of a key input, rubber, decreases dramatically. Show the effect in the AS/AD model and what happens to the short-run Phillips Curve.



Example #1: Answer


Price Level

AD

SRAS1

Real GDPY2

P1

LRAS

SRPC1

Unemployment

UY

LRPC

SRAS2

SRPC2

5%

U1

P2

Y1

7%


Example #2

• Assume that inflationary expectations have increased in Econville. Show the effect in the AS/AD model and what happens to the short-run Phillips Curve.



Example #2: Answer


Price Level

AD

SRAS1

Real GDPY1

P1

LRAS

Inflation

SRPC1

UnemploymentUY

LRPC

SRAS2

SRPC2

P2

Y2 U1

Inflation and unemployment increase

6%

5%


AS/AD and the Phillips Curve



What happens to SRPC based on shifts in the AS/AD Model?

• If there is an increase or decrease in AD, there is a movement along the SRPC




AS/AD and the Phillips Curve #1. Show what happens on both graphs if AD increases

Price Level

AD1

SRAS

Real GDPY1

P1

LRASInflation

SRPC

UnemploymentUY

LRPC

AD2

P2

Y2

Result: Higher inflation and lower unemployment

6%

5%

U1


McGraw-Hill/Irwin Colander, Economics

Price Level

39

AD1

SRAS


Real GDPY1

P1

LRAS

Inflation

SRPC

UnemploymentUY

LRPC

#2. Correctly draw the LRPC and SRPC with a recessionary gap. What happens when AD falls?

AD2

P2

Y2

Result: Lower inflation and higher unemployment

U1 U2

6%

5%


What happens to SRPC based on shifts in the AS/AD Model?

• If there is an increase or decrease in SRAS, there is a shift in SRPC





#3. Correctly draw the LRPC and SRPC at full employment. What happens when SRAS falls?

Price Level

AD

SRAS1

Real GDPY1

PL1

LRAS

Inflation

SRPC1

Unemployment

UY

LRPC

SRAS2

SRPC2

PL2

Y2 U1

Inflation and unemployment increase

6%

5%




#4. Correctly draw the LRPC and SRPC with a recessionary gap. What happens when SRAS increases?

Price Level

AD

SRAS1

Real GDPY2

PL1

LRAS

SRPC1

Unemployment

UY

LRPC

SRAS2

SRPC2

5%

U1

PL2

Y1

7%


Example #3A

• Assume that Econtopia is in a long-run equilibrium and that the natural rate of unemployment is 5% and the current inflation rate is 2%.

• Draw the AS/AD model and the SRPC and LRPC.



Example #3A: Answer


Price Level

AD

SRAS1

Real GDPY1

PL1

LRAS

Inflation

SRPC1

Unemployment

5%

LRPC

2%


Example #3B

• Now assume that government spending has increased and Econtopia is in short-run equilibrium. Show the impact this has on your graphs in part A.



Example #3B: Answer


Price Level

AD1

SRAS

Real GDPY1

P1

LRAS

Inflation

SRPC

Unemployment5%

LRPC

AD2

P2

Y2

Result: Higher inflation and lower unemployment

4%

2%

3%


Example 3B: Answer

• What else has happened?

• Inflation increased and is higher than expected inflation. Firms earn increased profits and increase output and employment, decreasing unemployment. Nominal wages are unchanged but real wages have declined (because inflation has increased).



Example #4Assume that the United States economy is in long-run equilibrium with an expected inflation rate of 6 percent and an unemployment rate of 5 percent. The nominal interest rate is 8 percent.

• (a) Using a correctly labeled graph with both the short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A.

• (b) Assume that the Federal Reserve action (targeting a 3% inflation rate) is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium?

• (i) The short-run Phillips curve. Explain.

• (ii) The natural rate of unemployment.



Example #4: Answer


Inflation

SRPC

Unemployment5%

LRPC

6%

a.)


Example #4: Answer

• (b) Assume that the Federal Reserve action (targeting a 3% inflation rate) is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium?

• (i) The short-run Phillips curve. Explain.

• The short-run Phillips curve will shift to the left because the Fed’s policy will lower inflationary expectations.

• (ii) The natural rate of unemployment.

• Will not change



Example #5

Assume the United States economy is operating at full-employment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recession.

• Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in consumption spending. Label the initial position “A” and the new position “B”.



Example #5: Answer


Inflation

SRPC

UnemploymentU1

Inflation rate1

Inflation rate2

A

B

U2


Chapter Summary

• The winners in inflation are people who can raise their wages or prices and still keep their jobs or sell their goods

• The losers are people who can’t raise their wages or prices

• People form expectations in many ways

• Three ways are to base expectations on economic models, on an average of the past, or on trends

• A basic rule to predict inflation is: Inflation equals nominal wage increases minus productivity growth

33-53


Chapter Summary

• The equation of exchange is MV = PQ

• When velocity is constant, real output is independent of the money supply, and causation goes from money to prices

• The equation of exchange becomes the quantity theory, and it predicts that the price level varies in direct response to changes in the quantity of money

• That is %∆M leads to an equal %∆P

33-54


Chapter Summary • Central banks sometimes print money knowing

that it will lead to inflation because the alternative might be a breakdown of the economy

• The institutional theory of inflation sees the source of inflation in the wage-and-price setting institutions

• Institutionalists see the direction of causation going from price increases to money supply increases

33-55


Chapter Summary

• The long-run Phillips curve is vertical, and it allows expectations of inflation to change

• The short-run Phillips curve is downward sloping, holds expectations constant, and shifts when expectations change

• Quantity theorists see a long-run trade-off between inflation and growth, but institutionalists are less sure about this trade-off

33-56

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