Overview-ch.16: Pdot and U rateOverview-ch.16: Pdot and U rate

Pdot = %∆P u = U/LFPdot = %∆P u = U/LF

The Phillips curve relates u and Pdot.The Phillips curve relates u and Pdot.

Shifts in the Phillips curve - the role of Shifts in the Phillips curve - the role of expectations. P and PE>>Pdot and PdotEexpectations. P and PE>>Pdot and PdotE

Shifts in the Phillips curve - the role of Shifts in the Phillips curve - the role of supply shocks.supply shocks.

The cost of reducing inflation.The cost of reducing inflation.

Pdot and uPdot and u

How are inflation and unemployment How are inflation and unemployment related in the short run? In the long run? related in the short run? In the long run?

What factors alter this relationship? What factors alter this relationship?

What is the short-run cost of reducing What is the short-run cost of reducing inflation? LR?inflation? LR?

How does this relate to AD and AS?How does this relate to AD and AS?

ConclusionConclusion

In the long run, inflation & unemployment are In the long run, inflation & unemployment are unrelated: Neutralityunrelated: Neutrality– The inflation rate depends mainly on growth in The inflation rate depends mainly on growth in

the money supply.the money supply.– Unemployment (the “natural rate”) depends Unemployment (the “natural rate”) depends

on the minimum wage, the market power of on the minimum wage, the market power of unions, efficiency wages, unions, efficiency wages, and the process of and the process of job search.job search.

– SRPC is related to cycles.—AD and SRAS.SRPC is related to cycles.—AD and SRAS.

How much Inflation? Rule of 70How much Inflation? Rule of 70

Inflation and UnemploymentInflation and UnemploymentThe The Natural Rate of Unemployment Natural Rate of Unemployment – depends on various features of the labour market, depends on various features of the labour market,

(e.g. minimum-wage laws, the market power of (e.g. minimum-wage laws, the market power of unions, the role of efficiency wages, and unions, the role of efficiency wages, and effectiveness of job search).effectiveness of job search).

– The The Inflation Rate.Inflation Rate.– depends primarily on growth in the quantity of depends primarily on growth in the quantity of

money, controlled by themoney, controlled by the

B of C.B of C.

Inflation and UnemploymentInflation and UnemploymentMacroeconomics focuses on three primary Macroeconomics focuses on three primary areas of our economy - output, prices, and areas of our economy - output, prices, and unemployment. unemployment. – If policy-makers If policy-makers expandexpand aggregate demand, they aggregate demand, they

can lower unemployment, in the short-run, but only can lower unemployment, in the short-run, but only at the cost of higher inflation.at the cost of higher inflation.

– If they If they contractcontract aggregate demand, they can lower aggregate demand, they can lower inflation, but at the cost of higher unemployment.inflation, but at the cost of higher unemployment.

The Phillips CurveThe Phillips CurveIllustrates the Illustrates the tradeofftradeoff between inflation and between inflation and unemployment -- a short-run relationship.unemployment -- a short-run relationship.

The Phillips Curve relates inflation and The Phillips Curve relates inflation and unemployment in the short-run unemployment in the short-run as shifts in the as shifts in the aggregate demand curve move the economy along aggregate demand curve move the economy along the short-run aggregate supply curve. the short-run aggregate supply curve.

1958: A.W. Phillips showed that 1958: A.W. Phillips showed that nominal wage growth (Wdot) was negatively nominal wage growth (Wdot) was negatively correlated with unemployment in the U.K. correlated with unemployment in the U.K.

Deriving the Phillips CurveDeriving the Phillips Curve

Suppose Suppose PP = 100 = 100 thisthis year. year.

The following graphs show two possible The following graphs show two possible outcomes for outcomes for nextnext year: year:

AA.. aggregate demand low, aggregate demand low, small increase in small increase in PP ( (i.ei.e., low inflation-P goes ., low inflation-P goes to 102), low output, high unemployment.to 102), low output, high unemployment.

BB.. aggregate demand high, aggregate demand high, big increase in big increase in PP ( (i.ei.e., high inflation-P to ., high inflation-P to 106), high output, low unemployment.106), high output, low unemployment.

Phillips Curve and AD-SRASPhillips Curve and AD-SRAS

The Phillips Curve in the 1950s and The Phillips Curve in the 1950s and 1960s1960s

0

1

2

3

4

5

6

7

8

9

0 2 4 6 8Unemployment Rate

Rat

e o

f In

flat

ion

1968

1967

1966

1956

19571962

1961

19601958

195919631964

1965

The Phillips Curve, Aggregate The Phillips Curve, Aggregate Demand and Aggregate SupplyDemand and Aggregate Supply

The greater the aggregate demand for goods The greater the aggregate demand for goods and services, the greater is the economy’s and services, the greater is the economy’s output and the output and the higher the overall price level.higher the overall price level.

A higher level of output results in a A higher level of output results in a lower level lower level of unemploymentof unemployment. .

Monetary and fiscal policy can shift the Monetary and fiscal policy can shift the aggregate demand curve along SRAS , thus aggregate demand curve along SRAS , thus moving the economy along the SR Phillips moving the economy along the SR Phillips curve.curve.

Phillips CurvePhillips CurveInflation

Rate

UnemploymentRate

0 4% 7%

2%

6%

A

B

The Tradeoff Between Inflation and The Tradeoff Between Inflation and UnemploymentUnemployment

Policy-makers face a tradeoff between Policy-makers face a tradeoff between inflation and unemployment, and the Phillips inflation and unemployment, and the Phillips Curve illustrates that tradeoff.Curve illustrates that tradeoff.– Okun’s law (PAST DATA) tells us that greater Okun’s law (PAST DATA) tells us that greater

output means a lower rate of unemployment but output means a lower rate of unemployment but the Phillips Curve says this is at a higher overall the Phillips Curve says this is at a higher overall price level.price level.

– SR RelationshipSR Relationship

Shifts in the Phillips CurveShifts in the Phillips Curve

It has been suggested that the Phillips It has been suggested that the Phillips curve offers policy-makers a “menu of curve offers policy-makers a “menu of possible economic outcomes.” Choicespossible economic outcomes.” Choices

Historical events have shown that the Historical events have shown that the Phillips Curve can shift due to:Phillips Curve can shift due to:– ExpectationsExpectations– Supply ShocksSupply Shocks

Shifts in the Phillips Curve Shifts in the Phillips Curve The concept of a stable Phillips Curve broke The concept of a stable Phillips Curve broke down in the 1970s and 1980s. During the 70s down in the 1970s and 1980s. During the 70s and 80s the economy experienced high and 80s the economy experienced high inflation inflation andand high unemployment high unemployment simultaneously.simultaneously.

Economists determined that monetary policy Economists determined that monetary policy was effective in the was effective in the short-runshort-run in picking a in picking a combination of inflation and unemployment, but combination of inflation and unemployment, but not in the not in the long-run.long-run.

The Breakdown of the Phillips The Breakdown of the Phillips CurveCurve

0

1

2

3

4

5

6

7

8

9

0 2 4 6 8Unemployment Rate

Rat

e o

f In

flat

ion

1968

1967

1966

1956

19571962

1961

19601958

195919631964

1965

1969 1970

1971

1972

1973

Phillips curve data--USPhillips curve data--US

LRPC and LRASLRPC and LRAS

Natural-rate hypothesisNatural-rate hypothesis: the theory that : the theory that unemployment eventually returns to its unemployment eventually returns to its normal or “natural” rate, regardless of the normal or “natural” rate, regardless of the inflation rate.inflation rate.

Based on the classical dichotomy Based on the classical dichotomy (neutrality) and the (neutrality) and the vertical vertical LRASLRAS curve. curve.

LRAS and LRPC: In LR faster LRAS and LRPC: In LR faster money growth just causes Pdotmoney growth just causes Pdot

Reconciling theory and dataReconciling theory and data

Evidence (from ’60s): Evidence (from ’60s): PCPC slopes downward. slopes downward.

Theory:Theory: PCPC is vertical in the long run. is vertical in the long run.

To bridge the gap between theory and To bridge the gap between theory and evidence, Friedman and Phelps evidence, Friedman and Phelps introduced a new variable: introduced a new variable: expected expected inflationinflation – a measure of how much people – a measure of how much people expect the price level to change.expect the price level to change.

The Phillips Curve EquationThe Phillips Curve Equation

U rate = Natural U – a (Actual inflation-expected inflation) Like the SRAS equation

Short run Short run BofCBofC can reduce u-rate below the natural u-rate by can reduce u-rate below the natural u-rate by making inflation greater than expected.making inflation greater than expected.

Long runLong run Expectations catch up to reality, u-rate goes back Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low. to natural u-rate whether inflation is high or low.

The Role of ExpectationsThe Role of ExpectationsIn the In the long-run, long-run, expected inflation adjusts to expected inflation adjusts to changes in actual inflation, and the short-run changes in actual inflation, and the short-run Phillips Curve shifts.Phillips Curve shifts.– Once people anticipate inflation, the only way to get Once people anticipate inflation, the only way to get

unemployment below the natural rate is for actual unemployment below the natural rate is for actual inflation to be above the anticipated rate.inflation to be above the anticipated rate.

– As a result, the long-run Phillips Curve is vertical at As a result, the long-run Phillips Curve is vertical at the natural rate of unemployment.the natural rate of unemployment.

The Role of ExpectationsThe Role of Expectations

In the long-run, with a vertical Phillips Curve at In the long-run, with a vertical Phillips Curve at the natural rate of unemployment, the actual the natural rate of unemployment, the actual rate of inflation and unemployment will depend rate of inflation and unemployment will depend upon aggregate supply factors and the fiscal upon aggregate supply factors and the fiscal and monetary policies pursued by the and monetary policies pursued by the government.government.

The Role of ExpectationsThe Role of Expectations

The view that unemployment eventually The view that unemployment eventually returns to its natural rate, regardless of the returns to its natural rate, regardless of the rate of inflation is called the rate of inflation is called the natural-rate natural-rate hypothesishypothesis..

Expected Inflation Shifts the SRExpected Inflation Shifts the SRPCPC

ExamExam

Same format as DecemberSame format as December

Monday April 18---9AMMonday April 18---9AM

Next week-chapter 17Next week-chapter 17

Last class Tuesday April 5—Review Last class Tuesday April 5—Review +discuss exam+discuss exam

Office hours after term ends:Office hours after term ends:

April 11: 3-4:30 and April 11: 3-4:30 and

April 13 and April 14 from 9:30-11April 13 and April 14 from 9:30-11

How Expected Inflation Shifts How Expected Inflation Shifts the the PCPC

At A, expected & At A, expected & actual inflation = 3%,actual inflation = 3%,unemployment =unemployment =natural rate (6%). natural rate (6%).

BOC makes inflation BOC makes inflation 2% higher than expected, 2% higher than expected, u-rate falls to 4% at B. u-rate falls to 4% at B.

In the long run, expected In the long run, expected inflation increases, inflation increases, PCPC shifts shifts upward, unemployment upward, unemployment returns to natural rate at C. returns to natural rate at C.

Phillips curvePhillips curve

Unstable in LR because PUnstable in LR because Peedot changes.dot changes.

SR: MS↑, AD ↑,Y ↑,u↓--Pdot ↑ on SRAS but SR: MS↑, AD ↑,Y ↑,u↓--Pdot ↑ on SRAS but sticky W&P so that Pdot> Psticky W&P so that Pdot> Peedotdot

Firms increase output but wages and other Firms increase output but wages and other costs are stickycosts are sticky

Workers supply more labour but greater Workers supply more labour but greater Pdot means real wages are lower.Pdot means real wages are lower.

When Pdot becomes fully expected, the SR When Pdot becomes fully expected, the SR changes are reversed as SRPC shiftschanges are reversed as SRPC shifts

Shifts in the Phillips Curve: Shifts in the Phillips Curve: The Role of Supply Shocks The Role of Supply Shocks

The short-run Phillips Curve also The short-run Phillips Curve also shifts shifts because of shocks to aggregate supply. because of shocks to aggregate supply.

An adverse supply shock, such as an increase An adverse supply shock, such as an increase in world oil prices, gives policy-makers a less in world oil prices, gives policy-makers a less favourable trade-off between inflation and favourable trade-off between inflation and unemployment.unemployment.

Example: 1974 OPEC price increases +2011Example: 1974 OPEC price increases +2011

The Role of Supply ShocksThe Role of Supply ShocksExample: OPEC in the 1970sExample: OPEC in the 1970s

(1) cut output and (2) raised prices. This shifts (1) cut output and (2) raised prices. This shifts SRAS up so P SRAS up so P ↑↑ and Yand Y ↓ ↓ . As Y . As Y ↓ ↓ , u , u ↑↑ . .

The tradeoff in this situation resulted in two The tradeoff in this situation resulted in two choices:choices:

Fight the unemployment battle with monetary Fight the unemployment battle with monetary expansion (and accelerate inflation).expansion (and accelerate inflation).

Stand firm against inflation (but endure even Stand firm against inflation (but endure even higher unemployment).higher unemployment).

Adverse supply shock and SRPCAdverse supply shock and SRPC

The 1970s Oil Price ShocksThe 1970s Oil Price Shocks

Oil $ per barrelOil $ per barrel

1973: $3.501973: $3.50

1974: $10.101974: $10.10

1979: $14.851979: $14.85

1980: $32.501980: $32.50

1981: $38.001981: $38.00

The BOC chose to The BOC chose to accommodate the firstaccommodate the firstshock in 1973 with shock in 1973 with faster money growth.faster money growth.

Result: Higher expected Result: Higher expected inflation, inflation, which further which further shifted shifted PC. PC.

1979-81: Oil prices 1979-81: Oil prices surged again, worsening surged again, worsening the BOC tradeoff. the BOC tradeoff.

Real and nominal oil pricesReal and nominal oil prices

The 1970s Oil Price ShocksThe 1970s Oil Price Shocks

The Cost of Reducing InflationThe Cost of Reducing InflationTo reduce inflation, the B of C has to pursue To reduce inflation, the B of C has to pursue contractionary monetary policy (e.g. contractionary monetary policy (e.g. Contractionary OMO, raising interest rates). Contractionary OMO, raising interest rates).

When the B of C slows the rate of money When the B of C slows the rate of money growth:growth:– It contracts aggregate demand (AD), whichIt contracts aggregate demand (AD), which

reduces the quantity of output that firms reduces the quantity of output that firms produce, which leads to a fall in employment.produce, which leads to a fall in employment.

Long run: output & unemployment return to Long run: output & unemployment return to their natural rates.their natural rates.

Disinflation: MP and ADDisinflation: MP and AD

The Cost of Reducing InflationThe Cost of Reducing Inflation

Given the actions of the B of C in Given the actions of the B of C in combating inflation, the economy moves combating inflation, the economy moves along (downward) the short-run Phillips along (downward) the short-run Phillips Curve, resulting in lower inflation but Curve, resulting in lower inflation but higher unemployment.higher unemployment.

If an economy is to reduce inflation it must If an economy is to reduce inflation it must endure a period of high unemployment endure a period of high unemployment and low output.and low output.

Zero inflation targetZero inflation target

Some economists believe that if the central bank Some economists believe that if the central bank makes a credible statement of its intention to makes a credible statement of its intention to deflate, that lower rates of inflation can be deflate, that lower rates of inflation can be obtained at smaller cost. PE adjusts faster.obtained at smaller cost. PE adjusts faster.In 1988, the Bank of Canada announced its In 1988, the Bank of Canada announced its zero-inflation target, and in 1989 monetary zero-inflation target, and in 1989 monetary contraction begancontraction beganThe target was reached in 1994, by which time The target was reached in 1994, by which time the unemployment rate exceeded 10 percent.the unemployment rate exceeded 10 percent.Inflation fell from 4.5% to 1.1%.Inflation fell from 4.5% to 1.1%.

The Cost of Reducing InflationThe Cost of Reducing Inflation

The The sacrifice ratio sacrifice ratio is the number of percentage is the number of percentage points of one year’s output that is lost in the points of one year’s output that is lost in the process of reducing inflation by one percentage process of reducing inflation by one percentage point. point.

A typical estimate of the sacrifice ratio is between A typical estimate of the sacrifice ratio is between 2 and 52 and 5 percentage points. percentage points.

We can also express the sacrifice ratio in terms of We can also express the sacrifice ratio in terms of unemployment. Reducing inflation by 1 unemployment. Reducing inflation by 1 percentage point requires a sacrifice of between 1 percentage point requires a sacrifice of between 1 and 2.5 percentage points of unemployment.and 2.5 percentage points of unemployment.

The Cost of Reducing InflationThe Cost of Reducing Inflation

In some years (e.g. 1979) the sacrifice ratio In some years (e.g. 1979) the sacrifice ratio was very large indicating a high level of was very large indicating a high level of unemployment was to be experienced in order unemployment was to be experienced in order to reduce inflation to acceptable levels.to reduce inflation to acceptable levels.

Rational Expectations Rational Expectations The theory of rational expectations suggested The theory of rational expectations suggested that the time and therefore the sacrifice-ratio, that the time and therefore the sacrifice-ratio, could be shorter and lower than estimated.could be shorter and lower than estimated.

The theory of The theory of rational expectations rational expectations suggests suggests that people optimally use all the information that people optimally use all the information they have, including information about they have, including information about government policies, when forecasting the government policies, when forecasting the future.future.

Rational Expectations (RE)Rational Expectations (RE)Expected inflation is an important variable that Expected inflation is an important variable that explains why there is a tradeoff between explains why there is a tradeoff between inflation and unemployment in the short-run, inflation and unemployment in the short-run, but not in the long-run.but not in the long-run.

How quickly the short-run tradeoff disappears How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.depends on how quickly expectations adjust.

RE says they adjust quickly, making U costs RE says they adjust quickly, making U costs smaller –less sacrifice.smaller –less sacrifice.

The Cost of Reducing InflationThe Cost of Reducing InflationThe Zero Inflation TargetThe Zero Inflation Target

The B of C in the 1980s, asserted that the The B of C in the 1980s, asserted that the sole goal of the B of C would thereafter be sole goal of the B of C would thereafter be to achieve and maintain a stable price to achieve and maintain a stable price level and close to zero inflation.level and close to zero inflation.

The Bank’s target was reached by 1992 by The Bank’s target was reached by 1992 by which time the unemployment rate had which time the unemployment rate had increased to over 11 percent.increased to over 11 percent.

Disinflation in the 80s and Disinflation in the 80s and 90s90s

INFLATION SINCE 1960sINFLATION SINCE 1960s

Low in 1960sLow in 1960s

Upward spike through 70s into 1980sUpward spike through 70s into 1980s

““Disinflation”-positive but declining in Disinflation”-positive but declining in the 1980sthe 1980s

Low and stable since.Low and stable since.

Bank of CanadaBank of Canada

Central banks wish to avoid future inflation Central banks wish to avoid future inflation episodes.episodes.

Analysis of 1970s indicated Analysis of 1970s indicated

Pdot = f (Mdot).Pdot = f (Mdot).

Since late 1980s, central banks have been Since late 1980s, central banks have been “credibly committed” to price stability.“credibly committed” to price stability.

Implies low PImplies low Peedotdot

Why so much inflation?Why so much inflation?

Mistakes by central banks—did not Mistakes by central banks—did not recognize that M growth would cause so recognize that M growth would cause so much inflation.much inflation.

Bad theory—inflation will “buy” lower Bad theory—inflation will “buy” lower U.---PCU.---PC

Political pressures to inflate (instead of Political pressures to inflate (instead of taxes to pay for spending).taxes to pay for spending).

Policy now—B of CPolicy now—B of C

Current M growth targets are designed to Current M growth targets are designed to limit M growth if:limit M growth if:

GDP approaches potential. >>YfeGDP approaches potential. >>Yfe

Prices start to increase by more than 2%.Prices start to increase by more than 2%.

ConclusionConclusion

Our understanding of the tradeoffs Our understanding of the tradeoffs between inflation and unemployment has between inflation and unemployment has changed dramatically over the past forty changed dramatically over the past forty years.years.New evidence, new experiences, and New evidence, new experiences, and additional analysis have led to more additional analysis have led to more agreement about this phenomena than in agreement about this phenomena than in the past. Particularly for the LR-Mankiw’s the past. Particularly for the LR-Mankiw’s rules.rules.

SummarySummary

The Phillips curve describes a negative The Phillips curve describes a negative relationship between inflation and relationship between inflation and unemployment.unemployment.

By expanding aggregate demand, policymakers By expanding aggregate demand, policymakers can choose a point on the Phillips curve with can choose a point on the Phillips curve with higher inflation and lower unemployment.higher inflation and lower unemployment.

By contracting aggregate demand, policymakers By contracting aggregate demand, policymakers can choose a point on the Phillips curve with can choose a point on the Phillips curve with lower inflation and higher unemployment.lower inflation and higher unemployment.

SummarySummary

The tradeoff between inflation and The tradeoff between inflation and unemployment described by the Phillips curve unemployment described by the Phillips curve holds only in the short run.holds only in the short run.

The long-run Phillips curve is vertical at the The long-run Phillips curve is vertical at the natural rate of unemployment.natural rate of unemployment.

The short-run Phillips curve also shifts because The short-run Phillips curve also shifts because of shocks to aggregate supply.of shocks to aggregate supply.

An adverse supply shock gives policymakers a An adverse supply shock gives policymakers a less favorable tradeoff between inflation and less favorable tradeoff between inflation and unemployment.unemployment.

SummarySummary

When the Bank of Canada contracts When the Bank of Canada contracts growth in the money supply to reduce growth in the money supply to reduce inflation, it moves the economy along the inflation, it moves the economy along the short-run Phillips curve.short-run Phillips curve.

This results in temporarily high This results in temporarily high unemployment.unemployment.

The cost of disinflation depends on how The cost of disinflation depends on how quickly expectations of inflation fall. REquickly expectations of inflation fall. RE