Unemployment, inflation and economic...

Unemployment, inflation and economic policy

Topic 7

1 Macroeconomics 309 - Lecture 7

Macroeconomics 309 - Lecture 72

Goals of topic 7

§ Definition of short-run and long-run equilibrium.

§ Analysis of demand and supply shocks.

§ Unemployment and inflation dynamics: Phillips curve.

§ Fed’s objectives and behaviour.


Caveat on the shape of the SRAS curve

§ The shape of the SRAS Curve is believed not to be linear:

§ The shape of the SRAS Curve looks more like:

§ It is bounded at some ‘technological constraints’.§ It flattens out at low levels of output.

SRAS(A0,W0)

P0

Y*0

P

Y


What is equilibrium for the economy?

§ Short-run equilibrium:

AD = SRAS and IS = LM

§ The labour market need not be in equilibrium (nominal wages are sticky, remember).

§ We need not be at the potential level of GDP

§ Long-run equilibrium:

AD = SRAS = Y* and IS = LM = Y* and Nd = Ns = N*

§ In the long run, by definition, we will move to Y*.§ In the long run, by definition, the labour market will clear.


Graphical representation of the economy in recession

Y

P

AD = f(G,PVLR,taxes,Yf,M,Πe)

Y*

SRAS = f(input prices)

Y* = f(N*,K,A)

Yesr

Below Potential!


More on equilibrium§ Equilibrium is a point of attraction for the economy:

§ Most macroeconomists believe that, in the absence of shocks, the economy would reach equilibrium after perhaps 5 years. Thus the economy is in equilibrium in the “long run” (after 5 years).

§ Is the economy ever in long-run equilibrium?

§ Given that shocks are always hitting, the economy is not likely to be in long-run equilibrium at any point in time. Yet the force of attraction of equilibrium keeps the economy hovering around the equilibrium.

§ Why is the long-run equilibrium point attractive?

§ Because there the labour market clears. Away from Y* workers are not on their labour supply curve (and firms may be off their labour demand curve). Maximising behaviour by workers and firms push the economy towards long-run equilibrium. Shocks push the economy away temporarily.


How do we represent recessions?§ Unofficial definition - 2 consecutive quarters of negative real GDP growth§ Our model: Y < Y* § We define the output gap as Y* - Ye

sr

§ Remember: Y* trends upward overtime (even though in our model - we have it constant - population growth, K grows (we abstract from these trends in our model), TFP is growing every period). It makes things easier to keep Y* constant initially.

§ Our model removes the trends in N and K due to population growth and K (by assumption).

§ Questions for the rest of class:§ What causes recessions?§ Why would the fed be concerned about inflation when Ye

sr >Y*?§ How do we get out of recessions once we are in them?§ Can the economy correct itself?


Where do recessions come from?

1. Temporary or permanent changes in technology (or productivity) -i.e. productivity shocks, drought?

2. Shocks to expectations (individual beliefs about the future) – i.e. stocks are overvalued, a recession will be coming (self-fulfilling prophesies), etc. See material on expectations for more.

3. Increases in relative prices of inputs (like oil prices)

4. Bad (or good) economic policy (monetary or fiscal)

5. External crises (for small open economies).


Analysis of the business cycle: examples

§ We now start analysing shocks to the economy that move it away from full-employment output.

§ In the examples that follows such shocks are permanent. You can also study their temporary counterparts.

§ Convention: the initial “shocked variable” (say, G, Ms, consumer confidence,etc.) has a 1 subscript (example if I tell you we are increasing G then we move from G0 to G1 > G0).


Some examples

§ 1974 Recession: OPEC - rapid increase in oil prices

§ 1980 Recession: OPEC II – Iran Revolution

§ 1982 Recession: Good Fed Policy! (Volker’s Recession)

§ 1990 Recession: Consumer confidence.

§ 1990’s Japan: end to speculative bubbles, bad policy, debt overhung and liquidity traps.

§ 2001 Recession: consumer Confidence (burst of stock market bubble - see reading on the Economist “The Kiss of Life?”).

§ 2009 Recession: credit crunch and home prices collapse


Example 1: changes in consumer confidence

§ A change in expectations about the future (whether founded or not) can have dramatic effects on the economy.

• Consumer confidence• Irrational exuberance• Paradox of savings (an increase in the savings rate will decrease

aggregate demand and may as well decrease savings and investment)

§ Households expect the future to be good or bad.

• No effect on labour demand (A hasn’t really changed).• Some effect on labour supply (households expect PVLR to have

changed).• Households work more or less (depending on whether they think PVLR

has decreased or increased). • Consumption changes and the AD and IS curves shift• Example: 1990-91 Recession (a fall in consumer confidence from the

Gulf War)• Note: I will often assume small (or no) income effects on labour supply.


Consumer confidence: 1978 - 2004


Analysing a decrease in consumer confidenceExample 1: 1990-91 Recession due to Gulf War I. Note: no effect on A or Af

SRAS(W0)

IS(C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y

• Assume we start at Y*• Assume consumers are standard PIH (i.e., non-liquidityconstrained, non-Ricardian).• Assume no income effect onlabour supply.

Ns

W0/P0

N*0

W/P

Nd


Analysing a decrease in cons. conf. (SR eq.)

SRAS(W0)

IS(C0)

LM(P0)

P1

AD(C0)

Y*0

Y*0

r

P

Y

Y


Consumer confidence per se does not affect labour supply or labour demand.

However in the short-run firms meet the lower demand at lower prices P1but higher labour costs W0 /P1

IS(C1)

AD(C1)Yesr

Yesr

P0

LM(P1) Ns

W0/P0

N*0

W/P

Nd

0W0/P1 1

Nesr


SRAS(W0)

IS(C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y

Eventually, nominal wages will fall to W1 (self-correcting mechanism). Nominal wages are fixed in the short run (that got us to point (1)). In the long run, they can adjust. We get back to the labour market equilibrium (0).

The fall in nominal wages makes production cheaper which will shift out the SRAS curve.

When production is cheaper, firms want to produce more at every given price!

IS(C1)

AD(C1)Yesr

Yesr

LM(P2)

SRAS(W2)

P1

IS(C0)

LM(P1)

P2

0

12

0

1

2

Analysing a decrease in cons. conf. (LR eq.)

Ns

W0/P0

N*0

W/P

Nd

= W2/P2

0W0/P1

1


Irrational exuberance: increase in cons. conf.

§ Mistaken belief in higher Af shifts IS/AD rightward, and shifts Y* leftward due to lower N* (income effect - may be small!).

§ The boost in perceived PVLR and future MPK raises demand for C and I goods, shifting the IS/AD rightward. The higher perceived PVLR reduces N* and shifts the LRAS. Note: current A does not rise (so labour demand does not shift).

§ In the SR, the economy moves to the new IS/ LM intersection, with higher Y and higher r. Firms respond to the higher goods demand by producing more (to achieve this they hire more N). The economy moves to Y > Y*, N > N*, and U < U*.

§ Prices increase! Irrational exuberance could cause inflation (higher prices - in both the short run and the long run)


Analysing the curves

§ The curves have meaning

§ Notice - the slopes of the curves give us different quantitative results. Steepness of curves matter

§ Look at SRAS-AD (flat (instantaneous) SRAS - versus upward sloping SRAS). The text book considers flat SRAS. In class increasing SRAS

§ Look at the IS-LM (money market vs IS-LM; Fed interest rate targeting).


Example 2: supply side of the economy - oil

§ Responsible (partially) for the 1975 and 1979-1980 economic recessions (OPEC I and OPEC II)

§ Also important for today’s economy. Stellar oil prices.

§ Supply shocks cause unemployment and prices to move in the same direction (very different from demand shocks).

§ Supply shocks - oil and technology. When an input is more expensive, I need to employ less of it and produce less.

§ Demand shocks: M, G, T and consumer confidence. § As we will see soon - supply shocks could have demand effects


Analysing an increase in oil prices

SRAS(Oil0,W0)

IS(C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y

• Assume we start at Y*• Assume the production functionis not affected.

Example 2: 1974 (and 1979) as OPEC countries set a world oil embargo.


Analysing an increase in oil prices: (SR eq.)

SRAS(Oil0,W0)

IS(I0,C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y

SRAS(Oil1,W0)

P1

LM(P1)

The economy is initially in equilibrium at point (0). As the AS curve shifts in (due to higher oil prices raising the cost of firm production), prices should RISE and the equilibrium level of output should fall to (Y1 – GDP in the short run). Also the AD shifts in because consumption and investment decrease.

The short-run equilibrium is at (1) for the economy.

We refer to this situation of rising prices (inflation) and high unemployment (low output) as stagflation.

Yesr

Yesr

0

0

1

IS(I1,C1)

1


Analysing an increase in oil prices: (LR eq.)

SRAS(Oil0,W0)SRAS(Oil1,W1)

SRAS(Oil0,W0)

IS(I0,C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y

SRAS(Oil1,W0)

P1

LM(P1)

Yesr

Yesr

0

0

2

1

IS(I1,C1)

Y*2

Y*2

1

2

The economy is in LR equilibrium at point (2).Notice that the permanent increase in oil prices diminishes productivity of factors of production. This can be considered like a negative TFP shock. Hence the LR potential output level will be lower, at Y*2.

What happens in the labour market in short run? Well if Y < Y*2, N < N*2 and people are working less than their optimal. In the short run, nominal wages are fixed. Prices go up. Real wages will fall.

What happens in the long run? We will go to Y*2 (by definition of the long run, that is what always happens). We will assume we get there via the self-correcting mechanism. As people work less then their optimum, firms will want to cut nominal wages. As nominal wages fall, SRAS will shift to the right, restoring general equilibrium at Y*2. Prices will drop further and the LM will shift back out.


Example 3: 1990s and increase in A§ Increase Y* (shift out labour demand and shift in labour supply -

regardless if N increases or decreases, Y* will likely increase - the TFP effect will usually dominate).

§ SRAS will shift out (cost of production falls)§ AD and IS will shift out (C and I will increase, PVLR and MPK will

increase)

§ How far will AD and SRAS shift out? Depends - many cases.

§ Summary, Y will increase in both short and long run. The effect on prices is ambiguous: they could rise, fall or stay the same, interest rates will likely rise (although, it is not guaranteed if there is a sufficiently large drop in the price level), C will rise in short and long run, I will likely rise in short run and may rise in long run, tax revenues will increase, public saving will rise, private saving is uncertain - may stay the same, may rise or may fall - depending on the timing of the technology changes and the instruments used to hold wealth (i.e., pensions).


Analysing an increase in TFP - labour market

N0

W0/P0

Nd

Ns

N2

W/P2 LR

0

An increase in A will increase Nd directly. An increase in technology (like an Internet revolution) will increase the marginal product of labour which will make labour more productive (and hence worth more to the firm).

And because of change in PVLR as real wages increase, Ns will fall.

If the substitution effect dominates, Y* will increase (both A and N rise). If the income effect dominates, it is uncertain whether Y* increases (A increases Y and lower N causes Y to fall).

N’s

N’d

1 SR

N1


Analysing an increase in TFP (A)

SRAS(A0,W0)

IS(C0,I0)

LM(P0)

P0

AD(C0, I0)

Y*0

Y*0

r

P

Y

Y

Example 3: The internet Revolution. Late 1990s in the U.S.


Analysing an increase in TFP (SR eq.)

IS(C0,I0)

LM(P0)

P0

AD(C0, I0)

Y*0

Y*0

r

P

Y

Y

AD(C1, I1)

Y*2

Y*2

There will be effects on both AS and AD. Since PVLR increased permanently, consumption will rise. This will shift out the AD curve. Additionally, as A increases, the MPK will increase causing firms to invest more. This will increase I and also shift out the AD curve. How far will it shift out? – It depends. There is no guarantee that it will shift all the way out to the new potential level of output. We will assume that it only goes part of the way (in reality, it could actually surpass the new Y*). What about the AS curve? An increase in A will shift out the AS curve (the new technology will make production cheaper so firms will increase production at any given price).

IS(C1,I1)

0

0

1

1

SRAS(A1,W0)

SRAS(A0,W0)

Y1

Y1


This representation of the economy is the one that the Fed thought that wewere in during Spring 2000 (read FOMC statements at the time):

1) Technology had improved.

2) Consumption had increased

3) Investment had been rising.

4) Unemployment was lower than the estimated natural rate ofunemployment.

5) Prices had been relatively stable despite the rapid GDP growth.

6) Fed thought the labour market was ‘tight’ – another word for wagespossibly rising in the future.

Analysing an increase in TFP (SR eq.)


Analysing an increase in TFP (LR eq.)

IS(C0,I0)

LM(P0)

P0

AD(C0, I0)

Y*0

Y*0

r

P

Y

Y

AD(C1, I1)

Y*2

Y*2

In the Long Run Nominal wages would rise to clear the labour market (workers are working so much –this can only be a temporary effect. In order to keep workers in the labour market, firms will have to raise wages (actually, the workers will demand it)). As nominal wages increase, the SRAS curve will shift in restoring equilibrium at the new long-run output Y2*. As the SRAS curve shifts in, what happens to prices? Prices will rise! The increase in prices is EXACTLY what the Fed was worried about!

IS(C1,I1)

0

0

1

1

SRAS(A0,W0)SRAS(A1,W1)

2 SRAS(A1,W0)P2

2

LM(P2)


Reviewing the data

§ In first class we saw that some falls in GDP were associated with no increase in prices.

§ We also saw that some falls in GDP were associated with large increase in prices.

§ Do our theories reconcile these facts?

• Yes. Demand shocks result in recessions without a corresponding rise in prices.

• Yes. Supply shocks (like changes in oil prices) result in recessions with a large corresponding positive change in prices.

• You should really understand the difference between demand shocks (things that primarily affect AD) and supply shocks (things that primarily affect AS) on the economy - their implications are much different from each other.


Economic policy

§ Monetary and fiscal policy: May they help in stabilising the economy from demand and supply shocks?

§ Not an exact science - How much stimulus is necessary to move the economy to Y*?

§ Policy creates uncertainty as economic agents try to anticipate Fed/Government rules.

§ Some argue avoid using no stabilisation policy (just a simple Quantity Theory representation) or suggest using very simple rules.

§ Policy often entails long and variable lags

§ Some research says that every sustained period of large inflation is due to the Fed


Fiscal policy in action: stabilising output

§ Another stabilisation mechanism is to shock AD through a change in G (fiscal policy).

§ Not necessarily the best approach (we know that an increase in G crowds out private investment by decreasing savings and increasing r – i.e. investment moves up along the Id curve in the goods market).

§ It suffers from even longer lags than monetary policy due to the budgeting process.

§ It may be inflationary.

§ Graphical analysis of an increase in G follows.


Analysing an increase in gov’t spending (G)

SRAS(W0)

IS(C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y



Analysing an increase in G

SRAS(W0)

IS(G0)

LM(P0)

P0

AD(G0)

Y*0

Y*0

r

P

Y

Y

• Assume we start at Y*• Assume consumers are standard PIH (i.e., non-liquidityconstrained, non-Ricardian).• Assume no income effect onlabour supply.• Wages are sticky.AD(G1)

IS(G1)

P1

Yesr


Analysing an increase in G (SR eq.)

SRAS(W0)

IS(C0)

LM(P0)

P0

AD(G0)

Y*0

Y*0

r

P

Y

Y

• Prices increase to P1 in the Short-run equilibrium.

AD(G1)P0

P1

Yesr

IS(G0)

LM(P0)

IS(G1)

LM(M0, P1)

1

0


Analysing an increase in G (LR eq.)

SRAS(W0)

IS(C0)

LM(P0)

P0

AD(G0)

Y*0

Y*0

r

P

Y

Y

• Nominal wages rise to offsetthe increase in prices.At any price, a rise in the nominalwage also rises the real wage, so firms employ less labour and produce less.

AD(G1)

SRAS(W1)

P0

P1

P2

LM(M0, P2)

Yesr

IS(G0)

LM(P0)

IS(G1)

LM(M0, P1)

0

1

0

1

2

2


Analysing an increase in the money supply

SRAS(W0)

IS(C0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y


LM(M0,P0)


Analysing an increase in the Ms (SR eq.)

SRAS(W0)

IS(C0)

LM(M0,P0)

P0

AD(M0)

Y*0

Y*0

r

P

Y

Y


AD(M1)

LM(M1, P1)

P1

Yesr

0

1

0

1


SRAS(W0)

IS(C0)

P0

AD(M0)

Y*0

Y*0

r

P

Y

Y

• Nominal wages rise to offsetthe increase in prices.At any price, a rise in the nominalwage also rises the real wage, so firms employ less labour and produce less.• In the long-run M0/P0 = M1/P2AD(M1)

LM(M1, P1)

SRAS(W1)

P0

P1

P2

LM(M1, P2)

Yesr

Analysing an increase in the Ms (LR eq.)

0

1

2

0

12

LM(M0,P0)


Some thoughts on money§ Let us look at the Fed increasing the nominal money supply

§ We are going to look at money supply setting (as opposed to interest rate setting – the Fed can only set either one or the other – Ld matters).

§ Assume we start at Y*.

§ Fed increases Ms and LM shifts right, r falls and I increases.

§ AD shifts out - Y increases (Y > Y*). Puts upward pressure on nominal wages (notice the key role of nominal wages as an indicator of future inflation).

§ As nominal wages rise - SRAS shifts in (up).

§ Prices rise and we return to Y* (basically - this is what is predicted by the quantity theory of money)


An example of monetary policy: stabilisationConsumer confidence falls by a lot

SRAS(W0)

IS(C0)

LM(P0)

P1

AD(C0)

Y*0

Y*0

r

P

Y

Y

• Same drop in consumer confidence as we saw in Example 1.

•As we saw – the economywill eventually correct itselfand bring us back to Y*0. Thedrawback is that the self-correcting mechanism worksslowly when Y < Y*0 (it takestime to cut nominal wages).Let’s for a moment – thinkabout how the Fed could bringus back to Y*0.

IS(C1)

AD(C1)Yesr

Yesr

P0

LM(M0,P1)


An example of monetary policy: stabilisationThe Fed increases money supply to stabilise the economy.

SRAS(W0)

IS(C0)

LM(P0)

P1

AD(C0)

Y*0

Y*0

r

P

Y

Y

•As M increases, I increasesand the AD curve shifts backout. Notice (this is subtle) –when I increased between theshort run and the long runwhen the economy correcteditself, the AD curve did notshift! The reason? Iincreased as P fell and M/Pincreased. The response ofchanging P on Investment(and as a result Y) is why theAD curve slopes down.•In the case of the self-correcting mechanism, we justmove along the AD curvewhen the economy correctsitself (because of the priceeffect on M/P). When Mchanges – the AD curve shifts.It says that at every given P,higher M is higher M/P –resulting in lower interestrates and higher investmentand higher Y. That means, atevery given P – an increase inM leads to higher Y ( arightward shift in the ADcurve).

IS(C1)

AD(C1)Yesr

Yesr

P0

LM(M1,P0)

LM(M0,P1)


SRAS(W0)

IS(C0)

LM(P0)

P1

AD(C0)

Y*0

Y*0r

P

Y

YIS(C1)

AD(C1)Yesr

Yesr

P0

LM(M1,P0)

LM(M0,P1)

SRAS(W0)

IS(C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0r

P

Y

YIS(C1)

AD(C1)Yesr

Yesr

LM(M0,P2)

SRAS(W1)

P1

LM(M0,P1)

P2

0

12

0

1

2

0 2

1

1

0

2

LR eq. : compare without and with stabilisationFed does not stabilise: longer & lower P Fed stabilises: faster & higher P


An example of monetary policy: inflation controlConsumer confidence increases by a lot (irrational exuberance)

SRAS (W0)

IS(C0)

LM(P0)

P0

AD(C0)

Y*0

Y*0

r

P

Y

Y

AD(C1)

IS(C1)


Goals of the Fed

§ Fed’s primary goals are to foster economic growth and job creation and

restrain inflationary pressure.

§ The Fed wants to set r so that

• r = r*, Y = Y*, U = U*, N = N* ( these are equivalent).

• p = p * (0-2% inflation).

§ The Fed wants to raise r when

• r < r*, Y > Y*, U < U*, N > N*

• p > p *

§ The Fed wants to lower r when the opposite conditions hold.


Fed timing

Recession Begins First Fed nominal rate cut

§ December 1969 11 months later

§ November 1973 13 months later

§ July 1981 4 months later

§ July 1990 5 months later

§ March 2001 3 months before

§ December 2007 5 months before


Rules vs. discretion

§ Should a central bank have a specific policy rule?

§ Rules are explicit and may be mandated by law

• Money should grow at 4% per year (Friedman preferred rule).• Explicit inflation target: UK has an inflation target of 2% (+/- 1%)

See main web page http://www.bankofengland.co.uk/

§ Rules may be implicit and known by all economic agents

• The Fed will target the inflation rate at 2-4% per year.

http://www.bankofengland.co.uk/


Benefits of rules

§ Commits central bank to some policy

§ Removes inflation temptation

§ Creates a more stable economic situation: Individuals and firms can anticipate the central bank actions. No surprises.

§ Prevents central bank from thinking too much - the economy is so complex that Fed policy can have delayed impact and is usually initiated too late. Central Bank actions can often be ‘destabilising’. (Freidman, Lucas: Both prefer simple rules).


Benefits of discretion

§ Central Bank uses all information possible to make the best decision at the time.

§ The Fed uses a discretionary rule. The members of the bank vote on a monetary policy at each FOMC meeting. The policy is not dictated by some explicit rule.

§ Benefits of discretion:• Allows central bank to choose from competing policy goals.

(sometimes inflation targeting is not best for the economy)• The fundamentals of the economy may change/or evolve over time -

the rule becomes outdated.• How do we know where the economy is relative to Y* and target

inflation rate? Information flows slowly and is complex to analyze.


Hawks and doves

§ How does the Fed balance price stability (p = p *) and full employment (U = U*) when they conflict?

[For example, when p > p* and U > U* at the same time.]

§ Hawks put more weight on p * (and have lower values for it).• U.K., Canada, New Zealand.• Bundesbank before; European Central Bank now?

§ Doves put more weight on staying near U* (and have higher p *).

§ Yellen tends to puts the same “weight” on each.


Fed’s policy behaviour: the Taylor Rule

§ Q: Can we approximate Fed’s decisions in a simple, synthetic way?

§ John Taylor of Stanford University: the Fed’s behaviour under Alan Greenspan (August 1987 to 2006) and Janet Yellen (until recently) are well-described by:

Taylor Rule: i = r* + πe + .5*(πe - πe*) + .5*(Y - Y*)/Y*

i = the nominal federal funds rate. r* = the real fed funds rate target (this is the r consistent with Y=Y*).πe = expected inflation. πe * = target inflation. Y = real GDP.Y* = equilibrium real GDP (Y-Y*)/Y* is the output gap or GDP gap. A positive output gap means overheating and potentially rising inflation (labour markets will demand higher wages).

§ Taylor used r* = 2% and πe* = 2%. The Taylor Rule explains about 2/3 of quarterly variation in the fed funds rate since 1987 (a lot).


Notes on the Taylor Rule

§ Fed economists find an even better fit with 1 on the GDP gap term.

§ This does not mean that Yellen used this ‘rule’, it is just that Fed behaviour looks very similar to this rule.

§ Furthermore, the Fed tends to smooth interest rates relative to the rule:

This quarter’s actual i = .6*(Last quarter’s actual i) + .4*(Taylor Rule’s i)

§ Studies have found that other G7 Central Banks (e.g., the Bundesbank, ECB) have also followed versions of a smoothed Taylor Rule.

§ Read the speeches by Yellen, Bernanke, Greenspan and Gramlich to see the Fed’s take on such subject.


A look at liquidity traps

§ Nominal interest rates are bounded at zero

§ People believe that there will be deflation in the future

§ Real interest rates are large and positive.

§ Fed would like to cut rates (to stimulate Y (shift out AD) which will put upward pressure on prices), but nominal rates cannot go below zero

§ The Fed is helpless. How do they stimulate investment and consumption when they cannot cut nominal interest rates?

§ This describes the situation in Japan during the late 1990s. Japan has experienced deflation and nominal rates are close to zero. Central Bank of Japan is helpless. Same in US for 2008-2016.


A look at liquidity traps1. Investment-Saving

IS-LM Equilibrium2. Liquidity-Money

r0

I0

M0/P Y0

I, S

Y

Id

Sd

Ld IS

LM

UNAVAILABLE

r

r

= -pe

-pe -pe

• The nominal interest rate paid by nonmonetary assets NM is bound from below at 0 and the real interest rate paid is bound from below at -pe.

• The reason is that i = r + pe so if r < -pe then r + pe < 0 and hence i < 0. But at that point M (the monetary assets which pays i= 0) would become suddenly more rewarding that NM (i.e. nobody would hold NM).

• This implies that trying to push real rates furtherdown through increases in M (hence shifting LMright) is not possible beyond the i = 0 bound.

0

0 0


Demand side effects of deflation§ Deflation can make borrowers - either consumers or firms, worse off.

§ As we saw early in the course, unexpected inflation makes borrowers better off. They expected to pay a certain real rate and when inflation is higher and the nominal rate is fixed, the real rate they pay is lower (in terms of lost purchasing power).

§ If the economy experiences unexpected deflation, the opposite happens: borrowers are paying more in terms of lost real purchasing power when there is unexpected deflation. Borrowers, both consumers and firms, will essentially be poorer. (even though, there is another side of the market -somebody’s got to lend to them, this could still have large effects on consumption and investment). This demand side effect of deflation is called ‘debt overhang’ or ‘debt deflation’. <<note, even the government is paying higher than expected real rates on their debt>>.

§ Even if the deflation is expected, large transfers can occur from borrowers to lenders because nominal interest rates are bounded by zero (shuts down lending channels).


Change in prices versus inflation

§ Labour markets are forward looking

§ If the purchasing power of workers’ nominal wages is systematically eroded by unexpected changes in prices, workers will try not to lose systematically.

§ Change in prices become dynamic.

§ Two examples: • Cost-push inflation: Consider an increase in production costs.

Accommodating supply shocks can lead to persistent inflation (the Fed in the mid and late 70s). Workers see this, and adjust. They ask for higher nominal wages in anticipation, this shifts up the SRAS, and this pushes prices up…

• Demand-pull inflation: Policy makers try to permanently keep the economy above its potential level by stimulating demand. Wages will keep adjusting then (you can’t fool all the people all the time).


Graphing accommodation of inflation

Cost-push and accommodation

Y

P

AD(M0)

AS(Oil0)

AS(Oil1)

Y*

P1

P0


Y

P

AD(M0)

AS(W0,Oil0)

Y*

AD(M1)

AS(W0,Oil1)

AS(W1,Oil1)

Graphing accommodation of inflation

P1

P0

P’2

P2

Cost-push and accommodation


How do we get out of cost-push inflation?

§ Fed can break the inflation. Reset expected inflation rates.

§ The 1982 - Volker Recession (Paul Volker, Fed Chair).

§ Through a cold-turkey cut of money supply and with a substantial effort to modify the market’s perception of the Fed he managed to cut inflation from double digits to 4%.

§ It did cost the economy a short but deep recession though.


Graphing demand-pull inflationGraph of a sustained policy to keep Y above Y*.

Y

P

AD(M0)

SRAS(W0)

Y*

P1

P0AD(M1)


Graphing demand-pull inflationGraph of a sustained policy to keep Y above Y*. May induce an upward spiral in P.

Y

P

AD(M0)

SRAS(W0)

Y*

P1

P0AD(M1)

AD(M2)

SRAS(W1)

P2


Business cycle and inflation§ Let us now stop and think.

§ What can we say about the relationship between output and prices in light of our analysis of shocks and the possible stabilisations through policy?

§ We know that in recessions labour supply is higher than labour demand (disequilibrium in the labour market), hence we have unemployment. In booms labour supply is lower than labour demand (disequilibrium in the labour market again), hence we have an utilisation rate of labour that is higher or some story for being able to extract more labour (see discussion of efficiency wages in the textbook – ch. 11).

§ We also know that prices change. Positively after a positive demand shock such as an increase in money supply or an expansionary fiscal policy is implemented (increase in G).

§ Can we see a pattern between unemployment and inflation?


The Phillips Curve

§ Discoverer: LSE economist A.W. Phillips.

§ Discovery: A negative correlation between the unemployment rate and the inflation rate across years within a country in the 1950s. Corr(π, u ) < 0

§ The correlation was also negative in the U.S. and other countries through the 1960s.

§ Old Keynesians in the 1960s: We have found a stable, exploitable tradeoff between the rate of inflation and the rate of unemployment. We can permanently lower the rate of unemployment at the cost of a permanently higher inflation rate.

§ No. The negative relation is only between unexpected inflation and cyclical unemployment. Expectations-augmented Phillips Curve (Friedman-Phelps)

Phillips Curve: π = πe - h*(u - u) u is the natural unemployment rate (structural and frictional unemployment only).


Unemployment and inflation 1960 - 1973


Friedman and Phelps: expectations matter

You cannot exploit the trade off between inflation and unemployment unless you constantly surprise people. That is, if workers and firms are rational they will incorporate the economic policy that exploits the trade off in their decisions and will not allow the government to fool them systematically by increasing Ms or G.

§ Milton Friedman in 1968: Theory predicts that the only AD shocks that are going to affect unemployment will be unexpected temporary ones. The LR Phillips Curve is vertical.

§ Vindicating evidence:

• The Phillips Curve broke down after 1970’s.

• Over time in the U.S., higher money growth just leads to more inflation and no higher real GDP.

• Across countries, higher money growth just leads to more inflation and no higher real GDP. Real GDP actually appears to be hindered by high levels of inflation.


Why is long-run Phillips Curve vertical?

§ Self-correcting mechanism

• You cannot Sustain Y > Y* forever• Quantity Theory

π

uSR Phillips Curve

LR Phillips Curve

u


Is there a short-run trade off?

Short-run tradeoff between the unemployment rate and inflation rate changes:

• Inflation tends to fall in years following U > U*.

• The cost of a permanently lower inflation rate is a temporarily higher unemployment rate.

• Inflation tends to rise in years following U < U*.

• The cost of temporarily lowering the unemployment rateis a permanently higher inflation rate.

• This is why Fed is currently worried about inflation

• Demand Shocks cause a negative relationship between P and U (early 80s)

• Supply Shocks cause a positive relationship between P and U (the 70s and the late 90s)


Conclusions

§ We have experimented with different types of shock to our aggregate economy. Supply and demand shocks.

§ We can describe in a simple, intuitive way most past booms and recessions. Also our simple graphical analysis is helpful for describing possible future scenarios.

§ We now have a way of modeling output stabilisation policies and inflation control policies.

§ The Fed’s objectives and the Taylor Rule.

§ Defined the Phillips Curve and the expectations-augmented Phillips curve.

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