Phillips Curve: Understanding the Relationship between Inflation and Unemployment, Slides of Dynamics

Download Phillips Curve: Understanding the Relationship between Inflation and Unemployment and more Slides Dynamics in PDF only on Docsity! The Phillips Curve Evaluating Short-Run Inflation/Unemployment Dynamics Elements of Macroeconomics ▪ Johns Hopkins University Outline 1. Inflation-Unemployment Trade-Off 2. Phillips Curve 3. Zero Bound for Inflation • Textbook Readings: Ch. 17 Elements of Macroeconomics ▪ Johns Hopkins University AD/AS Model Helps Us Derive the Phillips Curve Elements of Macroeconomics ▪ Johns Hopkins University • Recall: § The short-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect § The long-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect at the LRAS Short-Run Equilibrium LRAS. . AD jumps Gt) Prices and vido Hise poe oY, Is above LRAS, NX AS, Elements of Macroeconomics = Johns Hopkins University Long-Run Equilibrium LRAS. Workers dimud igh AS, As shits ALAS | Prices Rie, ouput lls Nah, RAR Elements of Macroeconomics = Johns Hopkins University The Long-Run Phillips Curve • In the long run, employment is determined by output, which in long run does not depend on the price level • A vertical LRAS curve is compatible with a vertical LRPC Elements of Macroeconomics ▪ Johns Hopkins University Relation to LTSG • Potential GDP grows over time LTSG = LFG + LPG • It does not depend on prices ➞ Vertical LRAS curve • Think of LTSG as the speed limit for economic growth •Monetary policy cannot make LF or LP grow faster Elements of Macroeconomics ▪ Johns Hopkins University Natural Rate of Unemployment • Optimal level of joblessness in an economy • Recall that there are 3 kinds of unemployment: § Structural: Some people have skills that don’t match any available jobs § Frictional: When people change jobs results in some unemployment § Cyclical: When economy is operating below full potential, willing workers can’t find work Elements of Macroeconomics ▪ Johns Hopkins University What If An Economy Operates Below Natural Rate? •When economy is below the natural rate of unemployment there is great competition for workers § Too many jobs for too few workers • Firms bid up the price of workers—wage rates—and soon find they need to raise prices to cover their higher labor costs • Soon wages and prices are rising rapidly Elements of Macroeconomics ▪ Johns Hopkins University When Is It Safe to Exceed the LTSG Speed Limit? •When U is very high, the economy can safely grow faster than the LTSG pace •Why? § Economic growth produces jobs for both new entrants to the LF and the cyclically unemployed members of the LF Elements of Macroeconomics ▪ Johns Hopkins University LRPC and SRPC •We had 2 curves for aggregate supply • Here we also have two curves: § Long run Phillips curve (LRPC) § Short run Phillips curve (SRPC) • The curves intersect at 𝜋e Elements of Macroeconomics ▪ Johns Hopkins University A Short-Run Phillips Curve For Every Inflation Rate • There is a SRPC for every level of expected inflation § Each SRPC intersects the LRPC at the 𝜋e rate § A 𝜋↑→𝑈↓ only if the increase in 𝜋 is unexpected •When 𝜋 = 𝜋e, the unemployment level is at its natural rate—i.e. the LRPC Elements of Macroeconomics ▪ Johns Hopkins University Implications for Monetary Policy • By the 1970s, most economists agreed that the LRPC was vertical § It was not possible to “buy” a permanently lower unemployment rate at the cost of permanently higher inflation • To keep unemployment lower than the natural rate, the Fed would need to continually increase inflation § With increasing inflation, SRPC would eventually shift up • Or it could decrease inflation at the cost of a temporarily higher unemployment rate Elements of Macroeconomics ▪ Johns Hopkins University Non-Accelerating Inflation Rate Of Unemployment • 𝜋 is stable only when U = U* • U ≠ U* results in the inflation rate increasing or decreasing • So, the natural rate of U is sometimes referred to as the non-accelerating inflation rate of unemployment § NAIRU: Unemployment rate at which the inflation rate has no tendency to increase or decrease Elements of Macroeconomics ▪ Johns Hopkins University Rational Expectations and a Vertical SRPC • Keynesians: § 1950s and 1960s showed an obvious short-run trade-off between 𝜋 & U • R. Lucas and T. Sargent (New classical school): § This happened because the Fed was secretive, not announcing changes in policy. If Fed announces its policies, people will correctly anticipate inflation and act in advance to counteract it • New Keynesians: § Wages and prices don’t adjust fast enough § Even if people anticipate inflation correctly, aggregate markets may not clear instantaneously to make the SRPC vertical Elements of Macroeconomics ▪ Johns Hopkins University Application: Oil Price Shocks in the 1970s • Start: US in 1973 § U = NAIRU • 1974: OPEC caused oil prices↑ § Supply shock: SRAS shift left • U↑ but so people’s expectations for 𝜋 § A higher SRPC Elements of Macroeconomics ▪ Johns Hopkins University What Could The Fed Do? • Fed wanted to fight both inflation and unemployment • But the SRPC makes clear that improving one worsens the other • The Fed chose expansionary monetary policy: § Reducing unemployment, at the cost of even more inflation • The newly high inflation was incorporated into people’s expectations and became self-reinforcing Elements of Macroeconomics ▪ Johns Hopkins University A Demonstration of the Phillips Curve At Work Elements of Macroeconomics ▪ Johns Hopkins University Volcker Disinflationary Policy • Brutal real economy effects dominated expectations as Volcker triumphed over inflation in early 1980s • Change in monetary policy to fight 𝜋➞ Back to back recessions § A rise of near 11% in joblessness • Phillips curve explains the fall for 𝜋 § Credibility was very hard to earn Elements of Macroeconomics ▪ Johns Hopkins University Predict the Disinflation During Volcker Recessions 𝜋t = 𝜋e + α (U* – Ut ) assume α=1.4 • Let 𝜋e = 𝜋t-1 (last year’s inflation) § Overstate the case for non-rational expectations Elements of Macroeconomics ▪ Johns Hopkins University Consider the Italian Experience • Great recession drove jobless rates to very high levels • But inflation did not fall below zero Elements of Macroeconomics ▪ Johns Hopkins University The Short-Run Phillips CURVE •Wages bounce along, just above zero • SRPC is indeed a curve (not a straight line) ➞ Recall ‘curved’ SRAS Elements of Macroeconomics ▪ Johns Hopkins University PLOGs Don’t Deliver Deflation • P Persistent • L Large • O Output • G Gaps • PLOGs –long periods of very high unemployment– don’t push price and wage gains below zero • It seems slowing pay and price increases is much easier than actually cutting wages and prices • The zero bound for inflation seems to matter Elements of Macroeconomics ▪ Johns Hopkins University Divine Coincidence and the Zero Bound • Divine coincidence: Situation where stabilizing inflation is the same as stabilizing output § Dual-mandate CB (both 𝜋 and U) vs Single-mandate CB (only 𝜋) • Scenario 1 - Falling prices: Inflation-fighting CB will be as accommodative as a dual-mandate CB • Scenario 2 - High U and low 𝜋: Dual-mandate CB will step on the gas while other CB fails to see deflation so is less stimulative § Over time, cyclical joblessness becomes structural • Zero bound for wage restraint kills the divine coincidence Elements of Macroeconomics ▪ Johns Hopkins University Absence of a Divine Coincidence • It may explain ECB tightening alongside FRB easing in 2008 and 2011 Elements of Macroeconomics ▪ Johns Hopkins University