Macro Chapter 8

Use the following Phillips curve equation to answer this question: πt - πt-1 = (m + z) - αut. What will cause an increase in the natural rate of unemployment?

An increase in z

What will cause a reduction in the natural rate of unemployment?

An increase in α

Why did the old relationship of the Phillips curve work?

Because they didn't expect inflation, but there was surprise inflation

When will there be persistent inflation?

If 1 > Θ > 0

As unemployment decreases, what happens to the nominal wage?

Nominal wage increases

What situation generally exists when deflation occurs?

The price level is decreasing

What is the natural rate of unemployment based on this equation, πt - πt-1 = (m+z) - αu, if m = .25, z = 2.25, and α = .5?

0 = (m+z) - αu = 2.5/5 = 5

Suppose the Phillips curve is represented by the following equation: πt - πt-1 = 20 - 2ut. Given this information, we know that the natural rate of unemployment in this economy is what?

10%

When inflation is 3%, wage setters can be reasonably confident inflation will be between 1% and 5%, so when it is 30%, it will be between what and what?

20% and 40% Implies a +/- 2% of real wages Implies +/- 10% of real wages (more uncertainty)

A reduction in the unemployment rate will cause what to happen?

A decrease in the inflation rate over time

What will tend to occur as a result of a reduction in the proportion of a country's workers who have indexed wages?

A given change in the unemployment rate will cause a relatively smaller change in the inflation rate

What is it called when Θ = 1

A random walk (drunk person could move in any direction, so not moving)

How do individuals (workers and firms) deal with this uncertainty?

Contracts tend to become shorter and wage indexation also becomes more prevalent Better in the short run Worse in the long run

What does current inflation depend on?

Depends on past inflation to a degree

What assumptions best characterize the assumption about how individuals formed expectations of inflation by the early 1970s?

Expected inflation for the current year was approximately equal to the previous year's inflation rate

f α = .5, u = 4 and un = 6, how much will inflation change if no one has wage indexation? How about if 75% of people in the economy have wage indexation?

If there is no wage indexation, -0.5(4-6) = 1% If there is 75% wage indexation, -(-.5/(1-0.75))(4-6) = -2(4-6) = 4%

What is a wage price spiral?

If wages are indexed, the price increase causes an immediate increase in wages, which causes another increase in prices, and wages, and so on

Assume that individuals form expectations of inflation according to the following equation πet = θπt-1. From 1970 on, the value of θ for this equation did what?

Increased over time and approached 1

When inflation has been persistent, as was the case in the United States during the 1970s, low unemployment rates will likely be associated with what?

Increases in the inflation rate

What explains why the original Phillips curve relation disappeared or, as some economists have remarked, "broke down" in the 1970s?

Individuals changed the way they formed expectations of inflation

What is the omitted variable bias in the Phillips curve?

Inflation expectations

As unemployment decreases, what happens to inflation?

Inflation increases

What is it called when Θ = 0?

Inflation is stationary (non persistent) the current value does not depend on the past value

If there is a recessionary gap, what will happen to inflation?

Inflation will fall, if there is an inflationary gap, inflation will rise

What is a major cost of high inflation?

It tends to be unpredictable

If inflation is higher than expected, what will happen to workers purchasing power?

Lose purchasing power

Assume that expected inflation is based on the following: πet = θπt-1. If θ = 1, we know what?

Low rates of unemployment will cause steadily increasing rates of inflation

What is NAIRU?

Non-accelerating inflation rate of unemployment SHOULD be non-increasing inflation or non-accelerating prices

Why do oil prices have an outsized impact?

Physiological effects because we see the price tick up at gas stations Visible price having large signs on highways and streets Immediate impact our real income because it is a frequent purchase

How and why did the Phillips curve relationships change?

QUIZ!

What is the Phillips curve?

Relationship between the central bank's trade off and their dual mandates of inflation and unemployment

Suppose policy makers overestimate the natural rate of unemployment. In situations like these, policy makers will likely implement policies that results in what?

Results in a lower inflation rate than necessary

Suppose policy makers underestimate the natural rate of unemployment. In a situation like this, policy makers might implement a policy that results in what?

Results in steadily rising inflation

The original Phillips curve implied or assumed what?

The expected inflation rate of inflation would be zero.

What does the Fed mean by "full employment"?

The natural rate of unemployment is the rate needed to keep inflation constant

Assume that the expected rate of inflation is a function of past year's inflation. Also assume that the unemployment rate has greater than the natural rate of unemployment for a number of years. Based on this information, what can we conclude?

The rate of inflation should steadily decrease

Suppose the Phillips curve is represented by the following equation: πt - πt-1 = 20 - 2ut. Given this information, which of the following is most likely to occur if the actual unemployment in any period is equal to 6%?

The rate of inflation will tend to increase

Since approximately 1970, the most stable Phillips-type relationship for the United States has been between what?

The unemployment rate and the change in the rate of inflation

What is wage indexation?

Wages are automatically increased with inflation (COLA, cost of living adjustment)

When does the natural rate occur?

When price equals expected price or equivalently inflation equals expected inflation πt - πt-1 = 0

What is stagflation?

When unemployment and inflation are both increasing (happened in the 1970s) because of OPEC Oil shocks

What is the old Phillips curve equation?

π = (m+z) - αu π = Inflation m = Markup z = worker bargaining power α = coefficient u = unemployment

What is the general Phillips curve equation?

π = πe + (m+z) - αu π = Inflation πe = Expected inflation (was the omitted variable) m = Markup z = worker bargaining power α = coefficient u = unemployment

What is the formula for persistent inflation?

πet = Θπt-1

What is the modified or accelerations Phillips curve?

πt - πt-1 = (m+z) - αu Inverse relationship between unemployment and the change in inflation

What is the formula for the inflation relation?

πt - πt-1 = - [α/(1- λ)]* (u - un) When λ= 0 then we get the equation from before: πt - πt-1 = - α(u - un) λ = proportion of contracts are indexed 1-λ = proportion are not indexed and set based on the expected price level

Consider the case where the natural rate is 8% but policymakers think it is 6% and α = 2. What is the change in inflation?

πt - πt-1 =- α(u - un) = -2(6-8) = +4

What is the autoregressive equation?

πt = Θπt-1+ εt εt = unpredictable error