Econ CH 16

the vertical long-run phillips curve

The greater the expansion of the money supply, the faster AD will shift to the right, resulting in a larger increase in prices - i.e. higher inflation. But this higher inflation will not produce lower unemployment: in the long run, unemployment always goes to its natural rate, whether inflation is high or low. In the long run, faster money growth only causes faster inflation.

Origins of the phillips curve

1958: New Zealand economist A. W. Phillips: A negative correlation between the rate of unemployment and the rate of inflation for the UK over the period of 1861-1957 . 1960: Canadian economist Richard Lipsey confirmed and extended Phillips's observations. American economists Samuelson and Solow: Phillips curve related to aggregate demand. They believed the curve held important lessons for policymakers.

the cost of reducing inflation - rational expectations and the possibility of costless disinflation

A new school of thought was emerging that started to question the sacrifice ratio. Rational expectations: People use all the available information when forecasting the future. Proponents of rational expectations built on the Friedman Phelps analysis argue that when economic policies change, people adjust their expectations of inflation accordingly. According to the rational expectations school of thought, the sacrifice ratio could be much smaller than suggested by previous estimates.

the cost of reducing inflation

After the 1979 increase in the price of oil, the Bank of Canada implemented a policy of disinflation. What would be the cost of this disinflation? Students should be able to explain the difference between disinflation and deflation. Sacrifice ratio: The loss in output from reducing inflation by one percentage point. Okun's law: The increase in unemployment rate when GDP falls by one percentage point. The figures on the next slide show some of the effects of a contractionary monetary policy. Canadian estimates of the sacrifice ratio range from 2 to 5. In other words, for each percentage point that inflation is reduced, between 2% and 5% of one year's output must be sacrificed during the transition.

Practice Problem: Natural rate of unemployment = 5%Expected inflation = 2%In PC equation, a = 0.5 A. Plot the long-run Phillips curve. B. Find the u-rate for each of these values of actual inflation: 0%, 6%. Sketch the short-run PC. C. Suppose expected inflation rises to 4%. Repeat part B. D. Instead, suppose the natural rate falls to 4%. Draw the new long-run Phillips curve, then repeat part B.

An increase in expected inflation shifts PC to the right. A fall in the natural rate shifts both curves to the left.

shifts in the phillips curve: the role of expectations

Does the menu of possible inflation-unemployment outcomes remain the same over time? Milton Friedman: monetary policy cannot pick a combination of inflation and unemployment on the Phillips curve.

Reconciling theory and evidence

Evidence (from '60s):  PC slopes downward. Theory (Friedman and Phelps' work): PC is vertical in the long run. To bridge the gap between theory and evidence, Friedman and Phelps introduced expected inflation

Aggregate demand, aggregate supply, and the phillips curve

Here's an example. Imagine that the price level equals 100 in the year 2020. Figure 16.2 shows two possible outcomes that might might occur in year 2021. Panel (a) shows the two outcomes using the model of AD and AS. Panel (b) illustrates the same two outcomes using the Phillips. In panel (a) we can see the implications for output and the price level in the year 2021. If the aggregate demand for goods and services is relatively low, the economy experiences outcome A. The economy produces output of 7500, and the price level is 102. By contrast, if aggregate demand is relatively high, the economy experiences outcome B. Output is 8000, and the price level is 106. Thus, higher aggregate demand moves the economy to an equilibrium with a higher output and a higher price. In panel (b) we can see what these two possible outcomes mean for unemployment and inflation. Because firms need more workers when they produce a greater output of goods and services, unemployment is lower in outcome B than in outcome A. In this example, when output rises from 7500 to 8000, unemployment falls from 7 percent to 4 percent. Moreover, because the price level is higher in outcome B than in outcome A, the inflation rate is also higher. In particular, since the price level was 100 in year 2020, outcome A has an inflation rate of 2%, and outcome B has a inflation rate of 6%. We can therefore compare to two possible outcomes for the economy either in terms of output and the price level (using AD AS) or in terms of unemployment and inflation (Phillips curve).

the long-run phillips curve graph

If the Bank of Canada increases the money supply slowly, the inflation rate is low and the economy finds itself at point A. If the Bank of Canada increases the money supply quickly, the inflation rate is high and the economy finds itself at point B. In either case, the unemployment rate tends toward this normal level. The vertical long-run Phillips curve shows that unemployment does not depend on money growth and inflation in the long run.

the zero-inflation target of the early 1990s

In 1988, the Bank of Canada announced its new target of zero inflation, and in 1989 monetary contraction began. The target was reached in 1994, by which time the unemployment rate exceeded 10%. The figure shows annual data from 1989 to 1999. In 1988, the Bank of Canada announced its new target of zero inflation, and in 1989 monetary contraction began. The target was reached in 1994, by which time the unemployment rate exceeded 10%. Note that points A, B, and C in this figure correspond roughly to the same points in Figure 16.10.

how expected inflation shifts the PC

Initially, expected & actual inflation = 3%,unemployment =natural rate (6%). The Central Bank makes inflation 2% higher than expected, u-rate falls to 4%. In the long run, expected inflation increases to 5%, PC shifts upward, unemployment returns to its natural rate. When people adjust their inflation expectations upward, then the PC shifts up: each value of the u-rate is associated with a higher inflation rate. Of course, we can extrapolate this: Suppose the Fed wants to PERMANENTLY keep unemployment at 4%. It must continually raise inflation above expectations. Expectations will keep adjusting upward, so the Fed will have to keep raising the inflation rate faster than expectations are adjusting. Inflation spirals upward as a result of the attempt to keep unemployment at 4%. Before long, people will come to expect not only higher inflation, but ever-increasing inflation, and they will factor this into their contracts. It will be extremely difficult for the Fed to continue this game. Ultimately, unemployment has to return to the natural rate, yet the economy will end up with something approaching hyperinflation, and the costs it imposes on society.

conclusion

Opinion is still divided among economists with regard to the cost of reducing inflation. Macroeconomists all agree, however, that having achieved low rates of inflation, the Bank of Canada should work hard to never again allow inflation to increase to the levels observed during the 1970s and 1980s.

the long-run phillips curve

Phelps: no long-run tradeoff between inflation and unemployment ->long-run Phillips curve is vertical.

the role of supply shocks

Supply shock: An event that directly alters firms' costs and prices, shifting the aggregate-supply curve and thus the Phillips curve. Different sources for shifts in the short-run Phillips curve. Example: Large increase in the price of oil. Leads to a shift in the aggregate-supply curve and also the Phillips curve.

The Phillips Curve

The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation is high and unemployment is low.

looking ahead

The evidence provided in this chapter also sheds light on two other macroeconomic issues: The increase in the 1970s, 1980s, and 1990s in the natural rate of unemployment was largely the result of badly designed government policies. External shocks such as the financial crisis of 2008-09 can have a powerful effect on the Canadian economy.

the philips curve 1968-1973

The figure highlights annual data from 1968 to 1973 on the Notice that the Phillips curve of the 1960s breaks down in the early 1970s.

the meaning of "natural"

The natural rate of unemployment is the unemployment rate toward which the economy tends to gravitate in the long run. Not necessarily the socially desirable rate of unemployment Nor is it constant over time In addition to shifting the long-run Phillips curve to the left, note that lower unemployment means more workers are producing goods and services, the quantity of goods and services supplied would be larger at any given price level, and the long-run aggregate-supply curve would shift to the right. The economy would enjoy lower unemployment and higher output for any given rate of money growth and inflation. Monetary policy cannot influence the natural rate of unemployment. However, other types of policy can. A policy change that reduced the natural rate of unemployment would shift the long-run Phillips curve to the left.

the 2008-2009 recession

The recession that began in Canada late in 2008 can be described as having been the result of a significant fall in aggregate demand caused by a financial crisis that began in 2007. In terms of the Phillips curve this recession is represented by a movement down the short-run Phillips curve to a lower rate of inflation and a level of unemployment above the natural rate. The 2008 recession produced unemployment and deflation. By 2011, the economy was seemingly on the road to recovery. This figure shows that the recession that began in late 2008 caused a sharp increase in the unemployment rate and a sharp drop in the rate of inflation. By 2011, the economy was seemingly on the road to recovery.

Problem 2: Discuss the factors determining the slope of the short-run Phillips curve. Is the linear shape appropriate? Why, or why not?

The short-run Phillips curve (SRPC) was derived starting from the short-run aggregate supply (SRAS) curve, assuming that there is an inverse relationship between unemployment and output: high output implies low unemployment and vice-versa. Thus, the slope of the SRPC is determined partly by the same factors that determine the slope of the SRAS curve: how sticky prices and wages are, and for how long suppliers confuse relative prices with the overall price level. The more informed people are, and the more flexible suppliers and employers are in changing prices and wages, the steeper the SRAS and the SRPC are. Another category of factors influencing the slope of the SRPC refers to the relationship between unemployment (or employment) and output. The linear shape of the SRPC may not be appropriate because it is much more difficult to increase output (or to decrease unemployment) when output is already higher than the full-employment output. Thus, a more plausible shape for the SRPC would be a curve that would be steeper at lower unemployment and flatter at higher unemployment.

disinflamatory monetary policy

The spirit behind the sacrifice ratio is quite obvious from the above figure. If a nation wants to reduce inflation, it must go through a period of high unemployment. The cost is shown by the movement of the economy through point B as it travels from point A to point C. The size of the cost depends on the slope of the Phillips curve and how quickly expectations of inflation adjust to changes in monetary policy. When the Bank of Canada pursues a contractionary monetary policy to reduce inflation, the economy moves along a short-run Phillips curve from point A to point B. Over time, expected inflation falls, the short-run Phillips curve shifts downward. When the economy reaches point C, unemployment is back at its natural rate.

the philips curve in the 1950s and 1960s

This is the Phillips curve in the 1950s and 1960s. Graph uses annual unemployment data and the inflation rate (as measured by the GDP deflator) to show the negatives relationship between inflation and the unemployment rate.

disinflation in the 1980s

When the Bank of Canada was faced in the early 1980s with the prospect of reducing inflation, the economics profession offered two conflicting predictions. One group claimed that reducing inflation was going to be very costly and thus the sacrifice ratio was going to be high. The rational expectations proponents predicted that reducing inflation would be much less costly. The reduction in inflation during 1982 to 1989 came at the cost of very high unemployment. The cause of high cost: BoC's announcement of reducing inflation was not credible The reduction in inflation during the period 1982 to 1989 came at the cost of very high unemployment from 1983 to 1986. Note that the points labelled A, B, and C in the figure correspond roughly to the points in Figure 16.10. The figure shows that the disinflation did come at the cost of high unemployment. Does this experience refute the costless disinflation theory advanced by the rational expectations theorists? The reason for this is that even though the Bank of Canada announced that it would aim monetary policy to lower inflation, the public did not believe it. Because few people thought the Bank of Canada would reduce inflation as quickly as it did, expected inflation did not fall, and the short-run Phillips curve did not shift down as quickly as it might have. In 1988, John Crowe, the then Governor of the Bank of Canada, delivered the Hansen lecture. In his speech, he presented a clear statement defining the future direction of monetary policy in Canada. Achieve and maintain a stable price level and zero inflation. As a result, the economy adjusted toward a lower rate of inflation from 1989 to 1999 in a way that closely corresponds to the pattern shown in Figure 16.10.

the phillips curve

a curve that shows the short-run tradeoff between inflation and unemployment

Problem 1: Suppose the natural rate of unemployment is 6 percent, the expected inflation is 2 percent, and the constant a in the short-run Phillips curve equation is 0.8. a) Draw the long-run and short-run Phillips curves. What is the inflation rate corresponding to the intersection of the two curves? b) Change the expected inflation to 3 percent and draw the new Phillips curves. How did they change? c) Describe the process of adjustment from the old to the new inflation−unemployment point when the expected inflation has changed.

u = un − a (π − πe) u = 6 −0.8(π − 2) u = 7.6 − 0.8π The 3 percent expected inflation SRPC is parallel to the 2 percent one, but shifted upwards by a vertical distance of 1 percent inflation rate. First, the actual inflation rate increases to 3 percent while the expected inflation stays at 2 percent. Unemployment decreases to 5 percent and the economy moves up the SRPC from A to B. Then, people adjust their expectations about inflation and the SRPC shifts upward to point C.

the short-run phillips curve equation

u=u>n - a(pi-pi>e) Short run Central Bank can reduce the u-rate below the natural rate by making inflation greater than expected Long run Expectations catch up with reality, the u-rate changes back to the natural rate whether inflation is high or low This equation is essentially the equation for aggregate supply introduced in the "aggregate demand and aggregate supply" chapter. The coefficient "a" is a positive number that measures the relationship between unexpected inflation and deviations of unemployment from its natural rate: A 1% increase in inflation causes the unemployment rate to fall by "a" (for given values of the natural rate and expected inflation). Point out to students that this equation - and its coefficient "a" - are very similar to the equation for the aggregate supply curve in the chapter "aggregate Demand and aggregate Supply." If the Fed wants to reduce unemployment below the natural rate, it has to surprise people with higher-than-anticipated inflation. The result will be lower unemployment - but only until people adjust their expectations to the new reality of higher inflation. Eventually, expectations catch up with reality - i.e., people see that inflation is higher than they'd expected, so they adjust their expectations upward.