Monetary Economics. Phillips curve and AS curve. Seyed Ali Madanizadeh. Sharif University of Technology. November 14, 2016
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1 Monetary Economics Phillips curve and AS curve Seyed Ali Madanizadeh Sharif University of Technology November 14, 2016 Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
2 Introduction If prices (output price, wages, interest rates,...) are flexible, then there is no relationship. Any frictions in labor or goods market can result in a positive relationship between price and output in the short run. In the long run, prices adjust and theeconomy returns to its natural rate of output. Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
3 Supply Side Labor market: Wages are sticky P w P Nd N Y Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
4 Aggregate Supply P LRAS AS Y Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
5 Phillips Curve A trade-off between inflation and unemployment Inflation LR PC PC Unemployment Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
6 Aggregate Supply P Classic Neoclassic or new Keynesian Keynesian Y Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
7 Aggregate Supply Wage and price stickiness (Keynesian): Demand fall Flexible prices (Classic): Perfect Market Wage stickiness but flexible prices: (Neoclassical or new Keynesian) Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
8 Data (Phillips Curve) Inflation and Unemployment in the United States, and Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
9 New AS curve Modern macroeconomics with micro-foundation (Friedman, Phleps, Lucas,...) Role of Expectations Specify the sources of frictions Information Price stickiness Wage stickiness Search frictions... Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
10 Aggregate Supply Curve Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
11 Shifts in Aggregate Supply Curves The long-run aggregate supply curve shifts to the right from when there is an increase in the total amount of capital in the economy an increase in the total amount of labor supplied in the economy an increase in the available technology a decline in the natural rate of unemployment Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
12 Shift in the Long-Run Aggregate Supply Curve Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
13 Shifts in the Short-Run Aggregate Supply Curve expected inflation price shocks a persistent output gap Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
14 Equilibrium in Aggregate Demand and Supply Analysis General Equilibrium: All market in equilibrium AS=AD Short run equilibrium Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
15 Adjustments to long run equilibrium Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
16 Self-Correcting Mechanism Regardless of where output is initially, it returns eventually to the natural rate Slow Rapid Wages are inflexible, particularly downward Need for active government policy Wages and prices are flexible Less need for government intervention Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
17 Changes in Equilibrium: Aggregate Demand Shock Analysis Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
18 The Volcker Disinflation Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
19 Changes in Equilibrium: Aggregate Supply (Price) Shocks The aggregate supply curve can shift from temporary supply (price) shocks in which the long-run aggregate supply curve does not shift, or from permanent supply shocks in which the long-run aggregate supply curve does shift Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
20 Changes in Equilibrium: Aggregate Supply (Price) Shocks Temporary Supply Shocks When the temporary shock involves a restriction in supply, we refer to this type of supply shock as a negative (or unfavorable) supply shock, and it results in a rise in commodity prices A temporary positive supply shock shifts the short-run aggregate supply curve downward and to the right, leading initially to a fall in inflation and a rise in output. In the long run, however, output and inflation will be unchanged (holding the aggregate demand curve constant) Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
21 Changes in Equilibrium: Temporary Supply Shocks Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
22 Changes in Equilibrium: Permanent Aggregate Supply Shock Real Business Cycle Theory A permanent negative supply shock such as an increase in ill-advised regulations that causes the economy to be less effi cient, thereby reducing supply would decrease potential output and shift the long-run aggregate supply curve to the left Because the permanent supply shock will result in higher prices, there will be an immediate rise in inflation and so the short-run aggregate supply curve will shift up and to the left One group of economists, led by Edward Prescott of Arizona State University, believe that business cycle fluctuations result from permanent supply shocks alone and their theory of aggregate economic fluctuations is called real business cycle theory Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
23 Changes in Equilibrium: Permanent Aggregate Supply Shock Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
24 Positive Supply Shocks, Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
25 Okun s Law Okun s law describes the negative relationship between the unemployment gap and the output gap Okun s law states that for each percentage point that output is above potential, the unemployment rate is one-half of a percentage point below the natural rate of unemployment. Alternatively, for every percentage point that unemployment is above its natural rate, output is two percentage points below potential output Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
26 Okun s Law Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
27 Phillips Curve Inflation and Unemployment in the United States, and Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
28 The Short- and Long-Run Phillips Curve Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
29 Short run effects of Money Supply Injections / Shifts of Money Demand Signal extraction problem: Is is real or is it nominal? Lucas (1996), Lucas (1972), Wallace (1992), McCallum (1984). Open Market Operations and Liquidity Effects with Segmented Asset Markets Classics: Grossman and Weiss (1983), Rotemberg (1984), Lucas (1990). Output Effects Fuerst (1992), Christiano and Eichenbaum (1992). Variations: Alvarez, Lucas, and Weber (2001), Alvarez, Atkeson, and Kehoe (2002), Occhino (2004), Edmond and Weill (2009), Alvarez and Lippi (2011). Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
30 Short run effects of Money Supply Injections / Shifts of Money Demand Nominal Rigidities: sticky prices One Period Prices Set in Advance: Blanchard and Kiyotaki (1987) Calvo-type dynamics: Yun (1996), Gali (2001). Revisiting Liquidity Effects. Revisiting the Friedman Rule: optimality of stable price level: Khan, King, and Wolman (2003), Yun (2005). Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
31 Short run effects of Money Supply Injections / Shifts of Money Demand Nominal Rigidities: Real effect on (s S) models Warm up: ss without aggregate shocks, Sheshinski and Weiss (1977), Benabou and Konieczny (1994) Money Neutrality : elevator coming up aggregation Caplin and Spulber (1987) Phillips Curve: elevator in a shaft : Caplin and Leahy (1991, 1997) also Chap 12 Stokey (2009) Phillips Curve with constant prob. changes price: Danziger (1999) Quantitative Examples: Golosov and Lucas (2007), Midrigan (2009). Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
32 Conclusions A shift in the aggregate demand curve affects output only in the short run and has no effect in the long run A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant) A permanent supply shock affects output and inflation both in the short and the long run The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
33 Conclusions There are two types of Phillips curves, long run and short run There is no long-run trade-off between unemployment and inflation There is a short-run trade-off between unemployment and inflation Seyed Ali Madanizadeh (Sharif University of Technology) Monetary Economics November 14, / 33
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