MACROECONOMICS - CLUTCH CH REVISITING INFLATION, UNEMPLOYMENT, AND POLICY

Transcription

1 !!

2 CONCEPT: SHORT-RUN PHILLIPS CURVE Two of the main macroeconomic concerns for policy makers are unemployment and inflation However, it is hard to control both at the same time! > If Aggregate Demand increases Price Level and Unemployment > If Aggregate Demand decreases Price Level and Unemployment EXAMPLE: Assume Year 1 is the base-year (price level = 100) and we are analyzing possible situations for Year 2. Short-Run Phillips Curve AD-AS Model Short-Run Phillips Curve SRAS ADH ADL Phillips Curve a graph showing the relationship between the and > As inflation increases, unemployment > As inflation decreases, unemployment Page 2

3 CONCEPT: LONG-RUN PHILLIPS CURVE Two of the main macroeconomic concerns for policy makers are unemployment and inflation Recall, in the long run, the economy is functioning at its GDP > Natural Rate of Unemployment unemployment rate when economy is at GDP > NAIRU unemployment rate at which inflation has no tendency to increase or decrease - Non-accelerating inflation rate of unemployment > If Aggregate Demand increases Price Level and Unemployment > If Aggregate Demand decreases Price Level and Unemployment Long-Run Phillips Curve AD-AS Model Long-Run Phillips Curve LRAS AD2 AD1 Page 3

4 CONCEPT: SHIFTS IN SHORT-RUN PHILLIPS CURVE AND EXPECTED INFLATION Two of the main macroeconomic concerns for policy makers are unemployment and inflation However, it is hard to control both at the same time! The position of the short-run Phillips Curve is related to inflation Real Wage = Nominal Wage Price Level The real wage (purchasing power) adjusts the amount of dollars you are actually paid for the price level in the economy - (i.e. The same nominal wage will buy less stuff at higher prices) If workers and firms expect a certain level of inflation (say 1.5%), but a higher inflation rate occurs (say 4.5%): Expected Real Wage Actual Real Wage Firms will hire workers leading to unemployment Price Level and Unemployment, but ONLY because the inflation was If the new inflation rate (i.e. 4.5%) persists, it becomes the expected level of inflation Shifts the SR Phillips Curve Rational Expectations Theory when forecasting the future, people use all publicly available information - In this case, people are making rational decisions about the level of expected inflation Long-Run Phillips Curve LR Phillips Curve 4.5% Exp. Inflation = 4.5% 1.5% Exp. Inflation = 1.5% 5% Page 4

5 CONCEPT: SUPPLY SHOCK AND THE PHILLIPS CURVE Supply Shocks an unexpected event that affects a firm s production costs and shifts aggregate Generally, a supply shock involves an unexpected increase in input prices (like gasoline) EXAMPLE: A sudden increase in gas prices affects the input costs of firm s production Short-Run Phillips Curve AD-AS Model Short-Run Phillips Curve SRAS AD Aggregate supply Output and Price Level - This leaves policymakers in the difficult position of fighting inflation and unemployment Page 5

6 CONCEPT: SACRIFICE RATIO Expectations about inflation rates are a determinant of the position of the short-run Phillips Curve If expected inflation increases Shift If expected inflation decreases Shift The expected inflation in the economy has implications throughout: Nominal Interest Rate vs. Real Interest Rate - If expected inflation increases, nominal interest rates will also increase to stabilize the real interest rate Assume the real interest rate a bank wants to earn is 5% on a loan. If expected inflation is equal to 2%, then: Now assume that expected inflation increases to 4%. To maintain the same real interest rate the bank would: If the Fed wishes to reduce the inflation rate, they must pursue monetary policy Money Supply Interest Rates Aggregate Demand Price Level and GDP Sacrifice Ratio percentage of GDP lost in the process of lowering inflation by 1% Sacrifice Ratio = Sacrifice Ratio % GDP % Inflation 1. Contractionary policy moves economy down the SR Phillips Curve LRPC 2. In the LR, expected inflation decreases, and SR Phillips Curve shifts left SRPC1 Page 6

7 CONCEPT: DISINFLATION AND DEFLATION Disinflation a significant reduction in the Note that inflation is still during disinflation, but at a rate Historical context: USA in the 1970s-1980s and Paul Volcker Disinflation During the 1970s, the USA experienced high inflation rates US Inflation Rates Source: Bureau of Labor Statistics In 1979, President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserve Volcker s strict anti-inflation monetary policy brought inflation down from 10% down to 4% Contractionary monetary policy brought inflation down, but increased short run unemployment (see graph below) As workers and firms lowered their expectations of future inflation, the SR Phillips curve shifted left (same graph) Fiscal policy during the Reagan era of the 1980s did not help combat inflation Increases in the budget deficit through increased spending, led to higher aggregate demand more inflation Phillips Curve and Contractionary Policy LRPC SRPC1 Page 7

8 Deflation a decline in the price level During deflation, the inflation rate is Note the difference between disinflation and deflation > Disinflation inflation still occurring but at a slower rate > Deflation lower price level in the economy Year Consumer Price Index Inflation Rate % % % % % % % % % % Page 8