TOPIC 7. Unemployment, Inflation and Economic Policy

Transcription

1 TOPIC 7 Unemployment, Inflation and Economic Policy

2 What is Equilibrium for the Economy? Short run equilibrium: AD = SRAS and IS = LM The Labor Market need not be in equilibrium We need not be at the potential level of GDP Long run equilibrium: AD = SRAS = Y* and IS = LM = Y* and N d = N s = N* In the long run, by definition, we will move to Y*. In the long run, by definition, the labor market will clear. 2

3 3 Graphical Representation of the Economy in Recession (1 P Y* = f(n*,k,a SRAS(1=f(input prices AD = f(g,pvlr,taxes,y f,m,π e Y e sr Y* Y

4 4 Graphical Representation of the Economy in Recession (2 P Y* = f(n*,k,a SRAS(2= f(input prices AD = f(g,pvlr,taxes,y f,m,π e Y e sr Y* Y

5 More on Equilibrium Equilibrium is a point of attraction for the economy: Most macroeconomists believe that, in the absence of shocks, the economy would reach equilibrium after perhaps 5 years. Thus the economy is in equilibrium in the long run (after 5 years. Is the economy ever in long run equilibrium? Given that shocks are always hitting, the economy is not likely to be in long run equilibrium at any point in time. Yet the force of attraction of equilibrium keeps the economy hovering around the equilibrium. Why is the long run equilibrium point attractive? Because at it the labor market clears. Away from Y* workers are not on their labor supply curve (and firms may be off their labor demand curve. Maximizing behavior by workers and firms push the economy towards long run equilibrium. Shocks push the economy away temporarily. 5

6 How do we represent recessions? Official Definition - two consecutive quarters of negative real GDP growth Our Model: Y < Y*, We define a recssionary gap (output gap as being Y* - Y e sr Remember: Y* trends upward overtime (even though in our model - we have it constant - population growth, K grows (we abstract from these trends in our model, TFP is growing every period. It makes things easier to keep Y* constant initially. Our Model removes the trends in N and K due to population growth and K (by assumption. Questions of the rest of class: What causes recessions? Why would the fed be concerned about inflation when Y sr e >Y*? How do we get out of recessions once we are in them? Can the economy correct itself? 6

7 7 Where Do Recessions Come From? 1. Shocks to Expectations (individual beliefs about the future - ie, stocks are overvalued, a recession will be coming (self fulling prophesies, etc. 2. Increases in relative prices of inputs (like oil 3. Temporary or Permanent changes in technology (or productivity - drought? 4. Bad (or good Policy (monetary or fiscal 5. Unexpected Deflations (maybe

8 Example 1: Changes in Consumer Confidence A change in expectations about the future (whether founded or not can have dramatic effects on the economy. Consumer Confidence Irrational Exuberance Paradox of Savings Households expect the future to be good or bad. No effect on labor demand (A hasn t really changed. Some effect on labor supply (Households expect PVLR to have changed. Households work more or less (depending on whether they think PVLR has decreased or increased. Consumption changes and the AD and IS curves shift 1990 Recession (a fall in consumer confidence from the Gulf War Note: I will often assume small (or no income effects on labor supply. 8

9 Consumer Confidence:

10 10 Analyzing a Decrease in Consumer Confidence No Effect on A or A(future P P 0 Y* 0 SRAS(W 0 AD(C 0 Y Assume we start at Y* Assume consumers are standard PIH (i.e., nonliquidity constrained, nonricardian. Assume no income effect on labor supply. r LM(P 0 IS(C 0 Y* 0 Y

11 11 Analyzing a Decrease in Consumer Confidence 1. What happens in the short run if SRAS is upward-sloping? 2. What happens in the short run if SRAS is horizontal? 3. What happens in the long run? DEMAND SHOCK: Unemployment and Prices move in opposite directions in the long run if there are no Policies!

12 12 Irrational Exuberance Mistaken belief in higher A f shifts IS/AD rightward, and shifts Y* leftward due to lower N* (income effect - may be small!. The boost in perceived PVLR and future MPK raises demand for C and I goods, shifting the IS/AD rightward. The higher perceived PVLR reduces N* and shifts the LRAS. Note: current A does not rise (so labor demand does not shift. In the SR, the economy moves to the new IS/ LM intersection, with higher Y and higher r. Firms respond to the higher goods demand by producing more (to achieve this they hire more N. The economy moves to Y > Y*, N > N*, and U < U*. Prices Increase!!! Irrational Exuberance could cause inflation (higher prices - in both the short run and the long run!

13 13 Example 2: an Increase in Oil Prices Responsible (partially for the 1975 and recession (OPEC I and II P SRAS(W 0, Oil 0 P 0 r Y* 0 AD Y LM(P 0 IS Y* 0 Y

14 14 Analyzing an increase in the price of Oil Supply shocks cause unemployment and prices to move in the same direction (VERY DIFFERENT FROM DEMAND SHOCKS! Supply Shocks: oil and technology! Demand Shocks: M, G, T and consumer confidence As we will see soon - supply shocks could have demand effects! A negative supply shock is BAD!!! STAGFLATION: increase in inflation + increase in unemployment

15 15 Example 3: An increase in A (a look at the 1990s P SRAS(W 0 P 0 r Y* 0 AD(C 0,I 0 Y LM(P 0 IS(C 0,I 0 Y* 0 Y

16 16 Analyzing an Increase in TFP (today Increase Y* (shift out labor demand and shift in labor supply - regardless if N increases or decreases, Y* will likely increase - the TFP effect will usually dominate. SRAS will shift Out (Cost of Production Falls AD and IS will shift Out (C and I will increase, PVLR and MPK will increase How far will AD and SRAS shift out? Depends - many cases. I give you one case (which the Fed believes the economy is currently in in the notes for this week. Summary, Y will increase in both short and long run. The effect on Prices is ambiguous, they could rise, fall or stay the same, interest rates will likely rise (although, it is not guaranteed if there is a sufficiently large drop in the price level, C will rise in short and long run, I will likely rise in short run and may rise in long run, Tax Revenues will increase, Public saving will rise, Private Saving is uncertain - may stay the same, may rise or may fall - depending on the timing of the technology changes and the instruments used to hold wealth (ie, pensions.

17 17 Analyzing an Increase in TFP Short Run This is what the Fed thought that we were in during Spring 2000: Technology rose Consumption has been increasing Investment has been rising Unemployment is lower than the estimated natural rate of unemployment Prices have been relatively stable DESPITE the rapid growth in GDP The labor market is tight another word for wages may rise in the future.

18 18 What the Fed was worried about? Long Run Given that Y > Y*, nominal wages have to rise to clear the labor market! This shifts the SRAS in. This will reduce Y back to Y*, but will increase prices! The Fed was worried exactly about Inflation!!!

19 Reviewing The Data From First Class: We saw that some falls in GDP were associated with no increase in prices. We also so that some falls in GDP were associated with large increase in prices. Do our theories reconcile these facts? YES! Demand shocks result in recessions without a corresponding rise in prices. YES! Supply shocks (like changes in oil prices result in recessions with a large corresponding change in prices. You should really understand the difference between demand shocks (things that primarily affect AD and supply shocks (things that primarily affect AS on the economy - their implications are much different from each other. 19

20 20 Review: A Look at U.S. Inflation 1970M1-2006M11 Black line - trend in CPI over time (left axis Red line - trend in CPI inflation rate (percentage change in CPI over time (right axis Shaded areas represent official recession dates (as calculated by National Bureau of Economic Research

21 Review: A Look at U.S. Real GDP 1970Q1 2006Q3 Black line - trend in real GDP over time (black axis Red line - trend in real GDP growth (percentage change in real GDP over time (right axis Shaded areas represent official recession dates (as calculated by National Bureau of Economic Research 21

22 Some Examples 1974 Recession: OPEC - rapid increase in prices Misguided Fed Policy 1980 Recession: OPEC II 1982 Recession: Good Fed Policy! (Volker Recession 1990 Recession: Consumer Confidence (Paradox of Saving 1990 s Japan: End to speculative bubbles, bad policy, debt overhand and liquidity traps. 22

23 23 Prelude to a Policy Notes on Monetary and Fiscal Policy: NOT AN EXACT SCIENCE - How much stimulus is necessary to move the economy to Y* Policy Creates uncertainty as economic agents try to anticipate Fed/Government rules Some argue to avoid using stabilization policy (just a simple Quantity Theory representation or suggest using very simple rules. Policy often entails long and variable lags! Some research says that every sustained period of large inflation is due to the Fed!

24 24 Back to Example 1: Can the FED do something? Back to the example of loss in the consumers confidence If the Fed want to bring the economy back to Y*, it could increase the nominal money supply We are going to look at money supply setting (as opposed to interest rate setting - we will do that soon Assume there has been a recession driven by loss of consumers confidence Fed increases M and LM shifts right, r falls and I increases. AD shifts out - Y increases (back to Y*. Nominal wages do not need to be cut Prices and Y* go back to where they started!

25 25 An Example of Monetary Policy: Stabilizing Output Loss of Consumers Confidence P SRAS(W 0 A P 0 B AD(C 0,M 0 r P 1 C Y 1 AD(C 1, M 0 Y* Y 0 LM(M 0,P 0 A LM(M 0,P 1 B C IS(C 0 Y 1 Y* 0 IS(C 1 Y

26 26 Fed versus Self-correcting Mechanism COMPARISON: 1. Real variables go back to the same long run equilibrium (both Fed or self-correcting mechanism 2. BUT prices and nominal wages behave differently! 3. Fed can increase the speed of adjustment

27 27 An Example of Fiscal Policy: Stabilizing Output Loss of Consumers Confidence P SRAS(W 0 A P 0 B AD(C 0,M 0 r P 1 C Y 1 AD(C 1, M 0 Y* Y 0 LM(M 0,P 0 A LM(M 0,P 1 B C IS(C 0 Y 1 Y* 0 IS(C 1 Y

28 28 An Example of Monetary Policy: Inflation Control Consumer Confidence Increases By A lot (Irrational Exuberance P SRAS (W 0 P 0 r Y* 0 AD(C AD(C 0 1 Y LM(P 1 LM(P 0 IS(C 1 IS(C 0 Y* 0 Y

29 29 When Does Policy Not Work? Vertical IS Curve: What if firms don t respond to interest rate changes (they think future economic conditions are going to be bad or interest rates will be lower in the future or the banking system has problems making loans. Monetary Policy Becomes Dampened. Central bank becomes powerless because nominal rates are already so low! (Deflationary periods Keynesian Liquidity Trap: Japan today

30 30 A Look At Liquidity Traps Read Krugman s Babysitting the Economy (From Week 1 Nominal Interest Rates Are Bounded At Zero! People Believe that there will be deflation in the future! Real Interest Rates are Large and Positive. Fed Would like to cut rates (to stimulate Y (shift out AD which will put upward pressure on prices, but nominal rates cannot go below zero! The Fed is helpless. How do they stimulate when they cannot cut rates? This describes the situation in Japan during the late 1990s. Japan has experienced deflation AND nominal rates are close to zero. Central Bank of Japan is helpless.

31 31 Demand Side Effects of Deflation Deflation can make borrowers - either consumers or firms, worse off. As we saw early in the course, unexpected inflation makes borrowers better off. They expected to pay a certain real rate and when inflation is higher and the nominal rate is fixed, the real rate they pay is lower (in terms of lost purchasing power. If the economy experiences unexpected deflation, the opposite happens: borrowers are paying more in terms of lost real purchasing power when there is unexpected deflation. Borrowers, both consumers and firms, will essentially be poorer. (Even though, there is another side of the market - somebody s got to lend to them, this could still have large effects on consumption and investment. This demand side effect of deflation is called debt overhang or debt deflation. <<Note, even the government is paying higher than expected real rates on their debt>>. Even if the deflation is expected, large transfers can occur from borrowers to lenders because nominal interest rates are bounded by zero (shuts down lending channels.

32 32 Change in Prices versus Inflation Labor Markets are forward looking! Change in prices become dynamic If workers expect high inflation they will try to get higher nominal wages! Two Examples: Supply Push Inflation: Accommodating supply shocks can lead to persistent inflation (the Fed in the mid and late 70s. Workers see this, and adjust. They ask for higher W and shift the SRAS in, pushing inflation up! Demand Pull Inflation: Policy makers try to permanently keep the economy above its potential level. Wages keep adjusting.

33 33 Accommodating Inflation after an Oil Shock Supply - Push and Accommodation P AS(Oil 1 AS(Oil 0 Y 1 * AD(Oil 0, M 0 Y* AD(Oil 1,M 0 Y

34 How do we get out of Supply-Push Inflation Fed Can Break the Inflation! Reset, expected inflation rates. The Volker Recession (Volker, an extremely underrated Fed Chair. Cold Turkey money cut to try to change individuals perception of the Fed policy (not try to stabilize output at the expense of inflation! Cut inflation from double digits to 4%! However this caused a short deep recession. 34

35 35 Graphing Demand Pull Inflation Supply - Push and Accommodation P SRAS(W 0 Y* AD(M 0 Y

36 36 On unemployment and inflation In the short run, if Y < Y*, we have a recession, then u > u* and unemployment goes up! If the negative shock was to the supply, then prices go up, if it was at the demand, they go down Output stabilization policies tend to generate inflation Inflation control policies tend to generate a recession Can we say something more about the relationship between unemployment and inflation?

37 The Phillips Curve is born. Discoverer: British economist A.W. Phillips. Discovery: A negative correlation between the unemployment rate and the inflation rate across years within a country in the 1950s. The correlation was also negative in the U.S. and other countries through the 1960s. Old Keynesians in the 1960s: We have found a stable, exploitable tradeoff between the rate of inflation and the rate of unemployment. We can permanently lower the rate of unemployment at the cost of a permanently higher inflation rate. 37

38 Unemployment and Inflation

39 39 Friedman, evidence killed it. Milton Friedman in 1968: The LR Phillips Curve is vertical. Vindicating evidence: The Phillips Curve broke down after Over time in the U.S., higher money growth just leads to more inflation and no higher real GDP. Across countries, higher money growth just leads to more inflation and no higher real GDP. Real GDP actually appears to be hindered by high levels of inflation.

40 Unemployment and Inflation

41 Unemployment and Inflation

42 42 Why is Long Run Phillips Curve Vertical Self Correcting Mechanism You Cannot Sustain Y > Y* forever Quantity Theory Graph! π e LR SR u* u

43 43 Is There a Short Run Trade Off? SR tradeoff between the unemployment rate and inflation rate changes: Inflation tends to fall in years following U > U*. The cost of a permanently lower inflation rate is a temporarily higher unemployment rate. Inflation tends to rise in years following U < U*. The cost of temporarily lowering the unemployment rate is a permanently higher inflation rate. This is why Fed is currently worried about inflation! Demand Shocks cause a negative relationship between P and U (early 80s! Supply Shocks cause a positive relationship between P and U (the 70s and the late 90s

44 44 Goals of the Fed The Fed wants to set r so that r = r*, Y = Y*, U = U*, N = N* ( these are equivalent. π = π * (0-2% inflation. The Fed wants to raise r when r < r*, Y > Y*, U < U*, N > N* π > π * The Fed wants to lower r when the opposite conditions hold.

45 45 Rules vs. Discretion Should a central bank have a specific policy rule? Rules are explicit and may be mandated by law Money should grow at 4% per year (Friedman preferred rule. Rules may be implicit and known by all economic agents The Fed will target the inflation rate at 2-4% per year.

46 46 Benefits of Rules Commits Central Bank to Some Policy Removes Inflation Temptation Creates a more stable economic situation: Individuals and Firms can anticipate the central bank actions. No surprises! Prevents central bank from thinking too much - the economy is so complex that Fed policy can have delayed impact and is usually initiated too late! Central Bank actions can often be destabilizing. (Freidman, Lucas: Both prefer simple rules.

47 47 Fed Timing Recession Begins First Fed nominal rate cut December months later November months later July months later July months later

48 48 Discretion Central Bank uses all information possible to make the best decision at the time. The Fed uses a discretionary rule. The members of the bank vote on a monetary policy eat each meeting. The policy is not dictated by some explicit rule. Benefits of Discretion: Allows Central Bank to choose from competing policy goals. (Sometimes inflation targeting is not best for the economy The Fundamentals of the Economy may change/or evolve over time - the rule becomes outdated. How do we know where the economy is relative to Y* and target inflation rate? Information flows slowly and is complex to analyze.

49 Hawks and Doves How does the Fed balance price stability (π = π * and full employment (U = U* when they conflict? [For example, when π > π * and U > U* at the same time.] Hawks put more weight on π * (and have lower values for it. U.K., Canada, New Zealand. Bundesbank before; European Central Bank now? Doves put more weight on staying near U* (and have higher π *. Bernanke tends to puts the same weight on each. 49

50 50 The Taylor Rule John Taylor of Stanford University: the Fed s behavior under Greenspan ( and Bernanke (today is well-described by: Taylor Rule: i = r* + π e +.5*(π e - π e * +.5*(Y - Y*/Y* i = the nominal federal funds rate. r* = the real fed funds rate target (this is the r consistent with Y=Y*. π e = expected inflation. π e * = target inflation. Y = real GDP. Y* = equilibrium real GDP (Y-Y*/Y* is the output gap or GDP gap. A positive output gap means overheating and potentially rising inflation (labor markets will demand higher wages. Taylor used r* = 2% and π e * = 2%. The Taylor Rule explains about 2/3 of quarterly variation in the fed funds rate since 1987.

51 Notes on the Taylor Rule Fed economists find an even better fit with 1 on the GDP gap term. This does NOT mean that Bernanke uses this rule, it is just that Fed behavior looks very similar to this rule. Furthermore, the Fed tends to smooths interest rates relative to the Taylor Rule: this quarter s actual i =.6*(last quarter s actual i +.4*(Taylor Rule i Studies have found that other G7 Central Banks (e.g., the Bundesbank have also followed versions of a smoothed Taylor Rule. Read the speeches by Bernanke, Greenspan and Gramlich to see the Fed s take on such subject. 51

52 52 What Should We Have Learned In the short run, wages (or prices are sticky, the labor market is in disequilibrium, output and employment are away from their potential level. Shocks to the aggregate demand make prices and unemployment move in opposite directions Shocks to the aggregate supply make prices and unemployment move in the same direction Inflation-unemployment trade-off! Stabilization policies can increase inflation and inflation-targeting policy can increase unemployment. Taylor rule seems to describe well the Fed policy.