PCP Macroeconomics Lecture 10. Chapter 12 Unemployment and Infla<on June 22

Transcription

1 PCP Macroeconomics Lecture 10 Chapter 12 Unemployment and Infla<on June 22

2 Goals of Chapter 12 A. Why study unemployment and infla<on together? 1. The most important macroeconomic problems 2. Phillips curve rela<onship B. Study rela<onship between infla<on and unemployment 1. Has it changed over <me? 2. Is there a trade off between infla<on and unemployment? C. Study the costs of infla<on and unemployment; consider the implica<ons for macroeconomic policy making

3 12.1 Unemployment and Infla<on: Is There a Trade off?

4 Many people think there is a trade off between infla<on and unemployment 1. The idea originated in 1958 when A.W. Phillips showed a nega<ve rela<onship between unemployment and nominal wage growth in Britain 2. Since then economists have looked at the rela<onship between unemployment and infla<on 3. In the 1950s and 1960s many na<ons seemed to have a nega<ve rela<onship between the two variables 4. The United States appears to be on one Phillips curve in the 1960s (text Fig. 12.1)

5 Figure The Phillips curve and the U.S. economy during the 1960s

6 5. This suggested that policymakers could choose the combina<on of unemployment and infla<on they most desired 6. But the rela<onship fell apart in the following three decades (text Fig. 12.2) 7. The 1970s were a par<cularly bad period, with both high infla<on and high unemployment, inconsistent with the Phillips curve

7 Figure Inflation and unemployment in the United States,

8 The expecta<ons augmented Phillips curve 1. Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unan(cipated infla<on (the difference between actual and expected infla<on) a. This theory was made before the Phillips curve began breaking down in the 1970s b. It suggests that the rela<onship between infla<on and the unemployment rate isn't stable

9 How does this work in the extended classical model? a. First case: an<cipated increase in money supply (Fig. 12.1; like text Fig. 12.3) (1) AD shi^s up and SRAS shi^s up, with no mispercep<ons (2) Result: P rises, Y unchanged (3) Infla<on rises with no change in unemployment

10 Long Run Supply Curve Full employment output level Poten<al output level It is determined by full employment Nominal Price does not maber.

11 Short Run Supply Curve Mispercep<on of price signal by producer If there is an unexpected price rise (for producers), producers think that price of his product have risen compared to other producers and increase the produc<on Thus upward sloping for unexpected price rise. Shi^s up as producers expected price rises.

12 Figure Ongoing inflation in the extended classical model

13 b. Second case: unan<cipated increase in money supply (Fig. 12.2; like text Fig. 12.4) (1) AD expected to shi^ up to AD 2, old (money supply expected to rise 10%), but unexpectedly money supply rises 15%, so AD shi^s further up to AD 2, new (2) SRAS shi^s up based on expected 10% rise in money supply (3) Result: P rises and Y rises as mispercep<ons occur (4) So higher infla<on occurs with lower unemployment (5) Long run: P rises further, Y declines to fullemployment level

14 Figure Unanticipated inflation in the extended classical model

15 c. Expecta<ons augmented Phillips curve: π = π e h(u ) (12.1) (1) When π = π e, u = (2) When π < π e, u > (3) When π > π e, u <

16 C. The shi^ing Phillips curve 1. The Phillips curve shows the rela<onship between unemployment and infla<on for a given expected rate of infla<on and natural rate of unemployment

17 2. Changes in the expected rate of infla<on (Fig. 12.5) a. For a given expected rate of infla<on, the Phillips curve shows the trade off between cyclical unemployment and actual infla<on b. The Phillips curve is drawn such that π = π e when u = c. Higher expected infla<on implies a higher Phillips curve

18 Figure The shifting Phillips curve: an increase in expected inflation

19 3. Changes in the natural rate of unemployment (Fig. 12.6) a. For a given natural rate of unemployment, the Phillips curve shows the trade off between unemployment and unan<cipated infla<on b. A higher natural rate of unemployment shi^s the Phillips curve to the right

20 Figure The shifting Phillips curve: an increase in the natural unemployment rate

21 4. Supply shocks and the Phillips curve a. A supply shock increases both expected infla<on and the natural rate of unemployment (1) A supply shock in the classical model increases the natural rate of unemployment, because it increases the mismatch between firms and workers (2) A supply shock in the Keynesian model reduces the marginal product of labor and thus reduces labor demand at the fixed real wage, so the natural unemployment rate rises b. So an adverse supply shock shi^s the Phillips curve up and to the right c. The Phillips curve will be unstable in periods with many supply shocks

22 The shi^ing Phillips curve in prac<ce a. Why did the original Phillips curve rela<onship apply to many historical cases? (1) The original rela<onship between infla<on and unemployment holds up as long as expected infla<on and the natural rate of unemployment are approximately constant (2) This was true in the United States in the 1960s, so the Phillips curve appeared to be stable

23 b Why did the U.S. Phillips curve disappear a^er 1970? (1) Both the expected infla<on rate and the natural rate of unemployment varied considerably more in the 1970s than they did in the 1960s (2) Especially important were the oil price shocks of and (3) Also, the composi<on of the labor force changed in the 1970s and there were other structural changes in the economy as well, raising the natural rate of unemployment (4) Monetary policy was expansionary in the 1970s, leading to high and vola<le infla<on (5) Plomng unan<cipated infla<on against cyclical unemployment shows a fairly stable rela<onship since 1970 (text Fig )

24 Figure The expectations-augmented Phillips curve in the United States,

25 Macroeconomic policy and the Phillips curve Can the Phillips curve be exploited by policymakers? Can they choose the op<mal combina<on of unemployment and infla<on?

26 a. Classical model: NO (1) The unemployment rate returns to its natural level quickly, as people's expecta<ons adjust (2) So unemployment can change from its natural level only for a very brief <me (3) Also, people catch on to policy games; they have ra<onal expecta<ons and try to an<cipate policy changes, so there is no way to fool people systema<cally

27 b. Keynesian model: YES, temporarily (1) The expected rate of infla<on in the Phillips curve is the forecast of infla<on at the <me the oldest s<cky prices were set (2) It takes <me for prices and expected prices to adjust, so unemployment may differ from the natural rate for some <me

28 Box 12.1: The Lucas cri<que a. When the rules of the game change, behavior changes b. For example, if babers in baseball were called out a^er two strikes instead of three, they'd swing more o^en when they have one strike than they do now c. Lucas applied this idea to macroeconomics, arguing that historical rela<onships between variables won't hold up if there's been a major policy change d. The Phillips curve is a good example it fell apart as soon as policymakers tried to exploit it e. Evalua<ng policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary

29 The long run Phillips curve 1. Long run: u = for both Keynesians and classicals 2. The long run Phillips curve is ver<cal, since when π = π e, u = (Fig. 12.8)

30 Figure The long-run Phillips curve

31 The long run Phillips curve (con<nued) 3. Changes in the level of money supply have no long run real effects; changes in the growth rate of money supply have no long run real effects, either 4. Even though expansionary policy may reduce unemployment only temporarily, policymakers may want to do so if, for example, <ming economic booms right before elec<ons helps them (or their poli<cal allies) get reelected

32 12.2 The Problem of Unemployment

33 The costs of unemployment 1 Loss in output from idle resources a. Workers lose income b. Society pays for unemployment benefits and makes up lost tax revenue c. Using Okun's Law (each percentage point of cyclical unemployment is associated with a loss equal to 2.5% of full employment output), if fullemployment output is $7.5 trillion, each percentage point of unemployment sustained for one year costs $187.5 billion

34 2 Personal or psychological cost to workers and their families a. Especially important for those with long spells of unemployment 3 There are some offsemng factors a. Unemployment leads to increased job search and acquiring new skills, which may lead to increased future output b. Unemployed workers have increased leisure <me, though most wouldn't feel that the increased leisure compensated them for being unemployed

35 The long term behavior of the unemployment rate 1. The changing natural rate a. How do we calculate the natural rate of unemployment? b. CBO's es<mates: 5% to 5½% today, similar to 1950s and 1960s; over 6% in 1970s and 1980s c. Why did the natural rate rise from the 1950s to the late 1970s? (1) Partly demographics; more teenagers, blacks, and women (a) Their unemployment rates are higher because of discrimina<on, language problems, lower educa<onal abainment, interrup<ons of careers to have children (b) Their propor<on of the labor force increased from WWII to about 1980

36 Figure Actual and natural unemployment rates in the United States

37 d. Since 1980, demographic forces have reduced the natural rate of unemployment (1) The propor<on of the labor force aged years fell from 25% in 1980 to 16% in 1998 (2) Research by Shimer showed this is the main reason for the fall in the natural rate of unemployment

38 e. Some economists think the natural rate of unemployment is 4.5% or even lower (1) The labor market has become more efficient at matching workers and jobs, reducing fric<onal and structural unemployment (2) Temporary help agencies have become prominent, helping the matching process and reducing the natural rate of unemployment (3) Increased produc<vity of workers can be a cause; if produc<vity growth of workers is faster than wage growth, firms will hire more workers and natural rate of unemployment will decline temporarily

39 Measuring the Natural Rate of Unemployment Policymakers need measures of the natural rate when they formulate economic policy. I.e. if policymakers observe that the unemployment rate is above natural rate then they might consider using expansionary monetary or fiscal policy to bring economy back to its full employment equilibrium. To use the unemployment rate as an indicator for semng policy, the policymaker needs a good measure of natural rate of unemployment.

40 However, economists widely disagree about how to measure the natural rate. According to the paper by Staiger, Stock and Watson (1997) in Journal of Economic Perspec(ves, natural rate could not be measured at all precisely. Their best es<mate is 5.75% but its 95% confidence interval is between 4.8% and 6.6%. This is too large to be of any use to policymakers

41 Given uncertainty about natural rate of unemployment, policymakers want to be less aggressive with policy changes than they would be if they knew the value of natural rate more precisely.

42 12.3 The Problem of Infla<on

43 The costs of infla<on 1. Perfectly An<cipated Infla<on a. No effects if all prices and wages keep up with infla<on b. Even returns on assets may rise exactly with infla<on c. Shoe leather costs: People spend resources to economize on currency holdings; the es<mated cost of 10% infla<on is 0.3% of GNP d. Menu costs: the costs of changing prices (but technology may mi<gate this somewhat)

44 2. Unan<cipated Infla<on a. Realized real returns differ from expected real returns (1) Expected r = i π e (2) Actual r = i π (3) Actual r differs from expected r by π e π (4) Numerical example: i = 6%, π e = 4%, so expected r = 2%; if π = 6%, actual r = 0%; if π = 2%, actual r = 4% b. Similar effect on wages and salaries

45 c. Result: transfer of wealth (1) From lenders to borrowers when π > π e (2) From borrowers to lenders when π < π e d. So people want to avoid risk of unan<cipated infla<on (1) They spend resources to forecast infla<on (2) Some of these costs can be eliminated by contracts that are indexed to the price level e. Loss of valuable signals provided by prices (1) Confusion over changes in aggregate prices vs. changes in rela<ve prices (2) People expend resources to extract correct signals from prices

46 The costs of Hyperinfla<on a. Hyperinfla<on is a very high, sustained infla<on (for example, 50% or more per month) (1) Hungary in August 1945 had infla<on of 19,800% per month (2) Bolivia had annual rates of infla<on of 1281% in 1984, 11,750% in 1985, 276% in 1986 b. There are large shoe leather costs, as people minimize cash balances c. People spend many resources gemng rid of money as fast as possible d. Tax collec<ons fall, as people pay taxes with money whose value has declined sharply e. Prices become worthless as signals, so markets become inefficient

47 Figh<ng Infla<on: The Role of Infla<onary Expecta<on 1. If rapid money growth causes infla<on, why do central banks allow the money supply to grow rapidly? a. Developing or war torn countries may not be able to raise taxes or borrow, so they print money to finance spending b. Industrialized countries may try to use expansionary monetary policy to fight recessions, then not <ghten monetary policy enough later

48 2. Disinfla<on is a reduc<on in the rate of infla<on a. But disinfla<ons may lead to recessions b. An unexpected reduc<on in infla<on leads to a rise in unemployment along the Phillips curve. c. The costs of disinfla<on could be reduced if expected infla<on fell at the same <me actual infla<on fell 3. The costs of disinfla<on could be reduced if expected infla<on fell at the same <me actual infla<on fell

49 Rapid versus gradual disinfla<on The classical prescrip<on for disinfla<on is cold turkey a rapid and decisive reduc<on in money growth (1) Proponents argue that the economy will adjust fairly quickly, with low costs of adjustment, if the policy is announced well in advance (2) Keynesians disagree (a) Price s<ckiness due to menu costs and wage s<ckiness due to labor contracts make adjustment slow (b) Cold turkey disinfla<on would cause a major recession (c) The strategy might fail to alter infla<on expecta<ons, because if the costs of the policy are high (because the economy goes into recession), the government will reverse the policy

50 Keynesian prescrip<on for disinfla<on is gradualism (1) A gradual approach gives prices and wages <me to adjust to the disinfla<on (2) Such a strategy will be poli<cally sustainable because the costs are low

51 Wage and price controls Pro: Controls would hold down infla<on, thus lowering expected infla<on and reducing the costs of disinfla<on Con: Controls lead to shortages and inefficiency; once controls are li^ed, prices will rise again

52 The Nixon wage price controls (1) Price controls from August 1971 to April 1974 (2) Shortages developed in many products (3) The controls reduced infla<on when they were in effect, but prices returned to where they would have been soon a^er the controls were li^ed (4) Macro policies remained expansionary, so infla<on didn't decline

53 The outcome of wage and price controls (whether they affect infla<on expecta<on or not) may depend on what happens with fiscal and monetary policy (1) If policies remain expansionary, people will expect renewed infla<on when the controls are li^ed (2) If <ght policies are pursued, expected infla<on may decline

54 Credibility and Reputa<on a. Key determinant of the costs of disinfla<on: how quickly expected infla<on adjusts b. This depends on credibility of disinfla<on policy; if people believe the government and if the government carries through with its policy, expected infla<on should drop rapidly c. Credibility can be enhanced if the government gets a reputa<on for carrying out its promises d. Also, having a strong and independent central bank that is commibed to low infla<on provides credibility

55