economic fluctuations. Part 1.

Transcription

1 Dynamic approach to short run economic fluctuations. Part 1. The Phillips Curve & Dynamic Aggregate Supply

2 Motivation The static AD/SAS model fails to take into account inflation The dynamic model, which we will start to discuss today, allows to model inflation and dynamic interactions between consecutive periods Today we will develop the famous Phillips curve (and the dynamic aggregate supply line) - the supply side of the dynamic DAD/DAS model slide 1

3 Important If you have difficulties with the AD/AS model, please read chapters 10, 11 and 13 from Mankiw! slide 2

4 Recall the aggregate supply curve (SRAS) Three broad explanations are offered: 1. The sticky-wage model 2. The imperfect-information model 3. The sticky-price model All three imply: agg. output natural rate of output e Y Y ( P P ) a positive parameter the actual price level the expected price level slide 3

5 Recall the aggregate supply curve (SRAS) P LRAS e Y Y ( P P ) P P P P P P e e e Y SRAS Y Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation. slide 4

6 Deriving the Dynamic Aggregate Supply & the Phillips curve from SRAS (1) e Y Y ( P P ) (2) e P P (1 )( Y Y ) e (3) P P (1 )( Y Y ) (4) ( P P ) ( P P ) (1 )( Y Y ) e 1 1 (5) e (1 )( Y Y ) (6) n (1 )( Y Y ) ( u u ) The DAS Curve - we will use it later! e n (7) ( u u ) slide 5

7 Inflation, Unemployment, and the Phillips Curve The Phillips curve states that is related to expected inflation, e. cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate supply shocks, e n ( u u ) where > 0 is an exogenous constant. slide 6

8 Intuition of the Phillips curve: an ongoing, anticipated inflation in the AS/AD model slide 7

9 Intuition of the Phillips curve: Unanticipated inflation in the AD/AS model slide 8

10 The Phillips Curve and SRAS Phillips curve: e SRAS: Y Y ( P P ) e n ( u u ) SRAS curve: Output is related to unexpected movements in the price level. Phillips curve: Unemployment is related to unexpected movements in the inflation rate. slide 9

11 Adaptive expectations Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation. A simple example: Expected inflation = last year s actual inflation E t 1 t t 1 Then, the P.C. becomes n 1 ( u u ) slide 10

12 Inflation expectations How should we measure inflation expectations, and how should we use that information for forecasting and controlling inflation? I certainly do not have complete answers to those questions, but I believe that they are of great practical importance July 10, 2007 Inflation Expectations and Inflation Forecasting Ben S. Bernanke slide 11

13 Inflation expectations We are assuming a very simple way of expectation formation; the reality can be much more complex. For example, recently some researches talk about anchored expectations, with very interesting implications for the P.C. slide 12

14 Inflation inertia n 1 ( u u ) In this form, the Phillips curve implies that inflation has inertia: In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate. Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set and actual inflation. slide 13

15 Two causes of rising & falling inflation n 1 ( u u ) cost-push inflation: inflation resulting from supply shocks Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up. demand-pull inflation: inflation resulting from demand shocks Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up. slide 14

16 Graphing the Phillips curve In the short run, policymakers face a tradeoff between and u. e e n ( u u ) 1 The short-run Phillips curve n u u slide 15

17 Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run. e 2 e 1 e n ( u u ) E.g., an increase in e shifts the short-run P.C. upward. n u u slide 16

18 Old-fashioned Phillips curve? Krugman writes: For one thing, the accelerationist doctrine that has dominated economic discussion of inflation and unemployment for 40 years has fallen flat. Anchored expectations. Price- and wagesetters now act as if they expect policymakers to hit their target (say: 2%) Operationally, of course, such a curve looks just like the old, pre-nairu Phillips curves people estimated in the 1960s. slide 17

19 slide 18

20 Dynamic aggregate supply (DAS) Relying on the relationship bewteen unemployment and production (Okun s Law), we can easily get the DAS from the PC. slide 19

21 Okun s Law Source: ECB, 2011 slide 20

22 Dynamic Aggregate Supply t E t 1 t Y Y t t t E t 1 t t 1 Adaptive Expectations t Y Y t t t DAS Curve t 1 slide 21

23 The Dynamic Aggregate Supply Curve t t 1 Y Y t t t t1 t π t DAS t DAS slopes upward: high levels of output are associated with high inflation. This is because of demandpull inflation Y t slide 22 Y t

24 The sacrifice ratio To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year s real GDP that must be foregone to reduce inflation by 1 percentage point. slide 23

25 Calculating the sacrifice ratio for the Volcker disinflation 1981: = 9.7% 1985: = 3.0% Total disinflation = 6.7% year u u n uu n % 6.0% 3.5% Total 9.5% slide 24

26 Calculating the sacrifice ratio for the Volcker disinflation From previous slide: Inflation fell by 6.7%, total cyclical unemployment was 9.5%. Okun s law: 1% of unemployment = 2% of lost output. So, 9.5% cyclical unemployment = 19.0% of a year s real GDP. Sacrifice ratio = (lost GDP)/(total disinflation) = 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation. slide 25

27 The natural rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the natural levels of output, employment, and unemployment slide 26

28 An alternative hypothesis: Hysteresis Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment. Negative shocks may increase u n, so economy may not fully recover. slide 27

29 Hysteresis: Why negative shocks may increase the natural rate The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends. Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves. Result: The cyclically unemployed outsiders may become structurally unemployed when the recession ends. CHAPTER 13 Aggregate Supply slide 28

30 During the recent crisis The surprise [about inflation] is that it s fallen so little, given the depth and duration of the recent downturn. Based on the experience of past severe recessions, I would have expected inflation to fall by twice as much as it has. (John Williams, 2010.) slide 29

31 The changing Phillips curve Source: Paul Krugman, slide 30

32 The Phillips Curve for France, Source: László Andor 01 October 2014; slide 31

33 The Phillips Curve for Germany Source: László Andor 01 October 2014; slide 32

34 Recently, questions about the PC are being asked Advanced economies have experienced little decline in inflation since the financial crisis of , calling into question one of the fundamental tenets of many macroeconomic theories: the Phillips curve linking the rate of change in prices to the level of economic activity We nowadays observe relatively major differences in unemployment rates, while inflation remains rather low and stable. The Phillips curve has not become vertical as the monetarists had predicted; it is much closer to being horizontal in recent years. Paul Krugman slide 33

35 Downward wage & price rigidity? Explanations based on recent labor market developments, such as long-term unemployed having smaller effects on wages, or downward wage rigidity preventing wages from falling as much as in prior downturns It s an interesting question why, one that has to be answered in terms of psychology and sociology, but it s simply a fact that actual cuts in nominal wages happen only rarely and under great pressure. Paul Krugman slide 34

36 On the other hand. Increasing evidence shows that after a flattening occurred in the immediate aftermath of the global financial crisis, the relationship between price inflation and economic slack became stronger in the euro area. Bulligan, Guido and Viviano, Eliana, Has the Wage Phillips Curve Changed in the Euro Area? (September 22, 2016). Bank of Italy Occasional Paper No slide 35

37 Summary 2. Phillips curve derived from the SRAS curve states that inflation depends on expected inflation cyclical unemployment supply shocks presents policymakers with a short-run tradeoff between inflation and unemployment slide 36

38 Summary 4. The natural rate hypothesis and hysteresis the natural rate hypotheses states that changes in aggregate demand can only affect output and employment in the short run hysteresis states that aggregate demand can have permanent effects on output and employment slide 37