AP Macro. Phillips Curve, Monetary Policy

Transcription

1 AP Macro Phillips Curve, Monetary Policy

2 The Phillips Curve (hypothetical example) tt% 4% 2% PC 5% 7% Note: Inflation Expectations are held constant

3 The Phillips Curve In a 1958 paper, New Zealand born economist, AW Phillips published the results of his research on the historical relationship between the unemployment rate () and the rate of inflation (tt%) in Great Britain His research indicated a stable inverse relationship between the and the tt% As, tt% ; and as, tt% The implication of this relationship was that policy makers could exploit the trade-off and reduce at the cost of increased tt%

4 Trouble for the Phillips Curve In the 1970 s the US experienced concurrent high & tt%, = stagflation 1976 American Nobel Prize economist Milton Friedman saw stagflation as disproof of the stable PC Instead of a trade-off between & tt%, Friedman and 2006 Nobel Prize recipient Edmund Phelps believed that Un was independent of the tt% This independent relationship is now referred to as the Long-Run Phillips Curve

5 1970 s Phillips Curve π% 4% 2% PC 5% 7%

6 The Long-Run Phillips Curve π% LRPC u n % Note: Natural rate of unemployment is held constant

7 Un defined The natural rate of unemployment (NRU) is defined as the equilibrium rate of unemployment ie the rate of unemployment where real wages have found their free market level It is where the aggregate supply of labor is in balance with the aggregate demand for labor At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and there is no involuntary unemployment There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions

8 The Long-Run Phillips Curve (LRPC) b/c the LRPC exists at the u n, structural changes in the economy that affect u n will also cause the LRPC to shift In order to reduce the Un, structural policies must be directed towards an economy's supply side Increases in u n will shift LRPC Decreases in u n will shift LRPC

9 Inflation rate LRPC 4% 2% SRPC (assumes 4 % expected inflation at each UR) SRPC (assumes 2% expected inflation at each UR) Natural rate of unemployment Unemployment rate Phillips Curve LR and SR

10 Summary There is a short-run trade off between & π% This is referred to as a short-run Phillips Curve (SRPC) In the long-run, no trade-off exists between & π% This is referred to as the long-run Phillips Curve (LRPC) The LRPC exists at the natural rate of unemployment (u n ) u n : LRPC u n : LRPC ΔC, ΔI G, ΔG, and/or ΔX N = Δ AD = Δ along SRPC AD : GDP R & PL : & π% : up/left along SRPC AD : GDP R & PL : & π% : down/right along SRPC Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC SRAS : GDP R & PL : & π% : SRPC SRAS : GDP R & PL : & π% : SRPC

11 Reconciling the LRPC and SRPC tt% tt 1 % B LRPC C In the long-run, the inflation rate at B (π 1 %) becomes the new expected inflation rate (π 1^%), and the economy returns to the natural rate of unemployment (point C) tt % In the short-run, assuming the policy is successful, inflation occurs and unemployment decreases as the economy moves from A to B A u N % SRPC (tt 1^ %) SRPC (tt^ %) Assume that either the government or the central bank enacts an expansionary policy to reduce the unemployment rate below its natural rate at point A

12 Reconciling the LRPC and SRPC π% LRPC In the long-run, the inflation rate at B (π 1 %) becomes the new expected inflation rate (π 1^%), and the economy, once again, returns to the natural rate of unemployment (point C) π % π 1 % In the short-run, assuming the policy is successful, disinflation occurs and unemployment increases as the economy moves from A to B A C u N % B SRPC (π^ %) SRPC (π 1^ %) Now assume that either the government or the central bank enacts a Contractionary policy to reduce inflation from it s current rate at point A

13 Relating Phillips Curve to AS/AD Changes in the AS/AD model can also be seen in the Phillips Curves An easy way to understand how changes in the AS/AD model affect the Phillips Curve is to think of the two sets of graphs as mirror images NOTE: The 2 models are not equivalent The AS/AD model is static, but the Phillips Curve includes change over time Whereas AS/AD shows one time changes in the price-level as inflation or deflation, The Phillips curve illustrates continuous change in the price-level as either increased inflation or disinflation

14 Increase in AD = Up/left movement along SRPC PL P 1 P LRAS SRAS π% π 1 π SRPC AD 1 AD Y Y F GDP R u n u C, I G, G and/or X N : AD : GDP R & PL : & π% : up/left along SRPC

15 Decrease in AD = Down/right along SRPC PL LRAS π% P P 1 SRAS SRPC π π 1 AD AD 1 Y F Y GDP R u u n C, I G, G and/or X N : AD : GDP R & PL : & π% : down/right along SRPC

16 SRAS = SRPC PL LRAS SRAS π% SRPC LRPC P P 1 SRAS 1 π π 1 SRPC 1 AD Y Y F GDP R u n u Inflationary Expectations, Input Prices, Productivity, Business Taxes, and/or Deregulation : SRAS : GDP R & PL : & π% : SRPC (Disinflation)

17 SRAS = SRPC PL LRAS SRAS 1 π% SRPC 1 LRPC SRAS 1 P SRPC π 1 π AD Y 1 Y F GDP R u n u 1 Inflationary Expectations, Input Prices, Productivity, Business Taxes, and/or Increased Regulation : SRAS : GDP R & PL : & π% : SRPC (Stagflation)

18 Phillips Curve Review SRAS increases = shift SRPC right SRAS decreases = shift SRPC left AD increases = movement up and left AD decreases = movement down and right Increases in u n will shift LRPC Decreases in u n will shift LRPC

19 NIR MS MS affected by actions of the Federal Reserve i1 MD MD Transaction demand determined by GDP Asset demand determined by NIR Q1 Q Money Market