CHAPTER 33 Inflation and the Phillips Curve The first few months or years of inflation, like the first few drinks, seem just fine. Everyone has more money to spend and prices aren t rising quite as fast as the money that s available. The hangover comes when prices start to catch up. Milton Friedman McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Review: Effects of Inflation Unexpected inflation redistributes income from lenders to borrowers If lenders charge a nominal rate of 5% and expect inflation to be 2%, the expected real rate is 3% If inflation is actually 4%, the real rate is only 1% 33-2
Productivity, Inflation, and Wages Changes in productivity and changes in wages determine if inflation is coming There will be no inflationary pressures if wages and productivity increase at the same rate Inflation = Nominal wage increases - Productivity growth 33-3
Nominal Wages, Productivity, and Inflation Nominal wage: the wage you get paid/make per year $7.50 per hour $50,000 per year McGraw-Hill/Irwin Colander, Economics 4
Nominal Wages, Productivity, and Inflation When nominal wages increase by more than the growth of productivity, the SRAS curve shifts left (decrease), resulting in inflation When nominal wages increase by less than the growth of productivity, the SRAS curve shifts right (increase), resulting in deflation McGraw-Hill/Irwin Colander, Economics 5
Theories of Inflation McGraw-Hill/Irwin Colander, Economics 6
The Quantity Theory of Money Theory #1: The quantity theory of money (inflation) emphasizes the connection between money and inflation If the money supply rises, the price level rises If the money supply does not rise, the price level will not rise 33-7
The Quantity Theory of Money The equation of exchange is: MV = PY M = Money supply V = Velocity P = Price level Y = Quantity of output Note: P * Y= GDP 33-8
The Quantity Theory of Money Assume the velocity is relatively constant because people's spending habits are not quick to change Also assume that output (Y) is not affected by the amount of money because it is based on production, not the value of the stuff being produced (Y is fixed as time is required for the quantity of output to change) McGraw-Hill/Irwin Colander, Economics 9
The Quantity Theory of Money Think of velocity as how well the economy is doing: is money being spent quickly or slowly? If velocity is high, money is changing hands quickly and a small money supply can fund a large amount of purchases Higher velocity = more inflation If velocity is low, money is changing hands slowly and it takes a much larger money supply to fund the same number of purchases McGraw-Hill/Irwin Colander, Economics 10
The Quantity Theory of Money Velocity of money is the number of times per year a dollar is spent and respent in a year Velocity = Nominal GDP Money Supply Know this formula McGraw-Hill/Irwin Colander, Economics 11
The Quantity Theory of Money What is the effect of a 3% increase in the money supply on the price level, given that output and velocity remain constant? Percent change in the money supply + Percent change in velocity = Percent change in the price level + percent change in output 3% + 0 =x% + 0 Result: A 3% increase in the price level (inflation is 3%) So, a 3% increase in the money supply leads to a 3% increase in the price level McGraw-Hill/Irwin Colander, Economics 12
Institutional Theory of Inflation Theory #2: The institutional theory emphasizes the relationship between market structure and price-setting institutions and inflation It is easier for firms to raise prices than to lower them and they do not take the effect of this into account McGraw-Hill/Irwin Colander, Economics 13
Institutional Theory of Inflation As workers push for higher nominal wages (or a firms raise prices) more people want higher wages (or more firms raise their prices) McGraw-Hill/Irwin Colander, Economics 14
Institutional Theory of Inflation According to the institutionalists, increases in prices force the government to increase the money supply or cause unemployment MV PY 33-15
Institutional Theory of Inflation In this theory, inflation is caused by the way in which prices as well as wages are set For example: if wages are increasing so is the price level At this point, the government must decide whether or not to increase the money supply If it increases it, inflation is accepted If not, unemployment increases McGraw-Hill/Irwin Colander, Economics 16
Review: Demand-Pull Inflation Demand-pull inflation: inflation that occurs when the economy is at or above potential output (creates inflationary gap) Characterized by shortages of goods and workers Associated with the quantity theory of money/inflation 33-17
Review: Cost-Push Inflation Cost-push inflation: inflation that occurs when the economy is below potential output Usually caused by an increase in input costs of one of the factors of production No excess demand but excess supply may exist Firms that raise prices may not sell their goods McGraw-Hill/Irwin Colander, Economics 18
Cost-Push Inflation Example: 1970s when OPEC raised the price of oil Associated with the institutional theory of Inflation McGraw-Hill/Irwin Colander, Economics 19
The Phillips Curve McGraw-Hill/Irwin Colander, Economics 20
Tradeoff between Inflation and Unemployment Some policymakers believe there is a tradeoff between inflation and unemployment The government can: Keep output high Low unemployment Higher inflation McGraw-Hill/Irwin Colander, Economics 21
Tradeoff between Inflation and Unemployment Decrease AD Low inflation Higher unemployment McGraw-Hill/Irwin Colander, Economics 22
The Phillips Curve This concept can be expressed in a new graph: the Phillips Curve 33-23
The Short-run Phillips Curve The short-run Phillips curve is a downwardsloping curve showing the relationship between inflation and unemployment when expectations of inflation are constant McGraw-Hill/Irwin Colander, Economics 24
The Short-Run Phillips Curve Actual inflation depends on both supply and demand forces and on how much inflation people expect At all points on the short-run Phillips curve (SRPC), expectations of inflation (the rise in the price level that the average person expects) are fixed 33-25
Draw the Graph: Short-run Phillips Curve Inflation Short-run Phillips curve (SRPC) Unemployment rate McGraw-Hill/Irwin Colander, Economics 26
The Long-Run Phillips Curve At all points on the long-run Phillips curve, expectations of inflation are equal to actual inflation The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment McGraw-Hill/Irwin Colander, Economics 27
Draw the Graph: The Long-run Phillips Curve Inflation LRPC 5% Unemployment rate 33-28
More on the Phillips Curve The sustainable combination of inflation and unemployment on the short-run Phillips curve is where it intersects the long-run Phillips curve this is where the unemployment rate is consistent with the economy's potential income McGraw-Hill/Irwin Colander, Economics 29
Draw the Graph: The Short-run and Long-run Phillips Curve Inflation LRPC Point A represents the (long-run equilibrium) 5% A SRPC 5% Unemployment rate 33-30
What Shifts the Short-Run Phillips Curve? Changes in productivity Changes in input prices Changes in inflationary expectations McGraw-Hill/Irwin Colander, Economics 31
Example #1 Assume the United States economy is currently in a recession in a short-run equilibrium. Draw a correctly labeled graph of the shortrun and long-run Phillips curves. Use letter A to represent a recession in the economy. McGraw-Hill/Irwin Colander, Economics 32
Example #1 Answer Inflation LRPC Why is point A to the right of LRPC and not to the left? A SRPC 5% Unemployment rate 33-33
Example #2 The price of a key input, rubber, decreases. i. Demonstrate graphically what happens in the AS/AD model. ii. Demonstrate graphically what happens to the short-run Phillips Curve. McGraw-Hill/Irwin Colander, Economics 34
Example #2: Answer Price Level LRAS SRAS 1 Inflation LRPC P 1 SRAS 2 7% P 2 5% SRPC 1 AD SRPC 2 Y 1 Y 2 Real GDP U 1 U Y Unemployment McGraw-Hill/Irwin Colander, Economics 35
Example #3 Assume that inflationary expectations have increased in Econville. i. Demonstrate graphically what happens in the AS/AD model. ii. Demonstrate graphically what happens to the short-run Phillips Curve. McGraw-Hill/Irwin Colander, Economics 36
Price Level Example #3: Answer LRAS SRAS 2 Inflation SRAS 1 LRPC Inflation and unemployment increase P 2 6% P 1 5% AD SRPC 1 SRPC 2 Y 2 U 1 Y 1 Real GDP Unemployment McGraw-Hill/Irwin Colander, Economics 37 U Y
AS/AD and the Phillips Curve McGraw-Hill/Irwin Colander, Economics 38
What happens to SRPC based on shifts in the AS/AD Model? If there is an increase or decrease in AD, there is a movement along the SRPC McGraw-Hill/Irwin Colander, Economics 39
AS/AD and the Phillips Curve Show what happens on both graphs if AD increases Price Level LRAS SRAS Inflation LRPC Result: Higher inflation and lower unemployment P 2 P 1 AD 2 6% 5% AD 1 SRPC Y 1 Y 2 Real GDP U Y Unemployment McGraw-Hill/Irwin Colander, Economics 40 U 1
AS/AD and the Phillips Curve Inflation Correctly draw the LRPC and SRPC with a recessionary gap. What happens when AD falls? Price Level LRAS SRAS Inflation LRPC Result: Lower inflation and higher unemployment P 1 6% P 2 AD 1 5% SRPC AD 2 McGraw-Hill/Irwin Y 2 Y 1 Y F Real GDP Colander, Economics U Y U 1 U 2 Unemployment
What happens to SRPC based on shifts in the AS/AD Model? If there is an increase or decrease in SRAS, there is a shift in SRPC McGraw-Hill/Irwin Colander, Economics 42
AS/AD and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when SRAS falls? Price Level LRAS SRAS 2 SRAS 1 Inflation LRPC Inflation and unemployment increase P 2 P 1 6% 5% AD SRPC 2 SRPC 1 Y 2 Y 1 Real GDP U Y U 1 Unemployment McGraw-Hill/Irwin Colander, Economics 43
AS/AD and the Phillips Curve Correctly draw the LRPC and SRPC with a recessionary gap. What happens when SRAS increases? Price Level LRAS SRAS 1 Inflation LRPC P 1 SRAS 2 7% P 2 Y 1 Y 2 5% SRPC 1 AD SRPC 2 Real GDP U Unemployment 1 McGraw-Hill/Irwin Colander, Economics 44 U Y
Example #4 A Assume that Econtopia is in a long-run equilibrium and that the natural rate of unemployment is 5% and the current inflation rate is 2%. Draw a correctly labeled AS/AD model and SRPC and LRPC. McGraw-Hill/Irwin Colander, Economics 45
Example #4 A: Answer Price Level LRAS Inflation LRPC SRAS 1 PL 1 2% AD SRPC 1 Y 1 Real GDP 5% Unemployment 46
Example #4 B Now, assume that government spending has increased and Econtopia is in short-run equilibrium. Show the impact this has on your graphs in part a. McGraw-Hill/Irwin Colander, Economics 47
Example #4 B: Answer Price Level LRAS SRAS Inflation LRPC Result: Higher inflation and lower unemployment P 2 4% P 1 2% AD 2 AD 1 SRPC Y 1 Y 2 Real GDP 3% 5% Unemployment McGraw-Hill/Irwin Colander, Economics 48
Example 4 B: Answer What else has happened? Inflation increased and is higher than expected inflation. Firms earn increased profits and increase output and employment, decreasing unemployment. Nominal wages are unchanged but real wages have declined (because inflation has increased). McGraw-Hill/Irwin Colander, Economics 49
Example #5 Assume that the United States economy is in long-run equilibrium with an expected inflation rate of 6 percent and an unemployment rate of 5 percent. The nominal interest rate is 8 percent. (a) Using a correctly labeled graph with both the short-run and longrun Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A. (b) Assume that the Federal Reserve action (targeting a 3% inflation rate) is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium? (i) The short-run Phillips curve. Explain. (ii) The natural rate of unemployment. McGraw-Hill/Irwin Colander, Economics 50
Example #5: Answer a.) Inflation LRPC 6% SRPC 5% Unemployment McGraw-Hill/Irwin Colander, Economics 51
Example #5: Answer (b) Assume that the Federal Reserve action (targeting a 3% inflation rate) is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium? (i) The short-run Phillips curve. Explain. The short-run Phillips curve will shift to the left because the Fed s policy will lower inflationary expectations. (ii) The natural rate of unemployment. Will not change McGraw-Hill/Irwin Colander, Economics 52
Example #6 Assume the United States economy is operating at fullemployment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recession. Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in consumption spending. Label the initial position A and the new position B. McGraw-Hill/Irwin Colander, Economics 53
Example #6: Answer Inflation Inflation rate 1 Inflation rate 2 A B SRPC U 1 U 2 Unemployment McGraw-Hill/Irwin Colander, Economics 54
Chapter Summary The winners in inflation are people who can raise their wages or prices and still keep their jobs or sell their goods The losers are people who can t raise their wages or prices A basic rule to predict inflation is: Inflation equals nominal wage increases minus productivity growth 33-55
Chapter Summary The equation of exchange is MV = PY (or PQ) When velocity is constant, real output is independent of the money supply, and causation goes from money to prices The equation of exchange becomes the quantity theory, and it predicts that the price level varies in direct response to changes in the quantity of money That is % M leads to an equal % P 33-56
Chapter Summary Central banks sometimes print money knowing that it will lead to inflation because the alternative might be a breakdown of the economy The institutional theory of inflation sees the source of inflation in the wage-and-price setting institutions Institutionalists see the direction of causation going from price increases to money supply increases 33-57
Chapter Summary The long-run Phillips curve is vertical, and it allows expectations of inflation to change The short-run Phillips curve is downward sloping, holds expectations constant, and shifts when expectations change Quantity theorists see a long-run trade-off between inflation and growth, but institutionalists are less sure about this trade-off 33-58