Session 9. The Interactions Between Cyclical and Long-term Dynamics: The Role of Inflation Potential Output and Inflation Inflation as a Mechanism of Adjustment The Role of Expectations and the Phillips Curve Disinflation and Credibility Commodity Prices and Inflation
Supply and Demand over the Business Cycle Fluctuations around trend are driven mostly by demand factors. Periods of high growth are those when firms get close to their capacity limit. If pushed too far, it will lead to inflation.
The Long-Run Equilibrium (Closed Economy) We start with the two equations describing the equilibrium on money market (LM) and on the goods market (IS): Y = C (Y, T, r, wealth) + I (r, Profitability) + G M P = L(r,Y) In the long-run prices are flexible, inflation adjusts. We have now three endogenous variables interest rates (r), output (Y), and prices (P). To solve this model we consider that in the long run output is determined by the factors of production (labor, capital) and their productivity.
Potential Output and Inflation Changes in the economic environment lead to changes in demand. In the short run demand determines output. If demand is below potential, the economy is in a recession (prices tend to go down), if demand is above potential the economy is in an expansion/overheating (prices tend to go up). Real interest rate Long-run aggregate supply Recession (Downward Pressure on Inflation) Overheating (Upward Pressure on Inflation) Y potential Output
Potential Output and Inflation An illustration of how the Swedish Central Bank looks at inflationary pressures. In November 2016, CPI inflation (measured as the annual change in the consumer price index) stood at 1.4 per cent (1.2 per cent in October 2016).
Supply and Demand Equilibrium We can represent supply constraints in our IS-LM Model with a vertical long-run supply curve. Real interest rate Long-run aggregate supply (LRAS) LM Equilibrium Real interest rate IS Potential Output (Y LR ) Output
How to Use the Model The economy is in equilibrium when all markets clear, i.e. when the three curves intersect in one point. 1. Short run equilibrium is where the IS and the LM curves intersect. This means that in the short run demand determines output. 2. Long run equilibrium is where the IS, LM and the LRAS curves intersect. 3. Adjustment to the LR equilibrium is via price changes that shift the LM curve to the point where the IS and the LRAS curves intersect.
Recession and Recovery: price adjustment leads to the long-run equilibrium Real interest rate Initial interest rate Long-run aggregate supply LM * 2. If the economy starts below potential, then demand is low and prices start falling. The fall in the price level increases demand and shifts the LM curve. Interest rate after adjustment IS 1. The economy is in a period of low growth or in a recession if it operates below potential Actual output Y LR Output
Monetary Expansion and Adjustment to Long-Run Equilibrium Real interest rate Equilibrium interest rate Long-run aggregate supply IS LM 4. Increase in Prices 1. Increase in Money 3. With demand exceeding the profit-maximizing level of supply (for the current price level), prices in the economy start to increase, which lowers demand. Equilibrium interest rate * 2. The economy is in a demand-driven boom (it is overheating) if it operates above potential. Y LR Actual output Output
The Everyday Business of the Central Bank Real interest rate Equilibrium interest rate IS LM Long-run aggregate supply 2. Increase in spending 1. Increase in Productivity 1. Potential output in the economy increases (LRAS) 2. This is matched with an increase in investment to take advantage of the new productivity (IS) 3. What should monetary policy do? Y LR New Y LR Output
Changes in the Economic Environment The long-run aggregate supply curve shifts to the right whenever the potential output in the economy increases: 1. Productivity in the economy increases 2. Factors of production (capital or labor) increase 3. Other growth conditions improve (political, macroeconomic stability, distortions) IS curve shifts to the right whenever the demand for goods goes up: 1. Government spending goes up 2. Taxes go down (including taxes on capital) 3. Investment or consumer confidence go up 4. Other factors that increase demand LM curve shifts to the right whenever the liquidity in the economy increases: 1. Money supply increases 2. Prices decrease 3. Financial markets innovation reduces the need to hold money (velocity goes up)
Taking the Model to the Data: Inflation and Unemployment The output gap (difference between actual GDP and potential GDP) is highly correlated with the unemployment rate. Both are measures of the slack in the economy. Euro area 1991-2016 13 Unemployment Rate 12 11 10 9 8 7-3 -2-1 0 1 2 3 4 Output Gap
Inflation and Unemployment Following the logic of the model, we can think about the relationship between unemployment, as a measure of slack in the economy, and inflation (the Phillips Curve). Natural Rate of Unemployment = Full Employment = Level consistent with Potential Output Inflation Overheating and increasing inflation Recession and Decreasing Inflation Phillips Curve (short run) Unemployment
Unemployment and Inflation: US in the 1960s During the 60s there seems to be a clear and negative relationship between unemployment and inflation 7 6 1969 5 1968 Inflation 4 3 1966 1967 2 1965 1963 1 1964 1962 1961 0 3 4 5 6 7 Unemployment
Unemployment and Inflation: 1960 2016 (US) The relationship breaks down in the years that follow. What happened? 14 12 10 1974 1979 1980 Inflation 8 6 4 2 0-2 1973 1978 1981 1975 1977 1990 1969 1970 1968 1976 1989 1988 1987 1985 1966 1967 2000 19721971 1984 2006 2005 2007 2001 1996 2004 1995 1991 1993 1992 1997 1994 1999 1998 19652016 2015 2003 2011 1963 2002 1964 1962 2015 2014 2013 2012 1986 2008 1961 1982 1983 3 4 5 6 7 8 9 10 11 2009 2010 Unemployment
Unemployment and Inflation: Understanding Long-term Anchors Back to theory: where do we expect the US economy to be in this chart in a normal year in the future? (say 2050) 14 12 10 Inflation 8 6 4 2 0-2 3 4 5 6 7 8 9 10 11 Unemployment
Inflation and Unemployment: Understanding Long-term Anchors The Phillips curve is anchored by two long-run parameters: the natural rate of unemployment and the inflation targeted by the central bank. If they change, the curve shifts. We observe a negative relationship when there is no change in regime (anchors are stable) When there is change in one of the anchors the correlation breaks down and we can observe many other correlations.
Disinflation: Reducing the Inflation Target Inflation 12.1% 1979 1980 In 1979/1980 the newly elected chairman of the U.S. Federal Reserve, sets as a goal to bring inflation below 4%. Tight monetary policy will be the tool to achieve this low inflation. The consequence is high unemployment for several years 1981 5.4% 3.3% 1984 1985 1982 1983 Phillips Curve (short run) Natural Rate of Unemployment (6%) 7.2% 7.1% 9.7% Unemployment
The Role of Expectations and Credibility From 1980 to 1983 the decrease in inflation has effects on relative (real) prices because Contracts are written in nominal terms (e.g. wages) and are not modifiable in the short run Even if contracts get changed, expectations (forecasts) of inflation take time to adjust. The length depends on the credibility of the policy maker. Changes in relative prices (such as increases in real wages or real interest rates cause unemployment) After 1983, policy becomes credible and contracts adjust. This adjustment gets reflected in lower unemployment and a return to potential (trend) output and the natural rate of unemployment. Notice that the economy does not return to its original position because inflation will now be lower forever (until the next change in policy)
Nominal and Real Interest Rates during a Disinflation The hike in nominal interest rates leads to a decline in inflation. As inflation goes down nominal interest rates also go down bringing the real interest rate back to normal.
Disinflation and the Phillips Curve Inflation Phillips Curve (long run) Every short run Phillips curve corresponds to specific inflation target (which is credible). Inflation target (expected Inflation) Phillips Curve (short run) Natural Rate of Unemployment Unemployment
Disinflation and the Phillips Curve Inflation Phillips Curve (long run) Inflation Target Phillips Curve (short run) New Inflation Target Decrease in expected inflation Natural Rate of Unemployment Unemployment
The Cost of Reducing Inflation The impact of low inflation on growth? But even those who concede that New Zealand's performance in keeping inflation low and stable has been good often argue that the cost of achieving this, in terms of economic growth and employment foregone, has been too high, and that perhaps something more moderate, or "less obsessive" in the words of some of our critics, would have been more desirable. There is not much doubt that the process of reducing inflation from around 15 per cent per annum in the mid-eighties to below 2 per cent in 1991 had an adverse impact on growth and employment during that period. I have often acknowledged that point, and indeed I know of no central banker who would claim with any confidence that inflation can be reduced from a high level to a low level without at least some, temporary, impact on growth and employment. The reasons for this are now widely understood and relate to the way in which a policy to reduce inflation interacts with expectations that inflation will continue at its previous pace. But shortly after inflation was first reduced to the 0 to 2 per cent target in 1991, the economy began to grow again and unemployment began to fall. Donald T Brash, Governor of the Reserve Bank of New Zealand (February 2000)
The Cost of Reducing Inflation As a result, if inflation accelerates to higher levels as it did during 2001 2003 and 2007-2009, tighter monetary policy (higher interest rates) would be needed to bring inflation down again, and that such tightening is initially likely to be accompanied by slower economic growth and concomitantly rising unemployment. A short-run pain for a long-run gain! Dr Monde Mnyande, Chief Economist, South African Reserve Bank (Central Bank), January 28, 2011.
The Cost of Reducing Inflation One of the reasons why it is hard to bring down high inflation is that workers continue to demand big pay rises as they expect prices to keep growing quickly in the future. A central bank that commits to target a given rate of inflation can change expectations, helping to break this vicious circle. Indeed, countries that implemented inflation targeting in the 1990s enjoyed lower inflation rates than would have been the case had they not adopted this framework. India s battle against inflation. Financial Times January 26, 2014.
Phillips Curve (Japan)
Phillips Curve (Japan)
What about Oil Prices? Aren t they a Cause of Inflation? In 1973 and 1979 the price of oil grew by about 60% and put upward pressure on prices in countries that were dependent on oil as a source of energy. 40.00 80.00 35.00 60.00 Price of Oiil (nominal) 30.00 25.00 20.00 15.00 10.00 5.00 40.00 20.00 0.00-20.00-40.00-60.00 Oil Price Inflation (annual %) 0.00 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986-80.00 Price of Oil Oil Price Inflation
What about Oil Prices? Aren t they a Cause of Inflation? Although all countries faced the same increase in the price of oil. Inflation behaved very differently depending on the response of monetary policy. 30 Inflation 25 20 15 10 5 0 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 Germany Japan United Kingdom United States
What about Oil Prices? Aren t they a Cause of Inflation? The differences in the response of monetary policy did not result in significant differences in GDP growth rates. Some of the countries that let inflation go up by a larger amount then had to deal with deeper recessions when inflation had to be brought back to normal levels (as in the case of the United Kingdom). 10 Real GDP Growth 8 6 4 2 0 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986-2 -4 Germany Japan United Kingdom United States
The Dilemma of Stagflation (2015-2016) Brazil's inflation hit a new 10-year high in mid-march even as the economy slipped closer to recession. Reuters March 20, 2015. South Africa s central bank raised interest rates for the second time in two months and slashed its growth forecast amid a deepening sense of economic crisis as the monetary authorities battle to counter inflationary pressures caused by a dramatic fall in the rand. South Africa s precarious economic position presents the central bank, considered one of the country s most independent institutions, with a stark dilemma. The economy stands on the brink of recession, yet inflationary pressures, particularly damaging to the country s poor, are expected to push inflation past the bank s 6 per cent upper limit. Financial Times January 28, 2016.
Session 12. Summary To understand long-term dynamics we need to think about the supply side of the economy. When an economy runs out of slack, prices (inflation) increases and the economy slows down. Therefore, in the short run, there is a trade off between inflation and unemployment. Disinflation episodes are those where central banks reduce inflation at the cost of slower growth.
Appendix: Stagflation and Oil Price shocks 1. We can think about an oil price shock as a shift of the long-run aggregate supply to the left. Long-run aggregate supply Real interest rate Equilibrium Real interest rate IS LM 2. What are the policy options? Y LR Output