Transcript The Phillips Curve

Chapter 18
Expectations and
Macroeconomics
Introduction
• We have put together a complete model of
aggregate demand, supply and wage
adjustment.
P M Y
AD:


P
M
Y
Y Y *
LRAS:

g
Y
Y*
P  w


 Y
SRAS:

 g   b
 g
P  w
 Y


E

w

P


Wage Eq: 
 g =
 c U  U *
P
 w

2
Introduction
• So far, we have maintained the assumption
that expectations of future inflation are
exogenous.
Now, we study the endogenous
determination of expectation.
• One approach, rational expectations, came
to dominate the way that expectations are
modeled in practice.
3
Postwar Economic History of the U.S.
• In ch17, we began our model in 1949
because our theory may not apply when the
government directly controls prices, as it
did during WWII.
• We use new-Keynesian theory to show that
a model in which expectations are fixed
cannot account for the experiences of the
1970s and 1980s.
4
Inflation
• To assume that expectations of price inflation
are constant is not unreasonable when looking
at the 1950s and 1960s:
-- inflation exceed 2% about as often as it fell
short of 2%.
-- After 1965, inflation began to climb and by
1969 it was higher than 4%.
However, a period of temporarily high inflation
in the late 1960s might reasonably have been
expected to decline in subsequent years.
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The History of Inflation, 1949–1969
Figure 17.6A
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The History of Inflation, 1949–1969
Figure 17.6B
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Inflation
• The history of the 1970s and 1980s was very
different from that of the two preceding decades.
-- From 1969 through 1981, inflation climbed in
almost every year.
-- After peaking in 1981, inflation had begun to
slow down, and by 1996 it had returned to the
level of the levels of the 1950s.
-- See BOX 18.1.
• Thus, constant expectation cannot be assumed
when applying the model to this period.
8
New-Keynesian Wage Equation
• From the New-Keynesian wage adjustment
equation, there is a trade-off relationship
between expected real wage rate inflation and
unemployment.
E

w

P


*

g


c
U

U




P
 w

New-Keynesian wage equation
9
The Phillips Curve
• The role of expectations was poorly understood
and expected price inflation was typically
omitted from the new-Keynesian wage eq.
• As a result, A.W. Phillips argued that there is a
stable trade-off relationship between
unemployment and inflation. (original Phillips
curve)
 P
 w
*
 g 
 c U  U 

P
 w

New-Keynesian wage equation
E
10
The Phillips Curve
• One way to test the validity of the newKeynesian wage equation and the Phillips
curve is to replace the expected inflation by
actual inflation.
 P
 w
*
 g 
 c U  U 

 w
 P
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The Phillips Curve
• BOX 18.2 indicates that
-- Phillips curve holds in the 1950s and 1960s,
but break down in the 1970s and 1980s.
--However, the new-Keynesian wage equation is
robust in each of the sample periods.
• This comes from the fact that Phillips curve is
conditional on constant expected inflation.
E

w

P


*

g


c
U

U




P
 w

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The Phillips Curve
• P.A. Samuelson further replaced the wage
inflation with the price inflation from the
Phillips curve.
w P MPL
w  P  MPL 


w
P
MPL
P w
P P E


g

 c U  U * 
P
w
P
P
• A trade-off relationship between price inflation
and unemployment.
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The Phillips Curve
P P E

 c U  U * 
P
P
• According to this view, the goal of economic
policy was to pick a point on the Phillips curve
by choosing the rate of money creation.
-- if Fed chose rapid monetary expansion, high
inflation but low unemployment would result.
-- if Fed chose low rate of monetary expansion,
low inflation and high unemployment would
result.
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The Phillips Curve
P P

 c U  U * 
P
P
E
• Since it is unreasonable to assume constant
expected inflation as actual inflation varies
with the unemployment, this Phillips curve
relationship suggested by Samuelson also
broke down as inflation took hold.
15
The Natural Rate Hypothesis (NAIRU)
• Two prominent critics of the trade-off view
were Phelps and Friedman.
-- Permanently low unemployment is
unsustainable in the long run.
-- The observed relationship between inflation
and unemployment occurs as a result of
mistaken expectations.
-- The economy has a natural rate of
unemployment which is independent of the
variables that shift the AD curve.
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The Natural Rate Hypothesis (NAIRU)
Unemployment can only be above or below this
natural this natural rate as a result of mistaken
expectations on the part of private decisionmakers.
-- If policymakers try to maintain unemployment
below its natural rate, the inflation will
accelerate with each successive attempt.
The result is a self-fulfilling spiral of wage and
price increases.
The natural unemployment rate is referred as
the non-accelerating inflation rate of
unemployment (NAIRU).
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The Natural Rate Hypothesis (NAIRU)
• Evidence: Figure 18.2, BOX 18.2
-- In the early 1970s, the government began to
run larger deficits.
Increased expenditures were financed by new
government bonds and some of these bonds
were bought by the Fed as it tried to keep down
the nominal interest rate.
As the Fed bought government debt, it created
new money to pay for it, and the rate of money
creation began to climb.
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Money Growth and Debt Creation in
the Postwar Period
Figure 18.2
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The Natural Rate Hypothesis (NAIRU)
Increases in the money supply led to higher
inflation.
However, the economy experienced higher
unemployment at the same time.
This is called stagflation.
the Phillips curve represent only a short-run
relationship between unemployment and
inflation that relies on misperceptions of future
inflation.
20
The New-Keynesian Model
• What we learned from the postwar events is
that expectations cannot be modeled using
mechanical rule.
• We now examine the implications of the newKeynesian model in the short-run and long-run.
21
Determining Growth and Inflation
• Growth and inflation are determined at the
point where the AD and the SRAS intersect.
• The AD curve crosses the LRAS curve when
M
inflation equals excess money growth, M  g .
• The SRAS curve crosses the LRAS curve when
w
g .
inflation equals excess wage inflation,
w
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Fixing the Position of the Aggregate
Demand and Supply Curves
Figure 18.3
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Short-Run Growth and Inflation
• Now that we understand how the position of
the AD and AS are determined, we can use the
AD-AS diagram to explain the effects of
monetary policy.
• We begin with a baseline case in which wage
inflation and money growth are equal :
M w

M
w
• Now consider the case the rate of money
creation increases.
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Short-Run Effects of an Increase in the
Rate of Money Creation
Figure 18.4
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Long-Run Growth and Inflation
• The Fed can increase employment and growth
in the short run. But what would be the longrun effect ?
• Two factors cause upward on the rate of wage
inflation:
1. Because unemployment is below its natural
rate, the rate of wage inflation will begin to
increase.
2. Firm and H.H. are surprised by the level of
price inflation and revise upward their
expectations of future price inflation.
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Long-Run Effects of an Increase in the
Rate of Money Creation
Figure 18.5
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Explaining Expectations Endogenously
• A key element in the explanation of historical
events is the idea that expectations adjust
endogenously.
• When the environment changes, people change
the way in which they forecast the future.
• The fact that human beings adapt to their
environment led to the theory of rational
expectation.
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Rational Expectations
• Rational expectations is based on the idea that
the world is a lot like a casino.
• In reality, nothing is certain. Let’s focus on
cases in which all uncertainty is associated
with aggregate demand – the rate of money
creation.
• The shocks to the AD is assumed to be
random.
• We say that is rational to calculate the inflation
using probabilities.
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Expected Price Inflation is Too Slow
P  P 


PL  P 
H
• Suppose that the probability that
is
p and the probability that P   P  is (1-p).
P  P 
• Then, the rational expectation of the inflation
rate is equal
 P 
 P 
 P 

p


(1

p
)







 P  rational
 P 
 P 
H
L
• This also can be viewed as the expectation of
the money creation.
• Lets consider two cases in which expectations
are not rational.
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The Determination of Inflation When
Expected Inflation Is Too Low
Figure 18.6
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The Determination of Inflation When
Expected Inflation Is Too High
Figure 18.7
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Rational Expectations of Price Inflation
• Rational expectations is a method of modeling
expectations that accounts for the ability of
human beings to adapt their environment.
• The rational expectation of the inflation rate is
equal to its average value which depends on
M / M .
• A consistent string of outcomes that are higher
(lower) than expected would cause workers and
firms to revise their expectations of inflation
upwards (downwards).
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The Rational Expectations of Inflation
Figure 18.8
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END