Transcript Document

Ch. 16: Expectations Theory and
the Economy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Phillips Curve Analysis
• The Phillips curve suggests that the rate of change
of money wage rates (wage inflation) and
unemployment are inversely related.
• This suggests a tradeoff between wage inflation
and unemployment. Higher wage inflation means
lower unemployment.
• It was impossible to lower both wage inflation and
unemployment: It was possible to do one or the
other.
• The good news was that high unemployment and
high wage inflation did not go together.
Theoretical Explanations for the
Phillips Curve
• Early explanations
focused on the state of
the labor market given
changes in aggregate
demand.
• Businesses must offer
higher wages to obtain
additional workers.
Americanizing the Phillips Curve
• Economists concluded that stagflation, or
high inflation together with high
unemployment was extremely unlikely.
• The Phillips curve gave policy makers a
menu of choices.
• To Keynesian economists, it was simply a
matter of reaching the right level of
aggregate demand.
The Phillips Curve & a Menu of
Choices
Samuelson and Solow’s
early work using American
data showed that the
Phillips curve was
downward sloping.
Economists reasoned that
stagflation was extremely
unlikely and that the
Phillips curve presented
policy makers with a menu
of choices: Point A, B, C,
or D.
Are There Two Phillips Curves?
• Economists began to question the Phillips
curve in the 1970s and early 80s.
• Focusing on the period of 1970 – 1996, we
notice that stagflation is possible.
• The Existence of stagflation implies that a
tradeoff between inflation and
unemployment may not always exist.
The Diagram
That Raises
Questions:
Inflation and
Unemployment
1961-1996
Friedman and the Natural Rate
Theory
• There are Two not One Phillips Curves.
• There is a Short Run Phillips Curve, and a
Long Run Phillips Curve.
• There is a tradeoff between inflation and
unemployment in the Short Run, but not in
the Long Run.
Friedman’s Theory
• In Window 1, we assume
that the expected inflation
rate and the actual inflation
rate are the same.
• The results of an increase
in aggregate demand with
no change in the expected
inflation rate are an
increase in Real GDP
(Window 2) and a
corresponding decrease in
the unemployment rate
(main diagram). The
economy has moved from
point 1 to 2.
Friedman’s Natural Rate Theory
• The short-run Phillips curve exhibits a tradeoff
between inflation and unemployment, while the
long-run Phillips curve does not.
• This is the Friedman Natural Rate Theory: in the
long run, the economy returns to its natural rate of
unemployment and the only reason it moved away
from the natural unemployment rate in the first
place was because workers were “fooled” (in the
short run) into thinking inflation was lower than it
really was.
The Mechanics of the Friedman’s
Natural Rate Theory
How Do People Form
Expectations
• Individuals form their
expected inflation rate
by looking at past
inflation rates.
• A person who forms
an opinion this way is
said to hold adaptive
expectations.
Q&A
• What condition must exist for the Phillips curve to
present policymakers with a permanent menu of
choices between inflation and unemployment?
• Is there a tradeoff between inflation and
unemployment? Explain your answer.
• The Friedman natural Rate Theory is sometimes
called the “fooling” theory. Who is being fooled
and what are they being fooled about?
Rational Expectations
• Rational expectations holds
that individuals form the
expected inflation rate not
only on the basis of their past
experience with inflation, but
also on their predictions
about effects of present and
future policy actions and
events.
• The expected inflation rate is
formed by looking at the past,
present, and future.
Do People Anticipate Policy?
Not all persons need to
anticipate policy. As
long as some do, the
consequences may be
the same as if all
persons do.
New Classical Theory: Effects of
Unanticipated and Anticipated Policy
Unanticipated Policy:
• In the Short Run, the
economy has moved up
the short-run Phillips
curve to a higher inflation
rate and lower
unemployment.
• In the Long Run, workers
correctly anticipate the
higher price level and
increase their wage
demands accordingly.
Anticipated Policy:
• There is no short run
trade off between
inflation and
unemployment.
• The Short Run Phillips
Curve and the Long
Run Phillips Curve are
the same: the Curve is
vertical.
Rational Expectations in an ADAS Framework
Policy Ineffectiveness Proposition
• If the rise in aggregate demand is unanticipated, there is a
short run increase in Real GDP, but if the rise in aggregate
demand is correctly anticipated, there is no change in Real
GDP.
• If the expansionary policy change is correctly anticipated,
individuals form their expectations rationally, and wages
and prices are flexible, then neither expansionary fiscal
policy nor expansionary monetary policy will be able to
increase Real GDP and lower the unemployment rate in the
short run.
• If under certain conditions, expansionary monetary and
fiscal policy are not effective at increasing Real GDP and
lowering the unemployment rate, the case for government
fine-tuning is questionable.
• People believe the Fed
will increase aggregate
demand by increasing
the money supply, but
they incorrectly
anticipate the degree to
which aggregate
demand will be
increased.
• A policy designed to
increase Real GDP and
lower unemployment
can do just the opposite
if the policy is less
expansionary than
anticipated.
Rational Expectations
and Incorrectly
Anticipated Policy
How to Fall into a Recession
Without Really Trying
• If government says it will do X but instead it
continues to do Y, the people will see
through the charade: the equation in their
heads will read “Say X=Do Y.”
• If the Fed says it is going to do X, then it
had better do X, because if it doesn’t, then
the next time it says it is going to do X, no
one will believe it, and the economy may
fall into a recession as a consequence.
Q&A
• Does the policy ineffectiveness proposition (PIP)
always hold?
• When policy is unanticipated, what difference is
there between the natural rate theory built on
adaptive expectations and the natural rate theory
built on rational expectations?
• If expectations are formed rationally, does it
matter whether policy is unanticipated, anticipated
correctly, or anticipated incorrectly? Explain your
answer.
New Keynesians and Rational
Expectations
• New classical theory assumes complete flexibility
of wages and prices.
• New Keynesian rational expectations theory
assumes rational expectations is a reasonable
characterization of how expectations are formed,
but drops the assumption of complete wage and
price flexibility.
• Long-term labor contracts often prevent wages
and prices from fully adjusting to changes in the
anticipated price level.
New Keynesians and Rational
Expectations
• Workers may realize that the
anticipated price level is higher
than they expected but will be
unable to do anything about it
until they renegotiate their
contracts.
• Keynesian economists today put
forth microeconomic-based
reasons why long-term labor
contracts and above-market
wages are sometimes in the best
interest of both employers and
employees.
The Short-Run Response to Aggregate Demand
Increase Policy (In the New Keynesian Theory)
Starting at point 1, an increase
in aggregate demand is
anticipated. As a result, this
short-run aggregate supply
curve shifts leftward, but not
all the way to SRAS2. Instead
it only shifts to SRAS2'
because of some wage and
price rigidities; the economy
moves to point 2' and Real
GDP increases from QN to
QA.
Looking at Things from the Supply
Side: Real Business Cycle Theorists
• Changes on the supply side of the economy can
lead to changes in Real GDP and unemployment.
• A decrease in Real GDP can be brought about by a
major supply-side change that reduces the capacity
of the economy to produce.
• What looks like a contraction of Real GDP
originating on the demand side of the economy
can be, in essence, the effect of what has happened
on the supply side.
Real Business Cycle Theory
Real Business Cycle Theory
• It is easy to confuse a demandinduced decline in Real GDP
with a supply-side induced
decline in Real GDP.
• The cause-effect analysis of a
contraction in Real GDP would
be turned upside down.
Changes in the money supply
may be an effect of a
contraction in Real GDP and
not its cause.
Q&A
• The Wall Street Journal reports that the
money supply has recently declined. Is this
consistent with a demand-induced or
supply-induced business cycle, or both?
Explain your answer.
• How are New Keynesians who believe
people hold rational expectations different
from new classical economists who believe
people hold rational expectations?