Transcript Phillips Curve and Demand Management

Wither the Phillips Curve?
Activist demand management
or
Laissez – faire ?
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Phillips Curve: Demand Side
Inflation – Unemployment Tradeoff
A.W. Phillips (1958): found wages rose with
falling unemployment in UK
an inverse relation between wage
inflation and unemployment.
– Paul Samuelson and Robert Solow: an
inverse relation between CPI inflation and
unemployment in the US.
– A downward-sloping “Phillips Curve”
 a policy trade-off between inflation
and unemployment.
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Phillips Curve,
United States,
1961–1969
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United States
1955–2000
The relationship
broke down
when
policymakers
tried to apply it
 no evidence
of a long-run
Phillips Curve.
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A Shifting
Phillips
Curve?
How to reconcile
the long-run data
with the Phillips
Curve trade-off:
Treat the longrun as a series
of short-run
curves.
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Aggregate Demand and Supply
 Phillips Curve
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Expectations
and the Phillips Curve
• Starting at (1): 5%
unemployment and 3%
inflation. People believe
inflation will continue at 3%
 Curve I.
• Then Fed hypes inflation to
6%  unemployment falls to
3% (Point 2 on Curve I).
• Expectations adjust to 6%
inflation  Wage demands
up  Economy moves to
point (3) Unemployment
returns to 5%.
• If expectations adjust
instantly, e.g., anticipating
Fed’s policy, economy moves
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directly from (1) to (3).
Inflation, Unemployment,
and Wage Expectations
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Inflation, Unemployment, and
Inventories
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Inflation, Unemployment,
and Wage Controls
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Expectations Formation
Adaptive Expectations: expectations of the
future based on history
The public acts on its expectations
The present depends on the past
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Expectations Formation
Rational Expectations: expectation based
on all available relevant information.
– The public understands how the economy
works.
– The public knows the structure and
linkages between variables in the
economy.
– The public anticipates policy actions and
their consequence
– The public acts now on its expectations
The present depends on the future
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Time Inconsistency: Kydland & Prescott
A policy is time inconsistent if it seems a
good idea at one time but becomes a bad
idea later.
– The way people anticipate and react to a policy
may make a “good” policy “bad”
Time inconsistency hurts the Fed’s
credibility.
– It’s hard to believe the Fed will stick to a tight
money policy once unemployment rises.
– People anticipate monetary easing and inflation
 INFLATION
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Time
Inconsistency:
An Example
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The Political Business Cycle:
If a short-run Phillips Curve trade-off exists, an incumbent
administration may hype demand and lower unemployment
before an election … and then rein prices in with a recession
after the election.
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The Political Business Cycle
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Real Business Cycles: Kydland and Prescott
Recessions and expansions may be
triggered by real shocks to the economy.
– Oil price shocks in the early 1970s 
higher production costs  inward shift of
AS  severe recession of 1973-1975.
Technological or productivity shocks may
also cause expansions or contractions.
– Gone fish’n’ in the 1930s?
“Real business cycles” are supply-side
cycles, not demand-side cycles.
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Real Business Cycles in Pictures
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The Government Budget Constraint
Budget constraint highlights the relation
between monetary and fiscal policy:
G - T = Bonds To Public+ Bonds to Fed
M = change in the money supply
m = Money multiplier
M = m x Bonds to Fed
(G – T) is the fiscal surplus or deficit.
Governments can offset the need to tax or to
borrow from the public by “printing” money
 Inflation Tax.
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