Transcript Chapter 13
Chapter 13 Inflation Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-1 Learning objectives • Derive and examine the implications of the so-called Phillips curve • Discuss whether there is any apparent trade-off between unemployment and inflation • Examine the natural rate hypothesis and use it to analyse Australia’s experiences with stagflation Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-2 Learning objectives (cont.) • Explore the links between the Phillips curve model and our model of aggregate supply • Discuss demand-pull and cost-push inflation in light of our understanding of the Phillips curve Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-3 Phillips curve: introduction • The aggregate expenditure model developed in Chapter 6 assumed that the economy could experience either unemployment or inflation but not both concurrently • Realistically both can occur as shown in the intermediate range of the AS curve • The simultaneous occurrence of increasing unemployment and inflation known as stagflation was a common macroeconomic problem in the 1970s and early 1980s • Stagflation was due to the leftward shift of the AS curve Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-4 Phillips curve • An inverse relationship suggestive of a trade-off between inflation and the unemployment rate • Generalisation – The greater the rate of growth of AD, the greater the resulting inflation and GDP, and the lower the unemployment level – The slower the rate of growth of AD, the lower the resulting inflation and GDP, and the higher the unemployment level Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-5 Changes in AD, real GDP and the price level ASLR Price level AD0 AD1 AS P2 AD3 P1 P0 0 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Q0 Q1 Q2 Real GDP 13-6 Phillips curve (cont.) • Evidence – Empirical work by economists in the 1950s and 1960s • Explanations for the trade-off between unemployment and inflation – Labour market imbalances Bottlenecks Structural problems – Market power of unions and big business Higher wages are passed on to the consumers Market power enables firms to seek higher profits (profit-push) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-7 The Phillips curve concept Annual rate of inflation (per cent) 7 6 as inflation declines... 5 unemployment increases 4 3 2 1 0 1 2 3 4 5 6 7 Unemployment rate (per cent) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-8 Phillips curve (cont.) • Stabilisation policy dilemma – Fiscal and monetary policies act on AD and not on labour market imbalances and market power • Two complications – Reversibility problem Price levels are usually flexible upwards, but quite inflexbile downwards – The Phillips curve assumed a fixed AS curve, but AS curve can shift leftwards for various reasons • Not a reliable basis for economic policy Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-9 Stagflation: a shifting Phillips curve Stagflation • Simultaneous experience of both high and increasing unemployment and inflation • Conflicts with the trade-offs embodied in the Phillips curve Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-10 Stability of the Phillips curve Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-11 Causes of stagflation • Aggregate supply shocks such as severe increases in fuel costs ( the OPEC oil shock), and devaluations of the Australian dollar • Productivity decline • Inflationary expectations and wages – Expectations about the likely future path and rate of increase of the general price level Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-12 Aggregate supply shocks Price level AS3 ASLR AS2 AS1 P3 P2 P1 AD1 0 Q3 Q2 Q1 QF Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Real GDP 13-13 Natural rate hypothesis • Suggests that there is a unique level of unemployment around which observed unemployment will fluctuate • LR stability corresponds with natural or fullemployment rate of unemployment • Two variants – Theory of adaptive expectations – Rational expectations theory Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-14 Theory of adaptive expectations • People form their expectation of future inflation based on previous and current rates of inflation • There is a short-run trade-off between unemployment and inflation, but in the long run no such trade-offs exists Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-15 Theory of adaptive expectations (cont.) • Consequently, there exists a short-run and a long-run Phillips curve • Series of short-run Phillips curves – Short-run trade-offs between inflation and unemployment • Long-run vertical Phillips curve • Can be employed to explain disinflation – Reductions in or elimination of the rate of inflation Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-16 Adaptive expectations theory PC3 PCLR Rate of interest (% p.a) PC2 12 A4 B3 PC1 A3 B2 9 6 A2 B1 C3 C2 A1 3 0 2 4 6 8 Unemployment (%) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-17 Rational expectations theory • Increases in money wages lag behind increases in the price level, giving rise to temporary increases in profits and employment • Argues that government measures to increase employment will only result in accelerating rates of inflation Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-18 Short-run aggregate supply • Short run: period in which input prices (especially wages) remain fixed in the presence of a change in the price level • Constant input prices – Lack of knowledge of existence of change – Fixed-wage contracts Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-19 Long-run aggregate supply • Long run: period in which input prices, including wages, are fully flexible in the presence of changes in the price level • Increasing input prices – Workers discover that prices have changed and demand higher nominal wages to restore their level of real wages Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-20 New classical policy implications • Price-level surprises – May create short-run macroeconomic instability – However, long-run stability occurs at fullemployment level of output • Long-run occurs either instantaneously or in a very short period • Government intervention is not endorsed Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-21 Short-run and long-run AS AS1 A2 P1 P3 A1 A3 Q3 Q1 B1 P2 Price Level Price level P2 Q2 AS2 PCLR Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal A2 AS3 A1 P1 A3 C1 P3 Real GDP (a) Short-run AS AS1 Qp Real GDP (b) Long-run AS 13-22 Modern Keynesian policy implications • Markets are not highly competitive – Instantaneous adjustments do not occur • Nominal wage adjustments are very slow • Stabilisation policies are required to reduce the severe costs of unemployment or inflation Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-23 Demand-pull inflation • Occurs when an increase in AD pulls up the price level • Graphically — AD shifts rightward along a stable AS curve • Short-run — increased prices and real output Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-24 Demand-pull inflation (cont.) AS2 ASLR Price level AS1 P3 e3 e2 P2 P1 e1 AD2 AD1 0 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Q1 Q2 Real GDP 13-25 Demand-pull inflation (cont.) • In the short run, demand-pull inflation will drive up the price level and increase output • In the long run, the increase in aggregate demand has only moved the economy along the vertical aggregate supply curve ASLR Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-26 Cost-push inflation • Occurs when an increase in the cost of production at each price level shifts the AS curve leftward, resulting in increased prices • Short run — increased prices and decreased real output (and more unemployment) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-27 Price level Cost-push inflation (cont.) ASLR AS2 AS1 P3 e′3 e′2 P2 P1 An attempt to increase AD will only further increase the price level e′1 AD2 AD1 0 Q2 Q1 Q3 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Real GDP 13-28 Cost-push inflation and policy dilemma • Government intervention (AD): If government intervenes to increase AD, an inflationary spiral will result • No government intervention (AD): If government does not intervene to increase AD, severe recession will result; however, nominal wages will eventually decline and restore AS to original position Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-29 Cost-push inflation: non-demand management options • Two categories of non-demand management policies – Market policies – Wage–price (or incomes) policies Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-30