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Lecture 34

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26 views22 pages

Lecture 34

Uploaded by

abaidullah bhatti
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Review of the Previous

Lecture
• Three Models of Aggregate Supply
 The sticky-wage model
 The imperfect-information model
 The sticky-price model
Topics under Discussion
• Stick Price Model (cont.)
• Inflation, Unemployment and the Philips
Curve
– Causes of Inflation
– Sacrifice Ratio
– Rational Expectations
• Natural Rate Hypothesis
The sticky-price model
e  (1  s ) a 
P  P    (Y  Y )
 s 

• To derive AS equation by solving for Y :

Y  Y   (P  P e ),

s
where  
(1  s )a
The sticky-price model
In contrast to the sticky-wage model, the sticky-
price model implies a procyclical real wage:
Suppose aggregate output/income falls. Then,
 Firms see a fall in demand for their products.
 Firms with sticky prices reduce production, and
hence reduce their demand for labor.
 The leftward shift in labor demand causes the
real wage to fall.
Three Models of Aggregate
Supply
P LRAS
Y  (P P e )
Y 
e
P P
SRAS
P P e Each of the
three models of
P P e agg. supply imply
the relationship
Y summarized by
Y
the SRAS curve
& equation
Three Models of Aggregate
Supply
Suppose a positive AD
SRAS equation: Y  Y   (P  P e )
shock moves output
SRAS2
above its natural rate P LRAS
and P above the SRAS1
level people had
expected. P3  P3e
Over time, P2
AD2
P e rises, P2e  P1  P1e
SRAS shifts up, AD1
and output returns Y
to its natural rate. Y2
Y 3  Y1  Y
Inflation, Unemployment,
and the Phillips Curve
The Phillips curve states that  depends on
 expected inflation, e
 cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
 supply shocks, 

where  > 0 is an exogenous constant.


Deriving the Phillips Curve
from SRAS
(1) Y  Y   (P  P e )

(2) P  P e  (1  ) (Y Y )

(3) P  P e  (1  ) (Y Y )  

(4) (P  P1 )  ( P e  P1 )  (1  ) (Y Y )  

(5)    e  (1  ) (Y Y )  

(6) (1  ) (Y Y )    (u  u n )

(7)    e   (u  u n )  
The Phillips Curve and SRAS
SRAS: Y  Y   (P  P e )
Phillips curve:    e   (u  u n )  
• SRAS curve:
output is related to unexpected movements in
the price level
• Phillips curve:
unemployment is related to unexpected
movements in the inflation rate
Adaptive expectations
• Adaptive expectations: an approach that
assumes people form their expectations of future
inflation based on recently observed inflation.
• A simple example:
Expected inflation = last year’s actual inflation

 e   1

• Then, the P.C. becomes


   1   (u  u n )  
Inflation inertia
   1   (u  u n )  
• In this form, the Phillips curve implies that
inflation has inertia:
– In the absence of supply shocks or cyclical
unemployment, inflation will continue
indefinitely at its current rate.
– Past inflation influences expectations of
current inflation, which in turn influences the
wages & prices that people set.
Two causes of rising & falling
inflation
   1   (u  u n )  
• cost-push inflation: inflation resulting from
supply shocks. Adverse supply shocks typically
raise production costs and induce firms to raise
prices, “pushing” inflation up.
• demand-pull inflation: inflation resulting from
demand shocks. Positive shocks to aggregate
demand cause unemployment to fall below its
natural rate, which “pulls” the inflation rate up.
Graphing the Phillips curve
In the short 
run, policymakers
face a trade-off

between  and u. 1 The short-run

e
 Phillips Curve

u
un
Shifting the Phillips curve
People adjust their

expectations over
time, so the
tradeoff only holds  e2  
in the short run.

e
1 

e.g., an increase
in e shifts the short-
run P.C. upward. u
un
The sacrifice ratio
• To reduce inflation, policymakers can
contract aggregate demand, causing
unemployment to rise above the natural rate.
• The sacrifice ratio measures the percentage
of a year’s real GDP that must be foregone to
reduce inflation by 1 percentage point.
• Estimates vary, but a typical one is 5.
The sacrifice ratio
• Suppose policymakers wish to reduce inflation
from 6 to 2 percent. If the sacrifice ratio is 5, then
reducing inflation by 4 points requires a loss of
45 = 20 percent of one year’s GDP.
• This could be achieved several ways, e.g.
– reduce GDP by 20% for one year
– reduce GDP by 10% for each of two years
– reduce GDP by 5% for each of four years
• The cost of disinflation is lost GDP. One could
use Okun’s law to translate this cost into
unemployment.
Rational expectations
Ways of modeling the formation of
expectations:
 adaptive expectations:
People base their expectations of future
inflation on recently observed inflation.
 rational expectations:
People base their expectations on all
available information, including information
about current and prospective future policies.
Painless disinflation?
• Proponents of rational expectations believe
that the sacrifice ratio may be very small:
• Suppose u = u n and  = e = 6%,
and suppose the central bank announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
• If the announcement is credible,
then e will fall, perhaps by the full 4 points.
• Then,  can fall without an increase in u.
The natural rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters, is
based on the natural rate hypothesis:

Changes in aggregate demand affect output and


employment only in the short run.
In the long run, the economy returns to the levels
of output, employment, and unemployment
described by the classical model
An alternative hypothesis:
hysteresis
• Hysteresis: the long-lasting influence of history on
variables such as the natural rate of unemployment.
• Negative shocks may increase u n , so economy may
not fully recover:
 The skills of cyclically unemployed workers deteriorate
while unemployed, and they cannot find a job when the
recession ends.
 Cyclically unemployed workers may lose their influence on
wage-setting; insiders (employed workers) may then
bargain for higher wages for themselves. Then, the
cyclically unemployed “outsiders” may become structurally
unemployed when the recession ends.
Summary
• Inflation, Unemployment and the Philips
Curve
– Causes of Inflation
– Sacrifice Ratio
– Rational Expectations
• Natural Rate Hypothesis
Upcoming Topics
• Government Debt and Budget Deficit
– Size of Govt. Debt
– Problems in measurement

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