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ECOS2002 Intermediate Macroeconomics Lecturer: Matthew Smith

ECOS2002 Intermediate Macroeconomics Lecturer: Matthew Smith. Topic 6 Inflation and Unemployment: The Phillips Curve Framework. School of Economics Faculty of Arts and Social Science. Explaining Inflation.

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ECOS2002 Intermediate Macroeconomics Lecturer: Matthew Smith

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  1. ECOS2002Intermediate MacroeconomicsLecturer: Matthew Smith Topic 6 Inflation and Unemployment: The Phillips Curve Framework School of Economics Faculty of Arts and Social Science

  2. Explaining Inflation • Price inflation is usually explained by reference to its original cause (or ‘catalyst’). • Identifying the main source of inflationary pressures - whether its originates from the supply side or demand side - is important in framing an effective anti-inflationary policy. • Example: a restrictive macroeconomic policy is likely to be effective in countering inflation caused by a demand shock, but will be less effective if the inflation is the result of a supply shock. • The ‘sources’ or ‘causes’ of inflation are usually divided into either ‘demand-pull’ inflation or ‘cost-push’ inflation.

  3. Demand-Pull Inflation • Refers to price inflation as a result of an excess aggregate demand for products associated with an excess demand for productive resources, especially labour. • Excess demand will consist of an aggregate demand which, given productive capacity, exceeds a level of output at which there is price stability (i.e. zero rise in the inflation rate). In AS-AD model excess demand is defined by: AD > YN P

  4. Demand-Pull Inflation SAS2 (P2e) SAS1 (P1e) P2e = P2 SAS (Pe) P1e = P1 AD2 Pe =P AD1 AD YN Y Y1

  5. Cost-Push Inflation Refers to price inflation caused by supply-side disturbances that cause an exogenous increase in the average costs of production in absence of any excess demand pressures in the economy. This can stem from the following causes:  Increase in the general level of money wages in excess of labour productivity growth by organised labour seeking higher ‘real wages’. • An exogenous increase in the mark-up over the cost of production by producers according to ‘monopoly’ power. • An exogenous increase in the price of material inputs with inelastic demand (i.e. limited substitutes such as oil). • A depreciation in the (nominal) exchange rate so raising the prices of (inelastic) imported inputs. • Increase in government charges and indirect taxes (e.g. GST). • Natural disasters, climatic conditions causing unproductive agricultural seasons, war and obstacles to trade and transport.

  6. Cost Push Inflation and Stagflation LAS P SAS1 SAS P2 P1 P* ADE AD ADC YN Y1 Y Y2

  7. Persistence of Inflation • While demand and supply shocks can cause a one-off increase in the rate of inflation, the question is why does a higher rate of inflation persist well after these shocks have abated? • The persistence of inflation basically requires a ‘wage-price’ spiral to continuously induce higher production costs and price level. • role of price expectations and ‘real’ income targeting • conflict over the distribution of income following a supply shock - whereby the inflationary process persists as a result of incompatible claims by social groups over (net) ‘real’ aggregate income.

  8. Incomes Policy • An approach which has been employed to curb price inflation is an incomes policy (e.g. 1980s ‘Accord Agreement’ in Australia) to short-circuit the conflict causing the wage-price spiral as connected with a reduction in net ‘real’ aggregate income. Attempts to more compatibly spread the burden of lower real income among social groups. • money wage growth geared to labour productivity growth • measures to moderate profit margins (or mark-up) connected with ensuring more competitive markets

  9. Inflation and Monetary Accommodation The persistence of price inflation also requires monetary accommodation. Refer to the monetary equation: M.V = P.Y Mt + Vt ≈πt + Yt For the inflation rate to increase it must be accommodated by an increase in the growth of effective money supply (Mt + Vt) so that for πt> 0: Mt + Vt >Yt • On the basis of the quantity theory of money the monetarists argued that all inflation, whatever the original cause, is always a monetary problem in the sense that by controlling M (i.e.Mt) the inflation can be brought to an end by stopping its monetary accommodation.

  10. Inflation and the Quantity Theory • The crucial issue is whether by controlling M (orMt) it is then possible to control M.V (orMt + Vt)? The quantity theory supposes that V is stable in the long-run, determined by institutional factors in the financial system independent of M. This ensures causality runs unambiguously from M.V to P.Y. • The endogenous money view is that V is not stable and in fact responds to changes in M so that a reduction in M will, through institutional changes tend in the long run to lead to an increase in V. By trying to control M the authorities lose effective control over V. • Effective influence over inflation by a central bank depends on monetary policy conducted through interest rates not the quantity of money.

  11. The Phillips Curve % πt= f (u) +  πt, wt πt1 πt2  0% u% u1% u2%

  12. Explanatory Problem of the Phillips Curve in the 1970s • Named after A.W. Phillips, ‘The Phillips Curve’ was based on a long standing empirical relationship between wage inflation and the rate of unemployment first established in 1959. In the 1960s, a period of relatively low inflation and unemployment, it became a popular framework for explaining inflation and unemployment used in policymaking. • By the 1970’s the Phillips Curve became discredited by the phenomenon of accelerating inflation together with rising unemployment so that any trade-off appeared to disappear. • It was noticed that price inflation persisted for a longer period of time which caused a focus on the role of expectations in inflation.

  13. Expectations Augmented Phillips Curve • Led by Milton Friedman, there were two central criticisms of the Phillips Curve: (1) it did not account for inflationary expectations by agents; and (2) it did not provide a precise definition of excess demand conditions which induced the acceleration of inflation. • In response to these criticisms a Philips Curve framework was developed to reflect the empirical evidence after 1970 that rather than there being an inverse trade-off between the inflation rate and the unemployment rate there was a trade-off between the change in inflation rate and the unemployment rate (see diagram below). • The reconstructed Phillips Curve framework incorporated both inflationary expectations into the analysis and provided a precise definition of excess demand by reference to the difference between the unemployment rate and the natural rate of unemployment.

  14. Australian Evidence for Expectations- Augmented Phillips Relation Changes in Inflation versus Unemployment in Australia,1970-2005 • The line that best fits the scatter of points for the period 1970-2005 is: Since 1970, there has been a negative relation between the unemployment rate and the change in the inflation rate in the Australia. pt- pt-1 = 1.87% – 0.3 u t(2.12) (2.40)

  15. Expectations-Augmented Phillips Curve πt= a [(un / ut) - 1] + b πet 1. Excess demand/supply pressures causing changes in the rate of inflation is expressed by first term: πt= a [ un / ut – 1] where a is a parameter which defines the negative relationship (or slope of SRPC) between ut and πtfor given un. It defines an inverse relationship between πtand ut, as follows: ut 0% :πt  ut 100% (umax):πt -a % ut =un :πt 0

  16. Short-Run Phillips Curve (SRPC) % πt Excess Demand (ut < un) Excess Supply (ut > un) πt = a [ un / ut – 1] u% 0 % un% - a %

  17. Expected Inflation Rate 2. The expected inflation rate feeding into the actual inflation rate in the equation is expressed by the term: +b πet where b represents the extent to which expected inflation feeds into the actual inflation rate and 0 <b  1. • Providing agents seek target ‘real’ incomes they will not overcompensate so that b  1; while, if b < 1, this represents the ‘stickiness’ in adjustment of πt to πetover time.

  18. Short-Run Phillips Curve (SRPC) For each value ofπetthere is a different SRPC. SRPC:πt = a [(un / ut) - 1] + b πet Assumingb = 1, then each SRPC will intersectunat πt=πetso that: Zero excess demand/supply: ut = un, πtconstant Excess demand: ut < unπt >πet, πtaccelerates Excess Supply: ut > unπt <πet, πtdecelerates

  19. Long-Run Phillips Curve (LRPC) The LRPC is vertical at un at which the inflation rate is constant over time: πt=πet , if ut= un (assuming b = 1) • One interpretation of LRPC is that it represents a position of long–run macroeconomic equilibrium in which the labour market has cleared and the real wage is at its equilibrium level. • An alternative interpretation refers to it as simply a position of ‘Non-accelerating Inflation Rate of Unemployment’ (NAIRU) with a different conception of its meaning from un.

  20. Expectations Augmented Phillips Curve Framework πt % LRPC or NAIRU LRPC: un = ut SRPC: πt = a [(un/ut) - 1] + b πet πt= 15% SRPC4 (te = 15%) πt= 10% SRPC3 (te = 10%) πt = 5% SRPC2 (te = 5%) u% un% SRPC1 (te = 0 %)

  21. Adaptive Expectations Formation Agents’ expected rate of inflation in the current period (πet) is equal to the actual inflation rate in the previous period (πt-1): πet = πt-1 SRPC:πt = a [(un / ut) - 1] + b πt-1 ut<un πt > πt-1 (with b = 1):Excess Demandut>un πt < πt-1 (with b = 1):Excess Supply LRPC: ut = unπt= πt-1(with b = 1)

  22. Rising Price Inflation πt % LRPC or NAIRU πt = 20% πte = 20% πt = 15% πte = 15% πt = 10% πte = 10% πt = 5% πte = 5% u% u1% un% πte = 0%

  23. Disinflation Policy πt % LRPC or NAIRU πt = 15% πt = 10% πte = 15% πt = 6% πte = 10% πt = 3% πte = 6% u% un% u1% πte = 3%

  24. Rational Expectations Model Agents do not make systematic errors in forming their expectation of the inflation rate. πet = πt + t where t is a randomly distributed error term with zero mean. πt= a [(un / ut) - 1] + b (πt + t) Given that over time t = 0 so that πet = πt, then, if b = 1, ut = un, the SRPC is synonymous with LRPC. Implication: No short-run trade-off between inflation rate and unemployment rate.

  25. πet < πt u1% Rational Expectations Hypothesis πt % LRPC(= SRPC) 15% πt = 0% u% un%

  26. Disinflation Policy and Hysteresis • Hysteresis is the notion that a disinflation policy conducted by a central bank leads to a permanently higher rate of unemployment (i.e. higher NAIRU). • Developed in the aftermath of the experience of severe recession and enduring high unemployment rates which followed the disinflation policies implemented in the US and UK in early 1980s. • Essentially based on the proposition that inflationary expectations are ‘sticky’ downward because of wage rigidities and imperfections in the labour market.

  27. Hysteresis πt % NAIRU NAIRU1 πt= 12% πt= 8% πte = 12% πt= 4% πte = 8% πte = 4% u% un% un1% u1 πte1 = 0%

  28. Monetary Policy and Inflation Targets • The comparative advantage of monetary policy lies in containing inflation rather than stimulating activity and employment. • Affording central banks institutional independence will enhance the ‘credibility’ of an anti-inflationary monetary policy • An inflation ‘target’ (e.g. 2-3%) also gives policy more ‘credibility’ to influence inflationary expectations and reduce adjustment costs.

  29. The Path of Disinflation This figure shows the path of unemployment and inflation stemming from a hypothetic disinflation policy. The social cost of disinflation depends on the path of disinflation Example: Path consists of five years of unemployment above the natural rate of unemployment lead to a permanent decrease in inflation.

  30. Measuring the Social Cost of a Disinflation Policy • The social cost can be measured by the trade-off of the higher accumulated unemployment rate required to achieve the reduction in the inflation rate. This trade-off is reflected theoretically by the slope along expectations-augmented Phillips curves. • A point-year of excess unemployment is a difference between the actual and natural unemployment rate of one percentage point for one year. Example: un = 6%, ut = 8% for 4 years 4 ×(8 – 6) = 8 point-years of excess unemployment

  31. Sacrifice Ratio • The sacrifice ratio is the number of point-years of excess unemployment needed to achieve a decrease in inflation of 1%. • Example: Suppose it has been empirically calculated for Australia that on average an excess unemployment of 1% causes 0.3% reduction in the inflation rate. This implies a sacrifice ratio of 3.33 in which a 1% disinflation requires 3.33 point-years of excess unemployment (i.e. = (ut – un)/(πt– πt –1)). The RBA could force excess unemployment of 3.33 percentage points for 1 year, 1.66 for 2 years, or 1.11 for 3 years.

  32. The Australian Disinflation Experience, 1989-1994 Cumulative unemployment is the sum of point-years of excess unemployment from 1990 on, assuming a natural rate of unemployment of 6.2%. Cumulative disinflation is the difference between inflation in a given year and inflation in 1989. The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation. TABLE: Inflation and Unemployment in Australia

  33. Okun’s Law and Unemployment Policy Targets • Okun’s Law refers to the relationship between the growth in output and changes in the unemployment rate over time. • It shows the benchmark growth rate necessary to maintain a constant rate of unemployment – that is, the growth rate necessary to prevent the unemployment rate from increasing. • It can also indicate the sustained growth rate of real GDP necessary to achieve, through macroeconomic policy, a target rate of unemployment.

  34. To derive this relationship we begin with the simple equation: Q = E x Q/E Re-written as: Q = E x APL where Q is output, E is employed labour and APL is average labour productivity. We then transform the above into changes: %ΔQ  %ΔE + %ΔAPL such that the growth in output is approximately equal to the growth in labour employment plus the growth in labour productivity. Okun’s Law

  35. Okun’s Law • To maintain a constant rate of unemployment, employment growth (%ΔE) must equal the growth in the labour force (%ΔLF); that is, the demand for labour must be sufficient to absorb the supply of labour. • Labour force growth will depend on demographic factors such as population growth (i.e. on the birth and death rate and immigration rate), the participation rate and the age structure of the working population.

  36. Okun’s Law • For the unemployment rate to remain constant, the growth rate must be approximately equal the growth in the labour force plus the growth in labour productivity: %ΔQ  %ΔLF + %ΔAPL Thus, if we assume %ΔAPL = 1% per annum and %ΔLF = 2%, then the benchmark %ΔQb = 3% to prevent unemployment from rising. In Australia %ΔQb has been estimated at 3.3% where 1.9  %ΔLF and 1.4  %ΔAPL. This means that: %ΔQ > %ΔQb↓u% %ΔQ < %ΔQb↑u%

  37. Australian Evidence of Okun’s Law, 1983-2005 High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemploymentrate. Changes in the Unemployment Rate versus Output Growth in Australia, 1983-2005

  38. Estimating Equation for Okun’s Law in Australia, 1983-2005 • The line that best fits the twenty years of data shown in the previous slide’s scatter diagram is given by the equation: ut – ut-1 = -0.5 (gt – 3.3) • To maintain the unemployment rate constant the growth rate must on average be 3.3% per annum. • Hence, to reduce the unemployment rate the growth rate must on average be greater than 3.3%. Example: Suppose policymakers aim to reduce the unemployment rate from 10% to 5% in 5 years. This would require gt ≥ 5.3% for 5 years, calculated from 5% –10% = -0.5 (gt – 3.3%)5.

  39. Monetary Policy and Nominal versus Real interest rates • While central banks can directly influence nominal interest rates, the effectiveness of their monetary policy relies on them being able to influence real rates of interest. It is through changes in the real rate of interest that central banks can influence economic activity and achieve their policy goals. • The real rate of interest is the return on a financial asset after discounting the nominal rate of interest by the expected inflation rate. Essentially the real rate measures the purchasing power of the nominal return on a financial asset. • Therefore central banks can at best only indirectly influence real interest rates by influencing the inflation rate and, thereby, inflationary expectations.

  40. Nominal and Real Rate of Interest (1+ rt) = (1 + it) Pt/ Pet+1(1) where Pet+1 /Pt =1 + et inverting,Pt/ Pet+1 = 1/(1 + et) where et = (Pet+1/Pt)/ - 1 Re-writing equation (1) above: (1+ rt) = 1 + it / 1 + et(2)

  41. Deriving Real Interest Equation Equation (2): (1+ rt) = 1 + it / 1 + et Re-arranging:(1+ rt) (1 + et) = 1 + it Expanding:1 + rt + et + rtet = 1 + it Then, reducing:rt + et + rtet = it Assuming the cross-variable, rtet , is small then we can obtain the following ‘approximating’ equation by simple re-arrangement: rt  it–et(3)

  42. Nominal and Real Interest Rates in Australia, 1975-2008 ---= nominal interest rate – actual future inflation rate • While the nominal interest rate has declined considerably since 1980, the real interest rate was actually higher in 2008.

  43. IS-LM Model with Long-Run Equilibrium Consider a IS-LM model in which aggregate demand is interest- responsive to the real rate of interest rather than the nominal rate: A (r). IS Function: Y = A (r) + Ā + (c–ct–m)Y re-written as: Y = A (i - e) + Ā + (c–ct–m)Y LM Function:M/P = YL (i) ;i=r + e + a ( - T) Long-run equilibrium is characterised by: (1) e = ;(2) =T;(3)Y = YN;&(4) in = rn + e where rn is the natural real rate determined by real forces and Ā above is its long run value based one = . • This assumes expected inflation adjusts to the actual inflation rate in the long run not in the short run. It also assumes the central bank can in the long run systematically achieve their inflation target by adjusting the nominal rate in response to the actual inflation rate diverging from the target rate.

  44. Disinflation Monetary Policy, the Nominal and Real Interest Rate B: iB > iA, πeB = πeA,rB > rA i C: iC < iA, πeC < πeA, r = rA , ↓∆πe ↓Ā B iB LMB πeB A iA iA LMA rB LMC iC πeA C πeC ISA rA ISC Y YN YB

  45. Adjustment from Short to Long Run i, r iA = in= rn+ πT iC = in1 = rn + πT1, where πT1 < πT iB iA Nominal interest rate rB iC rn= rA Real interest rate t Time

  46. Fisher Hypothesis • The Fisher Hypothesis, named after the American economist, Irving Fisher, proposes that in the long run the nominal rate of interest will be influenced by, and tend to move in sympathy with the inflation rate. • The argument in our IS-LM model rests much on the central bank responding to inflationary pressures by adjusting its policy, as conducted through altering the short rate on liquid funds. • There is evidence that independent of monetary policy higher (lower) inflation tends to cause rates on longer-term assets to increase (decline) relative to short rates due to a reduction (increase) in their market demand inducing a decline in asset prices (e.g. bond prices).

  47. Australian Evidence of the Fisher Hypothesis

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