Inflation, Unemployment and Monetary Policy

1. Inflation, Unemployment and Monetary Policy Mankiw 14.2

2. Learning Objectives • Understand the relationship between inflation and unemployment (the Philips Curve) • Understand what is the optimal level of inflation • Understand the modern prescription for independent central banks

3. Phillips Curve • The Philips Curve relates Unemployment to inflation • Similar to AS curve • Unemployment and inflation are of direct interest • Also Prices are usually rising so makes more sense to talk of declining inflation than declining prices

4. The Philips Curve mirrors the AS curve • Price level replaced by inflation • Output replaces unemployment • Natural rate of unemployment replaces potential output • In the SR there is a trade-off between inflation and unemployment • this is only for fixed expectations • In the LR there is no trade off

5. LRPC p SRPC(pe) U* U

6. Sources of Inflation • The Phillips curve tells us three sources of inflation • Expectations • Unemployment gap (demand pull) • Supply shocks (cost push) • First expectations: • If people expect inflation then actual inflation will occur • Self-fulfilling prophecy

7. How does it work? • Expect price increases • Demand higher wages • Need higher prices to pay for the wages • Same mechanism as before • Supply shocks • e.g. increase in price of oil • Feeds through to increase all other prices • Workers demand increase in wages to compensate • General inflation

8. Unemployment gap • Suppose increases AD to reduce unemployment (eg G rises) • Prices are driven up • Demand for labour shifts up • Workers revise expectations (else real wage would fall) • Expect inflation so actual wages are bid up (Labour Supply curve shifts up) • Output/employment doesn’t change • LR at “natural level” • Prices/inflation rise • Note when inflation is at it expected level, unemployment is the natural rate

9. Accelerationist Phillips Curve • How are expectations formed? • Assume pe=pt-1 • Can also model inertia • Inflation is constant when Unemployment is equal to the natural rate • NAIRU • Allows us to look at the effect of policy over time • Suppose start at A • NAIRU=6, and zero inflation • Government decides to expand AD to reduce U • Unemployment falls and economy moves to point B

10. Inflation has risen to (say) 6% • Higher prices needed to get firms to produce more • Point B cannot be long run eqm • Inflation is 6% but workers expect it to be 0% • This means real wage is falling • Workers revise there expectations after one period and demand higher wages • New SRPC where pe=6 • We are now at point C • Inflation is now 12% • Still not LR eqm

11. LRPC p C SRPC(pe=12) B SRPC(pe =6) A U* U SRPC(pe =0)

12. If gov persists in keeping unemployment below natural rate • Get ever increasing inflation • Accelerating prices • Cannot achieve LR eqm unless unemployment is equal to its natural rate • Achieve temporary reduction in U • Permanent increase in inflation • Potential for hyperinflation

13. Implications • There exists only a SR trade off between inflation and unemployment • Attempt to use this trade off for a longer period • Ever increasing inflation • Hyperinflation

14. How long is the Short Run? • For as long as it take expectations to adjust • My example was one period • Leaves open possibility of stabilization policy • Note how all this relates to AS and Labour Market

15. Disinflation • We can use the PC to analyse the issue of deflation • i.e. how do we lower inflation without causing (much) unemployment • This is the flip-side of what we just looked at • What happens when we try to reduce unemployment • We already know part of the answer • LR there is no trade-off • No LR increase in unemployment • SR there is a trade off • Reducing inflation will mean higher U • Expectations play a role

16. LRPC p A B SRPC(pe=12) C SRPC(pe =9) U SRPC(pe =0)

17. Suppose we are at A • Unemployment equals its natural rate (6%) • Inflation is 12% • Too high want to reduce it • Reduce AD (increase interest rates) • Unemployment rises: 8% > 6% • Move down the SRPC to B • Actual inflation falls • B cannot be LR eqm (why?) • Actual Inflation (9%) is lower than expected (12%) • Real wages higher than expected • Expectations adjust down – • New SRPC

18. New SR eqm at C • Still not a LR equilibrium • Inflation will keep falling for as long as U is kept above the natural rate • When the gov. is satisfied with the level of inflation, • allow unemployment to return to the natural rate • Inflation stable

19. Sacrifice Ratio • Disinflation achieved at a cost • U>U* for several years • Sacrifice ratio • The increase in unemployment (above the natural rate) needed to reduce inflation by one percentage point in one year. • My example: 0.66

20. Volker Disinflation Again • Inflation fell by 6.7% over 4 years (1982-85) • Unemployment was 9.5%, 9,5%, 7.4% and 7.1% • Natural rate was 6% • Sacrifice ratio 1.4

21. Painless Disinflation • Previous example assumed • In reality expectations could adjust a lot quicker • Think of extreme case • Expectations adjust fully and immediately • Full immediate fall in inflation without any increase in unemployment • Sacrifice ration of zero

22. CB Independence • What is required for this? • Policy must be announced • Policy must be credible • Willing to cause pain • Intermediate case is more realistic • More credible policy maker faces a lower sacrifice ratio • This is the justification for independent central bank • Bank can be mean in a way democratic politicians would find difficult

23. Independence • How independent should CB be? • How “political” or “accountable” • Varies: ECB to UK to Singapore • Empirical evidence that independence lowers inflation • Beware of missing variables • Theory suggests independence might matter

24. Policy makers have a bias towards inflation • Would like to reduce unemployment • Works in the short run • Leads to inflation in long run • Better to prevent yourself from using the trade-off • insulate the CB from political process • ECB • Also can help affect expectations through credibility

25. Mandate of Central Banks • Whether independent or not what should a CB seek to do? • Most central banks are required to achieve low inflation and low unemployment • Federal Reserve – Humphrey-Hawkins Act 1978 • Maximum employment and stable prices • ECB – Maastricht Treaty • Stable prices

26. In practice the fed takes “Max employment” to mean unemployment at the natural rate • Both Central banks take “stable” prices to mean inflation at 2% or so • Quality issues • Preferences • Boskin Commission

27. Taylor Rule • See Mankiw 15.1 • John Taylor proposed a rule for Central Banks: Set rates to respond to • the gap between actual inflation and some target inflation rate • the gap between actual unemployment and the “natural” rate Or • The gap between output and its natural rate

28. The Rule • i* =  + r* + ( – *) + log(Y/Y*) • The monetary authorities set i*, where i* = r +  and r* is the LR eqm interest rate

29. Using the Rule • Suppose • r* = 0.03 • Y = Y* so (Y/Y*) = 1, • * = 0.02 •  = 0.06; •  =  = 0.5 • then: i* = 0.06 + 0.03 + 0.5(0.06 – 0.02) = 0.11 • Short-term nominal interest rate is 0.11 or 11%

30. The rule in a Recession • But suppose (Y/Y*) = 0.9 i.e. recession • then: i* = 0.06 + 0.03 + 0.5(0.06 – 0.02) + 0.5 log(0.9) = 0.11 – 0.5(0.046)  0.085 or 8.5% • So rule will lead the central bank to lower interest rates in a recession • Do Central Banks follow a Taylor Rule?

31. EUROZONE MMR* ACTUAL V TAYLOR RULE 1999 - 2007

32. FEDERAL RESERVE FFR* ACTUAL V TAYLOR RULE 1999 - 2007

33. Optimal Rate of Inflation • Why have the optimal rate at (or close to) zero? • Hyperinflation costly – money ceases to function • Moderate Inflation has Costs and Benefits • Erode value of money • Shoe leather costs • “trip to bank” • Electronic banking reduce a lot

34. Tax Distortions • Taxed on nominal prices/income • Higher tax when inflation higher • Bracket creep • e.g. VAT, Cap Gains tax (US) • Tax system could be indexed • Money Illusion • people think nominal increase represents a real increase • e.g. Wages in AS-AD diagram • Other prices also • Agents make the wrong decision • Akerloff book looks at this

35. Volatility • Changes in inflation imply greater risks in the future • Inflation that is higher on average tends also too be more volatile • Seignorage • Benefit of inflation • Government gets to print more money • Alternative to other taxes • Inflation can be viewed as a tax • Important in cases of hyper-inflation

36. Money Illusion (again!) • Could view as benefit • Think of adjustment to to a shock • Need real wages to go down • Nominal wages wont go down • Can get real wages down if nominal wages increase by less than inflation • May not be illusion

37. Negative real interest rates • Real interest rate=nominal – inflation • Reflects the true return on an investment • With inflation can get negative real interest rates • Raise output • Japan • Why not index? • What is the optimal rate of inflation? • Anything between zero and 5%

38. Why Monetary policy? • Stabilization • Suppose there is a shock • Economy will eventually recover • But could help it along • Fiscal policy slower • Long and variable lags • In Europe it is not centralised

39. Standard Prescription • Independent CB • Focuses on low inflation (not zero) • And keeping u=u* • Fiscal Policy should focus on longer term • Not stabliztion • Public services • Infrastructure • Pensions (big deal now)

40. Conclusions • Philips curve • SR trade-off of U and inflation dependent on expectations • Understand what is the optimal level of inflation • Costs of low inflation are probably small • Understand the modern prescription for independent central banks • Independent CB seeks to stablise economy in general and secure low inflation (c2%)

41. What’s Missing? • Philips curve was really just a reformulation of the AS curve • We still haven't said where unemployment comes from • We also need to more explicit about how interest rates can affect parts of AD e.g. consumption and investment