Transcript Slide 1
Inflation and the Phillips Curve
CHAPTER 33
The first few months or years of inflation, like the first few drinks, seem just fine. Everyone has more money to spend and prices aren’t rising quite as fast as the money that’s available. The hangover comes when prices start to catch up.
— Milton Friedman
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Inflation
•
Inflation:
a rise in the price level • Measured with price indexes Inflation and the Phillips Curve 33 33-2
Inflation and the Phillips Curve 33
Effects of Inflation
•
Unexpected inflation redistributes income from lenders to borrowers
• If lenders charge a nominal rate of 5% and expect inflation to be 2%, the expected real rate is 3% • If inflation is actually 4%, the real rate is only 1% 33-3
Inflation and the Phillips Curve 33
Expectations of Inflation
•
Rational expectations:
predicted by economists’ models •
Adaptive expectations:
based on the past •
Extrapolative expectations:
a trend will continue expectations that 33-4
Inflation and the Phillips Curve 33 •
Productivity, Inflation, and Wages Changes in productivity and changes in wages determine if inflation is coming
•
There will be no inflationary pressures if wages and productivity increase at the same rate
•
Inflation = Nominal wage increases Productivity growth
33-5
Inflation and the Phillips Curve 33
Nominal Wages, Productivity, and Inflation
• When nominal wages increase by
more
than the growth of productivity, the SRAS curve shifts up (left), resulting in
inflation
• When nominal wages increase by
less
than the growth of productivity, the SRAS curve shifts down (right), resulting in
deflation
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Inflation and the Phillips Curve 33
Theories of Inflation
•
Theory #1: The quantity theory of inflation emphasizes the connection between money and inflation
• If the money supply rises, the price level rises • If the money supply does not rise, the price level will not rise 33-7
Inflation and the Phillips Curve 33
Theories of Inflation
•
Theory #2: The institutional theory emphasizes the relationship between market structure and price-setting institutions and inflation
• It is easier for firms to raise prices than to lower them and they do not take the effect of this into account
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Inflation and the Phillips Curve 33
Theories of Inflation
• As workers push for higher nominal wages (or a firms raise prices) more people want higher wages (or more firms raise their prices)
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The Quantity Theory of Money and Inflation
• The equation of exchange is: MV = PQ • M = Quantity of money • V = Velocity of money • Q = Real GDP • P = Price level 33-10
Inflation and the Phillips Curve 33
The Quantity Theory of Money and Inflation
•
Velocity of money
is the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income • Velocity = Nominal GDP
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The Quantity Theory of Money and Inflation
•
Three assumptions of the quantity theory: 1. Velocity is constant due to the structure of the economy 2. Real output (Q) is independent of money supply
•
Q is autonomous (determined by outside forces in the economy)
33-12
Inflation and the Phillips Curve 33
The Quantity Theory of Money and Inflation 3. Causation goes from money to prices
•
The price level varies in response to changes in the quantity of money
•
The quantity theory of money is stated as %∆M %∆P
•
If the money supply goes up 5% so does the price level
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Inflation and the Phillips Curve 33
Central Banks and the Money Supply
• If the central bank must buy government bonds to finance a government deficit, the money supply increases and inflation may occur 33-14
Inflation and the Phillips Curve 33
Central Banks and the Money Supply
•
Central banks have to make a policy choice:
• Bailing out their governments with expansionary monetary policy OR… • Do nothing and risk a recession
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Inflation and the Phillips Curve 33
Institutional Theory of Inflation
• According to the
institutionalists,
increases in
prices
force the government to increase the money supply
or
cause unemployment • MV PQ 33-16
Inflation and the Phillips Curve 33
Institutional Theory of Inflation
•
In this theory, inflation is caused by the way in which prices as well as wages are set
• For example: if wages are increasing so is the price level •
At this point, the government must decide whether or not to increase the money supply
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– If it increases it, inflation is accepted – If not, unemployment increases
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Inflation and the Phillips Curve 33
Demand-Pull Inflation
•
Demand-pull inflation:
inflation that occurs when the economy is at or above potential output (creates inflationary gap) • Characterized by shortages of goods and workers •
Associated with the quantity theory of money/inflation
33-18
Inflation and the Phillips Curve 33
Cost-Push Inflation
•
Cost-push inflation:
inflation that occurs when the economy is below potential output • • • Usually caused by an increase in input costs of one of the factors of production
No excess demand but excess supply may exist Firms that raise prices may not sell their goods
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Inflation and the Phillips Curve 33
Cost-Push Inflation
• • Example: 1970s when OPEC raised the price of oil
Associated with the institutional theory of Inflation
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Inflation and the Phillips Curve 33
Addressing Inflation with Monetary Policy
•
Some policymakers believe there is a tradeoff between inflation and unemployment
•
Government can:
• Keep output high (AD
0; inflationary gap)
• Low unemployment • Higher inflation
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Inflation and the Phillips Curve 33
Addressing Inflation with Monetary Policy
• Decrease AD ( to AD
1 )
• • Low inflation Higher unemployment
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Inflation and the Phillips Curve 33
Addressing Inflation with Monetary Policy Price level LRAS P 1 P 0 P 2 Q 1 AD 1 Q 0 SRAS 1
Inflationary pressure
SRAS 0 AD 0 Real output
33-23
Inflation and the Phillips Curve 33 •
The Phillips Curve This concept can be expressed in a new graph: the Phillips Curve
33-24
Inflation and the Phillips Curve 33
The Short-run Phillips Curve
• The
short-run Phillips curve
is a downward sloping curve showing the relationship between
inflation
and
unemployment
expectations of inflation are constant when
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Inflation and the Phillips Curve 33
Draw the Graph: Short-run Phillips Curve Inflation
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Short-run Phillips curve (SRPC) Unemployment rate Colander, Economics
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Inflation and the Phillips Curve 33
The Short-Run Phillips Curve
•
Actual inflation depends on both supply and demand forces and on how much inflation people expect
• At all points on the
short-run Phillips curve (SRPC)
, expectations of inflation (the rise in the price level that the average person expects) are
fixed
33-27
Inflation and the Phillips Curve 33
The Long-Run Phillips Curve
• At all points on the
long-run Phillips curve
, expectations of inflation are
equal
to actual inflation • The
long-run Phillips curve (LRPC)
is vertical at the natural rate of unemployment
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Draw the Graph: The Long-run Phillips Curve Inflation LRPC
5%
Unemployment rate
33-29
Inflation and the Phillips Curve 33
More on the Phillips Curve
•
The sustainable combination of inflation and unemployment on the short-run Phillips curve is where it intersects the long-run Phillips curve—this is where the unemployment rate is consistent with the economy's potential income
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Inflation and the Phillips Curve 33
Draw the Graph: The Short-run and Long-run Phillips Curve Inflation LRPC
Point A represents the (long-run equilibrium) 5% A
SRPC
5%
Unemployment rate
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Inflation and the Phillips Curve 33
Price level
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Inflation and the AS/AD Model LRAS C A B SRAS 3 SRAS 2 SRAS 1 AD 1 AD 2 Real GDP
• Start at point A (long-run equilibrium) • AD moves from AD
1
to
AD 2
—above its potential • Firms then raise prices (SRAS 2 , point B) • At SRAS 2 we are still above potential • This causes SRAS to shift up to SRAS 3 , point C—we see the economy is in equilibrium again
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4 2 0 Inflation SRPC 1 B Inflation and the Phillips Curve Refer to Figure 33-5 A and B in the text Long-run Phillips Curve SRPC 2 C A
•
SRPC 1 shifts to SRPC 2 when the economy is trying to account for the inflationary gap at point B on the AS/AD graph
•
Then, when SRAS 2 shifts to SRAS 3 , we are at point C on the LRPC and back at long-run equilibrium in the AS/AD model
4.5
5.5
Unemployment rate
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Inflation and the Phillips Curve
AS/AD and the Phillips Curve #1. Show what happens on both graphs if AD increases
33
Price Level LRAS SRAS Inflation LRPC Result: Higher inflation and lower unemployment P 2 P 1
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6%
AD 2
5%
AD 1 Y 1 Y 2 Real GDP
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SRPC U 1 U Y Unemployment
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AS/AD and the Phillips Curve
Inflation and the Phillips Curve 33
#2. Correctly draw the LRPC and SRPC with a recessionary gap. What happens when AD falls? LRAS Price Level SRAS Inflation LRPC Result: Lower inflation and higher unemployment P 1 P 2
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Y 2
6% 5%
Y 1 AD 2 AD 1 Real GDP
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U Y U 1 Unemployment U 2 SRPC
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AS/AD and the Phillips Curve
Inflation and the Phillips Curve 33
#3. Correctly draw the LRPC and SRPC at full employment. What happens when SRAS falls? Inflation and Price Level LRAS Inflation SRAS 2 SRAS 1 LRPC unemployment increase PL 2 PL 1
6% 5%
AD SRPC 2 SRPC 1
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Y 2 Y 1 Real GDP
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U Y U 1 Unemployment
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Price Level PL 1 PL 2 AS/AD and the Phillips Curve
Inflation and the Phillips Curve 33
#4. Correctly draw the LRPC and SRPC with a recessionary gap. What happens when SRAS increases? LRPC LRAS SRAS 1 SRAS 2
7% 5%
SRPC 1 AD SRPC 2
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Y 1 Y 2 Real GDP
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U Y U 1 Unemployment
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Inflation and the Phillips Curve 33
Chapter Summary
•
The winners in inflation are people who can raise their wages or prices and still keep their jobs or sell their goods
•
The losers are people who can’t raise their wages or prices
•
People form expectations in many ways
•
Three ways are to base expectations on economic models, on an average of the past, or on trends
•
A basic rule to predict inflation is: Inflation equals nominal wage increases minus productivity growth
33-38
Inflation and the Phillips Curve 33
Chapter Summary
•
The equation of exchange is MV = PQ
•
When velocity is constant, real output is independent of the money supply, and causation goes from money to prices
•
The equation of exchange becomes the quantity theory, and it predicts that the price level varies in direct response to changes in the quantity of money
•
That is %∆M leads to an equal %∆P
33-39
Inflation and the Phillips Curve 33 •
Chapter Summary Central banks sometimes print money knowing that it will lead to inflation because the alternative might be a breakdown of the economy
•
The institutional theory of inflation sees the source of inflation in the wage-and-price setting institutions
•
Institutionalists see the direction of causation going from price increases to money supply increases
33-40
Inflation and the Phillips Curve 33
Chapter Summary
•
The long-run Phillips curve is vertical, and it allows expectations of inflation to change
•
The short-run Phillips curve is downward sloping, holds expectations constant, and shifts when expectations change
•
Quantity theorists see a long-run trade-off between inflation and growth, but institutionalists are less sure about this trade-off
33-41