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

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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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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)

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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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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

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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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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

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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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Cost-Push Inflation

• • Example: 1970s when OPEC raised the price of oil

Associated with the institutional theory of Inflation

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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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Addressing Inflation with Monetary Policy

• Decrease AD ( to AD

1 )

• • Low inflation Higher unemployment

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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

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Inflation and the Phillips Curve 33 •

The Phillips Curve This concept can be expressed in a new graph: the Phillips Curve

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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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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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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

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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

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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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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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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

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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

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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

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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

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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

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