Transcript Macroeconomics - University of Oxford

Inflation & Unemployment
Gavin Cameron
University of Oxford
OUBEP 2006
AD curve
• The level of output given by
any point on the AD curve is
such that if that level of output
is produced, planned
expenditure at the given price
will exactly equal actual
expenditure and the demand
for money will equal the
supply of money.
prices
AD
Y
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why does the AD curve slope down?
• Three reasons why the aggregate demand curve slopes downwards:
• The first is the Real Balance Effect. When prices rise unexpectedly,
the real value of assets whose prices are fixed in nominal terms (such
as some government bonds, money, and gold) falls. This leads to less
consumer spending.
• The second is the real exchange rate. When prices rise unexpectedly,
the real exchange rate appreciates (if the nominal exchange rate is
fixed). This leads to an deterioration in the primary current account.
• The third is the Keynes effect. When prices rise unexpectedly,
people need more money for day to day transactions and so try to
switch their money balances from bonds and shares. This raises
interest rates and hence reduces interest-sensitive spending, such as
investment.
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long-run aggregate supply
• The labour market is in equilibrium when inflation is stable.
• At the equilibrium unemployment rate, there will be both voluntary
unemployment (workers who do not wish to work at the current real
wage) and involuntary unemployment (workers who would like to
work but cannot find jobs at the current real wage).
• In the long-run, the economy should return to its equilibrium rate of
output, ‘money is neutral’.
• However, according to Keynes, ‘..in the long-run, we are all dead’.
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shifts in aggregate supply
prices
LRAS1
• Long-run aggregate supply is
determined by:
LRAS2
•
•
•
•
productivity;
the capital stock;
supply and demand for labour;
and real input prices
Y
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is LRAS stable?
• Lots of evidence that equilibrium unemployment and natural output
are useful concepts.
• We can estimate the NAIRU from statistical models.
• However, three complications:
• the NAIRU shifts over time and is hard to estimate precisely;
• even when unemployment is above the NAIRU, very rapid rises
in demand could still lead to increased inflation;
• if unemployment is high for a very long time, the NAIRU may
rise due to ‘hysteresis’.
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short-run aggregate supply
• In the short-run, there is no reason to expect actual output to equal its
equilibrium rate.
• Here are four reasons why output can deviate from its equilibrium
rate:
• worker-misperception;
• imperfect information;
• sticky-prices;
• wage bargaining.
• All of these lead to a ‘surprise-supply’ function, where
output = equilibrium output + b(inflation – expected inflation)
• Therefore output deviates from its equilibrium level by the extent to
which inflation deviates from its expected level.
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the worker-misperception model
• Workers may suffer from ‘money illusion’.
• This means that while firms know the price level with certainty,
workers temporarily mistake nominal changes in wages for real
changes.
• If prices rise unexpectedly, firms offer higher nominal wages but
workers mistake these higher nominal offers for higher real wages,
and so offer more labour.
• At every real wage, workers supply more labour because they think
the real wage is higher than it actually is.
• Eventually workers realise that real wages haven’t risen, so their
expectations correct themselves and labour supply returns to its
previous level.
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the imperfect information model
• Consider an economy consisting of many self-employed people, each
producing a single good, but consuming many goods.
• In this economy, a yeoman farmer can monitor the price of wheat and
so knows of any price change immediately. But she cannot monitor
other prices as easily, so she only notices price-changes after one
time-period has passed.
• How does the farmer react if wheat prices rise unexpectedly?
• One possibility is that all prices have risen, and so she shouldn’t work
any harder.
• Another possibility is that only the price of wheat has risen (and so
its relative price has risen), so she should work harder.
• In practice, any change could be a combination of an aggregate price
change and a relative price change.
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the sticky-price model
• It may also be the case that firms cannot adjust their prices
immediately either, since they may have long-term contracts or there
may be costs to changing prices (‘menu costs’).
• If aggregate demand falls and a firm’s price is ‘stuck’, it will reduce
its output, its demand for labour will shift inwards, and output will
fall.
• Notice that sticky-prices have an external effect since if some firms do
not adjust their prices in response to a shock, there is less incentive
for other firms to do so.
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the wage bargaining model
• ‘I hold that in modern conditions, wages in this country are, for
various reasons, so rigid over short periods that it is impracticable to
adjust them…’ J.M.Keynes
• In many industries, especially unionized ones, nominal wages are set
by long-term contracts. Social norms, efficiency wages and implicit
contracts may also be important.
• When the nominal wage is fixed, an unexpected fall in prices raises
the real wage, making labour more expensive.
• Higher real wages induce firms to reduce employment;
• Reduced employment leads to reduced output;
• When contracts are renegotiated, workers accept lower nominal
wages to return their real wages to their original level, so
employment rises.
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taxonomy of aggregate supply models
Yes
Markets
clear?
No
WorkerMisperception:
workers confuse
nominal wage
changes with real
changes
Imperfect-Information:
suppliers confuse
changes in the price level
with changes in their
own prices
Wage Bargaining:
nominal wages
adjust slowly
Sticky-Prices: The prices of
goods and services adjust
slowly
Labour
Goods
Market with imperfection
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ASAD
prices
LAS
SAS (Pe=P1)
• The economy is in equilibrium
when aggregate supply equals
aggregate demand – there is no
tendency for inflation to rise or
fall.
• The short-run aggregate
supply curve is drawn for a
particular level of inflation
expectations.
AD
Y*
Y
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ASAD in disequilibrium
SAS (πe=π0)
prices
LAS
SAS (πe=π2)
P0
P1
P2
AD1
AD2
Y*
Y
• In the short-run, the economy
can be in disequilibrium with
the wrong level of inflation
expectations.
• Here, an unexpected fall in
aggregate demand temporarily
decreases output below its
equilibrium level.
• Once inflation expectations
adapt, the economy returns to
equilibrium.
• But why (and how fast) do
expectations adapt?
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expectations
inflation
Adaptive
inflation
t
Rational
• Adaptive Expectations: people
form their expectations of the
future based upon the past.
• But this means you can fool all
the people, all of the time!
• Rational Expectations: people
form their expectations of the
future based upon all the
information available.
• This means that you can
surprise people, but not
systematically.
t
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unexpected inflation
• In 1958, A.W. Phillips of the LSE found relation an empirical
relationship between unemployment and inflation in the UK – the
Phillips curve.
• The Phillips curve is the counterpart of the aggregate supply curve.
• Original interpretation:
• There is a permanent trade-off between inflation and
unemployment.
• Problem:
• After sustained inflation, the empirical relationship broke down.
• New interpretation:
• There is a trade-off between unemployment and unexpected
inflation in the short-run:
• But in the long-run, there is no such trade-off.
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inflation and the NAIRU
real wage
wage-setting
price-setting
With employment at E, an
inflationary gap exists where
unions attempt to obtain real wages
that are higher than wage offers.
E*
E’
employment
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the Phillips Curve
prices
inflation
LRAS
LRPC
SRAS (πe=π1)
SRPC (πe=π1)
AD1
Y*
•
•
Y
Y*
Y
Just as the short-run aggregate supply curve is drawn for a particular level of inflation expectations, we
can draw a short-run Phillips curve which depicts the trade-off between output and unexpected
inflation.
Phillips curves can also be drawn between inflation and unemployment, in which case they slope
downwards!
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inflation adjustment
prices
LRAS
inflation
LRPC
SRAS (πe=π2)
SRPC (πe=π2)
SRAS (πe=π1)
C
C
B
B
SRPC (πe=π1)
A
A
AD2
AD1
Y*
•
•
Y
Y*
Y
For a given rate of expected inflation, the economy can sustain lower unemployment at the cost of
rising inflation. In the long-run, there is no trade-off.
A positive aggregate demand shock raises output in the short-run (point B), and inflation in the longrun (point C).
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Okun’s Law
• The unemployment-sacrifice
ratio is the unemployment cost
of reducing inflation.
• For any given unemployment
cost, there is also an output
cost. This was first described
as Okun’s Law in 1960’s USA
where output rises by about
2% for every 1% fall in
unemployment.
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the sacrifice ratio
• The output-sacrifice ratio (OSR) is therefore equal to the Okun
coefficent (OK) times the unemployment-sacrifice ratio (USR).
• The unemployment-sacrifice ratio is a function of real wage rigidity
(RWR) and nominal inertia (NI). RWR is when unions don’t change
their wage claims in response to rising unemployment. NI is when
previous inflation plays a big role in the setting of current wage
claims and offers.
• OSR= Okun’s coefficient . unemployment sacrifice ratio
USR= nominal wage rigidity = real wage rigidity . nominal inertia
• A typical finding is that of a G7 average USR of 1.61 and an OSR of
2.67 (Zhang, 2001).
• Lower sacrifice ratios (and hence steeper SRPC) tend to be associated
with low union aggressiveness, low inflation inertia, high openness,
high initial inflation.
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Source: Zhang (2001), figure 5.
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monetary policy reaction
inflation
• The monetary authority will
seek to offset a demand shock
by raising interest rates.
• In order to reduce inflation,
unemployment must rise
above its equilibrium.
• No pain, no gain!
• The steeper the SRPC, the less
pain there will be, owing to the
lower sacrifice ratio.
LRPC
SRPC (πe=π2)
C
B
D
SRPC (πe=π1)
A
Y*
Y
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summary
• Equilibrium in the economy is determined by the interaction of
aggregate demand (the goods and money market) and aggregate
supply (the labour market).
• In the long-run, a country’s capacity to produce goods and services
determines the standard of living of its citizens.
• In the short-run, aggregate demand influences the amount of goods
and services the a country produces.
• In the long-run, the rate of money growth determines the rate of
inflation but does not affect the rate of unemployment.
• In the short-run, policymakers face a trade-off between
unemployment and unexpected changes in inflation.
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a slight exaggeration
• “I do not think it is an
exaggeration to say history
is largely a history of
inflation, usually inflations
engineered by governments
for the gain of
governments,” Friedrich
August von Hayek (18991992).
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syndicate topics
• What determines the slope of the aggregate demand curve?
• What determines the slope of the short-run aggregate supply curve
and the Phillips curve?
• How would an oil shock affect the economy? Does it matter whether
a country is a net exporter or importer?
• Should policymakers try to stabilize the economy?
• How costly is inflation, and how costly is reducing inflation?
• Can the economy get ‘stuck’ away from equilibrium?
• Might there be more than one equilibrium for the economy?
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