Transcript 5. Okuns Law and the Philips Curve

Philips curve
• Works in a “cycle”
Firms raise prices, the inflation rate increases
Less demand for products
Firms cut costs and lay off workers
Inflation rate falls back down to previous levels
The Empirical Fit of the Phillips
Curve
• Empirically, the slope is approximately onehalf.
– Meaning: if output exceeds potential by 2
percent, the inflation rate increases one
percentage point.
12.3 The Phillips Curve
• Recall the inflation rate is the percent
change in the overall price level.
• Firms set their prices on the basis of
– Their expectations of the economy-wide
inflation rate
– The state of demand for their product.
• Expected inflation
– The inflation rate firms think will prevail in the
economy over the coming year.
• Firms expect next year’s inflation rate to be
the same as this year’s inflation rate.
• Under adaptive expectations firms adjust their
forecasts of inflation slowly.
• Expected inflation embodies the sticky
inflation assumption.
• The Phillips curve
– Describes how inflation evolves over time as a
function of short-run output
This
year’s
inflation
Last
year’s
inflation
Short run
output
• If output is below potential
– Prices rise more slowly than usual
• If output is above potential
– Prices rise more rapidly than usual
• Using the equations:
Change in
inflation
• Therefore, the Phillips curve can be expressed as:
The parameter measures
how sensitive inflation is
to demand conditions.
Price Shocks and the Phillips Curve
• We can add shocks to the Phillips curve to
account for temporary increases in the price
of inflation:
• The actual rate of inflation now depends on
three things:
Expected rate
of inflation
• Rewrite again:
Adjustment
factor for state
of economy
Shock to
inflation
• Oil price shock
– The price of oil rises
– Results in a temporary upward shift in the Phillips
curve
Cost-Push and Demand-Pull Inflation
• Price shocks to an input in production
– Cost-push inflation
– Tends to push the inflation rate up
– Shift of Philips Curve
• The effect of short-run output on inflation in the Phillips
curve
– Demand-pull inflation
– Increases in aggregate demand pull up the inflation
rate.
– Movement along the Philips Curve
Case Study: The Phillips Curve and
the Quantity Theory
• An increase in the growth rate of real GDP
would reduce inflation.
• The Phillips curve, however, seems to say a
booming economy causes the rate of
inflation to increase.
• Which one is correct?
• The quantity theory
– Long-run model
– An increase in real GDP reflects an increase in
the supply of goods, which lowers prices.
• The Phillips curve
– Part of our short-run model
– An increase in short-run output reflects an
increase in the demand for goods.
12.4 Using the Short-Run Model
• Disinflation
– Sustained reduction of inflation to a stable lower
rate
• The Great Inflation of the 1970s
– Misinterpreting the productivity slowdown
contributed to rising inflation.
The Volcker Disinflation
• Reducing the level of inflation requires a sharp
reduction in the rate of money growth–a tight
monetary policy.
• Because of the stickiness of inflation
– The classical dichotomy is unlikely to hold exactly
in the short run.
– Just a reduction in the rate of money growth may
not slow inflation immediately.
• Thus, the real interest rate must increase to
induce a recession.
– The recession causes inflation to become
negative.
– As demand falls firms raise their prices less
aggressively to sell more.
• Lowering the inflation rate
– Can create the cost of a slumping economy
– High unemployment and lost output
• Once inflation has declined sufficiently
– Real interest rate can be raised back to MPK
– Allowing output to rise back to potential
The Short-Run Model in a Nutshell
Case Study: The 2001 Recession
• The recession of 2001 had a “jobless
recovery.”
– Even after the return of strong GDP, employment
continued to fall.
– This is an exception to Okun’s law.
Case Study: The Lender
of Last Resort
• Central banks ensure a sound, stable financial
system by:
– Making sure banks abide by certain rules
– Including the maintenance of a certain amount of
reserves to be held on hand
• Central banks ensure a sound, stable financial
system by:
– Acting as the lender of last resort
• lending money when banks experience
financial distress
– Having deposit insurance on small- and mediumsized deposits
• can increase risky behavior
Important thing about the Philip Curve
• This is about accelerating and decelerating
inflation. This is a change in the change of the
price level
• Is the Philips Curve fixed?
– Supply Shocks.
– Expectations.
Okun’s law
Okun’s Law
Cyclical
unemployment
Current rate of
unemployment
Natural rate of
unemployment
Short-run
output
Okun’s Law 1960 Recession
Okun’s Law 1969 Recession
Okun’s Law 1980/1981 Recession
Okun’s Law 1990 Recession
Okun’s Law Great Recession
Great recession