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Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Macroeconomics Chamberlin and Yueh Chapter 10 Lecture.

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Presentation on theme: "Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Macroeconomics Chamberlin and Yueh Chapter 10 Lecture."— Presentation transcript:

1 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Macroeconomics Chamberlin and Yueh Chapter 10 Lecture slides

2 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Unemployment, Inflation and Monetary Policy The Phillips Curve: the unemployment- inflation trade-off Theories of Unemployment Costs and Benefits of Inflation Policy Choices: preferences between unemployment and inflation Expectations Augmented Phillips Curve NAIRU: Policy Implications

3 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Learning Objectives Understand the theory of the Phillips curve, which shows that there is a trade-off between unemployment and inflation. Recognise that the trade-off is different in the short run and the long run, and the transition between short and long run is governed by the way expectations are formed and the degree of flexibility in wages and prices. Analyse the policy choices while considering the costs of unemployment and inflation.

4 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Learning Objectives Explain how monetary policy can be used to control the rate of inflation, and how the Phillips Curve framework is used to formulate monetary policy. Recognise how the importance of monetary policy has grown as policy makers place an increasing emphasis on the control of inflation. Investigate the reasons behind the recent trend for making central banks independent and analyse the time inconsistency problem Cover the concepts of seignorage and hyper-inflation

5 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Unemployment and Inflation The control of unemployment and inflation has been a longstanding preoccupation of macroeconomists. This takes on an added degree of fascination, as the theory of the Phillips curve argues that there is a trade-off between the two. Therefore, policy makers are faced with a conundrum: if either unemployment or inflation can only be controlled at the expense of the other, then which combination is the best choice?

6 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Unemployment and Inflation To shed some light on this question, two sets of issues need to be discussed. Firstly, what are the relative costs of unemployment and inflation? Secondly, what is the nature of the trade-off between the two? The nature of the trade-off is where economic theory has a lot to contribute. There is ample evidence to suggest that the trade-off is different in the short run and the long run, and the transition between short and long run is governed by the way expectations are formed and the degree of flexibility in wages and prices.

7 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Monetary policy Monetary policy refers to the control of either the quantity or the price of money. The importance of monetary policy has grown as policy makers place a growing emphasis on the control of inflation. The traditional goal of full employment has been supplanted by target of economic stability, and as a result, the tools the government uses to control the economy have shifted away from fiscal (demand management) to monetary policy. The theory of the Phillips curve is very useful here, as it can explain how monetary policy could be used to control the rate of inflation.

8 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Phillips Curve: the unemployment-inflation trade-off The level of inflation refers to the rate at which prices are changing: The definition of unemployment varies, but the accepted International Labour Organisation (ILO) measure describes it as those who are without a job, and are both looking and are available for work. A proposed link between unemployment and inflation is described by the Phillips curve.

9 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Phillips Curve: U.S. 1960s

10 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Phillips Curve The Phillips curve has been at the centre of economic policy making for over 40 years. It originated from a simple empirical relationship discovered by A.W.H. Phillips (who was actually an engineer and also invented the Phillips machine highlighted in chapter 1), which showed an inverse relationship between unemployment and inflation. As unemployment falls, inflation would be expected to rise, and vice versa. Following the empirical evidence, economists developed the theory behind the trade-off relationship. The basic rationale accounting for the Phillips curve is taken to be a disequilibrium relationship in the labour market.

11 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Theories of Unemployment There are two important concepts of labour market equilibrium, but both share similar foundations, that is, wages will move in the same direction as the difference between demand and supply pressures in the labour market. The natural rate of unemployment is essentially the level of unemployment that results when the labour market is in equilibrium. Under competitive conditions, the labour market is in equilibrium when the demand and supply of labour are equal to each other.

12 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Competitive labour market

13 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Natural rate of unemployment The price of labour is the real wage. The demand for labour is downward sloping, meaning that as the real wage falls, firms demand more labour. The supply of labour is upward sloping – as the real wage increases, more workers are prepared to swap leisure for work, so supply increases. If there are people in the labour market, then this will consist of employed (N) and unemployed (U) workers, so. If is the level of employment in a labour market in equilibrium, then the corresponding equilibrium level of unemployment is: U*=L-N*. The natural rate of unemployment is:

14 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Disequilibrium in competitive labour markets

15 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Natural rate of unemployment The nature of the labour market suggests that the change in wages is related to the size of the disequilibrium in the labour market. When there is a large degree of excess demand, the rate of wage increase will be much higher than at levels of low excess demand. Likewise, the downward rate of wage inflation (wage deflation) will be greater when there is higher excess supply.

16 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Natural rate of unemployment Therefore, the change in wages can be written as a negative function of the level of unemployment: More specifically, the relationship between demand and supply in the labour market will be related to the difference between the actual and equilibrium level of unemployment: The change in wages is a function of the difference between unemployment and its equilibrium level.

17 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Phillips Curve When prices are set equal to marginal costs – price inflation is equal to wage inflation, so the Phillips curve can be written as: The natural rate of unemployment is the traditional concept of unemployment in the labour market. The Phillips curve implies that inflation will be negatively related to the difference between unemployment and the natural rate.

18 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Phillips Curve

19 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Non-Accelerating Inflation Rate of Unemployment (NAIRU) The NAIRU is defined as the level of unemployment where there is no pressure on prices to change. The natural rate and the NAIRU differ in their theoretical foundations. The natural rate theory refers to the disequilibrium adjustments in competitive markets. The NAIRU comes out of an imperfect competition model. Here the equilibrium level of unemployment and wages are the result of bargaining between firms and labour (unions). Both the unions and firms have some power to determine wages and prices, so the price level is not competitively determined.

20 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning NAIRU In this set up, unions set wages and firms set prices. The wage-setting relationship, described as the Bargained Real Wage (BRW), implies those nominal wages demands are positively related to expected prices, negatively related to unemployment, and are also determined by a set of factors Z, which accounts for things such as trade union power and the replacement ratio of unemployment benefits to wages, etc.:

21 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning NAIRU The bargained real wage is downward sloping with respect to unemployment, implying that unions will moderate wage demands when unemployment is high, but in times of a tight labour market, will be more ambitious about what can be achieved. The price-setting relationship, also known as the Feasible Real Wage (FRW), describes the way that firms set prices. Essentially, these are just a mark up over costs, which are in turn defined by the ratio of wages to labour productivity (LP):

22 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning NAIRU In terms of the real wage, the FRW is unrelated to the level of unemployment and is just determined by product market conditions (mark up) and productivity. The NAIRU is found at the intersection of the price-setting (FRW) and wage-setting (BRW) schedules. Again, prices will change as a result of disequilibrium. If unemployment is below the NAIRU, then the BRW is above the FRW. Consequently, high wage demands by workers will lead to higher prices. Correspondingly, when unemployment is above the NAIRU, moderating wage demands will put downward pressure on prices. Again, the rate at which prices change is assumed to be proportionally related to the size of the disequilibrium.

23 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning NAIRU

24 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Phillips curve As the change in nominal wages reflects the difference between unemployment and the NAIRU, then we can once again generate a Phillips curve type relationship:

25 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Natural rate or NAIRU? Both the natural rate of unemployment and the NAIRU reflect an equilibrium position in the labour market. Any movement of actual unemployment away from this position generates a change in wages proportional to the disequilibrium. Because prices are just a mark up on wages, wage inflation feeds directly into price inflation:

26 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Empirical Evidence In general, wage inflation lies above price inflation, although both clearly follow similar trends. The difference is mainly accounted for by a positive growth in productivity, which allows the real wage to grow over time in line with living standards.

27 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Natural rate or NAIRU? Many economists use the concepts of the natural rate and the NAIRU interchangeably. Although the two measures are similar – strictly speaking, they are not the same. The main difference concerns the existence of involuntary unemployment. In the natural rate definition, there is no involuntary unemployment. The difference can then largely be summed up by the size of the mark up in the price-setting (FRW) schedule. In competitive markets, prices are equal to marginal costs, so μ=0. In imperfectly competitive industries, prices exceed marginal costs so that μ>0. The consequence is that there is now a wedge between the price levels of the imperfectly and perfectly competitive markets, and the natural rate is below the NAIRU.

28 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning NAIRU falls with a declining mark up

29 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Natural rate or NAIRU? Unemployment rises with the size of because increasing prices reduce aggregate demand. As the NAIRU lies above the natural rate of unemployment, inflation will be higher at every level of unemployment, so the presence of market imperfections will create an inflation wedge. This the main difference between the natural rate and the NAIRU. We will concentrate on the NAIRU, as most policy makers through the world do. The reason is not just because of some empirical justification, but also because the imperfect competition model provides a useful model for analysing structural factors in the labour market.

30 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Inflation Although the trade-off between unemployment and inflation started out as an empirical observation, the Phillips curve has played a central role in policy making for more than 30 years. The Phillips curve was seen as a trade-off frontier for policy makers. Lower unemployment can be bought with higher inflation and vice versa. The role of economic policy is to choose the preferred point on this frontier. In making these policy choices, the government is effectively trying to reach the lowest level of misery – neither inflation nor unemployment is desirable. The theory of choice is therefore not about utility maximisation but the minimisation of disutility.

31 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Costs of Unemployment The costs associated with unemployment can be divided into two sorts: social and economic. Social Costs: Poverty, crime, social/personal esteem. Economic Costs: There are two main economic costs associated with unemployment. –Efficiency –Budgetary

32 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Is zero unemployment a sensible policy? (Full employment) Recognising that unemployment is costly, governments might optimally pursue a policy of zero unemployment. In fact, full employment was the goal of policy makers for many decades. However, are full employment and zero unemployment the same thing? Would it be possible for an optimal choice to have a positive amount of unemployment? Frictional unemployment: people who are between jobs. The presence of this could be optimal, as the process of job matching is not an immediate occurrence. However, this does not discount the usefulness of policies that reduce frictional unemployment by increasing the speed of efficient job matching.

33 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Costs of Inflation The costs associated with rising prices can be split, depending on whether inflation is anticipated or unanticipated. Anticipated: Menu and shoe leather costs Unanticipated: –Redistribution –Instability: Probably, the main concern for maintaining low and stable inflation is that it creates conditions which are amenable for long term investment.

34 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Benefits of Inflation If there are costs to inflation, should policy makers aim to achieve zero inflation? In fact, should we go further and actually target a negative rate of inflation? This would imply falling prices known as deflation. The answers to these questions are: –Policy makers tend to prefer a low positive rate of inflation rather than zero inflation. –Deflation is regarded as being just as bad, if not worse, than high inflation. Global Applications 10.2 Japan

35 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Policy Choices: preferences between unemployment and inflation If the Phillips curve acts as a constraint on policy making, then it is just left to policy makers to choose their most preferred combination on this frontier. The rational choice would be that which maximises utility, or in this case minimises disutility. The policy choice will depend on the preferences of the policy maker, which are represented in a utility function:

36 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Policy Choices An indifference curve plots the combinations of inflation and unemployment that give the same level of (dis)utility. Each level of (dis)utility will be synonymous with a different indifference curve. As both inflation and unemployment are ‘bads,’ the lower the indifference curve, the better. The policy maker is made better off as he moves from I 1  I 2  I 3.

37 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Policy Choices

38 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Policy Choices The indifference curves are concave to the origin, which implies that policy makers prefer averages to extremes. This suggests that if unemployment is high, the policy maker would be preferred to trade off a higher increase in inflation to reduce unemployment than if unemployment were low. The same would apply to inflation. The policy maker will act to minimise the total amount of disutility that is suffered. The Phillips curve represents the menu of inflation- unemployment outcomes from which the policy maker can choose. The rational choice is the lowest indifference curve that is consistent with a position on the Phillips curve. This is where the two curves are tangential to each other.

39 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Optimal unemployment-inflation combination

40 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Policy Choices In this framework, the combination of unemployment and inflation that the economy ends up with will reflect the preferences of the policy maker. If the policy maker is very adverse to high unemployment, then he is now more willing to trade off higher inflation for lower unemployment, the indifference curves are skewed towards verticality. If the policy maker is highly adverse to inflation, then he would be prepare to trade off higher levels of unemployment for lower inflation. The indifferences curves reflecting these preferences are flatter and the economy ends up in a position where unemployment is higher and inflation is lower.

41 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Unemployment averse policy maker

42 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Inflation averse policy maker

43 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Stagflation: The death of the Phillips cure This simple model is a good reflection of macroeconomic policy before the 1970s. It was believed that the Phillips curve was a stable frontier on which the economy could move along in accordance with the decrees of governments. This view, though, ended spectacularly in the 1970s when unemployment and inflation rose simultaneously – an outcome which is completely at odds with the Phillips curve as a trade-off constraint.

44 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Phillips Curve, 1970s, 1980s

45 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Expectations Augmented Phillips Curve If the Phillips curve was to maintain its place at the heart of macroeconomic analysis, it would have to offer an explanation for these events. The solution was the expectations augmented Phillips curve. The typical Phillips curve equation:

46 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Expectations Augmented Phillips Curve What effect, though, would an increase in inflationary expectations have on the level of inflation and the NAIRU? From the wage-setting curve, higher expectations of inflation will lead to higher nominal wage growth as workers aim to maintain the value of the real wage. The change in the bargained real wage is related to the change in price expectations in the following way:

47 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Expectations Augmented Phillips Curve Therefore, the rate of wage inflation equals: The price-setting relationship then describes how this would feed into price inflation:,, Therefore:

48 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Expectations Augmented Phillips Curve A persistent increase in the rate of expected inflation will lead to a persistent increase in the actual level of inflation, but what would be the impact on the NAIRU? The answer is nothing. As the rate of wage and price inflation is the same, the real wage will remain constant. A 10% increase in the wage level will have no effect on the real wage if the price level also increases by 10%. As a result, a change in inflation expectations produces a change in the inflation rate in the economy, but doest not affect the NAIRU.

49 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Expectations Augmented Phillips Curve This means that different rates of inflation are possible at the same rate of unemployment depending on prevailing inflation expectations. This gives rise to the expectations augmented Phillips curve: The actual rate of inflation is now the product of the disequilibrium in the labour market, and also the expected level of inflation. Therefore, the Phillips curve will shift vertically with changes in the expected level of inflation.

50 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Expectations Augmented Phillips Curve

51 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Long run Phillips Curve The expectations augmented Phillips curve posits that inflation is the product of two factors: (1) the disequilibrium between the rate of unemployment and the NAIRU, and (2) the degree of inflation expectations. The disequilibrium story gives rise to the traditional Phillips curve. This is known as the short run Phillips curve, as disequilibria are not expected to persist in the long run. In the long run, the economy will rest at its NAIRU, but there are many different rates of inflation that are consistent with this depending on the rate of inflation expectations. This gives rise to a long run Phillips curve, which is vertical at the NAIRU.

52 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Processes of Expectations Formation Adaptive Expectations Under adaptive expectations, inflation expectations are a weighted average of last period’s actual and expected rates of inflation: This backward –looking approach has clear implications for how the economy will react to shocks and policies.

53 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Adaptive Expectations

54 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Adaptive Expectations Suppose the economy starts of with unemployment at the natural rate, and actual and expected inflation equal to one another at point a. The government, however, decides that the current rate of unemployment is too high and unleashes an expansionary policy (fiscal or monetary) with the aim of reducing unemployment. As the expected price level rises, the Phillips curve will shift upwards to point b. However, because the expected price level lags behind the actual price level, the expected real wage will still exceed the equilibrium level. There will be further upward pressure on prices and the economy moves to point c.

55 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Adaptive Expectations Over time, the expected level of inflation will eventually catch up with the actual level of inflation and the economy will return to is long run equilibrium position. This exercise demonstrates that under the adaptive expectations framework, policy changes will only be able to exploit a short run trade-off between unemployment and inflation. In the long run, when expectations fully adjust, it will be the case that policy can have no effect on the level of unemployment, only on inflation which has risen permanently to a higher level representing a higher point on the long run Phillips curve, point d.

56 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Rational Expectations The major criticism levelled at adaptive expectations is that it only makes use of past information. Forming expectations using only a subset of information available is deemed to be sub-optimal and irrational behaviour. Expectations which are formed rationally use all available information: where I t represents the set of information available to the private sector at time t.

57 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Rational Expectations

58 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Rational Expectations Rational expectations was a revolutionary concept, arguing that the short run trade-off between unemployment and inflation no longer existed. When expectations are formed rationally, changes in policy will not influence the level of unemployment at all, not even in the short run. Agents in the private sector are fully aware of the consequences of the policy action and will immediately adjust their expectations of inflation. Consequentially, wages will stay in tune with prices. If the real wage does not change, the rate of unemployment will not deviate from the NAIRU. Rational expectations and the vertical long run Phillips curve are very important in monetary policy.

59 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Supply Shocks Supply side shocks can lead to a change in the equilibrium level of unemployment. These have been explained previously and principally fall into two categories. First, there are factors which impact upon labour productivity, which leads to shifts in the price-setting or feasible real wage schedule. Second, anything which affects the bargaining power of labour will also influence the equilibrium level of unemployment via movements in the wage-setting or bargained real wage schedule. These might include labour market legislation, trade union power, and the replacement ratio, amongst others.

60 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Supply Shocks

61 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Policy Neutrality The important implication of the NAIRU concept is that in the long run, the unemployment rate can only change as a result of a change in the NAIRU. This has a strong bearing on policy makers. If unemployment is to be tackled in the long term, then policies should concentrate on the supply rather than the demand side.

62 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Hysteresis In the long run, the Phillips curve is vertical at the equilibrium rate of unemployment, indicating that no trade- off exists between unemployment and inflation. However, this does not rule out the possibility that the equilibrium rate of unemployment is open to change. The NAIRU has been found to have changed over time and the evidence suggests that there is a close relationship between the NAIRU and the actual rate of unemployment. Hysteresis refers to the notion that short run changes in unemployment can influence the NAIRU. In this case, short run changes in unemployment can become remarkably persistent.

63 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Hysteresis

64 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Hysteresis The concept of hysteresis is of growing importance in economics. This is due to a new interest in what is defined as the medium run. As the short run can effectively be a considerable period of time, the medium run is used to describe situations where there are fairly persistent, but not necessarily permanent, movements in a series such as unemployment. This might be one reason why estimates of the NAIRU tend to track the actual rate of unemployment. One important example of hysteresis is the rise in unemployment in Europe.

65 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Global Applications 10.4 Eurosclerosis Why is hysteresis empirically most applicable to the economies of continental Europe?

66 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Hysteresis Mechanisms How do short run movements in the unemployment rate become permanent? Several different types of hysteresis mechanisms have been proposed: –Insider-Outsider Mechanisms –Long run unemployment

67 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Insider-Outsider Mechanisms

68 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Long run unemployment

69 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning NAIRU: Policy Implications The NAIRU has become a very important concept in macroeconomic policy making. It is significant to two main ways. The first is that in the long run, unemployment is determined by structural factors; therefore, the only way to reduce unemployment is to reduce the NAIRU. Hysteresis adds another dimension to this. The second area where the NAIRU is undoubtedly important is in the operation of monetary policy. As the control of inflation has become the increasing preoccupation of macroeconomic policy, the NAIRU has gained importance by association.

70 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Monetary Policy and Inflation Controlling inflation has been the predominant aim of government policy in recent times. This possibly reflects the changing emphasis of economic policy – away from direct intervention and maintaining full employment, and towards creating a stable economic environment in which private sector firms can prosper. As inflation is considered to be a root cause of economic instability, monetary policy has become increasingly important for maintaining price stability as much as an influence on aggregate demand and output.

71 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Monetary Policy and Inflation It has been established that in terms of output, monetary policy is neutral in the long run, and perhaps also in the short run if expectations are formed rationally. Therefore, controlling the money supply appears to be a key ingredient in controlling inflation. In addition, we have seen that inflation expectations feed through directly into inflation, so the management of expectations is also important.

72 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Controlling the money supply Recall that the Quantity Theory of Money suggests the following relationship between the level of nominal output and the amount of money in circulation: Mv=PY M is the money stock v is the velocity of circulation P is the price level Y is the level of real output

73 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Controlling the money supply As v and Y are fixed, then the quantity theory equation can be rearranged so that: So, The policy prescription suggested by the quantity theory is that controlling the growth of the money supply is key to controlling inflation. Inflation is everywhere a result of an excessive growth in the money supply.

74 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Monetary Targeting The expectations augmented Phillips curve highlights the important role that expectations of inflation play in establishing the actual rate of inflation in an economy. If the government considered the current level of inflation to be too high, it could simply reduce the money supply. When expectations are formed adaptively, the level of output will rise above the natural rate and there will be downward pressure on prices. Eventually, as expectations catch up with the actual rate of inflation, the economy will settle at the equilibrium rate of unemployment, but also at a lower actual and expected rate of inflation.

75 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Monetary Targeting However, under rational expectations, the use of monetary policy is far more successful, in that higher unemployment does not need to be created in order to reduce the rate of inflation. In fact, not even a contraction in the money supply is required – only a credible announcement of such. Once the government or other monetary policy authority has made public their intentions to reduce the money supply, then rational inflation expectations will be immediately revised downwards. These lower expectations will then feed through the economy through wage bargains and the lower actual rate of inflation will arise.

76 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Monetary Targeting

77 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Inflation targeting Continued financial deregulation means that monetary authorities are unlikely to exert complete control over the domestic money supply. This was described as trying to control without controls. The policy of targeting the money supply is aimed at achieving a target inflation rate. The solution to the problems might be to target the inflation rate directly. Inflation is likely to arise when the economy deviates form the NAIRU. Therefore, maintaining an inflation target requires the economy to be maintained at this level. As the interest rate is likely to control domestic activity, it can be used in keep the economy at its NAIRU.

78 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The credibility of inflation targets For monetary or inflation targeting to work, any announcement has to be seen as credible. That is, the private sector really must believe that the monetary policy authority will be prepared to make the contraction in the money policy it has announced – even if it may create unemployment. A reason why targeting may fail could well be because these policy announcements just aren’t viewed as being credible. Once the private sector has doubts over the government’s resolve to carry out the means necessary to reduce inflation, it will no longer rationally reduce inflation expectations downwards on announcement.

79 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Time Inconsistency Problem and Central Bank Independence If agents have rational expectations, then inflation targeting should prove to be remarkably successful. Whenever a new target is announced, inflation expectations will automatically adjust to the new level. No policy needs to be activated, the private sector is simply aware that if inflation differs from the target then policy would be forthcoming. Therefore, changing expectations will simply pre-empt any need for policy implementation. However, when a target is announced should the government be believed?

80 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Time Inconsistency Problem and Central Bank Independence Looking at the Phillips curve relationship, it is clear that in the long run there is no trade-off between unemployment and inflation. Accepting this, the government would probably have a preferred level of inflation towards the bottom of the vertical line. All that is required is for the government to choose their favoured position on the long run Phillips curve and announce it as their inflation target. The problem, though, for the government is in making its announcements credible. Credibility becomes an issue because of the presence of the short run Phillips curve.

81 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Time Inconsistency Problem If the government were to announce a low inflation target which is adopted into private sector expectations, the government may then face an incentive to expand the economy. If the public believes this announcement and sets expectations equal to the target inflation rate, then the short run Phillips curve with this expectation forms the policy frontier faced by the government. This original inflation announcement is now incredible. It is clearly the case that the government can move on to a lower indifference curve by trading off higher inflation for lower unemployment.

82 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Time Inconsistency Problem The public is aware of the government’s preferences and this inflation announcement is time inconsistent. If the public were to believe it, the government would then have the incentive to renege on the target. In fact, the lowest level of inflation where time inconsistency does not occur is  3. If this is the public’s inflation expectation then the government cannot move to a lower indifference curve by launching an inflation ‘surprise.’ At any inflation announcement below this level, the incentive to cheat would be restored. The public would therefore not believe any inflation announcement below  3.

83 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Time Inconsistency Problem This problem with credibility is known as the time inconsistency of low inflation monetary policy. Low inflation announcements cannot be believed because once they are acted upon, the government has the incentive to change their target level of inflation. The private sector is fully aware of these incentives and will not allow themselves to be duped. Therefore, their anticipated level of inflation would be somewhat higher. The presence of the opportunity to exploit a short run gain can actually make the government worse-off in the long run. This is an important feature of time inconsistency in policy making. Even if a government is sincere in its proclamations, it will find it hard to enforce its best outcome.

84 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning The Time Inconsistency Problem

85 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Solving the Time Inconsistency problem in monetary policy Delegating Policy to Conservative Central Bankers: One possible solution would be to delegate monetary policy making to an agent or an institution that does not share the same incentives over unemployment and inflation; this is Rogoff’s famous conservative central banker. Monetary policy is set by an independent central bank which is only interested in achieving the target rate of inflation. As its objective is independent of the rate of unemployment, its indifference curves are horizontal. Inflation announcements are now highly credible. This is the logic behind the move to make central banks independent.

86 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Conservative Central Bankers

87 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Global Applications 10.6 Central Bank Independence (CBI) and Inflation What is the evidence?

88 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Solving the Time Inconsistency problem in monetary policy Optimal Contracts Delegation does not necessarily need to be made to a central banker with very conservative attitudes towards inflation. All that is required is that the central bankers are given the incentives to act in such a way. These incentives can be formalised through performance contracts; these are known as Walsh contracts after Carl Walsh who proposed the idea.

89 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Solving the Time Inconsistency problem in monetary policy Reputation Looking at the time inconsistency problem, it is clear that the government is made worse-off in the long run. Given that this is universally known, the government should be able to find a credible way of maintaining a low inflation announcement. This simply requires the government to care about the future. If the government has a sufficiently long horizon, then they may have an incentive to try and build a reputation on being tough on inflation. The problem with reputation building is that government terms are finite and relatively short.

90 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Solving the Time Inconsistency problem in monetary policy Wider considerations: Global Applications 10.8 Coordinating monetary and fiscal policies Global Applications 10.9 What Role is Left for Fiscal Policy?

91 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage and Hyper-Inflation There are two ways in which a government can finance a deficit other than restricting fiscal policy. The first and conventional way is to borrow by issuing bonds. The second is that the government, usually with the cooperation of the central bank, can finance its deficit by printing money. The value of the real resources (real goods and services) that the government obtains by simply running the printing presses is known as seignorage revenue.

92 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage and Hyper-Inflation If the change in the money stock is  M, and the price level in the economy is P, then seignorage revenue S is given as follows: Alternatively, if both sides of this equation are multiplied and divided by M, then Seignorage is equal to the growth in the money supply g M multiplied by the current real money stock (M/P).

93 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage and Hyper-Inflation If the government wished to fund its budget deficit B from seignorage revenues (so S=B), then the required growth in the money stock can be found from rearranging: If the current budget deficit represents x percent of the money stock, then this is the required growth rate of the money stock or so we would think! The reason why the relationship isn’t as clear cut as this is because the current money stock might be influenced by the growth in the money supply.

94 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage and Hyper-Inflation In chapter 5, the amount of money balances that the public are willing to hold is given by liquidity preference theory: where the demand for money balances is positively related to income Y and negatively related to the level of interest rates r. The nominal interest rate represents the opportunity cost of money. It consists of two parts, the real interest rate and the expected level of inflation:

95 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage and Hyper-Inflation The growth in the money supply, through the Quantity Theory of Money, will lead to an increase in the rate of inflation. As inflation increases, the value of the domestic money stock falls. Given the reduction in purchasing power, people move out of money into either financial assets or real goods and services. The current money stock will be determined by the expected rate of inflation, and hence the expected rate of money growth:

96 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage and Hyper-Inflation The growth in the money supply has two effects on seignorage revenues. Seignorage can be thought of as an inflation tax, if g M = . Higher g M will increase seignorage revenues gained from the existing money stock, but it will also have the effect of reducing the money stock held by the public on which seignorage revenues can be obtained. As the growth in the money stock rises, seignorage revenues will at first rise but eventually the second order effect where money demand falls will eventually dominate. Therefore, the revenue from seignorage will be inverse U- shaped with respect to the growth in the money supply.

97 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Seignorage revenue

98 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Hyper-inflation In the short run, an increase in the growth rate of the money supply may lead to little change in real money balances. However, over time as prices adjust, the government will find the same rate of money growth yields lower seignorage revenue. Therefore, in order to fund persistent deficits, it will have to continuously increase the growth of its money supply. If there was no lag between money growth and the updating of inflation expectations, then the demand for money would fall immediately when the money growth rate was increased. Therefore, hyper-inflation requires the acceleration in the growth of money to stay one step ahead of the updating of expectations. Ever increasing growth in the money stock will generate an increase in seignorage revenues.

99 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Hyper-inflation Hyper-inflation usually starts when a government faces a large budget deficit that requires painful policy measures to offset. Seignorage is then seen as an easy way out. Hyper-inflations do not blow themselves out; inflation will continue to accelerate and can only be stopped by intervention: –A credible commitment to reducing the budget deficit through tax increases or reductions in government spending. –A credible commitment from the monetary authorities to stop printing money for the purposes of paying the debt.

100 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Summary The control of unemployment and inflation has been a longstanding preoccupation of macroeconomists. We covered the theory of the Phillips curve, which shows that there is a trade-off between the two. We saw that there is ample evidence to suggest that the trade-off is different in the short run and the long run, and the transition between short and long run is governed by the way expectations are formed and the degree of flexibility in wages and prices. Policy makers face a dilemma in trading off unemployment and inflation. They use policy to make the trade-off based on their preferences between unemployment and inflation.

101 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Summary The theory of the Phillips curve is very useful here, as it can be used to explain how monetary policy can be used to control the rate of inflation. More than this, it is the framework that is generally used to formulate monetary policy. The importance of monetary policy has grown as policy makers place an increasing emphasis on the control of inflation. Also, the traditional goal of full employment has been supplanted by target of economic stability, and as a result, the tools the government uses to control the economy have shifted away from fiscal (demand management) to monetary policy.

102 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning Summary The reasons behind the recent trend for making central banks independent can be described using the Phillips curve theory. In particular, the time inconsistency problem can be understood. Solving the time inconsistency problem involves delegation of monetary policy and the creation of an independent central bank, among others. Finally, seignorage and hyper-inflation were covered as interesting episodes.


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