1. BRINNER 1 902mit02.ppt The Policy Tradeoff: Unemployment vs. Changes in Inflation Introduction to Macro Policy and Models

2. BRINNER 2 902mit02.ppt Focus Today u Simple Micro: Prices, Demand and Supply u Simple Dynamics: Disequilibrium Means Change u An example central to policy choices: managing the economy to produce a desired outcome

3. BRINNER 3 902mit02.ppt Simple Micro in the Labor Market : Prices, Demand and Supply u Demand: More Workers/Hours Will Be Demanded by Employers the Lower the Real Wage, Other Things Equal u Supply: More Hours Will Be Supplied by Individuals the Higher the Real Wage u Equilibrium: Demand=Supply »All Those Wanting to Work at the Current Real Wage Can Find Work after a Reasonable Period of Search

4. BRINNER 4 902mit02.ppt Simple Micro in the Labor Market : Prices, Demand and Supply DEMAND SUPPLY REAL WAGE WORKERS or HOURS DEMANDED AND SUPPLIED EQUILIBRIUM

5. BRINNER 5 902mit02.ppt Simple Dynamics: Disequilibrium Means Change in the Labor Market u Unemployed Workers: –Voluntary, as in searching for a job at a wage higher than they or their peers are being offered: not a sign of disequilibrium –Involuntary: Would accept the prevailing wage but no offer forthcoming. »By definition, Supply greater than Demand...at the prevailing wage u Involuntary Unemployment Creates Pressure for (Real) Wages to Fall

6. BRINNER 6 902mit02.ppt Simple Dynamics: Disequilibrium Means Change in the Labor Market DEMAND SUPPLY REAL WAGE WORKERS / HOURS DEMANDED AND SUPPLIED DISEQUILIBRIUM INVOLUNTARY UNEMPLOYMENT

7. BRINNER 7 902mit02.ppt Fluctuations in Unemployment

8. BRINNER 8 902mit02.ppt Fluctuations in Unemployment

9. BRINNER 9 902mit02.ppt Fluctuations in Unemployment

10. BRINNER 10 902mit02.ppt Changes in Nominal and Real Wages (Annual Change)

11. BRINNER 11 902mit02.ppt THE APPARENT POLICY OPTIONS IN THE 1960s 1969 1965 1959 1962

12. BRINNER 12 902mit02.ppt A LONGER PERSPECTIVE

13. BRINNER 13 902mit02.ppt THE LONG-TERM POLICY CHOICES AREN'T AS OBVIOUS 1947 1959 1980 1983 1974

14. BRINNER 14 902mit02.ppt Changes in Real Wages vs. Unemployment Unemployment Gap Real Wage Growth 1994 1991 1989 1985

15. BRINNER 15 902mit02.ppt The Equation for Wage Inflation RW=RP\1+A0-A1*(U-U@VOL) The rate of change of wages (RW) equals u the rate of change in prices (RP) in the past year (“\1”) as a proxy for expected inflation u plus a constant (A0) for productivity growth and other factors not defined here u minus an adjustment for the existence of involuntarily unemployed workers:total unemployment (U) - voluntary (U@VOL)

16. BRINNER 16 902mit02.ppt A Companion Equation for Price Inflation u If prices are a simple “mark-up” on wages.. u P = K * W u hence RP = RK + RW u..and this markup falls when the economy is sluggish »RK = B0 - B1 * (U-U@VOL) u Then : RP = B0 - B1 * (U-U@VOL) + RW

17. BRINNER 17 902mit02.ppt The Final Form Model of Price Inflation u RP = B0 - B1 * (U-U@VOL) + RW u AND, EARLIER, RW=RP\1+A0-A1*(U-U@VOL) u THUS RP=(A0+B0)-(A1+B1)*(U-U@VOL)+RP\1 u OR RP-RP\1 = THE CHANGE IN INFLATION= (A0+B0) - (A1+B1)*(U-U@VOL) The acceleration in prices is tied to the level of excess demand.

18. BRINNER 18 902mit02.ppt Real Wage Inflation Inflation-Igniting Threshold: (5.5% unemployment) Nominal Wage Inflation Inflation (%) Unemployment Rate Real Wages Accelerated As Usual after Q1 1997, As Unemployment Fell Below 5.5%

19. BRINNER 19 902mit02.ppt Useful Inflation Rules of Thumb (Validated 1959-93) Consumer price inflation will rise......By 0.5 for each percentage point the unemployment rate falls below the full employment norm....By 0.1 for each percentage point increase in wholesale energy prices. Wholesale price inflation (for finished goods) will rise......By the same 0.4 for each percentage point the unemployment rate falls below the full employment norm....By 0.2 for each percentage point increase in wholesale energy prices.

20. BRINNER 20 902mit02.ppt The Track Record for the CPI Rule (The Actual and Predicted Changes in CPI Inflation) (Percentage points) HistoryForecast -6 -4 -2 0 2 4 6 8 10 12 14 19611966197119761981198619911996 Consumer Price Inflation Actual Predicted

21. BRINNER 21 902mit02.ppt The Policy Tradeoff: Unemployment vs. Changes in Inflation u RP-RP\1= THE CHANGE IN INFLATION= -0.5 * (U-U@VOL) u THIS IS THE TRADEOFF FACING ANY POLICY-MAKER WITH TARGETS INVOLVING BOTH THE INFLATION RATE AND THE UNEMPLOYMENT RATE

22. BRINNER 22 902mit02.ppt The Policy Tradeoff: Unemployment vs. Changes in Inflation u Two endogenous variables: RP and U u In terms of the earlier model, think of U as varying inversely with GNP, hence the endogenous variables are RP and GNP u If these are the only targets policy-makers care about, then they need only two policy instruments to achieve them.......if we achieve perfect coordination......and have perfect system knowledge.

23. BRINNER 23 902mit02.ppt The Policy Tradeoff: Unemployment vs. Changes in Inflation u The first priority of the Federal Reserve, the manager of one instrument--credit policy, is one target--inflation control. –The second priority/target is growth. u The first priority of elected officials, the managers of other instruments--taxes and government spending, is usually unemployment / growth –Their second priority is inflation control. u In practice, they do not collaborate well.

24. BRINNER 24 902mit02.ppt The Policy Tradeoff: Unemployment vs. Changes in Inflation u Other problems, beyond lack of collaboration, preventing simple achievement of inflation and growth goals. –Political disagreement on targets. –Scientific disagreement on, or stubborn refusal to recognize, the “model” –External shocks without adequate warning. –Desire for policy stability. –.....

25. BRINNER 25 902mit02.ppt The Policy Tradeoff: Unemployment vs. Changes in Inflation u Short-term interest rates, managed by the Fed, reveal Fed sensitivity to inflation, unemployment. and policy stability. They also reveal a lack of complete foresight.

26. BRINNER 26 902mit02.ppt THE FED REACTS PREDICTABLY TO THE ECONOMY