Expectations and Macroeconomics Chapter 18

2 Introduction We have put together a complete model of aggregate demand, supply and wage adjustment.

3 Introduction So far, we have maintained the assumption that expectations of future inflation are exogenous. Now, we study the endogenous determination of expectation. One approach, rational expectations, came to dominate the way that expectations are modeled in practice.

4 Postwar Economic History of the U.S. In ch17, we began our model in 1949 because our theory may not apply when the government directly controls prices, as it did during WWII. We use new-Keynesian theory to show that a model in which expectations are fixed cannot account for the experiences of the 1970s and 1980s.

5 Inflation To assume that expectations of price inflation are constant is not unreasonable when looking at the 1950s and 1960s: -- inflation exceed 2% about as often as it fell short of 2%. -- After 1965, inflation began to climb and by 1969 it was higher than 4%. However, a period of temporarily high inflation in the late 1960s might reasonably have been expected to decline in subsequent years.

6 ©2002 South-Western College Publishing Figure 17.6A The History of Inflation, 1949–1969

7 ©2002 South-Western College Publishing Figure 17.6B The History of Inflation, 1949–1969

8 Inflation The history of the 1970s and 1980s was very different from that of the two preceding decades. -- From 1969 through 1981, inflation climbed in almost every year. -- After peaking in 1981, inflation had begun to slow down, and by 1996 it had returned to the level of the levels of the 1950s. -- See BOX Thus, constant expectation cannot be assumed when applying the model to this period.

9 New-Keynesian Wage Equation From the New-Keynesian wage adjustment equation, there is a trade-off relationship between expected real wage rate inflation and unemployment.

10 The Phillips Curve The role of expectations was poorly understood and expected price inflation was typically omitted from the new-Keynesian wage eq. As a result, A.W. Phillips argued that there is a stable trade-off relationship between unemployment and inflation. (original Phillips curve)

11 The Phillips Curve One way to test the validity of the new- Keynesian wage equation and the Phillips curve is to replace the expected inflation by actual inflation.

12 The Phillips Curve BOX 18.2 indicates that -- Phillips curve holds in the 1950s and 1960s, but break down in the 1970s and 1980s. --However, the new-Keynesian wage equation is robust in each of the sample periods. This comes from the fact that Phillips curve is conditional on constant expected inflation.

13 The Phillips Curve P.A. Samuelson further replaced the wage inflation with the price inflation from the Phillips curve. A trade-off relationship between price inflation and unemployment.

14 The Phillips Curve According to this view, the goal of economic policy was to pick a point on the Phillips curve by choosing the rate of money creation. -- if Fed chose rapid monetary expansion, high inflation but low unemployment would result. -- if Fed chose low rate of monetary expansion, low inflation and high unemployment would result.

15 The Phillips Curve Since it is unreasonable to assume constant expected inflation as actual inflation varies with the unemployment, this Phillips curve relationship suggested by Samuelson also broke down as inflation took hold.

16 The Natural Rate Hypothesis (NAIRU) Two prominent critics of the trade-off view were Phelps and Friedman. -- Permanently low unemployment is unsustainable in the long run. -- The observed relationship between inflation and unemployment occurs as a result of mistaken expectations. -- The economy has a natural rate of unemployment which is independent of the variables that shift the AD curve.

17 The Natural Rate Hypothesis (NAIRU) Unemployment can only be above or below this natural this natural rate as a result of mistaken expectations on the part of private decision- makers. -- If policymakers try to maintain unemployment below its natural rate, the inflation will accelerate with each successive attempt. The result is a self-fulfilling spiral of wage and price increases. The natural unemployment rate is referred as the non-accelerating inflation rate of unemployment (NAIRU).

18 The Natural Rate Hypothesis (NAIRU) Evidence: Figure 18.2, BOX In the early 1970s, the government began to run larger deficits. Increased expenditures were financed by new government bonds and some of these bonds were bought by the Fed as it tried to keep down the nominal interest rate. As the Fed bought government debt, it created new money to pay for it, and the rate of money creation began to climb.

19 ©2002 South-Western College Publishing Figure 18.2 Money Growth and Debt Creation in the Postwar Period

20 The Natural Rate Hypothesis (NAIRU) Increases in the money supply led to higher inflation. However, the economy experienced higher unemployment at the same time. This is called stagflation.  the Phillips curve represent only a short-run relationship between unemployment and inflation that relies on misperceptions of future inflation.

21 The New-Keynesian Model What we learned from the postwar events is that expectations cannot be modeled using mechanical rule. We now examine the implications of the new- Keynesian model in the short-run and long-run.

22 Determining Growth and Inflation Growth and inflation are determined at the point where the AD and the SRAS intersect. The AD curve crosses the LRAS curve when inflation equals excess money growth,. The SRAS curve crosses the LRAS curve when inflation equals excess wage inflation,.

23 ©2002 South-Western College Publishing Figure 18.3 Fixing the Position of the Aggregate Demand and Supply Curves

24 Short-Run Growth and Inflation Now that we understand how the position of the AD and AS are determined, we can use the AD-AS diagram to explain the effects of monetary policy. We begin with a baseline case in which wage inflation and money growth are equal : Now consider the case the rate of money creation increases.

25 ©2002 South-Western College Publishing Figure 18.4 Short-Run Effects of an Increase in the Rate of Money Creation

26 Long-Run Growth and Inflation The Fed can increase employment and growth in the short run. But what would be the long- run effect ? Two factors cause upward on the rate of wage inflation: 1. Because unemployment is below its natural rate, the rate of wage inflation will begin to increase. 2. Firm and H.H. are surprised by the level of price inflation and revise upward their expectations of future price inflation.

27 ©2002 South-Western College Publishing Figure 18.5 Long-Run Effects of an Increase in the Rate of Money Creation

28 Explaining Expectations Endogenously A key element in the explanation of historical events is the idea that expectations adjust endogenously. When the environment changes, people change the way in which they forecast the future. The fact that human beings adapt to their environment led to the theory of rational expectation.

29 Rational Expectations Rational expectations is based on the idea that the world is a lot like a casino. In reality, nothing is certain. Let’s focus on cases in which all uncertainty is associated with aggregate demand – the rate of money creation. The shocks to the AD is assumed to be random. We say that is rational to calculate the inflation using probabilities.

30 Expected Price Inflation is Too Slow Suppose that the probability that is p and the probability that is (1-p). Then, the rational expectation of the inflation rate is equal This also can be viewed as the expectation of the money creation. Lets consider two cases in which expectations are not rational.

31 ©2002 South-Western College Publishing Figure 18.6 The Determination of Inflation When Expected Inflation Is Too Low

32 ©2002 South-Western College Publishing Figure 18.7 The Determination of Inflation When Expected Inflation Is Too High

33 Rational Expectations of Price Inflation Rational expectations is a method of modeling expectations that accounts for the ability of human beings to adapt their environment. The rational expectation of the inflation rate is equal to its average value which depends on. A consistent string of outcomes that are higher (lower) than expected would cause workers and firms to revise their expectations of inflation upwards (downwards).

34 ©2002 South-Western College Publishing Figure 18.8 The Rational Expectations of Inflation

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