Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 17 Inflation, the Phillips Curve, and Central Bank Commitment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Chapter 17 Topics The Phillips curve, as observed in U.S. data. The Friedman-Lucas Money Surprise Model. Understanding the behavior of the inflation rate in the United States. Central bank learning Central bank commitment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.1 The Phillips Curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Friedman-Lucas Money Surprise Model Assume the central bank sets the inflation rate. Workers cannot observe all prices and so can misperceive their real wage. The central bank can fool workers into working harder – if the central bank sets the inflation rate higher than expected, then real output will be higher than its trend value.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 17.1 Friedman-Lucas model can be summarized by:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equation 17.2 Rewrite the previous equation:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Observed Phillips Curve Correlations Phillips curve relations do not exist in all U.S. data sets. We can observe a Phillips curve prior to 1980, but not after that. The Phillips curve shifts over time.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.2 The Phillips Curve, 1947–1959

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.3 The Phillips Curve, 1960–1969

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.4 The Phillips Curve, 1970–1979

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.5 The Phillips Curve, 1980–1989

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.6 The Phillips Curve, 1990–1999

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.7 The Phillips Curve, 2000–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.8 The Shifting Phillips Curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 17.9 The Inflation Rate in the United States, 1947–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure Deviations From Trend in Real GDP, 1947–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Explaining U.S. Inflation: Central Bank Learning Story: Fed observes the Phillips curve relation that holds in the data in the 1950s, 1960s, and 1970s, and assumes that it can increase output at the expense of some extra inflation. After experimenting with high inflation and reading Friedman and Lucas, the Fed learns the error of its ways. In the early 1980s, the Fed commits to reducing inflation.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Phillips Curve relationship in the Friedman-Lucas money surprise model

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Effects of an Increase in the Expected Inflation Rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Feds Preferences Over Inflation Rates and Output

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Fed Exploits the Phillips Curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Fed Attempts to Increase Y Permanently

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Explaining U.S. Inflation: Central Bank Commitment The Fed cannot commit to low inflation. So long as inflation is low, there is a temptation for the Fed to create surprise inflation to increase output. In equilibrium with rational expectations, people cannot be fooled, so in equilibrium inflation is at a sufficiently high level that there is no temptation for the Fed to increase inflation further.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure The Commitment Problem