1. Overview-ch.16: Pdot and U rate Pdot = %∆P u = U/LF The Phillips curve relates u and Pdot. Shifts in the Phillips curve - the role of expectations. P and PE>>Pdot and PdotE Shifts in the Phillips curve - the role of supply shocks. The cost of reducing inflation.

2. Pdot and u How are inflation and unemployment related in the short run? In the long run? What factors alter this relationship? What is the short-run cost of reducing inflation? LR? How does this relate to AD and AS?

3. Conclusion In the long run, inflation & unemployment are unrelated: Neutrality –The inflation rate depends mainly on growth in the money supply. –Unemployment (the “natural rate”) depends on the minimum wage, the market power of unions, efficiency wages, and the process of job search. –SRPC is related to cycles.—AD and SRAS.

4. How much Inflation? Rule of 70

5. Inflation and Unemployment The Natural Rate of Unemployment – depends on various features of the labour market, (e.g. minimum-wage laws, the market power of unions, the role of efficiency wages, and effectiveness of job search). – The Inflation Rate. – depends primarily on growth in the quantity of money, controlled by the B of C. B of C.

6. Inflation and Unemployment Macroeconomics focuses on three primary areas of our economy - output, prices, and unemployment. – If policy-makers expand aggregate demand, they can lower unemployment, in the short-run, but only at the cost of higher inflation. – If they contract aggregate demand, they can lower inflation, but at the cost of higher unemployment.

7. The Phillips Curve Illustrates the tradeoff between inflation and unemployment -- a short-run relationship. The Phillips Curve relates inflation and unemployment in the short-run as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. 1958: A.W. Phillips showed that nominal wage growth (Wdot) was negatively correlated with unemployment in the U.K.

8. Deriving the Phillips Curve Suppose P = 100 this year. The following graphs show two possible outcomes for next year: A.aggregate demand low, small increase in P (i.e., low inflation-P goes to 102), low output, high unemployment. B.aggregate demand high, big increase in P (i.e., high inflation-P to 106), high output, low unemployment.

9. Phillips Curve and AD-SRAS

10. The Phillips Curve in the 1950s and 1960s

11. The Phillips Curve, Aggregate Demand and Aggregate Supply The greater the aggregate demand for goods and services, the greater is the economy’s output and the higher the overall price level. A higher level of output results in a lower level of unemployment. Monetary and fiscal policy can shift the aggregate demand curve along SRAS, thus moving the economy along the SR Phillips curve.

12. Phillips Curve Inflation Rate Unemployment Rate 04%7% 2% 6% A B

13. The Tradeoff Between Inflation and Unemployment Policy-makers face a tradeoff between inflation and unemployment, and the Phillips Curve illustrates that tradeoff. – Okun’s law (PAST DATA) tells us that greater output means a lower rate of unemployment but the Phillips Curve says this is at a higher overall price level. – SR Relationship

14. Shifts in the Phillips Curve It has been suggested that the Phillips curve offers policy-makers a “menu of possible economic outcomes.” Choices Historical events have shown that the Phillips Curve can shift due to: – Expectations – Supply Shocks

15. Shifts in the Phillips Curve The concept of a stable Phillips Curve broke down in the 1970s and 1980s. During the 70s and 80s the economy experienced high inflation and high unemployment simultaneously. Economists determined that monetary policy was effective in the short-run in picking a combination of inflation and unemployment, but not in the long-run.

16. The Breakdown of the Phillips Curve

17. Phillips curve data--US

18. LRPC and LRAS Natural-rate hypothesis: the theory that unemployment eventually returns to its normal or “natural” rate, regardless of the inflation rate. Based on the classical dichotomy (neutrality) and the vertical LRAS curve.

19. LRAS and LRPC: In LR faster money growth just causes Pdot

20. Reconciling theory and data Evidence (from ’60s): PC slopes downward. Theory: PC is vertical in the long run. To bridge the gap between theory and evidence, Friedman and Phelps introduced a new variable: expected inflation – a measure of how much people expect the price level to change.

21. The Phillips Curve Equation U rate = Natural U – a (Actual inflation-expected inflation) Like the SRAS equation Short run BofC can reduce u-rate below the natural u-rate by making inflation greater than expected. Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low.

22. The Role of Expectations In the long-run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips Curve shifts. – Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. – As a result, the long-run Phillips Curve is vertical at the natural rate of unemployment.

23. The Role of Expectations In the long-run, with a vertical Phillips Curve at the natural rate of unemployment, the actual rate of inflation and unemployment will depend upon aggregate supply factors and the fiscal and monetary policies pursued by the government.

24. The Role of Expectations The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation is called the natural-rate hypothesis.

25. Expected Inflation Shifts the SRPC

26. Exam Same format as December Monday April 18---9AM Next week-chapter 17 Last class Tuesday April 5—Review +discuss exam Office hours after term ends: April 11: 3-4:30 and April 13 and April 14 from 9:30-11

27. How Expected Inflation Shifts the PC At A, expected & actual inflation = 3%, unemployment = natural rate (6%). BOC makes inflation 2% higher than expected, u-rate falls to 4% at B. In the long run, expected inflation increases, PC shifts upward, unemployment returns to natural rate at C.

28. Phillips curve Unstable in LR because P e dot changes. SR: MS↑, AD ↑,Y ↑,u↓--Pdot ↑ on SRAS but sticky W&P so that Pdot> P e dot Firms increase output but wages and other costs are sticky Workers supply more labour but greater Pdot means real wages are lower. When Pdot becomes fully expected, the SR changes are reversed as SRPC shifts

29. Shifts in the Phillips Curve: The Role of Supply Shocks The short-run Phillips Curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives policy-makers a less favourable trade-off between inflation and unemployment. Example: 1974 OPEC price increases +2011

30. The Role of Supply Shocks Major changes in aggregate supply can “worsen” the short-run tradeoff between unemployment and inflation. Eg higher oil prices shift the SRPC rightward.

31. The Role of Supply Shocks Example: OPEC in the 1970s (1) cut output and (2) raised prices. This shifts SRAS up so P ↑ and Y ↓. As Y ↓, u ↑. The tradeoff in this situation resulted in two choices: The tradeoff in this situation resulted in two choices: Fight the unemployment battle with monetary expansion (and accelerate inflation). Stand firm against inflation (but endure even higher unemployment).

32. Adverse supply shock and SRPC

33. The 1970s Oil Price Shocks Oil $ per barrel 1973: $3.50 1974: $10.10 1979: $14.85 1980: $32.50 1981: $38.00 The BOC chose to accommodate the first shock in 1973 with faster money growth. Result: Higher expected inflation, which further shifted PC. 1979-81: Oil prices surged again, worsening the BOC tradeoff.

34. Real and nominal oil prices

35. The 1970s Oil Price Shocks

36. The Cost of Reducing Inflation To reduce inflation, the B of C has to pursue contractionary monetary policy (e.g. Contractionary OMO, raising interest rates). When the B of C slows the rate of money growth: – It contracts aggregate demand (AD), which reduces the quantity of output that firms produce, which leads to a fall in employment. reduces the quantity of output that firms produce, which leads to a fall in employment. Long run: output & unemployment return to their natural rates.

37. Disinflation: MP and AD

38. The Cost of Reducing Inflation Given the actions of the B of C in combating inflation, the economy moves along (downward) the short-run Phillips Curve, resulting in lower inflation but higher unemployment. If an economy is to reduce inflation it must endure a period of high unemployment and low output.

39. Zero inflation target Some economists believe that if the central bank makes a credible statement of its intention to deflate, that lower rates of inflation can be obtained at smaller cost. PE adjusts faster. In 1988, the Bank of Canada announced its zero-inflation target, and in 1989 monetary contraction began The target was reached in 1994, by which time the unemployment rate exceeded 10 percent. Inflation fell from 4.5% to 1.1%.

40. The Cost of Reducing Inflation The sacrifice ratio is the number of percentage points of one year’s output that is lost in the process of reducing inflation by one percentage point. A typical estimate of the sacrifice ratio is between 2 and 5 percentage points. We can also express the sacrifice ratio in terms of unemployment. Reducing inflation by 1 percentage point requires a sacrifice of between 1 and 2.5 percentage points of unemployment.

41. The Cost of Reducing Inflation In some years (e.g. 1979) the sacrifice ratio was very large indicating a high level of unemployment was to be experienced in order to reduce inflation to acceptable levels.

42. Rational Expectations The theory of rational expectations suggested that the time and therefore the sacrifice-ratio, could be shorter and lower than estimated. The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

43. Rational Expectations (RE) Expected inflation is an important variable that explains why there is a tradeoff between inflation and unemployment in the short-run, but not in the long-run. How quickly the short-run tradeoff disappears depends on how quickly expectations adjust. RE says they adjust quickly, making U costs smaller –less sacrifice.

44. The Cost of Reducing Inflation The Zero Inflation Target The B of C in the 1980s, asserted that the sole goal of the B of C would thereafter be to achieve and maintain a stable price level and close to zero inflation. The Bank’s target was reached by 1992 by which time the unemployment rate had increased to over 11 percent.

45. Disinflation in the 80s and 90s

46. INFLATION SINCE 1960s Low in 1960s Upward spike through 70s into 1980s “Disinflation”-positive but declining in the 1980s Low and stable since.

47. Bank of Canada Central banks wish to avoid future inflation episodes. Analysis of 1970s indicated Pdot = f (Mdot). Since late 1980s, central banks have been “credibly committed” to price stability. Implies low P e dot

48. Why so much inflation? Mistakes by central banks—did not recognize that M growth would cause so much inflation. Mistakes by central banks—did not recognize that M growth would cause so much inflation. Bad theory—inflation will “buy” lower U.-- -PC Political pressures to inflate (instead of taxes to pay for spending).

49. Policy now—B of C Current M growth targets are designed to limit M growth if: GDP approaches potential. >>Yfe Prices start to increase by more than 2%.

50. Conclusion Our understanding of the tradeoffs between inflation and unemployment has changed dramatically over the past forty years. New evidence, new experiences, and additional analysis have led to more agreement about this phenomena than in the past. Particularly for the LR-Mankiw’s rules.

51. Summary The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.

52. Summary The tradeoff between inflation and unemployment described by the Phillips curve holds only in the short run. The long-run Phillips curve is vertical at the natural rate of unemployment. The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

53. Summary When the Bank of Canada contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve. This results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall. RE