1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-1 Chapter 13 Inflation

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-2 Learning objectives Derive and examine the implications of the so-called Phillips curve Discuss whether there is any apparent trade-off between unemployment and inflation Examine the natural rate hypothesis and use it to analyse Australia’s experiences with stagflation

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-3 Learning objectives (cont.) Explore the links between the Phillips curve model and our model of aggregate supply Discuss demand-pull and cost-push inflation in light of our understanding of the Phillips curve

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-4 Phillips curve: introduction The aggregate expenditure model developed in Chapter 6 assumed that the economy could experience either unemployment or inflation but not both concurrently Realistically both can occur as shown in the intermediate range of the AS curve The simultaneous occurrence of increasing unemployment and inflation known as stagflation was a common macroeconomic problem in the 1970s and early 1980s Stagflation was due to the leftward shift of the AS curve

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-5 Phillips curve An inverse relationship suggestive of a trade-off between inflation and the unemployment rate Generalisation –The greater the rate of growth of AD, the greater the resulting inflation and GDP, and the lower the unemployment level –The slower the rate of growth of AD, the lower the resulting inflation and GDP, and the higher the unemployment level

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-6 Changes in AD, real GDP and the price level 0 P0P0 Q0Q0 AD 0 AS Price level Real GDP AS LR P1P1 Q1Q1 AD 1 P2P2 Q2Q2 AD 3

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-7 Phillips curve (cont.) Evidence –Empirical work by economists in the 1950s and 1960s Explanations for the trade-off between unemployment and inflation –Labour market imbalances  Bottlenecks  Structural problems –Market power of unions and big business  Higher wages are passed on to the consumers  Market power enables firms to seek higher profits (profit-push)

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-8 The Phillips curve concept Annual rate of inflation (per cent) Unemployment rate (per cent) 7654321076543210 1 2 3 4 5 6 7 unemployment increases as inflation declines...

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-9 Phillips curve (cont.) Stabilisation policy dilemma –Fiscal and monetary policies act on AD and not on labour market imbalances and market power Two complications –Reversibility problem  Price levels are usually flexible upwards, but quite inflexbile downwards –The Phillips curve assumed a fixed AS curve, but AS curve can shift leftwards for various reasons Not a reliable basis for economic policy

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-10 Stagflation: a shifting Phillips curve Stagflation Simultaneous experience of both high and increasing unemployment and inflation Conflicts with the trade-offs embodied in the Phillips curve

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-11 Stability of the Phillips curve

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-12 Causes of stagflation Aggregate supply shocks such as severe increases in fuel costs ( the OPEC oil shock), and devaluations of the Australian dollar Productivity decline Inflationary expectations and wages –Expectations about the likely future path and rate of increase of the general price level

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-13 Aggregate supply shocks 0 P1P1 AS 1 AD 1 AS 2 P2P2 P3P3 AS LR QFQF Price level Real GDP AS 3 Q2Q2 Q3Q3 Q1Q1

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-14 Natural rate hypothesis Suggests that there is a unique level of unemployment around which observed unemployment will fluctuate LR stability corresponds with natural or full- employment rate of unemployment Two variants –Theory of adaptive expectations –Rational expectations theory

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-15 Theory of adaptive expectations People form their expectation of future inflation based on previous and current rates of inflation There is a short-run trade-off between unemployment and inflation, but in the long run no such trade-offs exists

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-16 Theory of adaptive expectations (cont.) Consequently, there exists a short-run and a long-run Phillips curve Series of short-run Phillips curves –Short-run trade-offs between inflation and unemployment Long-run vertical Phillips curve Can be employed to explain disinflation –Reductions in or elimination of the rate of inflation

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-17 Adaptive expectations theory B2B2 0 3 6 9 12 2 468 A1A1 C2C2 A4A4 A3A3 B1B1 PC LR PC 2 C3C3 B3B3 PC 3 PC 1 A2A2 Rate of interest (% p.a) Unemployment (%)

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-18 Rational expectations theory Increases in money wages lag behind increases in the price level, giving rise to temporary increases in profits and employment Argues that government measures to increase employment will only result in accelerating rates of inflation

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-19 Short-run aggregate supply Short run: period in which input prices (especially wages) remain fixed in the presence of a change in the price level Constant input prices –Lack of knowledge of existence of change –Fixed-wage contracts

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-20 Long-run aggregate supply Long run: period in which input prices, including wages, are fully flexible in the presence of changes in the price level Increasing input prices –Workers discover that prices have changed and demand higher nominal wages to restore their level of real wages

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-21 New classical policy implications Price-level surprises –May create short-run macroeconomic instability –However, long-run stability occurs at full- employment level of output Long-run occurs either instantaneously or in a very short period Government intervention is not endorsed

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-22 Short-run and long-run AS PC LR AS 3 C1C1 B1B1 A1A1 A3A3 A1A1 A2A2 AS1 P3P3 Q3Q3 Price level Real GDP Price Level P1P1 P2P2 P3P3 P1P1 P2P2 Q1Q1 Q2Q2 A3A3 A2A2 AS 1 AS 2 Q p (b) Long-run AS (a) Short-run AS Real GDP

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-23 Modern Keynesian policy implications Markets are not highly competitive –Instantaneous adjustments do not occur Nominal wage adjustments are very slow Stabilisation policies are required to reduce the severe costs of unemployment or inflation

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-24 Demand-pull inflation Occurs when an increase in AD pulls up the price level Graphically — AD shifts rightward along a stable AS curve Short-run — increased prices and real output

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-25 AS 2 Demand-pull inflation (cont.) AD 2 0 AS 1 AS LR AD 1 Q1Q1 Price level Real GDP P1P1 e1e1e1e1 P2P2 Q2Q2 e2e2e2e2 P3P3 e3e3e3e3

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-26 Demand-pull inflation (cont.) In the short run, demand-pull inflation will drive up the price level and increase output In the long run, the increase in aggregate demand has only moved the economy along the vertical aggregate supply curve AS LR

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-27 Cost-push inflation Occurs when an increase in the cost of production at each price level shifts the AS curve leftward, resulting in increased prices Short run — increased prices and decreased real output (and more unemployment)

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-28 AD 2 Cost-push inflation (cont.) 0 AS 1 AS LR AD 1 Q1Q1 Price level Real GDP AS 2 Q3Q3 P1P1 e′1e′1e′1e′1 P2P2 e′2e′2e′2e′2 Q2Q2 e′3e′3e′3e′3 P3P3 An attempt to increase AD will only further increase the price level

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-29 Cost-push inflation and policy dilemma Government intervention (AD): If government intervenes to increase AD, an inflationary spiral will result No government intervention (AD): If government does not intervene to increase AD, severe recession will result; however, nominal wages will eventually decline and restore AS to original position

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 13-30 Cost-push inflation: non-demand management options Two categories of non-demand management policies –Market policies –Wage–price (or incomes) policies