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Econ140

p, U and policy trade-offs

Lecture 21-22

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Econ140 1

Overview

MainpointsThis model extends the basic model by relaxing the assumption thatdemand alone determines output.

It examines how output and prices may change in the short run, andhow the economy returns to a long run equilibrium.

Key words / terms:

Natural rate of unemployment (U*), potential/full employment level of

output (Yf), short run/long run Phillips Curve (SRPC/LRPC), inflation-

unemployment trade-off, short run inflation adjustment (SRIA) curve,expected inflation (pe), exogenous/adaptive/rational expectations,inflation-output stability trade-off

Text reference: Ch 34, 37; pp 747, 819-827, 832-833

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Econ140 2

Policy tradeoffs

We have looked at aggregate demand and supply shocks

affecting inflation. A core result is that in the long run output

returns to its full employment level.

Now we will look at how the economy adjusts back to the

full employment level of output following a shock. We will

consider how economic activity affects inflation, and the

tradeoffs policy makers face in managing fluctuations in

output, employment and inflation.

To consider these tradeoffs we will develop two new tools:

the Phillips Curve (PC) and the Short Run Inflation

Adjustment (SRIA) curve.

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Econ140 3

Inflation and unemployment

The natural rate of unemployment (U*) is the level of

unemployment when output is at its full employment level: Y

= Yf U = U*.

U* includes some level of seasonal, frictional, and

structural unemployment.

Frictional: waiting for movement to other jobs

Structural: lacking of necessary skills to joint labour

market (long term)

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Econ140 4

Inflation and unemployment

When U= U* there is no change in wage growth, and no

increase in inflation.

IfU> U*, then there is cyclical unemployment, slack in the

labor market, and Y< Yf, wage growth slows, so inflation

falls.

IfU< U*, then there is a tight labor market, more overtime,

Y> Yf, and wage growth increases, so inflation rises.

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Econ140 5

The Phillips curve

The Phillips curve (PC) captures the trade-off betweenoutput and unemployment in the SR.

This relationship reflects the idea that:

Y Y* pressure in the labour market.Raising output lowers unemployment

and as people work more they demand higher wages

but higher wages appear as inflation

as firms pass on this cost increase to customersU p

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Econ140

SRPC

U p

U p

The Phillips curve (2)

Inflation

rate (%)

Unemployment

rate (%)

U*

(Y0=Yf)

p0

Beginning at Y0=Yfsuppose

the government moves to an

expansionary fiscal policy, G :

AD Y

U1(Yf

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Econ140 7

The Phillips curve in the US

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Econ140

Short run inflation adjustment:line and

curve

SRIA line will show actual/current inflation and being

horizontally. This is very simple ideal

SRIA curve is upward sloping. This is more practical to be

explained the relationship between Y and Inflation

8

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Econ140

SRIA and SRPC: same assumption

9Yf

Y

The short run inflation adjustment (SRIA) curve is positivelysloped: moving along a SRIA curve reflects the Phillips

curve and the impact of an output gap

if Yf

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Econ140

In the short-run, the Phillips curve implies we can trade offunemployment for inflation. Each SRPC is associated withone specific pe

But what happens in the LR?

In the LR, inflation expectations may change. Differentinflation rates may be consistent with Y=Yfand U=U*; in eqmp depends on pe.

Suppose the central bank lifts its target inflation rate. It begins

by lowering the interest rate, stimulating employment, but witha given level of wages/growth (i.e. based on a given level ofpe).

This is shown by the SRPC shifting right. In the LR

SRPC and LRPC

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Econ140

As pe the SRPC shifts to the right. Firms hire fewer workersat a higher real wage rate given p2, U to U*.

The short and long of it (2)

p

UU*

(Y0=Y*)

p0U1

(Y1>Y*)

p1A

E

At B, workers get it right:

pe = p.

In the LR there is no trade-

off between unemploymentand inflation.

11

PC1

The economy moves to B

on PC2

.

B

PC2

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Econ140

LRPC

The LRPC is vertical: the economy adjusts back to U*regardless ofp.

In the LR, there is no trade-off

between p and U:

U returns to U*.

The long-run Phillips curve

p

UU*

(Y0=Y*)

p0U1

(Y1>Y*)

p1BA

12

PC2

PC1

The SRPC shows a short-run

trade-off: its positiondepends upon

expectations about inflation (whichaffect their nominal wage demand).

Expectations are fixed in the SR

but may change in the LR.

E

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Econ140

The long-run Phillips curve (2)

The vertical LRPC implies that sooner or later, the economywill return to U* whatever the inflation rate.

The LRPC and SRPC intersect when actual and expected

inflation equalise.

At this point, the economy is in a LR eqm: Y=Yf, U=U* and

p=pe.

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Econ140

The adjustment process

Changes in AE lead to fluctuations in output in the SR.

Over time, deviations from full employment lead the central

bank to temporarily change interest rates to combat the

change in AE (or the central bank adjusts its targets; we will

come to this shortly).

But the economy (gradually) works its way back to potential

output.

How this adjustment occurs depends on the central bankscredibility and the adjustment of inflation expectations in the

long-run.

What drives peoples expectations of inflation?

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Econ140

Expectations of the future (3)

Suppose Y=Yfand pe = p0. If the government pushes outputbeyond potential (Yf

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Econ140

Combining ADI and SRIA: LR adjustment

Combining the ADI and SRIA allows us to see how theeconomy adjusts over time to a shock, as output,

unemployment and inflation expectations adjust.

Suppose G rises

16Yf Y

SRIA0 (pe=p0)

p0

p

E0

ADI0

p1

Y1

E1

ADI1

SRIA1 (pe=p1)

p2

SRIA2 (pe=p2)

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Econ140

A boost to economic activity can boost

inflation

We can now see that a boost to economic activity such as acut in the OCR will be associated with firms producing more

output andan increase in inflation.

To produce more output, firms will want more inputs,

including capital and labour. Suppose the economy is close

to its full-employment level of output and there are very few

idle resources in the economy.

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Econ140

A boost to economic activity can boost

inflation (2)

In the short run:

if the stock of capital is fixed, firms will compete against

each other to acquire this increasingly scare resource.

Therefore, the price of capital will rise.

to hire more workers, firms will either have to poach good

workers from other firms or encourage people not

currently in the labour force to work for them. This drives

up wage rates.

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Econ140

A boost to economic activity can boost

inflation (3)

To meet the increased demand, firms try to produce moreoutput. This leads to an increase in the costs of production.

Because of the high demand for its output, firms will seek to

pass on their higher costs and, further, to ration demand by

raising the price of its output.

As many firms across the economy simultaneously

increasing the price of their output, the overall price level in

the economy rises; inflation rises.

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Econ140

Monetary policy changes and inflation

Suppose the central bank reduces

its inflation target to p1.p

U

p0

PC1

U1(Y1

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Econ140

Tradeoffs in monetary objectives

When all shocks are demand shocks, stabilising inflationalso stabilises output.

The central bank can alter its monetary policy to counteract

changes to AD (and shifts of the ADI).

E.g. the CB could counter an expansionary demand shock which

increases in flation by lifting its target interest rate, i*. Higher interest

rates discourage investment, causing ADI to fall. Inflation returns to

its target level and output to Yf.

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Econ140

Y* Y

SRIA

Suppose there is a fiscalexpansion, lifting AE. The ADI

shifts right. In the short run, Y and

p will rise, if the central bank doesnot respond.

p*

p

Tradeoffs in monetary objectives (3)

ADI0

E

22

ADI1

pAA

YA

The central bank could defend its

inflation target by adjusting its

MPR. An appropriate shift in the

policy rule keeps ADI at ADI0,

stabilsing p and keeping output atYf.

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Econ140

Tradeoffs in monetary objectives (2)

When shocks are supply shocks, stabilising inflation doesnot stabilise output: there is a trade-off.

Stabilising inflation may lead to highly variable output, while

stabilising output may lead to highly variable inflation.

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Econ140

Tradeoffs in monetary objectives (3)

The central bank may react to the tradeoff with acompromise.

Recall, the CBs reaction to inflation deviations is measured by the

parameterd. dis smaller for more flexible targeting.

Flexible inflation targeting gives the central bank somediscretion about how quickly they reach the inflation target

(e.g. over the medium run).

A flexible target is shown by a non-vertical policy rule (MPR), and a

downward sloping ADI.

By accommodating a greater change in inflation following a

supply shock, the CB may cause a smaller change in output.

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Econ140

Y* Y

SRIA

p*

p

Tradeoffs in monetary objectives (4)

Monetary policy cannotstabilise both output and

inflation with supply shocks.

Maintaining the central banksinflation target ofp* followingsupply shocks, causes output to

fluctuate between Y and Y, as

the bank strongly adjusts interest

rates.

SRIA'

Y'

SRIA

Y

ADI0

A flexible inflation approach, shown by ADI0, has lower output

fluctuations (between YA and YB). Interest rates are changed by less as

the bank allows some change in p.

pAA

YA

pBB

YB

E

25