Topic 5 (Chapters 8-9)

1. Topic 5(Chapters 8-9) Evolution of the Phillips curve; theories of expected inflation; inflation & economic activity.

2. Chapter 8 The Natural Rate of Unemployment and the Phillips Curve

3. The Natural Rate of Unemployment and the Phillips Curve During the period 1900-1960 in Australia, a low unemployment rate was typically associated with a high inflation rate, and a high unemployment rate was typically associated with a low or negative inflation rate.

4. Section 8.1: Inflation, Expected Inflation and Unemployment • The above equation is the aggregate supply relation derived in chapter 7. This relation can be rewritten to establish a relation between inflation, expected inflation, and the unemployment rate. • First, let the function, F, assume the linear form: • Then, replace this function in the one above:

5. Inflation, Expected Inflation and Unemployment • The appendix to this chapter shows how to go from the equation above to the relation between inflation, expected inflation, and the unemployment rate below: Divide both sides by P-1. Since 1+p= P/P-1,, and 1+p e= P e /P-1, we get (1+p)=(1+p e)(1+m)(1-au+z). Expanding the right-hand-side and dropping any cross product terms because they will be very small, we get:

6. Inflation, Expected Inflation and Unemployment • According to this equation: • An increase in the expected inflation, e, leads to an increase in inflation, . • Given expected inflation e, an increase in the markup, , or an increase in the factors that affect wage determination, z, lead to an increase in inflation. • Given expected inflation, e, an increase in the unemployment rate, u, leads to a decrease in inflation, .

7. Inflation, Expected Inflation and Unemployment • When referring to inflation, expected inflation, or unemployment in a specific year, the equation above needs to include time indexes, as follows: • The variables, et, and ut refer to inflation, expected inflation and unemployment in year t.  and z are assumed constant and don’t have time indexes.

8. Section 8.2: The Phillips Curve • If we set et = 0, then: • This is the negative relation between unemployment and inflation that Phillips found for the United Kingdom and Australia, and Solow and Samuelson found for the United States (or the originalPhillips curve). • The wage-price spiral: • Low unemployment leads to higher nominal wage. • Responding to higher wages firms raise their prices. • Higher prices lead to higher wages. • Higher wages begets higher prices…etc. • Resulting in higher inflation of prices and wages.

9. Mutations • The negative relation between unemployment and inflation held throughout the 1960s, but it vanished after that, for two reasons: • An increase in the price of oil, but more importantly; • A change in the way wage setters formed expectations due to a change in the behaviour of the rate of inflation. • The inflation rate became consistently positive; and • Inflation became more persistent.

10. Mutations The steady decline in the unemployment rate throughout the 1960s was associated with a steady increase in the inflation rate in both Australia and the US.

11. Mutations From mid-1970, the relation between the unemployment rate and the inflation rate disappeared in Australia and the US

12. Inflation in Australia and the US from 1901 to 2008 Since the 1960s, the Australian (and the U.S.) inflation rate has been positive. Inflation has also become more persistent: A high inflation rate this year is more likely to be followed by a high inflation rate next year.

13. The Formation of Expectations • Suppose expectations of inflation are formed according to: • The parameter  captures the effect of last year’s inflation rate, t-1, on this year’s expected inflation rate, et. • The value of  steadily increased in the 1970s, from zero to one.

14. The Formation of Expectations • In the equation above, when  equals zero, the relation between the inflation rate and the unemployment rate is: • When  is positive, the inflation rate depends on both the unemployment rate and last year’s inflation rate: • When  equals 1, the change in the inflation rate depends on the unemployment rate:

15. The Formation of Expectations • When  =1, the unemployment rate affects not the inflation rate, but the change in the expected inflation rate. • Since 1970, a clear negative relation emerged between the unemployment rate and the change in the inflation rate.

16. Changes in Inflation versus Unemployment in Australia, 1970-2007 Since 1970, there has been a negative relation between the unemployment rate and the CHANGE in the inflation rate in Australia. • The line that best fits the scatter of points during 1970-2007 is: pt - pt-1 = 2.0% – 0.32 u t

17. Changes in Inflation versus Unemployment in the US, 1970-2007 Since 1970, there has been a negative relation between the unemployment rate and the CHANGE in the inflation rate in the US. • The line that best fits the scatter of points during 1970-2007 is: pt - pt-1 = 2.64% – 0.44 u t

18. The Formation of Expectations • The original Phillips curve is: • The modified Phillips curve, also called the expectations-augmented Phillips curve, or the accelerationist Phillips curve, is: • Note the key difference on the left side of the equations.

19. then, Back to the Natural Rate of Unemployment • Friedman and Phelps questioned the trade-off between unemployment and inflation. They argued that the unemployment rate could not be sustained below a certain level, a level they called the “natural rate of unemployment.” • The natural rate of unemployment is the unemployment rate such that the actual inflation rate is equal to the expected inflation rate.

20. Back to the Natural Rate of Unemployment  • This is an important relation because it gives another way of thinking about the Phillips curve in terms of the actual and the natural unemployment rates, and the change in the inflation rate. Given: then, Finally, assuming that et is well approximated by t-1,

21. Back to the Natural Rate of Unemployment • The equation above gives us another way of thinking about the natural rate of unemployment: • The non-accelerating-inflation rate of unemployment, (or NAIRU), is the rate of unemployment required to keep the inflation rate constant.

22. Chapter 9 Inflation and Economic Activity

23. Section 9.1: Output, Unemployment and Inflation This chapter builds on three relations: Okun’s Law, which relates the change in unemployment to output growth. The Phillips curve, which relates the changes in inflation to unemployment. The dynamicaggregate demand relation, which relates output growth to inflation.

24. Output, Unemployment and Inflation

25. Okun’s Law: From Output Growth to Unemployment The actual relation between output growth (gy) and the change in the unemployment rate is known as Okun’s law. Using more than twenty years of data, the line that best fits the Australian data is given by: ut - ut-1 = - 0.5 ( gyt - 3.2% )

26. High output growth is associated with a fall in the unemployment rate; low output growth is associated with an increase in the unemployment rate. Okun’s Law in Australia 1982-2007: From Output Growth to Unemployment

27. According to the equation above: Okun’s Law: From Output Growth to Unemployment ut - ut-1 = -0.5(gyt - 3.2%) • To maintain the unemployment rate constant, output growth must be 3.2% per year. This growth rate of output is called the normal growth rate.

28. Using letters rather than numbers: Okun’s Law: From Output Growth to Unemployment ut - ut-1 = -0.5(gyt - 3.2%) • Output growth above (below) normal leads to a decrease (increase) in the unemployment rate. This is Okun’s law:

29. Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. When et is well approximated by t-1, then: According to the Phillips curve: The Phillips Curve: From Unemployment to Inflation

30. The Phillips Curve: for Australia 1982-2007 Re-estimating Australia’s Phillips curve for 1982 to 2007 gives:

31. Dynamic Aggregate Demand Relation: From Inflation to Output Growth • Goods market equilibrium (IS relation) can be written as: • Again, since we are not interested in fiscal policy in this chapter, we shall ignore GandT, and use a special form (as an example) for the above: represents all those factors that are associated with output, income and aggregate demand growing at the normal rate.

32. Dynamic Aggregate Demand Relation: From Inflation to Output Growth This goods market equilibrium relation can be written in growth terms: In words: • Output grows at the normal rate if the interest rate is constant (git=0). • Output growth exceeds the normal rate if the interest rate is falling (git<0). • Output growth is less than the normal rate if the interest rate is rising (git>0).

33. Dynamic Aggregate Demand Relation: From Inflation to Output Growth The goods market equilibrium relation in growth terms: • Since we are interested in inflation now, we can recognise the reality that the central bank has an inflation target, pT (rather than the price level target of chapter 7). • Assume interest rates are rising if inflation exceeds the target, falling if below target, and unchanged if on target: fmeasures the strength of the central bank’s reaction to inflation

34. Dynamic Aggregate Demand Relation: From Inflation to Output Growth Combining these two: gives the dynamic aggregate demand relation AD: • According to this dynamic aggregate demand relation:

35. Estimating the Dynamic Aggregate Demand Relation for Australia 1982-2007 This says that if inflation increases by 1%, the RBA will raise the interest rate and slow growth by 0.45 percentage points within a year.

36. The Short and the Medium Run The 3 relations are: i. Okun’s law: ii. Phillips curve: iii. Dynamic AD:In the medium run:

37. The Short and the Medium Run in Australia, 1982-2007 The 3 relations are: a) Phillips curve: b) Okun’s law: c) Dynamic AD: In the medium run:

38. Section9.2: The Effects of a Monetary Policy Disinflation: The Medium Run Disinflation = a reduction of the actual and target inflation rates) In the medium run, there are no real effects of disinflation – unemployment returns to the same natural rate

39. To achieve lower inflation target, the interest rate must be raised. Here is what happens: Disinflation in the Short Run • From dynamic aggregate demand: • Then, from Okun’s law: • Finally, from the Phillips curve: But over time, • According to the Phillips curve : • From aggregate demand: • Then, from Okun’s law: • After initial rise in i, u first increases, but eventually, it must start decreasing.

40. This figure shows the path of unemployment and inflation implied by the disinflation path, when the central bank aims for 6 years of disinflation. (If the central bank instead follows its interest rate rule, the path actually spirals as it converges to C). Working Out a Path if Central Bank uses Discretion to set the Interest Rate each period to get inflation down in about 6 years About 6 years of unemployment above the natural rate of unemployment lead to a permanent decrease in inflation.

41. Section 9.4: The Australian Disinflation, 1989-1994

42. The Australian Disinflation, 1989-1994 The Australian disinflation of the early 1990s was associated with a substantial increase in unemployment. The Phillips curve relation proved more robust than many economists anticipated.