W8B Outline

1. W8B Outline • Akerlof on Markets + Behavior Expectations • Phillips Curve • Static 1960’s • Why did it shift? • Keynesian Supply & Demand Shock Explanation • Gov. policy error explanation • Sacrifice? • Contending Perspective on Policy and the Natural Rate.

2. Box 11.2 A liquidity trap

3. Akerlof Link on 306 page doesn’t work right. Takes you to Nobel Prize Home page. Search for Akerlof and download the address. Why not buy into the New Classical emphasis on fully rational expectations and fully rational optimizing behavior? Because Keynes was right! People act according to “cognitive bias, reciprocity, fairness, herding, and social status” Seek common ground with sociology + psychology.

4. 6 things poorly explained by standard market optimization • 1/6 Involuntary Ue, why can’t they get work by • Offering a slightly lower wage?(Sabotage) • 2/6 Why does M policy have an impact? • Firms and workers focus on the important things. Small amounts of price stickiness in the face of inflation have small impact on individual firm profits, but the money has a large impact on sales.

5. 3/6 Prevalence of Undersaving • People regret not having saved more. • Undersaving happens despite gov. efforts. • Happens due to time inconsistency, hyperbolic discounting. • So let people lock in today, next year’s saving sacrifice for retirement.

6. 6 things poorly explained by standard market optimization • 4/6 Failure of Deflation to accelerate. • After initial deflation in Great Depression the price level stabilized and Ue stayed high. Deflation did not get faster. • 5/6 Excess Volatility of Stock Prices. Keynes GT p. 154-156, (R. Shiller today) • 6/6 Self Destructive Underclass Akerlof last paragraphs.

7. Figure 12.01 The Phillips curve and the U.S. economy during the 1960s The Phillips curve and the U.S. economy during the 1960s Solow and Samuelson 1960 Provided veiw

8. Figure 12.02 Inflation and unemployment in the United States, 1970-1998 Figure 12.02 Inflation and unemployment in the United States, 1970-1998

9. Figure 12.05 The shifting Phillips curve: an increase in expected inflation Figure 12.05 The shifting Phillips curve: an increase in expected inflation inf Late 60’s u

10. Figure 12.06 The shifting Phillips curve: an increase in the natural unemployment rate Figure 12.06 The shifting Phillips curve: an increase in the natural unemployment rate

11. Figure 12.07 The expectations-augmented Phillips curve in the United States, 1970-1998 Figure 12.07 The expectations-augmented Phillips curve in the United States, 1970-1998

12. Components of Ue and inf They vary inversely, as if on a short run Phillips curve. Sargent: The conquest of American inflation: A summary

13. Scatter plot Ue inf

14. Why Can’t I Draw? 79 inf 73 Early 80’s End 60’s Late 90’s Ue

15. US 49-00

16. US 42-68

17. US 70’s

18. US 80’s

19. US 90’s

20. Dallas FRB Economic Data

21. Supply Side vs Demand Side views of inflation = e+h(u-unatural) This is a demand side view of inflation as caused by deviations of u from unatural which is Y from Yp All “demand” side interpreters also Think that supply side shocks—oil— Have also been important. Y=YP+h(P-Pe) or Y=YP+h(- e) U is det by Y Unexpected prices or  Cause output and U Changes, This is Lucas’s SRAS supply-side story

22. Sargent on US Policy He hopes US has learned that the Nat Rate of unempolyment Is constant. But suspects that the FRB just looks at the past Behavior of inflation and unemployment. When inflation has been stable the Phillips curve is temporarily Stable, because people don’t expect inflation. The FRB then picks Its 0ptimal choice on this Phillips curve “menu”. As the Phillips Curve shifts up the FRB learns that it can’t be exploited, and lowers Inflation. But once inflation has been low for a while…..the whole Thing starts over. Or so Sargent’t simulations and text suggest.

23. Figure 12.03 Ongoing inflation in the extended classical model Figure 12.03 Ongoing inflation in the extended classical model

24. Figure 12.04 Unanticipated inflation in the extended classical model Figure 12.04 Unanticipated inflation in the extended classical model

25. The long-run Phillips curve Figure 12.08 The long-run Phillips curve

26. Sacrifice? Sacrifice ratio: cumulative loss in GDP in order to get inflation Down by 1%. (Text ratios from 1-3%) Kyenesians tend to emphasize large ratios. Sargent and the RBC tradition emphasize the possibility of costless dis-inflation If the public is convinced that inflation is abruptly ending then:. SRAS Contractionary AD policy with falling expected price level yields lower P AD Y

27. Hysteresis and other unnatural phenomena. Labor market hysteresis: high cyclical unemployment raises the natural rate because i) workers loose skills ii) firms regard unemployment as a bad signal-stigma Also high cyclical unemployment may depress the labor participation rate as more workers become ‘discouraged’ or opt not to enter the workforce. Low investment during recessions may lower the capital stock and rate of productivity growth which would retard the growth of labor demand in the next upswing.

28. A changing “natural” rate Hysterisis Can give rise To a non-vertical LRPC. inf SR PC u

29. Unemployment rates in Western Europe Figure 12.11 Unemployment rates in Western Europe

30. Figure 12.09 Actual and natural unemployment rates in the United States CBO natural rate

31. US demographic groups Figure 12.10a Unemployment rates by demographic group What was so great about the 60’s.

32. Akerlof on M policy In contrast to Sargent—who hopes but doubts that the FRB has Learned that the natural rate does not change and is a single #-- Akerloff is fears that the FRB is too cautious in steering between Inflation and unemployment. At low rates of inflation people don’t revise their inflation expectations, so you can lower unemployment at the cost of non-accelerating inflation (good old fashioned stable Phillips Curve) over some range.

33. Similar to Ch12N4 1/3

34. Similar to Ch12N4 2/3 We want the positive “root”.

35. Similar to Ch12N4 3/3

36. Taylor Rule Is a “rule” describing rather than prescribing FRB action.

37. Interest rate targeting • Fairmodel: • Central bank can • Target only 1: • Interest rate • Money supply • Gov Debt • They target (a) Able and Bernanke Ch 14

38. The discount rate and the Fed funds rate Figure 14.05 The discount rate and the Fed funds rate

39. FAIR MODEL Fair Model http://fairmodel.econ.yale.edu We will look at some of the equations in the Faimodel Which are found in Appendix A (pdf) of the US model. It contains Table A.1 the 6 sectors of the model. Table A.2 the variables in Alphabetical Order Table A.3 the equations of the model Table A1-Equations 1-30 then follow (this ought to be Table A.4) Table A.5 Sources of raw data

40. FAIR MODEL • We will look at Appendix A, Table 3, FairModel’s Equations • Spending Behavior equations 1-3 cons/eq 4housing/eq 12 investment • Price and Output Behavior eq10 and eq12 • FRB Behavior eq 30 Then we will look at the Forecast Memo http://fairmodel.econ.yale.edu/memo/index.htm After that we will run one experiment with the FairModel by how much will lower interest rates increase inflation?

41. FAIR MODEL Then we will look at the Forecast Memo http://fairmodel.econ.yale.edu/memo/index.htm After that we will run one experiment with the FairModel: by how much will lower interest rates increase inflation? Start by naming a data base and copying the base data http://fairmodel.econ.yale.edu/usmodel/index.htm Then pick option 2: monetary policy options allow the interest rate to be exogenous Pushes us to a screen where we put in a new value for the interest rate for future quarters. Hit enter and see the changes on the screen. Then click “commit to changes”.

42. FAIR MODEL Now solve the model (option 8) and examine the results. Graph 1: pick graph one per variable pick the comparison dataset UseBase option select the 5 main variables from the US variable list: GDPR, GDPD, RS, M1, UR, SGP Graph 2: GDPD percentage change Graph3: Y, YS (full employment output by firm sector) (In Fairmodel Y and YS referr only to the firm sector.)