Economics in the medium-run

1. Economics in the medium-run • In developing the AD-AS framework, we developed a model in levels- price levels, output levels and interest rates. • In the last lecture, we used the labour market equations to derive the Phillips curve- a relationship between growth in price level (inflation) and unemployment. • In this lecture we will complete the transition and develop a model in growth- inflation, output growth, money stock growth and unemployment.

2. Levels When we were talking in levels, our variables are: Interest rates Output Prices Unemployment Wages Growth When we are talking in growth (percentage change in levels), our variables of interest are: Interest rates Growth in Output Growth in Prices Unemployment Levels versus growth

3. Okun’s Law • Okun’s Law (named after an economist on Kennedy’s Council of Economic Advisors) states that there is a negative linear relationship between growth in output and changes in the unemployment rate. • If economic growth is low, unemployment will rise. • If economic growth is high, unemployment will fall.

4. Derivation of Okun’s Law Y = Y (N/N) (L/L) Y = (Y/N) (N/L) (L) = (Y/N) (1-u) L Growth in Y = (Growth in Y/N) + (Growth in L) – (Growth in u) • Growth in Y/N has been 1.5% per year in Australia. Growth in L has been 1.9% per year in Australia. (Change in ut) = gYt – 3.4%

5. Derivation of Okun’s Law • Our best estimate of Okun’s Law is that: ut – ut-1 = -0.5 (gYt – 3.4%) • So if gyt > 3.4%, then unemployment rises, and if gyt < 3.4%, then unemployment falls. • In general: ut – ut-1 = -β (gYt – g*Y) • Intuition: The labour market is growing (in numbers and productivity) every year. Output must grow at least this fast, or the economy will not absorb all of the labour.

6. Phillips curve • The Phillips curve shows a linear relationship between changes in the inflation rate and changes in the unemployment rate: πt - π te = - α (ut – un) • If inflationary expectations are merely last year’s inflation rate: πt - πt-1 = - α (ut – un) • Where we call 1/α the “sacrifice ratio”, as it represents the number of percent-years of unemployment required to reduce inflation by 1%.

7. What is a dynamic aggregate demand? • In developing the AD-AS framework, we developed a static model for output and introduced the RBA- treating the RBA as though it had a “target price level”. • But the natural rate of output is growing over time and the RBA does not aim for a price level- instead a target inflation rate. • We want an AD relation in growth of output and growth of prices.

8. Dynamic aggregate demand • With our previous AD equations, we had two forms: • RBA controls money supply Yt = Y((Mt/Pt), Gt, Tt) • RBA controls interest rates Yt = Y(it, Gt, Tt) • We want to turn equations into “growth” relations.

9. Growth relations • Growth is the (Change in variable)/(Total of variable). Let gx be the “growth of x”. There are some simple rules we can invoke for growth relationships: A = BC then gA = gB + gC A = B/C then gA = gB – gC • You can prove this with some basic calculus.

10. RBA controls money supply • RBA controls money supply Yt = Y((Mt/Pt), Gt, Tt) = (Mt/Pt) f(Gt, Tt) • If we hold G and T constant, then they drop out in a growth relation: gYt = gMt – gPt • But gP is just inflation, so we have: gYt = gMt – πt

11. RBA controls interest rate • RBA controls interest rates Yt = Y(it, Gt, Tt) = Y*t / it • Where Y* is the natural rate of output. gYt = g*Y - git • If the RBA follows an interest rate target then the rule for the RBA might be git = φ(πt – πT) gYt = g*Y - φ(πt – πT)

12. Model in growth rates • So we have three relations in growth rates: Okun’s Law: ut – ut-1 = -β (gYt – g*Y) Phillips curve: πt - π t-1 = - α (ut – un) DAD: gYt = g*Y - φ(πt – πT) • Or DAD: gYt = gMt – πt • Parameters: g*Y, un, πT , gMt • Variables to be solved: gYt, ut, πt • As these are growth models, we will typically be solving for values of variables over time.

13. Solution of the model • Unless we want to allow for a solution that spirals away, ie. πt > πt-1 for all t, then we will require that πt = πt-1. • From our Phillips Curve, then ut = un for all t, so through our Okun’s Law, gYt = g*Y for all t. • Our DAD relations will then determine monetary policy. • πt = πT • gMt = g*Y + πT • So to maintain stability in our model, the path of money supply is determined by our targets and parameters.

14. What is the cause of inflation? • In our solution, we have • πt= gMt - g*Y • Inflation simply depends on how much faster the money supply grows than the natural rate of output growth. • This is what the book means by “Inflation is always and everywhere a monetary phenomenon.” Inflation in the medium-run does not depend oil shocks or wages policy or anything other than the rate of money creation.