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ECON 102
Barry Mc Clinchey

CHAPTER 8—BUSINESS CYCLES: AN INTRODUCTION • Business Cycles: are fluctuations in aggregate economic activity in which many economic activities expand and contract together in recurring, but not periodic, fashion. • • Mark the points on the horizontal axis where wavy lines reaches a trough, or low point of economic activity • Peak is the high point of economic activity • The period from a trough to a peak is a business cycle expansion (also called a boom) • The period from a peak to a trough is a business cycle contraction (recession) Movement of Business Cycle Variables • Many economic activities expand and contract together over time • Co-movement of Economic Variables is either: o Procyclical: economic variable moves up during expansions and down during contractions o Countercyclical: economic variables move opposite to aggregate economic activity (up during contractions and down during expansions) o Acyclical: when it’s up and downs do not consistently coincide with those of the business cycle • Timing Relative to the Business Cycle: o Leading variable: reaches a peak or trough before the turning points of a business cycle o Lagging Variable: turning points occur after the business cycle changes course o Coincident Variable: reaches its peaks and troughs at the same time the business cycle reaches its peaks troughs Macroeconomics in the News: Leading Economic Indicators • The US Conference Board combines 10 variables into an index of leading indicators that some economists use to forecast changes in the economy • There are reasons to question the predictive power of the Conference Board’s monthly index of leading indicators in forecasting the business cycle: o For one, the conference board regularly revises the index when more accurate data becomes available, sometimes many months after the fact. The initial readings of data that underlies the index do not predict recessions nearly as well as the revised data o Second, conference board economists change components of the index over time, improving the index’s historical record. A true test of the index’s performance would use only real-time data available at the time—and such research shows that the index is far less accurate than the revised data would suggest at predicting recessions Macroeconomic Variables and the Business Cycle • Real GDP: broad measure of aggregate economic activity that it is sometimes viewed as a proxy for the business cycle • Real GDP and its Components o Two components of real GDP, consumer spending and investment, are Procyclical and coincident • Unemployment o Unemployment rate is highly countercyclical. Not completely clear whether the unemployment rate leads or lags the business cycle • Inflation o Rate of increase in the price level usually during expansions and falls during recessions, making inflation a Procyclical variable. Inflation rate is lagging—it keeps rising for a time after the peak of the business cycle and falls for a time after the recession is over • Financial Variables o Financial assets like stocks and bonds also tend to move with the business cycle, best known financial variable is the stock market and bonds, which tends to top out before the business cycle’s peak and begin to rise before the economy emerges from recession o Rate of interest paid on short-term US gov’t bonds is both Procyclical and leading o Spread between long term and short term gov’t bonds is leading and Procyclical, and a good predictor of recessions o When the economy is weaker and companies are more likely to run out of money, the spread between the rates paid on corporate bonds and gov’t bonds rises dramatically o This is why we see a rise in this spread during recessions • International Business Cycles o When a large economy like the US is booming, demand for foreign products increases causing foreign economies to boom as well o Financial disruption that start in one economy frequently spill over to another o The spread of financial disruptions across borders provides another reason why business cycles are correlated across countries o When financial market conditions deteriorate simultaneously in many countries, the negative shock to their economies leads to a simultaneous economic contractions CHECK SLIDES 6-13 ON PDF FILE FOR GRAPHS Time Horizons in Macroeconomics • The study of business cycles focuses on short-run economic fluctuations • John Maynard Keynes questioned the classical view that economies moved quickly to their long-run equilibriums • Stating that “in the long-run, we are all dead”, Keynes argued that the primary focus of macroeconomists should be the short run • The followers of Keynes, or Keynesians, also argue that the gov’t should pursue active policies to stabilize economic fluctuations • Other economists, often referred to as classicals, maintain that the economy moves to the long run quite quickly • Gov’t should focus on policies that promote high run economic growth, such as keeping inflation low Short Run versus the Long Run • In the long run, prices of goods and services as well as the price of labour (wages) are completely flexible: they adjust all the way to their long-run equilibrium where supply equals demand • Classical models make use of a flexible-price framework • The flexible-price framework results in the classical dichotomy in which there is a total separation between real and nominal variables • Keynesian models focus on the short run when prices respond slowly to changes in supply and demand—sticky prices • Price Stickiness • There are different views of market structure that affect the views on the role of price stickiness: perfect competition and monopolistic competition o Classical models which include the traditional supply and demand analysis you have seen in other economics courses, we assume that economic actors are price takers. o First we assume that they are purchasing standardized products such as a commonly traded type of soybean of a financial instrument like US Treasury bond. o Keynesians focus on the importance of monopoly power Sources of Price Stickiness • Menu Costs: the cost a firm bears when it changes the price of its goods are one source of price stickiness • Menu costs are an important source of price stickiness for several reasons: o Changing prices is a complex process that involves many hidden costs o Collecting info is costly, so firms and households may engage in rational inattention by only making decisions about prices at infrequent intervals because it is rational for them to do so given the time and effort that is required to make these decisions o Changing prices frequently may alienate customers o Small menu costs also may lead to price stickiness in the face of macroeconomic shocks come from changes in individual product markets • Staggered Price Setting: when competitors adjust prices at different intervals. Price of computers adjusts slowly with staggered pricing than with synchronized pricing decisions. Staggered prices thus slow down price adjustment and increase the stickiness of prices Empirical Evidence on Price Stickiness • Empirical evidence indicates substantial price stickiness in markets • Example: Alan Blinder of Princeton University asked firms how often they set prices. He found that only 10% of firms changed their prices as often as one a week, while close to 40% changed prices once a year and 10% less than once a year CHAPTER 9: THE IS CURVE • Planned Expenditure: the total amount of spending on domestically produced goods and services that households, businesses, the government, and foreigners want to make. • Aggregate demand: is the total amount of output demanded in the economy is viewed the same as planned expenditure. • The total amount of planned expenditure (aggregate demand) is the sum of four types of spending: 1. Consumption expenditure (C): the total demand for consumer goods and services (e.g., hamburgers, iPods, rock concerts, visits to the doctors, etc.) 2. Planned investment spending (I): the total planned spending businesses on new physical capital (machines, computers, factories) plus planned spending on new homes 3. Government Purchases (G): spending by all levels of government on goods and services (aircraft carriers, government workers, red tape) not including transfer payments 4. Net Exports (NX): the net foreign spending on domestic goods and services, equal to exports minus imports PE  Total planned expenditure: Y = C + I +G + NX Consumption Expenditure • Consumption expenditure is related to disposable income, the total income available for spending, equal to aggregate income minus taxes T, (Y-T) • The relationship between disposable income Y Dnd consumption expenditure C the consumption function and expressed it as follows: o C = C + mpc x Y D OR C = C + mpc X (Y-T) o The term C stands for autonomous consumption expenditure, the amount of consumption expenditure that is exogenous (independent (not) of variables in the model, such as disposable income or interest rates). It is related to consumers’ optimism about their future income and household wealth, which induce consumers to increase spending o The term mpc, the marginal propensity to consume, reflects the change in consumption expenditure that results from an additional dollar of disposable income. Assumed that mpc was constant between the values of 0 and 1. ($1.00 increase in disposable income leads to an increase in consumption expenditure of $0.60, then mpc = 0.6). • Consumption expenditure is negatively related to real interest rate because when real interest rate is higher, the real return to saving is also higher, and so you will spend less. Negative relationship between consumption expenditure and real interest rate, r, is: o C = C + mpc X (Y-T) – cr o ‘c’ is the parameter that reflects how responsive consumption expenditure is to the real interest rate o Above equation made up of autonomous consumption, marginal propensity to consume times disposable income, and a term that indicates that how much consumption decreases in response to a rise in the real interest rate • Investment spending is another key component of total expenditure. There are two types of investments: Fixed and Inventory o Fixed Investment: is planned spending by firms on equipment and structures (factories etc.) and planned spending on new residential housing o Inventory Investment: is spending by firms on additional holding of raw materials, parts, and finished goods, calculated as the change in holdings of these items in a given time period (like year)  an important feature of inventory investment is that some inventory investment can be unplanned (in contrast, fixed investment is always planned) pe • Planned investment spending, a component of planned expenditure, Y , is equal to planned fixed investment plus the amount of inventory investment planned by firms. • When real interest rate is high, planned investment spending with be low • When real interest rates and hence the cost of borrowing are low, business firms are more likely to undertake an investment in physical capital and planned investment spending will increase. • Real interest rate, instead of investing in physical capital, can purchase a security such as bond and if the real interest rate on this security is high, say 10%, the opportunity cost (forgone interest earnings) of an investment is high. Planned investment spending will then be low • As the real interest rate and opportunity cost of investing fall, say 1%, planned investment spending will increase because investment in physical capital are likely to earn greater income for the firm than the measly 1% the security earns. • Planned investment spending is heavily influenced by business expectations about the future • Businesses that are optimistic about future profit opportunities are willing to spend more, while pessimistic businesses cut back their spending • Autonomous investment, I: a component of planned investment spending that is completely exogenous. (unexplained by variables) • Planned investment spending is related to the real interest rate and autonomous investment : o I = I – dr o ‘d’ is a parameter reflecting how responsive investment is to the real interest rate. o Above equation: investment is positively related to business optimism, as represented by autonomous investment, and is negatively related to the real interest rate Net Exports • Net exports is considered being make up of two components: autonomous net exports, and the part of net exports that is affected by changes in real interest rates o Real Interest rates and net exports:  Real interest rates influence the amount of net exports through the exchange rate  When US real interest rate rise, US dollar asses earn higher returns relative to foreign assets. People then want to hold more dollars so they bid up the values of dollars and thereby increase its value relative to other currencies. Thus a rise in US real interest rates leads to a higher value of the dollar  It also makes US exports more expensive in foreign currencies so foreigners will buy less of them, thereby driving down net exports  It also makes foreign goods less expensive in terms of dollars, so US imports rise, also causing a decline in net exports  We therefore see that a rise in the real interest rate which leads to a rise in the value of the dollar, in turn leads to a decline in net exports o Autonomous Net Exports:  The amount of exports is also affected by the demand by foreigners for domestic goods, while the amount of imports is affected by the demand by domestic residents for foreign goods  For example: is the Chinese have a poor harvest and want to buy more US wheat, US exports will rise. If US consumers discover how good Chilean wine is and want to buy more, US imports will rise.  Net exports are determined by real interest rates as well as by a component, autonomous net exports, NX, which is the level of net exports that is treated as an exogenous (outside the model). o Net Export Function  Putting these two components together you get:  NX = NX – xr  `x`is a parameter that indicates how net exports respond to the real interest rate  Tells us: net exports are positively related to autonomous net exports and are negatively related to the level of real interest rate Government Purchases and Taxes • Government affect planned expenditure in two ways : through its purchases and taxes o Fixed level of Government Purchases  Government purchases adds directly to planned expenditure. Here we assume that government purchases are also exogenous:  G = G (government purchases are set at fixed amount) o Taxes  Disposable income is equal to income minus taxes, Y – T, and disposable income affects consumption expenditure. Higher taxes, T, reduce disposable income for a given level of income and hence cause consumption expenditure to fall. Government taxes are exogenous and are a fixed amount:  T = T Goods Market Equilibrium • Equilibrium would occur in the economy when the total quantity of output produced in the economy equals the total amount of planned expenditure (aggregate demand). That is, o Y = Ype o Producers are able to sell all their output and have no reason to change their production because there is no unplanned inventory investment. Solving for Goods Market Equilibrium • Y = C + I + G + NX • Y = [C + I + G + NX – mpc X T] X 1 – c + d + x X r (equation 10) 1 – mpc 1 – mpc • 1/(1-mpc) multiplied by G is known as the expenditure multiplier • -mpc/(1-mpc) multiplied T is called the tax multiplier and is smaller in absolute value because mpc < 1 Deriving the IS Curve • The above equation is the IS curve and it shows the relationship between aggregate output and the real interest rate when the foods market is in equilibrium • The first term (1/(1-mpc)) tells us that increases in autonomous consumption, investment, government purchases, or net exports, or a decrease in taxes, leads to an increase in output at any given real interest rate. In other words, the first term tells us about shifts in the IS curve. • The second term tells us that an increase in real interest rates results in an decline in output, which is a movement along the IS curve What the IS Curve Tells US: Intuition • The IS curve traces out the points at which the goods market is in equilibrium • For each given level if the real interest rate, the IS curve tells us what aggregate output must be for the goods market to be in equilibrium. • As the real interest rate rises, consumption expenditure, planned investment spending and net exports falls, which in turn lowers planned expenditure; aggregate output must be lower for it to equal planned expenditure and satisfy goods market equilibrium. Hence the IS curve is downward sloping. Why the IS Curve Has Its Name and Its Relationship with the Saving-Investment Diagram • Goods market equilibrium of the IS curve is equivalent to the equilibrium at which desired investment, I, equals desired saving, S. o Y = C + I o Y – C = I and since Y – C equals savings, S = I • Goods market equilibrium occurs when I = S and this is why the IS curve has its name • The saving curves are upward sloping because as the real interest rate rises, consumption expenditure falls and saving, S = Y – C, rises. The investment curve is downward sloping because as the interest rate rises, planned investment falls • At any given level of real interest rate r, when there is an increase in aggregate output Y, consumption increases by less than Y because the marginal propensity to consume is less than one. • Thus, at any given level of r, an increase in Y will lead to an increase in Y – C = S Factors that Shift the IS Curve • The IS curve shifts whenever there is a change in autonomous factors (factors independent of aggregate output and the real interest rate). • Note than a change in real interest rate that affects equilibrium aggregate output causes only a movement along the IS curve. • A shift in the IS curve, by contrast, occurs when equilibrium output changes at each given real interest rate • In equation 10 above, we identified five candidates as autonomous factors that can shift planned expenditure and hence affect the level of equilibrium output. Although the equation directly tells us how these factors shifts the IS curve, we will develop some intuition as to how each autonomous factor does so: Changes in Government Purchases • An increase in gov’t purchases that causes planned expenditure to rise also causes equilibrium output to rise, thereby shifting the IS curve to the right. • Conversely, a decline in gov’t purchases causes planned expenditure to fall at any given real interest rate and leads to a leftward shift in the IS curve. Changes in Taxes • At any given real interest rate, a rise in taxes causes planned expenditure and hence equilibrium output to fall, thereby shifting the IS curve to the left. • Conversely, a cut in taxes at any given real interest rate increases disposable income and causes planned expenditure and equilibrium output to rise, shifting the IS curve to the right Changes in Autonomous Spending • In equation 10 you can see that autonomous spending, investment and net exports, C, I, NX, are all multiplied by the term 1/(1-mpc) in the same way the G term is. • Thus an increase in any of these variables has the same impact on the IS curve as an increase in gov’t purchases. For this reason, we can lump these variables together as autonomous spending, exogenous spending that is unrelated to variables in the model such as output or real interest rates. • The resulting rise in autonomous consumption would raise planned expenditure and equilibrium output at any given interest rate, shifting the IS curve to the right. Conversely, a decline in autonomous consumption expenditure causes planned expenditure and equilibrium output to fall, shift the IS curve to the left • Changes in planned investment spending arising from a change in real interest rates causes a movement along the IS curve and not a shift. An increase in autonomous investment spending there increases equilibrium output at any given interest rate, shifting the IS curve to the right. On the other hand, a decrease in autonomous investment spending causes planned expenditure and equilibrium output to fall, shifting the IS curve to the left. • An autonomous increase in net exports thus leads to an increase in equilibrium output at any given interest rate and shifts the IS curve to the right. Conversely, an autonomous fall in net exports causes planned expenditure and equilibrium output to decline, shifting the IS curve to the left. CHAPTER 10 – MONETARY POLICY AND AGGREGATE DEMAND The Federal Reserve and Monetary Policy • The Federal Reserve controls the federal funds rate by varying the liquidity it provides to the banking system. The more liquidity provided, banks have more money to lend to each other and this excess liquidity causes the federal fund rates to fall. Drainage of liquidity leads less money for banks to lend and leads to a rise in federal funds rate • The federal funds rate is a nominal interest rate, it is the real interest rate that affects household and business spending, thereby determining the level of equilibrium output o Recall that real interest rate, r, is the nominal interest rate, i, minus expected π e π e inflation, : r = i - • Changes in nominal interest rates can change the real interest rate only if actual and expected inflation remain unchanged in the short run • When prices are sticky, changes in monetary policy will not have an immediate effect on inflation and expected inflation. As a result, when the Federal Reserve lowers the federal funds rate, real interest fall; and when the Federal Reserve raises the federal funds rate, real interest rise. • Federal Reserve is not able to control the real interest rate in the long run. In the long run, prices are flexible. Real interest rate in the long run is determined by the interaction of saving and investment and not by the central bank Monetary Policy Curve • The monetary policy (MP) curve indicates the relationship between the real interest rate the central bank sets and the inflation rate: o r = r + ƛπ o Where r is the autonomous component of the real interest rate set by the monetary policy authorities, which is unrelated to the current level of the inflation rate, while ƛ is the responsiveness of the real interest rate to the inflation rate o Monetary policy raises real interest rates when the inflation rate rises The Taylor Principle: Why the Monetary Policy Curve has an Upward Slope • In order to stabilize inflation, monetary policymakers follow the Taylor Principle in which they raise nominal rates by more than any rise in expected inflation so that real interest rates rise when there is a rise in inflation, as the MP curve suggests • To see why monetary policy makers follow the Taylor principle, in which higher inflation results in higher real interest rates. An increase in inflation would lead to a decline in the real interest rate which would increase aggregate output, which would in turn cause inflation to rise further, which would cause the real interest rate to fall further, increasing aggregate output further : o π ↑=¿r↓=¿Y ↑=¿π ↑=¿r↓=¿Y ↑=¿π ↑ o Inflation would continually keep rising and spin out of control Shifts in the MP Curve • Federal Reserve is said to tighten monetary policy when it raises real interest rates, and to ease it when it lowers real interest rates • To distinguish between changes in monetary policy that shift the monetary policy curve, which we call autonomous changes, and the Taylor principle-driven changes that are reflected as movements along the monetary policy curve, which are called automatic adjustments to interest rates • To lower inflation they could increase r by one percentage point, and so raise the real interest rate at any given inflation rate, what we will refer to as an autonomous tightening of monetary policy • This autonomous monetary tightening would shift the monetary policy curve upward by one percentage from point MP to1MP , th2reby causing the economy to contract and inflation to fall • If the economy if going into recession, monetary policy makers would want to lower real interest rates at any given inflation rate, an autonomous easing of monetary policy, in order to stimulate the economy and also to prevent inflation from falling. This autonomous easing of monetary policy would result in downward shift in the monetary policy curve • We contrast there autonomous changes with automatic, Taylor Principle-drive changes, a central bank’s normal response (also known as an endogenous response) of raising interest rates when inflation rises • These changes in interest rates are reflected in movement along the monetary policy curve (not shifts) The Aggregate Demand Curve • Relationship between the inflation rate and aggregate demand when the goods market is in equilibrium, the aggregate demand curve. Deriving the Aggregate Demand Curve Graphically • As real interest rise, consumption, investment, and net exports decline, leading to a decline in aggregate demand • The line that connects the three points in panel (c)page 246 is the aggregate demand curve, AD, and it indicates the level of aggregate output corresponding to each of the three real interest rates consistent with equilibrium in the goods market for any given inflation rate. • The aggregate demand curve has a downward slope, because a higher inflation rate leads the central bank to raise real interest rates, thereby lowering planned spending, and hence lowering the level of equilibrium aggregate output Factors that Shift the Aggregate Demand Curve • Movements along the aggregate demand curve describe how the equilibrium level of aggregate output changes when the inflation rate changes. When factors beside the inflation rate change, however, the aggregate demand curve can shift • Shifts in the IS curve: the same factors cause the aggregate demand curve to shift as well: 1. Autonomous consumption expenditure 2. Autonomous investment spending 3. Government purchases 4. Taxes 5. Autonomous net exports Refer to page 247 to learn how to deriving the Aggregate Demand Curve Algebraically • Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction • An autonomous tightening of monetary policy – that is, a rise in the real interest rate at any given inflation rate – shifts the aggregate demand curve to the left. Similarly, an autonomous easing of monetary policy shifts the aggregate demand curve to the right. Money Market and Interest Rates • Liquidity preference framework: determines the equilibrium nominal interest rate by equating the supply and demand for money Liquidity Preference and the Demand for Money • When people decide how much money they want to hold (demand), they consider real money balances, the quantity of money in real terms • In this model, demand for real money balances depends on real income, Y, and the nominal interest rate, i,. Liquidity preference theory in equation as follows: o M /P = L (i, Y) - + • Liquidity preference function: the minus sign below i means that as the nominal interest rate, i, rises, the demand for real money balances falls; the plus sign below Y means that as income, Y, rises, the demand for real money balances also rises • Opportunity cost: the amount of income forgone (sacrificed) by holding money rather than alternative assets such as bonds, provides intuition • As the interest rate i rises, it becomes more costly to hold money instead of bonds – that is, the opportunity cost rises – and the quantity of money demanded falls. • Real money balances are positively related to income for two reasons: 1. As income rises, households and firms conduct more transactions and so keep more money on hand to make purchases 2. Higher incomes make households and firms wealthier, and the wealthy tend to hold larger quantities of all financial assets, including money Demand Curve for Money • For the short run, we will assume that prices are sticky and so the price level is fixed in the short run at P. • It slopes downwards since lower interest rates increase the quantity of real money balances demanded, all else being equal Supply Curve for Money • Reserves: represent increased liquidity in the banking system • Flush with additional liquidity from higher reserves, banks loan out more money to their customers, increasing bank deposits • Open market purchases lead to an increase in liquidity and the money supply • An open market sale of government securities leads to a decrease in liquidity and a decrease in the money supply • If the Fed can fix the money supply at the level M, and the price level is also fixed in the short run at P, then the quantity of real money balances supplied, M /P, is fixed at M/P regardless of the interest rate Equilibrium in the Money Market • In the money market, equilibrium occurs when the quantity of real money balances demanded equals the quantity of real money balances supplied:  M = M S P P Response to excess supply • Once people have satisfied their demand for real money balances, they want to put any additional money into alternative assets like bonds or interest-bearing bank accounts. This condition of excess supply of money occurs when the interest rate is higher than the equilibrium level Response to excess demand • When people want to hold more money than is available, they will sell alternative assets like bonds and withdraw from interest-bearing bank account until they replenish their desired level of real money balances. This scenario of excess demand for money occurs when the interest rate is below the equilibrium interest rate i*. Changes in the Equilibrium Interest Rate • When quantity demanded changes as a result of a change in the interest rate, there is a movement along the demand curve. • A shift in the demand (or supply) curve, by contrast, occurs when the quantity demanded (or supplied) changes at each given interest rate in response to a change in some other factor besides the interest rate Factors that shift the demand curve • Changes in i do not shift the demand curve, they instead lead to a movement along the demand curve. A change in Y does shift the demand curve, since the quantity of real money balances demanded changes at any given interest rate • When income rises (holding other variables constant such as the price level and the quantity of money), interest rates will rise Factors that shift the supply curve S • The quantity supplied of real income balances, M /P, can change, shifting the supply curve, for either of two reasons: 1. The quantity of money supplied by the Federal Reserve, M , changes 2. The price level, P, changes • When the money supply increases (holding other economic variables constant), interest rates will decline • When the price level rises (holding the supply of money and other variables constant), interest rates will rise CHAPTER 11: AGGREGATE SUPPLY AND THE PHILLIPS CURVE • The negative relationship between unemployment and inflation they found for many countries became known naturally enough, as the Phillips curve. • The idea behind Phillips curve is that when labour markets are tight – that is, the unemployment is low – firms may have difficulty hiring qualified workers and may even have a hard time keeping their present employees. • Due to shortage of workers, firms will raise wages to attract needed workers The Friedman-Phelps Phillips Curve Analysis • In 1967 and 1968, Milton Friedman and Edmund Phelps pointed out a severe theoretical flaw in the Phillips curve analysis: o It was inconsistent with the view that workers and firms care about real wages o The amount of real goods and services that wages can purchase o Not nominal wages • Wage and overall inflation will rise one-for-one with increases in expected inflation, as well as respond to tightness in the labour market • In the long run the economy would reach the level of unemployment that would occur if all wages and prices were flexible, which they called the natural rate of unemployment • The natural rate of unemployment is the full-employment level of unemployment, because there will still be some unemployment even when wages and prices are flexible • The Friedman-Phelps reasoning suggested a Phillips curve that we can write as follows: ∪−∪  π=π e- ω¿ n  The presence of the π eterm explains why the equation above is also referred to as the expectations-augmented Phillips curve: it indicates that inflation is negatively related to the difference between the unemployment ∪−∪ rate and the natural rate of unemployment ¿ n), a measure of tightness in the labour markets called the unemployment gap  In the long run, expected inflation must gravitate to actual inflation, and above equation therefore indicates that U must be equal to ∪ n • The Phillips curve displays no long-run tradeoff between unemployment and inflation and is thus consistent with the classical dichotomy that indicates that changes in the price level should not affect the real economy (pg.271) • The line connecting Point 1 and 4 vertically which does not shift on above page is thus the long-run Phillips curve: 1. There is no long-run tradeoff between unemployment and inflation because, as the vertical long-run Phillips curve shows, a higher long-run inflation rate is not associated with a lower level of unemployment 2. There is a short-run tradeoff between unemployment and inflation because with a given expected inflation rate, policy makers can attain a lower unemployment rate at the expense of a somewhat higher inflation rate. 3. There are two types of Phillips curves, long run and short run. The expectations are actually short-run Phillips curves: they are drawn for given values of expected inflation and will shift if deviations of unemployment from the natural rate cause inflation and expected inflation to change The Phillips Curve after the 1960s • The Phillips curve shows that the negative relationship between unemployment and inflation breaks down when the unemployment rate remains below the natural rate of unemployment for any extended period of time The Modern Phillips Curve • Supply shocks are shocks to supply that change the output an economy can produce from the same amount of capital and labour • These supply shocks translate into price shocks, that is, in inflation that are independent of the tightness in the labour markets or of expected inflation (Eg. When the supply of oil is restricted, as it was following the war between the Arab states and Israel in 1973, the price of oil more than quadrupled and firms had to raise prices to reflect their increased costs of production, thus driving up inflation) • Price shocks also could some from a rise in import prices or from cost-push shocks, in which workers push for wages higher than productivity gains, thereby driving up costs and inflation • Adding price shocks ( ρ ) to the expectations-augmented Phillips curve leads to the modern form of short-run Phillips curve (pg271): π=π e ∪−∪ ρ  - ω¿ n +  Modern, short run Phillips curve implies that wages and prices are sticky ω  The more flexible wages and prices imply that the absolute value of is higher, which implies that the short-run Phillips curve is steeper. If ω wages and prices are completely flexible, then becomes so large that the short run Phillips curve is vertical, and it would be identical to the long-run Phillips curve  In this case, there is no long-run or short-run tradeoff between unemployment and inflation The Modern-Phillips Curve with Adaptive (Backward-Looking) Expectations • We need to understand how firms and households form expectations about inflation • One simple way of thinking about how firms and households form their expectations about inflation is that they do by looking at past inflation:  π e= π -1  Where π is the inflation rate in the previous period. This form of -1 expectations is known as adaptive expectations or backward-looking expectations because expectations are formed by looking at the past π π e and therefore change only slowly over time substituting -1or gives the following short-run Phillips curve:  π = π -1 - ω(∪−∪) + ρ Inflation = Expected - ω X Unemployment + Price Inflation Gap Shock  Two advantages of this equation over the general formula are: 1. it takes a very simple mathematical form that is convenient 2. Provides two additional realistic reasons why prices may be sticky. (1 reason is inflation expectations adjust only slowly as past inflation changes: inflation expectations are therefore sticky, which results in some inflation stickiness…Another reasons is the presence of past inflation in the Phillips curve formulation can reflect the fact that some wage and price contracts might be backward looking, that is, tried to past inflation, and so inflation might not fully adjust to changes in inflation expectations in the short run)  Another convenient way to look at the adaptive expectations form of the π Phillips curve is by subtracting -1from both sides: ∆ π=π−π ∪−∪ ρ • -1= −ω¿ n) + • This indicates that a negative unemployment gap (tight labour market) causes the inflation rate to rise, that is accelerate • This equation often referred to as an accelerationist Phillips curve • Since inflation stops accelerating (changing) when the unemployment rate is at ∪ n, we also refer to this term as the non-accelerating inflation rate of unemployment or more commonly as NAIRU The Aggregate Supply Curve • Aggregate supply curve: represents the relationship between the total quantity of output that firms are willing to produce and the inflation rate Long-Run Aggregate Supply Curve • What determines the amount of output an economy can produce in the long-run? Available technology, the amount of capital in the economy, and the amount of labour supplied in the long-run, all of which are unrelated to the inflation rate • Natural rate of output: level of aggregate output supplied at the natural rate of unemployment, more commonly referred to as potential output because it is the level of production that an economy can sustain in the long run • The vertical LRAS is when wages and prices can fully adjust; there is a decoupling of the relationship between unemployment and inflation. • The classical dichotomy indicates that what happens to the price level is divorced from what is happening in the real economy Short-Run Aggregate Supply Curve • Can translate Phillips curve to SRAS curve by replacing the unemployment gap ∪−∪ ¿ n) with the output gap, the difference between output and potential output (Y – Y ) • Okun’s law describes the negative relationship between the unemployment gap and the output gap o When output is above potential so the output gap is positive, the unemployment rate is below the natural rate of unemployment. (Pg. 275) ∪−∪ o ¿ n) = -0.5 X (Y – Y ) o Okun’s law thus states that for each percentage point that output is above potential, the unemployment rate is one-half of a percentage point below the natural rate of unemployment. Alternatively, for every percentage point that unemployment is above its natural rate, output is two percentage points below potential output o When output rises, firms do not increase employment commensurately with the increase, a phenomenon known as labour hoarding o When the economy is expanding, more people enter the labour force because job prospects are better and so the unemployment rate does not fall by much as employment increases ∪−∪ o Using Okun’s law from above equation to substitute ¿ n) in the SR Phillips curve it yields the following: Y –Y  π=π e+ 0.5ω¿ P) + ρ  Replacing 0.5ω by γ , which describes the sensitivity of inflation to the output gap, produces the SRAS curve: π=π e γ Y –Y P ρ  + ¿ ) + Inflation = Expected + γ X Output + Price Inflation Gap Shock  As with the Phillips curve analysis, we need to make an assumption about how expectations of inflation are formed and will assume that they π π adaptive so that e= -1 The SRAS curve then be
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