Week 5: Short To Medium Run [Phillips Curve, Expectations, IS-LM-PC] Flashcards
How does PC work?
- PC brings together resource utilisation, inflation and expected
inflation
π = πe − α (u − un)
π−πe =−α(u−un) - It also tracks together deviations of unemployment from its structural level and of inflation from expected inflation;
As such, PC reveals correlation b/w unemployment and inflation,
but not causation, and so offers 2 possible interpretations
1 Indicator tool: unemployment low ⇒ inflation high (inflation
reflects changes in resource utilisation);
2 Policy tool: more inflation ⇒ less unemployment (changes in inflation can produce those in unemployment);
Where did Phillips’ PC disappear?
■ The unemployment rate can deviate from the structural rate only if our forecast of inflation πe is wrong;
■ Thus for unemployment to be permanently below the structural rate, we have to be constantly wrong!
■ We saw that our ability to predict in the medium run is actually very strong;
■ As we correct our predictions and πe reaches π, unemployment returns back to un
Modeling expectation:
■ Expected inflation can exhibit different forms of behaviour, and we need to reflect this variety in our model;
■ Consider first two extremes: we fully believe that inflation is to stay constant at the target rate
π te = π ̄
■ On the opposite extreme, suppose that we do not believe in
constant inflation at all;
■ We still need to forecast it when bargaining/deciding over wages;
■ We can use the most recent rate of inflation as our guide π te = π t − 1
Expectations: between the extremes
■ That is, we can assign a weight to either extreme, for example πt^e = 21 π ̄ + 12 π t − 1
■ The equation indicates that we do not endorse either extreme, but instead have our believes right in the middle;
■ We can generalise further by choosing weights different from 1/2, 1/2;
■ We will use the following functional form: πte =(1−θ)π ̄+θπt−1
■ Thetaisbetween0and1(thatis,0 ⩽ θ ⩽ 1),andtracksthe strength of our belief that inflation is going to be constant;
■ Low θ ⇒ πte is close to π ̄ – we believe in constant inflation;
■ Highθ⇒πte isclosetoπt−1 –wedonot,andweupdateour beliefs based on πt−1 – the most recent observable value of the inflation rate;
■ Naturally, θ does not have to stay constant – we would expect it to rise during persistent acceleration or deceleration of inflation and fall otherwise;
θ=0, θ=1: π t = π ̄ − α ( u − u n )
■ At t = 1 unemployment falls below un, say, by 1% – what may we expect to happen with inflation?
π1 =π ̄−α(u−un)=π ̄−α(un −1−un)
π 1 = π ̄ + α
π 2 = π ̄ + α
■ Inflation just increases once by a constant value
We think inflation is not constant and keep updating our
expectations πe = πt−1
∆π1 = α
■ So what is the actual inflation rate?
π 1 = π 0 + ∆ π 1 = π ̄ + α
π 2 = π ̄ + 2 α
π 3 = π ̄ + 3 α
■ This time inflation keeps growing indefinitely!
■ As inflation grows, so do our expectations, and this produces even more growth in inflation!
Comparison:
■ Comparing the two cases θ = 0 and θ = 1 illustrates the idea
of a self-fulfilling prophecy;
■ When we anticipate inflation to be variant, it becomes exactly so – and just owing to our expectations!
■ One takeaway at this point is that controlling inflation is simpler when it is already expected to be under control;
■ Thus directing economic agents towards these beliefs is an important aspect of macroeconomic policy – it is achieved through open communication by the CB on its future policy decisions, and is called forward guidance;
■ Crucially, the CB has to be credible, which is commonly achieved through its political independence (e.g., it is so for BoE, BoJ, ECB, Federal Reserve);
θ = 0 and θ = 1 as degrees of expectation anchoring
■ The situation of a low θ corresponds to anchored inflation expectations (i.e. they are tied to a particular value π ̄ and do not move away from it);
■ High values of θ (close to 1) produce unanchored inflation expectations (likewise, here they are not tethered to anything and move around following actual inflation);
■ As we saw, persistent changes in inflation increase θ, making expectations less anchored;
■ Thus the inability of the CB to control inflation is likely to make its job even more difficult owing to expectations becoming less anchored;
Macroeconomic stabilization - implications
■ Stabilisation recipe: inflation is high/growing ⇒ implement contractionary policies, if it is low/falling ⇒ support the economy with expansionary policies;
■ Policy aims of modern CBs are formulated exactly in terms of explicit inflation targets (2% in the Eurozone, Japan, UK, US);
■ If a CB has a successful track record of controlling inflation, it is likely to find keeping on doing that even easier owing to an increasing degree of expectation anchoring;
PC: steep end, flat end
Steep end:
■ Suppose inflation is high, and as a result, wages paid are directly linked to the price level: that is, if prices increase by the factor of, say, 2, so do wages;
■ Let λ < 1 be the share of indexed wage contracts – we can reflect that by modifying the PC
■ Remember that without indexation we negotiate over wages at the beginning of a period, and then they are set in stone;
■ With indexation, however, if unemployment falls and thus wages increase, they then push up prices immediately, which in turn increases indexed wages, etc. – a multiplier effect;
Flat end
■ Flattening would mean that when unemployment grows much above the structural rate, inflation does not drop too much – why so?
■ From our discussion, inflation is driven by wage growth, and thus we need to look into why wages do not fall (downward wage rigidity);
■ Imposing a salary cut is often illegal;
■ Even firing and hiring on a lower salary can lead to large
turnover, which might be destabilising for a firm;
■ From the Shapiro-Stiglitz perspective, if wages drop too low, there is nothing preventing workers from shirking;
Putting IS-Lm and PC together
■ IS-LM tells us how shocks impact on production through
spending;
■ PC describes how deviations of resource utilisation from its normal level are manifested through inflation;
■ We need to combine the two together to describe macro stabilisation policies;
■ At the moment, however, we have inflation connected with unemployment, while in production we have output Y ;
■ At the end of the day, PC connects fluctuations in unemployment above and below un with those in the inflation rate;
■ We will replace u with Y now;
■ And thus we will need to define fluctuations in output in
relation to potential output, which corresponds to unb
Introduction Y to PC: Fluctuations and final result
■ Naturally, when unemployment drops below un in the above, output is larger than potential output;
■ In the PC equation, we have fluctuations of u, and we need to replace them with those in output using the above formula
■ Again, even though the PC is different now, it encapsulates exactly the same idea;
■ When an economy’s resources are over-extended and it produces above its potential level Yn, inflation increases;
IS-LM-PC: types of shocks
■ We have seen shocks acting through spending (consumer and
investor confidence, etc.) – these are demand-pull shocks;
■ The second kind is cost-push shocks, which impact on
producers’ costs (and thus prices);
Spending Driven Recession: No 1
■ Suppose that as a result of financial crisis, consumer/investor confidence drops, risk increases;
■ For contrast, consider the case of anchored expectations;
■ This time we believe the inflation will stay at its medium run
level π ̄;
■ Everything else is exactly the same!
■ Unanchored expectations entail dealing with a widening output gap and accelerating/decelerating inflation;
■ Stabilisation with unanchored expectations involves not just closing the output gap, but pushing the economy over the trend;
■ Neither is the case with anchored expectations;
New Keynesian model: Differences and Similarities
Differences:
■ Economic agents are introduced explicitly;
■ More complex mechanism of expectation formation (rational expectations);
■ Boundary between the short run and medium run is more blurred;
■ Specifically, producers’ costs can change in the short run;
■ No explicit wage bargaining: sticky prices are enough on their own to generate responses we have studied;
Similarities
■ Prices are (limitedly) sticky/rigid in the short run;
■ When producers face more demand and cannot adjust prices, they have to step up production;
■ Has the equivalents of IS (Y decreases in i), shifts in LM/MP (commonly through the Taylor rule) and PC (link between output gap (over-/underproduction) and inflatio
Short & Medium Run
Short run:
■ In the short run, an economy is constantly subjected to various shocks;
■ Shocks impact on spending, and this affects production;
■ Shocks can also work through producers’ costs;
Medium run:
■ Producing above or below the trend results in either over-stretching or under-utilisation;
■ These are reflected in how prices behave: with over-extension inflation increases/accelerates, and it decreases/slows down during under-utilisation;
Expectations and Wage-Setting
■ Anchored inflation expectations – a way of forming inflation expectations, which is not sensitive to changes in the economic situation (for example, changes in the unemployment rate and the output gap). The opposite of anchored expectations are unanchored expectations;
■ Forward guidance – a policy employed by the CB, which constitutes explicit communication on, and commitment to, the future course of the CB’s policies aimed at maintaining stable inflation;
■ Downward wage rigidity – the lack of the nominal wage rate’s ability to adjust downwards in response to a contraction of demand from employers in the labour market (as caused, for example, by an economic downturn);
■ Wage indexation – the arrangement whereby the size of the nominal wage rate is linked directly with an indicator of the price level in the economy (e.g., the CPI);
Shock types
■ Demand-pull shocks – the class of shocks affecting an economy through the level of spending;
■ Cost-push shocks – the class of shocks affecting an economy through the level of costs incurred by producers;
