Macroeconomics Lecture 5 Inflation and unemployment Outline • Empirical facts • The dynamic AD-AS model (the Phillips Curve Model). • Using the Phillips Curve Model to make sense of the 70ies, 80ies and 90ies. Unemployment as a % of the labour force, United Kingdom, 1960-1997 12 Unemployment 10 8 6 4 2 0 1950 1960 1970 1980 1990 2000 OECE, Main indicators. 80s 70s Inflation, GDP deflator (annual, %) United Kingdom, 1961-96 30 25 20 Inflation 15 10 5 0 1950 1960 1970 1980 1990 2000 OECD. Main indicators. Inflation and unemployment in the UK is the early 1980s 20 15 % 10 5 0 79 80 81 82 83 84 85 86 19 19 19 19 19 19 19 19 Inflation Unemployment Inflation and unemployment in the short-run Static model Dynamic model Inflation and P and Y unemployment Aggregate demand Dynamic Aggregate (AD) demand (DAD) Short-run aggregate Short-run Phillips Curve supply (SAS) (SPC) Long-run aggregate Long-run Phillips supply (LAC) curve (LAC) The Phillips Curve Aggregate supply: Y Y (P P )e Rewrite: P P (Y Y ) e 1 Subtract P-1: P P1 P P1 (Y Y ) e 1 (Y Y ) e 1 Inflation Okun’s law The deviation of output from its equilibrium level is inversely related to the deviation of unemployment from its equilibrium level (Y Y ) (u u ) N Slope of the Phillips Random curve supply shocks (u u ) e N Expected inflation Cyclical unemployment (u u ) e N 1 e 1 e 1 e 0 1 0 0 0 e SPC ( 1e , 1 ) SPC ( , 0 ) e 0 U UN P The static AD curve M up (G - T) up AD0 AD1 Y Dynamic Aggregate demand (DAD) Growth in real Growth in government money supply deficit (G-T) Y Y (m ) BDg S Dynamic multipliers m (Y Y ) BDg S 1 Use Okun’s Law Slope Growth of the DAD of government curve deficit m (u u ) BDg S N Money Demand growth Cyclical shock unemployment m (u u ) BDg S N S 1 DAD(m , BD ) 1 g m BD s 1 1 g S DAD(m , BD ) 0 0 g m BD s 0 0 g U UN Long-run equilibrium Steady state equilibrium • Stable (constant) inflation. • Expectations are fulfilled. • The growth of the deficit is zero. • No shocks. Characterization of long-run equilibrium e u u N Non-accelerating inflation rate of Real unemployment (NAIRU) rigidity = the structural rate of unemployment Nominal rigidity The natural rate of unemployment Characterization of long-run equilibrium BDg 0 m S Short-run analysis The model in action • Stagflation in the 70ies (high inflation and unemployment in response to supply shocks). • Disinflation in the 80ies. • Central bank independence in the 90ies. LPC DAD(m , BDg 0) s A m e s Long-run equilibrium SPC ( 0 , 0 0) e U UN • Negative supply shock leading to stagflation in the 70ies • Accommodating economics policy d LPC DAD1 (m1s ) 1 s C DAD 0 ( m0 ) B A m e s 0 SPC ( 0 , 1 ) e SPC ( , 0 0) e 0 U UN u1 Dis-inflation in the beginning of the 1980s d LPC DAD ( m1s ) SPC ( ) e s 1 DAD ( m )2 C 1 B B 1 1e m2 s C SPC ( 0 ) e U UN UB u uN Time 0 Fig 1 Time The cost of disinflation Credibility Adjustment speed • Does the private sector believe the • How fast do expectations adjust (rational government will go through with the versus adaptive expectations)? plan. • How fast do changes in expectations get • Institutions and ideology locked into nominal wage contracts? What is next? • Stabilization policy in a closed economy. • Fiscal and monetary policy.
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