Macroeconomics by Ix4g2Jd9

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```									  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

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  P1  P  P1   (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

M up

(G - T) up
Y
Dynamic Aggregate demand
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
curve               deficit


  m  (u  u )  BDg 
S

N       


Money                                  Demand
growth                 Cyclical         shock
unemployment

  m  (u  u )  BDg 
S

N    



S           1
1           g

m  BD
s
1


1
g
S
0
0
g

m  BD
s
0


0
g

U
UN
Long-run 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

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

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

SPC ( )
e                                s
1
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

• Does the private sector believe the
• How fast do expectations adjust (rational
government will go through with the