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Disinflation

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					                Disinflation
• Objectives
  – To understand the best way to reduce inflation,
    drawing on the case of the US in the late 1970s
• Reading
  – Blanchard, chap 9
                      Okun’s Law
           ut  ut 1  0.4g yt  3% 
• The relationship is negative
• To sustain a constant unemployment-rate, output growth
  must be 3%. Why?
   – Labour force growth
   – Productivity growth
• An increase in output growth of 1% leads only to a 0.4%
  decrease in unemployment-rate. Why only 0.4%?
   – Labour hoarding
   – Change in the labour force
Okun’s Law across countries
     ut  ut 1    ( g yt  g y )
Table 1   Okun’s Law Coefficients Across Countries and
          Time
Country                1960-1980 β         1981-2003 β
United States              0.39               0.39
United Kingdom             0.15               0.54
Germany                    0.20               0.32
Japan                      0.02               0.12
         The Phillips curve

         t     ut  u n 
                e



– Expected inflation is uapproximately last years
  inflation
– The natural rate of unemployment, 6% and
  alpha 1
        t   t 1  ut  6% 
Aggregate demand

        Mt           
Yt  f 
        P  , Gt , Tt 
                      
        t            
            Mt
     Yt  
             Pt
 g yt  g mt   t
Review of the model

ut  ut 1    g yt  g y 

 t   t 1   ut  un 

   g yt  g mt   t
                Medium-run
• Assume   gm
                  g yt  g y
                 t  gm  g y
                    ut  u n

• What does this tell us about inflation in the
  medium-run, and how to reduce inflation?
                    Short-run
• Sacrifice ratio
                Summary
• In medium-run, a contraction in the nominal
  money supply reduces inflation
• In short-run, a contraction in the nominal
  money supply reduces inflation and output
  growth, and increases unemployment

Q: How best to design a disinflationary
 monetary policy? How fast to disinflate?
          Traditional approach
Policy objective: Reduce inflation from 14% to 4%
          t   t 1  ut  un 
• Policy option 1: Aim to achieve in 1 year.
   – 10% excess unemployment over 1 year
• Policy option 2: Aim to achieve in 2 years.
   – 5% excess unemployment for 2 years
• Policy option 3: Aim to achieve in 5 years.
   – 2% excess unemployment over 5 years
      Lucas critique and rational
            expectations
• What are ‘rational expectations?’

          t     ut  u n 
                 e
                Credibility
•   Policy announcements
•   Independence of Central Banks
•   Clear mandates for Central Banks
•   Long-term appointments
•   Quick disinflation
 Nominal rigidities and contracts
• Fixed nominal contracts
• Staggering of wage decisions
Nominal rigidities and optimal
        disinflation
US disinflation, 1979-1985
         US disinflation, 1979-1985

Table 1 Inflation and Unemployment, 1979-1985
                             1979   1980   1981   1982   1983   1984   1985
GDP growth                    2.5   0.5   1.8    2.2   3.9    6.2    3.2
Unemployment rate             5.8   7.1    7.6    9.7    9.6    7.5    7.2
CPI inflation                13.3   12.5   8.9    3.8    3.8    3.9    3.8
Cumulative unemployment             1.0    2.6    6.3    9.9    11.4   12.6
Cumulative disinflation             0.8    4.4    9.5    9.5    9.4    9.5
Sacrifice ratio                     1.25   0.59   0.66   1.04   1.21   1.32
        Summary of evidence
• Disinflations lead to a period of higher
  unemployment
• Faster disinflations are usually associated
  with smaller sacrifice ratios
• Sacrifice ratios are smaller in countries with
  shorter wage contracts
                            Exercise
Credibility and disinflation [Blanchard, ch 9, Q6]
Suppose that the Phillips curve and expected inflation are given by
                  t   e t  ut  5% 
                 t   t 1
                  e


a)   What is the sacrifice ratio in the economy?

Suppose that the unemployment rate is initially equal to the natural
    rate and inflation is 12%. The CB decides to lower inflation
    and it will maintain unemployment at 1% above the natural
    rate until inflation is 2%
b)   Compute the rate of inflation for years t, t+1, t+2,…
c)   For how many years must the CB keep unemployment above the
     natural rate? Is the implied sacrifice ratio consistent with your
     answer in a)

Now suppose that people know that the CB wants to lower
   inflation to 2% but they are unsure about the Banks
   willingness to accept excess unemployment. So, their
   expectations of inflation is a weighted average of the target of
   2% and last years inflation-rate, given by

                 t   2%  1    t 1
                   e



where lambda is the weight they put on the Banks target
d)   Let lambda = 0.25. How long will it take before inflation is 2%?
What is the sacrifice ratio? Why is it different from
   the answer in c)?

e) Suppose that after the policy has been in effect
   for one year, people believe that the Bank is
   indeed committed to reducing inflation to 2%, so
   they revise their expectations to
                    t  2%
                     e



    From what year onward can the Bank let the
    unemployment rate return to the natural rate?
    What is the sacrifice ration now?

				
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