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 0.4g 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?