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Stabilisation

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									  Macroeconomic Analysis 2003

An Example of a Stabilisation Programme




                    Lecture 9             1
                    Contents
• Need for Stabilisation: Costs of Inflation and
  Unemployment
• Review of Wage and Price Spiral and Inflation
• Output gap and Mark ups
• Stabilisation experience
• Phillips’ and Okun Curves
• Set up of the Stabilisation Programme
• Inflation reduction and Unemployment
• Growth rate of output, inflation and money supply
• Sacrifice Ratio
• inflation policy game between public and the
  government: Rules or Discretion?
• Analysis of Stabilisation using AS-AD diagrams
                        Lecture 9                     2
Movement of Economy Around the Trend: A Reminder


       35 million unemployed
Y      in the OECD
                                          Boom




                                      Recession




             1982                  1992           2003

                       Lecture 9                     3
    Needs for Stabilisation: Costs of Inflation
• Inflation distorts relative prices and makes the market system
  less efficient as prices cannot signal relative scarcity
• Inflation transfers resources from creditors to debtors
• Redistributes income from fixed income group to property
  holders
• Taxes are not indexed for inflation, low income families are
  pushed up to the tax threshold
• Shoe leather and bookkeeping costs rise with inflation
• It creates uncertainty. Creates illusions, confusions and
  complicates economic calculation
• It is harmful for economic growth; reduces saving and
  investment activities
• It create social tension

                             Lecture 9                        4
    Needs for Stabilisation: Costs of Unemployment
• Loss of output and income and utility
• Personal psychological costs
   –   Unhappiness
   –   Stress and tension
   –   Discouragement and disappointment
   –   Morale and motivation
   –   Uncompetitive feeling
   –   Dignity of human life
   –   Insecurity
   Loss of productive skills
   productivity
   Lack of learning by doing opportunity
   Rise in social unrest and crimes
                               Lecture 9             5
,        =0.2       Main cause of Inflation: Wage Price Spiral
Time     Wage    Price   Modernisation or Negotiation?
     1    1.00    1.00
     2    1.20    1.20
     3    1.44    1.44                         Price
     4    1.73    1.73
     5    2.07    2.07
     6    2.49    2.49
     7    2.99    2.99
     8    3.58    3.58
     9    4.30    4.30
    10    5.16    5.16
    11    6.19    6.19
    12    7.43    7.43
    13    8.92    8.92
                                                                     wage
    14   10.70   10.70
    15   12.84   12.84
    16   15.41   15.41
    17   18.49   18.49
    18   22.19   22.19
    19   26.62   26.62
    20   31.95   31.95             Lecture 9                     6
    21   38.34   38.34
Price Level to Inflation Rate




                  Ignore these small numbers
             Lecture 9                         7
Inflation to Aggregate Supply or Expectation
          Augmented Phillips Curve




                   Lecture 9                   8
Inflation, Output and Unemployment in the Short Run
                      LAS
                                       AS=f(w,pe)




                                           AD =f(M,G, T)
       o


                      Lecture 9                       9
Supply Shock and Stagflation
                  LAS         AS1
                                    AS=f(w,pe)

    Stagflation




                                       AD =f(M,G, T)
o


                  Lecture 9                      10
Inflation


                        Rational Expectation

                                    Time

Deflation

                Expectation die very slowly.
            Lecture 9                      11
Friedman (1966, 1968) and Phelps (1967) natural
       rate of unemployment hypothesis




                     Lecture 9                    12
Natural Rate of Unemployment Hypothesis




                  Lecture 9               13
          Four Main Theories of Natural Rate of Unemployment
    1. Search cost and job                3. Efficiency wage theory
        mismatch theory:                  Firms pay higher wages to
    s = job separation rate               workers to reduce hiring
    f = job finding rate                  and firing costs and to
    u = unemployment rate                 reduce shirking and the
                                          monitoring costs or to
                                          appear as an ideal employer
                                          but that makes others
2. Insider-Outsider theory:               unemployed
   Inefficient Bargaining
   between firms and                 4. Rigidity in the labour
   workers                                 Market:
Members of the union                 Minimum wage laws
   demand higher wages and           Entry deterrence and labour
   non-member remain             Lecture 9
                                           market standards         14
   unemployed
Determination of the Natural Rate of Unemployment: An Example




                               Lecture 9                    15
Recent Experience of Stabilisation in the UK




              Lecture 9                        16
Inflation is a Monetary Phenomenon




               Lecture 9             17
 Standard Measures of Stabilisation
• Control of Aggregate Demand
  – Increase or decrease in money supply
  – Control in the tax and spending programme
  – Monetisation or contraction of the budget deficit
• Aggregate supply
  – Wage renegotiations
  – Efficiency enhancing measures
• Trade and Exchange Rates Measures
  – Appreciation or depreciation of the currency
  – Trade and exchange rate agreements

                          Lecture 9                     18
          Unemployment and Output Gap: Okun’s Curve


Output Gap
                                   Higher growth rate means
                                   lower unemployment rate
                Sacrifice ratio
Inflation gap



                  Higher unemployment causes
                  wages and inflation to fall


                              Unemployment Gap
                             Lecture 9                        19
 Inflation Reduction Programme:
Output, Inflation and Unemployment




               Lecture 9             20
Stabilisation: Table 1




       Lecture 9         21
Basic Parameters for the Stabilisation Programme Model




                           Lecture 9                     22
Disinflation (Stabilisation Program




                Lecture 9             23
Parametric Specification and solution steps for
       inflation reduction Programme




                     Lecture 9                    24
            Transitional path of output and money growth
           and unemployment rate in the inflation reduction
                              programme
                Time       pi          u    gy       gm
                 0         14          5     3       17
                 1         12          9    -5       7
    =14%
                 2         10          9     3       13
-
                 3         8           9     3       11
a = 0.5          4         6           9     3       9
                 5         4           9     3       7
b = 0.5
                 6         2           9     3       5
                 7         2           5    11       13
                 8         2           5     3       5
                 9         2           5     3       5
                                Lecture 9                     25
Lecture 9   26
Stabilisation: Table 2




          Lecture 9      27
Stabilisation: Table 3




          Lecture 9      28
Disinflation Path and the Steady State




                Lecture 9                29
Another Set of Parameters for the Stabilisation Programme Model




                              Lecture 9                      30
Transitional path of output and money growth
and unemployment rate in the inflation reduction programme




                          Lecture 9                     31
Lecture 9   32
Inflation Policy Game




         Lecture 9      33
Inflation Policy Game
                      C is the most preferred and
                      B is the least wanted
                      scenario of the government
                         Non cooperative Game
                         may end at point D
                         with high inflation and
                          high unemployment
                         rate


     uL                uH

          Lecture 9                       34
        Adaptive and Rational Expectation Views on a Positive
                           Demand Shock
                                       LAS                SAS
            P2                   c

              P1                                     b
        P
              P0                                 a

                                                               AD1


                                                             AD0

                0                               Yn
Reply to demand shock                                    Y
Adaptive Expectation: a to b to c
Rational expectation: a to c        Lecture 9                      35
Movement of Aggregate Demand and Supply Around the Natural Rate
                                              AS2
                                                      SA3     AS1
              P2                d             e
              P3                                              AS0
Price Level                                       c
               P1
                                          f            b

              P0
                                                            AD3          AD1
                                              a


                                                                  AD0

                   0                  YL Yn           YH
                              Lecture 9                             36
               Exercises
• Okuns’ Curve
• Phillips curve
• Inflation reduction program
• Sacrifice ratio
• Money supply, inflation and economic
  growth rate in the steady state
• Policy Game

                   Lecture 9             37

								
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