Lecture 12 The

Principles of KOF, ETH Zurich, Prof. Dr. Jan-Egbert Sturm Fall Term 2008 General Information

23.9. Introduction Ch. 1,2 30.9. National Accounting Ch. 10, 11 7.10. Production and Growth Ch. 12 14.10. and Investment Ch. 13 21.10. Ch. 15 28.10. The Monetary System Ch. 16, 17 4.11. International (incl. Basic Concepts of Ch. 3, 7, 9 /Demand/Welfare)

11.11. Open Macro Ch. 18 18.11. Open Economy Macro Ch. 19 25.11. and Ch. 20 2.12. Monetary and Ch. 21 9.12. Phillips Curve Ch. 22 16.12. Overview / Q&A

Q&A Session next week (december 16)

• Please send your questions to • [email protected]

• Questions received before Friday, december 12, 23:59 will be discussed during the Q&A session

Remember: Natural Rate of Unemployment

• The natural rate of unemployment is unemployment that does not go away on its own even in the long run • There are two reasons why there is a positive natural rate of unemployment: 1. search () 2. rigidity () • Minimum-wage laws • Unions • Efficiency

Remember: The

• The quantity equation: M × V = P × Y • relates the quantity of (M) to the nominal of (P×Y) • The quantity equation shows that an increase in money must be reflected in one of three other variables: • The level must rise, • the quantity of output must rise, or • the velocity of money must fall • The velocity of money is considered to be (relatively) fixed • The classical dichotomy • Real economic variables do not change with changes in the money • Hence, changes in the only affect the

Remember: A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run Price Level Long-run Short-run aggregate aggregate supply, AS supply

P A

P B 2 1. A decrease in aggregate demand . . . P3 C Aggregate demand, AD

AD2

0 Y2 Y Quantity of Output Short-Run Trade-Off between and Unemployment • Unemployment and Inflation • Society faces a short-run tradeoff between unemployment and inflation. • If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. • If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. THE PHILLIPS CURVE The Phillips curve shows the short-run trade- off between inflation and unemployment. The Phillips Curve

Inflation Rate (percent per year)

6 B

A 2

Phillips curve

0 4 7 Unemployment Rate (percent) Aggregate Demand, Aggregate Supply, and the Phillips Curve • The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. • The greater the aggregate demand for and services, the greater is the economy’s output, and the higher is the overall price level. • A higher level of output results in a lower level of unemployment. How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation Level Short-run Rate aggregate (percent supply per year) B 106 B 6

102 A High A aggregate demand 2 Low aggregate Phillips curve demand 0 7,500 8,000 Quantity 0 4 7 Unemployment (unemployment (unemployment of Output (output is (output is Rate (percent) is 7%) is 4%) 8,000) 7,500) Okun’s Law states Okun’s Law Okun’s Law states that a one-percent that a one-percent Percentage decreasedecrease inin change 10 unemployment is in real GDP unemployment is associatedassociated withwith twotwo 8 1951 percentagepercentage pointspoints 6 1984 ofof additionaladditional growthgrowth 2000 in real GDP 4 1999 in real GDP

2 1993 1975 0

-2 1982

-3 -2 -1 0 1 2 3 4 Change in unemployment rate Full-time equivalent vs. GDP

2.0

1.0

0

Employment -1.0

-2.0

-3.0 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0

GDP (2-years average) Source: BFS and KOF SHIFTS IN THE PHILLIPS CURVE:

• The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes. The Long-Run Phillips Curve

• In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. • As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. • could be effective in the short run but not in the long run. The Long-Run Phillips Curve

Inflation Rate Long-run Phillips curve

High B 1. When the inflation CB increases the growth rate of the money supply, the rate of inflation 2. . . . but unemployment remains at its natural rate increases . . . Low A in the long run. inflation

0 Natural rate of Unemployment unemployment Rate The Meaning of “Natural”

• The “natural” rate of unemployment is the rate to which the economy gravitates in the long run. • The natural rate is not necessarily desirable, nor is it constant over time. • Monetary policy cannot change the natural rate, but other government policies that strengthen labor markets can. How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Long-run aggregate Inflation Long-run Phillips Level supply Rate curve 1. An increase in 3. . . . and the money supply increases the increases aggregate inflation rate . . . B P2 demand . . . B 2. . . . raises the price A level . . . P A AD2 Aggregate demand, AD 0 Natural rate Quantity 0 Natural rate of Unemployment of output of Output unemployment Rate 4. . . . but leaves output and unemployment at their natural rates. Reconciling Theory and Evidence

• Question: How can classical macroeconomic theories predicting a vertical long run Phillips curve be reconciled with the evidence that, in the short run, there is a tradeoff between unemployment and inflation? The Short-Run Phillips Curve

• Expected inflation measures how much people expect the overall price level to change. • In the long run, expected inflation adjusts to changes in actual inflation. • The CB’s ability to create unexpected inflation exists only in the short run. • Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. The Short-Run Phillips Curve

• This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation. The Unemployment Rate = a Actual − Expected Natural rate of unemployment - (inflation inflation )

SRAS: Y =+YPPα () −e The Phillips Curve in the 1960s (USA) Inflation Rate (percent per year) 10

8

6

1968 4 1966 1967 2 1965 1962 1964 1961 1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) The Natural Experiment for the Natural-Rate Hypothesis • The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. • Historical observations support the natural- rate hypothesis. • The concept of a stable Phillips curve broke down in the in the early ’70s. • During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously. WHY?? The Breakdown of the Phillips Curve (USA)

Inflation Rate (percent per year)

10

8

6 1973 1971 1969 1970 4 1968 1972 1966 1967 2 1965 1962 1964 1961 1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) How Expected Inflation Shifts the Short-Run Phillips Curve

2. . . . but in the long run, expected inflation rises, and the short-run Inflation Phillips curve shifts to the right. Rate Long-run Phillips curve

C B

Short-run Phillips curve with high expected inflation

A Short-run Phillips curve 1. Expansionary policy moves with low expected the economy up along the inflation short-run Phillips curve . . . 0 Natural rate of Unemployment unemployment Rate SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • Historical events have shown that the short-run Phillips curve can shift due to changes in expectations. • The short-run Phillips curve also shifts because of shocks to aggregate supply. • Adverse changes in aggregate supply can worsen the short-run trade-off between unemployment and inflation. • An adverse gives policymakers a less favorable trade-off between inflation and unemployment. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • A supply shock is an event that directly alters the firms’ costs, and, as a result, the they charge. • This shifts the economy’s aggregate supply curve… • . . . and as a result, the Phillips curve.

An Adverse Shock to Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation Level AS Rate 4. . . . giving policymakers 2 Aggregate a less favorable tradeoff supply, AS between unemployment and inflation. B P2 B 3. . . . and 1. An adverse raises A shift in aggregate A the price P supply . . . level . . . PC2 Aggregate demand Phillips curve, PC 0 Quantity 0 Unemployment Y2 Y of Output Rate 2. . . . lowers output . . . Two causes of rising & falling inflation

• demand-pull inflation: • inflation resulting from demand shocks. Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up. • cost-push inflation : • inflation resulting from supply shocks. Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.

World and oil

7 % USD per barrel 140

6 120

5 100

4 real (in 2000 USD) 80

3 60

2 40

1 20

nominal (in USD) 0 0 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

NEXANS Fachseminar 24. Oktober 2007 Quellen: IMF, BFS Shifts in the Phillips Curve: The role of supply shocks

• In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. • Fight the unemployment battle by expanding aggregate demand and accelerate inflation. • Fight inflation by contracting aggregate demand and endure even higher unemployment. The Supply Shocks of the 1970s

Inflation Rate (percent per year)

10 1981 1980 1975 1974 1979 8 1978

6 1977 1973 1976

4 1972

2

0 1 2 3 4 5 6 7 8 9 10Unemployment Rate (percent) United States 14

12

10

8

Inflation 6

4

2

0 345678910 Unemployment United States 14 80

12 79

10

8

76

Inflation 6 69

4 92 83

2 60 86

0 345678910 Unemployment United States 14 80

12 79 74 10

8

73

Inflation 6

84 4 92 99 2 86

0 345678910 Unemployment The Cost of Reducing Inflation • To reduce inflation, the CB has to pursue contractionary monetary policy.

• When the CB slows the rate of money growth, it contracts aggregate demand. • This reduces the quantity of that firms produce. • This leads to a rise in unemployment.

Disinflationary Monetary Policy in the Short Run and the Long Run 1. Contractionary policy moves the economy down along the Inflation Long-run short-run Phillips curve . . . Rate Phillips curve

A

Short-run Phillips curve with high expected inflation

C B

Short-run Phillips curve with low expected inflation 0 Natural rate of Unemployment unemployment 2. . . . but in the long run, expected Rate inflation falls, and the short-run Phillips curve shifts to the left. The Sacrifice Ratio

• To reduce inflation, an economy must endure a period of high unemployment and low output. • When the CB combats inflation, the economy moves down the short-run Phillips curve. • The economy experiences lower inflation but at the cost of higher unemployment. The Sacrifice Ratio

• The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. • An estimate of the sacrifice ratio is five.

• To reduce inflation from about 10% to 4% in 1979 would have required an estimated sacrifice of 30% of annual output! and the Possibility of Costless • The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. Rational expectations

Ways of modeling the formation of expectations: ƒ : People base their expectations of future inflation on recently observed inflation. ƒ rational expectations: People base their expectations on all available information, including information about current and prospective future policies. Rational Expectations and the Possibility of Costless Disinflation • Expected inflation explains why there is a trade-off between inflation and unemployment in the short run but not in the long run. • How quickly the short-run trade-off disappears depends on how quickly expectations adjust. • The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated. The Volcker Disinflation

• When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the United States’ foremost problems.

• Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high unemployment (about 10 percent in 1983). Figure 11 The Volcker Disinflation

Inflation Rate (percent per year)

10 1980 1981 A 1979 8

1982 6

1984 4 B 1987 1983 1985 C 2 1986

0 1 2 3 4 5 6 7 8 9 10Unemployment Rate (percent) The Greenspan Era

• Alan Greenspan’s term as Fed chairman began with a favorable supply shock. • In 1986, OPEC members abandoned their agreement to restrict supply. • This led to falling inflation and falling unemployment. The Greenspan Era

• Fluctuations in inflation and unemployment in recent years have been relatively small due to the Fed’s actions. Figure 12 The Greenspan Era

Inflation Rate (percent per year)

10

8

6

1990 1991 4 1989 1984 1988 1985 2001 1987 2000 1995 1992 2 1997 1994 1986 1999 1993 2002 1998 1996

0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) United States 14 80

12 79 74 10

8

73

Inflation 6

84 4 92 99 2 86

0 345678910 Unemployment United States

14 80

12 79 74 10 75

8

73 76

Inflation 6 69 70

71 84 4 72 92 83 99 2 60 86

0 345678910 Unemployment Germany 8

7

6

5

4

3 Inflation

2

1

0 0246810 -1 Unemployment Germany 8

74 7 81 6 75 92 5 76 4 70 77

3 Inflation 78 85 2 97

60 91 1

0 86 0246810 -1 Unemployment Germany 8

74 7 81 6

92 5

79 4 70

3 Inflation

85 2 97

60 91 1 99 0 86 0246810 -1 Unemployment Germany 8

74 7 81 6 75 92 5 76 79 4 70 77

3 Inflation 78 85 2 97

60 91 1 99 0 86 0246810 -1 Unemployment Summary

• The Phillips curve describes a negative relationship between inflation and unemployment. • By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. Summary

• By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment. Summary

• The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run. • The long-run Phillips curve is vertical at the natural rate of unemployment. Summary

• The short-run Phillips curve also shifts because of shocks to aggregate supply. • An adverse supply shock gives policymakers a less favorable trade-off between inflation and unemployment. Summary

• When the CB contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve. • This results in temporarily high unemployment. • The cost of disinflation depends on how quickly expectations of inflation fall.