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Aggregate Supply and the Phillips Curve

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Aggregate Supply and the Phillips Curve Inflation and the Phillips Curve Short‐Run Supply Andrew Rose, Global Macroeconomics 13 1 Why is Aggregate Supply not Vertical in Short Run? • Would like some theoretical reason why aggregate supply is horizontal/sloped in short‐run • Why can we treat prices as fixed in short run? – Alternatively: why do we have short‐run and long‐run supply curves, but only one aggregate demand curve? P D Y Andrew Rose, Global Macroeconomics 13 2 Theoretical Model of Nominal Rigidity • Stic ky Long‐term NilNominal Wages ((y//y)Gray/Fischer/Taylor): unions fix nominal wages in short run (≈ three years?) Andrew Rose, Global Macroeconomics 13 3 Shock to Aggregate Demand – Unexpected increase in demand raises prices, hence lowers real wages, induces hiring; employment and output are boosted (boom) P B A Y Andrew Rose, Global Macroeconomics 13 4 Two Serious Problems 1. How ittimportant are uni?ions? – Also, are unions foolish enough to set nominal wages? 2. Are real wages counter‐cyclic in practice? Andrew Rose, Global Macroeconomics 13 5 Worker Misperceptions (Friedman) • Similar, but with flexible nominal wages. – Labor supply depends on real wages set with expected prices because workers look at many prices – Labor demand depends on actual prices as firms looks at a few prices • Unexpected price increase leads to same sequence of events – Still have counter‐cyclic real wages – Are information problems so serious in reality? • Other models exist too Andrew Rose, Global Macroeconomics 13 6 Common Problems with Theories • Difficu lt to discr im ina te btbetween modldels of aggregate supply empirically • All models yield positively‐sloped/flat aggregate short‐run supply curve • Most hard to believe (e.g ., if they predict counter‐cyclic real wages) Andrew Rose, Global Macroeconomics 13 7 Empirical Motivation for Short‐Run Aggregate Supply • DtData clllearly iditindicate tha t shthort‐run supply is not vertical – Dis‐inflation via aggregate demand contraction costs recession • OiOngoing research on shthort‐run aggregate suppl y – most historic focus on demand Andrew Rose, Global Macroeconomics 13 8 Phillips Curve • The negative, shthort‐run reltilations hip btbetween unemppyloyment and inflation • Initially, Phillips created, then plotted historical inflation and unemployment Andrew Rose, Global Macroeconomics 13 9 Graphically π * * * * * * * * * * * * U Andrew Rose, Global Macroeconomics 13 10 Formal Theory for Phillips Curve • Start from the aggregate short‐run supply curve, and manipulate it: e y = yNR + (p‐p ) >0 e => p = p + (1/)(y‐yNR)Rearrange e => p‐p‐1 = p ‐p‐1 + (1/)(y‐yNR) Subtract e => Π = Π + (1/)(y‐yNR)Define inflation e => Π = Π ‐β(u‐uNR) + ε Use Okun’s Law • End up with negative “Phillips Curve” inflation/unemployment relationship Andrew Rose, Global Macroeconomics 13 11 Notes 1) prices not wages matter 2) expected inflation matters 3) supply shocks (ε) imply there is no deterministic relationship between unemployment and inflation Andrew Rose, Global Macroeconomics 13 12 Interpretation of Phillips’ Empirical Finding • The negative relationship found empirically indicates that Phillips was essentially tracing out aggregate supply – Hence the inflation/unemployment tradeoff is only generally valid for demand shocks Andrew Rose, Global Macroeconomics 13 13 Graphically P A Equilibrium A Y u P B Demand A B A C Shocks C Y u P B Supply Shocks B A A C C Y u Andrew Rose, Global Macroeconomics 13 14 More on Phillips Curve Interpretation • Phillips' correlation means that most shocks were demand shocks for his sample of data – Historically though, many shocks are demand shocks Andrew Rose, Global Macroeconomics 13 15 Transition from Business Cycles to Long Run • Chang ing expecttitations of ifltiinflation shift shthort‐ run aggreg ate suppl y curve, provide link between short‐run (prices fixed) and long run (prices flexible) Andrew Rose, Global Macroeconomics 13 16 Graphically P Large Open or Closed Economy A A Y Y Expansionary P Monetary B A Shock A B Y Y P Eventually… C C = Inflation B A A B Y Y Andrew Rose, Global Macroeconomics 13 17 Notes • Demand shocks (monetary/fiscal/investment) raises inflation by lowering U/raising y above natural rate • Key question for dis‐inflations: how are inflation expectations formed/changed? • Lowering inflation through contractionary aggregate dddemand policy is costly unless expectations can be changed quickly Andrew Rose, Global Macroeconomics 13 18 Key Takeaways • Phillips Curve: tradeoff between inflation and unemployment • Tradeoff only for a) demand shocks, and b) in short run Andrew Rose, Global Macroeconomics 13 19.
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