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Home , Output gap, Phillips curve

SGPE Summer School: Lecture 9 and adjustment in the short run (Chapter 9)

• In the IS-LM model, we assumed that were given in the short run • But prices are not constant. We need a theory for how and prices adjust in the short run • In the long run, production and should go back to the equilibrium levels found in Lectures 2 and 6 • Analysis of wage and price adjustment ties the short and the long run together

2 Wage and price adjustment: Introduction

Questions: • What factors determine short run wage and price adjustment? • Is there a choice between low and low ?

3 Wage and price adjustment: The The wage-setting equation:

d DW DW n If unemployment is lower (higher) t = t - b u - u W W ( t ) t-1 t-1 than the equilibrium level, companies want to raise wages more (less) than the average rate of

4 Wage and price adjustment: The Phillips curve Wage-setting in the short run:

• Share 1 - l of companies set wages W r at the end of the previous year • Share l of companies that have flexible wages: W x • Average rate of wage increase in the economy: DW DW x DW r t = l t +(1- l) t Wt-1 Wt-1 Wt-1

Wage increase in firms Wage increase in firms that can adjust wages that can’t adjust wages during the period during the period

5 Wage and price adjustment: The Phillips curve

• Wage-setting in companies that can adjust wages:

DW x DW t = t - b u - un ( t ) these firms set their desired wage Wt-1 Wt-1 • Wage-setting in companies that cannot adjust wages:

DW r DW e these firms set wages based on their t = t expectations about average wage W W t-1 t-1 development

Intuition: If they were to set any other wage, they would be consciously setting the wrong wage! Those who are flexible set the wage correctly given the labour situation

6 Wage and price adjustment: The Phillips curve

Average rate of wage increase in the economy:

DW DW x DW r éDW ù DW e t = l t + 1- l t = l t -b u -un + 1- l t ( ) ê ( t )ú ( ) Wt-1 Wt-1 Wt-1 ëWt-1 û Wt-1

DW DW e  t (1- l) = (1- l) t - lb u - un ( t ) Wt-1 Wt-1

DW DW e lb t = t - u - un ( t ) Wt-1 Wt-1 1- l ˆ lb DW DW e where b = The Phillips curve t = t - bˆ u - un 1- l ( t ) Wt-1 Wt-1

7 Wage and price adjustment: The Phillips curve The Phillips curve: e lb DW DW n ˆ t = t - bˆ u - u where b = ( t ) 1- l Wt-1 Wt-1

8 Wage and price adjustment: The Phillips curve

The slope of the Phillips curve is determined by:

• The parameter b How much unemployment influences the company’s wage- setting decisions • The parameter l What percentage of companies can adjust wages freely If b and l are large, the Phillips curve has a steep slope and vice-versa

9 Wage and price adjustment: The Phillips curve

P - P Definition of inflation: t t-1 p t = Pt-1 To analyse short run wage and price adjustment, we simplify the production function and set a = 0 : Y Y = EN Þ MPL = APL = = E N W W Price-setting: P = (1+ m)MC = (1+ m) = (1+m) MPL E DW DE Inflation: p = - W E DW e DEe Expected inflation: p e = - W E

10 Wage and price adjustment: The Phillips curve We can write the Phillips curve in terms of unemployment and price inflation: DW DE DW e DE p = - = -bˆ u -un - W E W ( ) E

DEe DE æDE DEe ö p = p e + -bˆ(u -un ) - = p e -bˆ(u -un ) -ç - ÷ E E è E E ø

Inflation is determined by: • expected inflation • unemployment • unexpected changes in productivity

11 Wage and price adjustment: The Phillips curve The Phillips curve in terms of unemployment and inflation: æ DE DEe ö p = p e - bˆ(u - un ) -ç - ÷ è E E ø To simplify, we write: p = p e - bˆ(u -un ) + z where z represents unexpected changes in productivity and also changes in cost or taxes that affect prices when wages have been set

12 Wage and price adjustment: The Phillips curve

L - N • Definition, unemployment: u = L • Production function: Y = EN Y n = EN n

L- N L- N n N - N n Y / E -Y n / E Y n Y -Y n • u - un = - = - = - = - L L L L EL Y n When production is above the natural level, unemployment is below the natural level Y -Y n • Definition, gap: Yˆ = Y n Y n lb Y n • The Phillips curve: p = p e + b Y ˆ + z where b = bˆ = EL 1- l EL

13 Wage and price adjustment: The Phillips curve

p = p e + bYˆ + z

14 Wage and price adjustment: The Phillips curve

p = p e + bYˆ + z

Inflation is determined by: • Expected inflation • • Unexpected shocks to productivity and non-wage costs such as energy prices

15 Wage and price adjustment: The Phillips curve

Adjustment is probably slower for several reasons: • Many wage agreements are multi-year agreements • Those who set wages and prices have imperfect information about the economic situation and it takes time to react • Changes in wages and prices are not synchronised All these factors influence the speed of wage and price adjustment and hence the slope of the Phillips curve

16 Expectations: Introduction

Question: The position of the Phillips curve depends on expected inflation, but how are expectations about inflation formed and what are the consequences for the relation between inflation and production/employment?

17 Expectations: Introduction

Three cases: p e = 0 The is expected to be the same as last year

e p t = pt-1 Inflation is expected to be the same as last year p e = p Ä Inflation is expected to equal the inflation target

18 Expectations: Price level the same (p e = 0) Phillips curve: p = bYˆ + z What happens if the supply increases more quickly?

The effect of increasing M will be higher inflation and higher production and employment. There is a -off between inflation and unemployment

19 e Expectations: Inflation the same (p = p-1) But if inflation is higher, people should realise that sooner or later. An alternative Phillips curve is ˆ p t = p t-1 + bYt + zt

20 Expectations: Inflation the same

What happens if the increases faster?

ˆ p = p-1 + bY + z

Phillips curve is not stable: when expectations have adjusted, the effect of a faster increase of M is higher inflation but no effect on unemployment

21 Expectations: Inflation the same

p = p + bYˆ + z • Phillips curve: -1

p • Subtraction of - 1 yields Dp = bYˆ + z • If production is kept above the equilibrium level, inflation will accelerate and vice-versa • Equilibrium unemployment is sometimes called the non-accelerating-inflation rate of unemployment (NAIRU) • The vertical line at the equilibrium level of production (or unemployment rate) is sometimes called the long-run Phillips curve (LRPC)

22 Expectations: Inflation the same

• In the long run there is no real choice between inflation and unemployment • It is costly to keep production above the natural level: the result will be permanently higher inflation • If inflation is high, it can be worthwhile to try to reduce it even if it is costly in terms of production and employment in the short run. The result is permanently lower inflation

23 Expectations: A strict and credible inflation target (p e = p Ä ) Phillips curve: p = p Ä + bYˆ + z What happens if the money supply increases faster?

The effect of increased M is higher inflation and production. The Phillips curve is not affected as long as the target remains credible

24 Relation between economic activity and inflation

25 Relation between economic activity and inflation

Why is there no clear relation – no stable Phillips curve? • When inflation has increased to a high level, it tends to remain high because expected inflation is higher • Equilibrium unemployment can change over time On the other hand there is a fairly strong relation between the output gap and the change in inflation, e which supports the Phillips curve with p = p-1 ˆ that is ˆ p = p-1 + bY + z Dp = bY + z

26 Relation between economic activity and inflation

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