Philips curve

Works in a “cycle” Firms raise prices, the inflation rate increases Less demand for products Firms cut costs and lay off workers Inflation rate falls back down to previous levels

The Empirical Fit of the Phillips Curve Empirically, the slope is approximately one- half. – Meaning: if output exceeds potential by 2 percent, the inflation rate increases one percentage point.

12.3 The Phillips Curve Recall the inflation rate is the percent change in the overall price level. Firms set their prices on the basis of – Their expectations of the economy-wide inflation rate – The state of demand for their product.

Expected inflation – The inflation rate firms think will prevail in the economy over the coming year.

Firms expect next year’s inflation rate to be the same as this year’s inflation rate. Under adaptive expectations firms adjust their forecasts of inflation slowly. Expected inflation embodies the sticky inflation assumption.

The Phillips curve – Describes how inflation evolves over time as a function of short-run output If output is below potential – Prices rise more slowly than usual If output is above potential – Prices rise more rapidly than usual This year’s inflation Last year’s inflation Short run output

Using the equations: Therefore, the Phillips curve can be expressed as: Change in inflation The parameter measures how sensitive inflation is to demand conditions.

Price Shocks and the Phillips Curve We can add shocks to the Phillips curve to account for temporary increases in the price of inflation:

The actual rate of inflation now depends on three things: Rewrite again: Expected rate of inflation Adjustment factor for state of economy Shock to inflation

Oil price shock – The price of oil rises – Results in a temporary upward shift in the Phillips curve

Cost-Push and Demand-Pull Inflation Price shocks to an input in production – Cost-push inflation – Tends to push the inflation rate up – Shift of Philips Curve The effect of short-run output on inflation in the Phillips curve – Demand-pull inflation – Increases in aggregate demand pull up the inflation rate. – Movement along the Philips Curve

Case Study: The Phillips Curve and the Quantity Theory An increase in the growth rate of real GDP would reduce inflation. The Phillips curve, however, seems to say a booming economy causes the rate of inflation to increase. Which one is correct?

The quantity theory – Long-run model – An increase in real GDP reflects an increase in the supply of goods, which lowers prices. The Phillips curve – Part of our short-run model – An increase in short-run output reflects an increase in the demand for goods.

12.4 Using the Short-Run Model Disinflation – Sustained reduction of inflation to a stable lower rate The Great Inflation of the 1970s – Misinterpreting the productivity slowdown contributed to rising inflation.

The Volcker Disinflation Reducing the level of inflation requires a sharp reduction in the rate of money growth–a tight monetary policy.

Because of the stickiness of inflation – The classical dichotomy is unlikely to hold exactly in the short run. – Just a reduction in the rate of money growth may not slow inflation immediately. Thus, the real interest rate must increase to induce a recession. – The recession causes inflation to become negative. – As demand falls firms raise their prices less aggressively to sell more.

Lowering the inflation rate – Can create the cost of a slumping economy – High unemployment and lost output Once inflation has declined sufficiently – Real interest rate can be raised back to MP K – Allowing output to rise back to potential

The Short-Run Model in a Nutshell

Case Study: The 2001 Recession The recession of 2001 had a “jobless recovery.” – Even after the return of strong GDP, employment continued to fall. – This is an exception to Okun’s law.

Case Study: The Lender of Last Resort Central banks ensure a sound, stable financial system by: – Making sure banks abide by certain rules – Including the maintenance of a certain amount of reserves to be held on hand

Central banks ensure a sound, stable financial system by: – Acting as the lender of last resort lending money when banks experience financial distress – Having deposit insurance on small- and medium- sized deposits can increase risky behavior

Important thing about the Philip Curve This is about accelerating and decelerating inflation. This is a change in the change of the price level Is the Philips Curve fixed? – Supply Shocks. – Expectations.

Okun’s law

Okun’s Law Natural rate of unemployment Current rate of unemployment Short-run output Cyclical unemployment

Okun’s Law 1960 Recession

Okun’s Law 1969 Recession

Okun’s Law 1980/1981 Recession

Okun’s Law 1990 Recession

Okun’s Law Great Recession

Great recession