Macroeconomics Lecture 12 Inflation and unemployment

Goods market Keynesian Cross (IS) Financial markets (LM) IS-LM (R, Y) AD Labour market (AS) AD-AS (R,P,Y) Foreign exchange markets AD * (R*,Y,e, CA) DAD-SAS (R, ,u)

Outline Empirical facts The dynamic AD-AS model (the Phillips Curve Model). Using the Phillips Curve Model to make sense of the 80ies.

The Phillips curve Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK Unemployment rate (%) Inflation rate (%) The Phillips curve shows that a higher inflation rate is accompanied by a lower unemployment rate. Phillips curve It suggests we can trade-off more inflation for less unemployment or vice versa.

Unemployment as a % of the labour force, United Kingdom OECD, Main indicators.

Inflation, GDP deflator (annual, %) United Kingdom OECD. Main indicators.

Inflation and unemployment in the UK

Inflation and unemployment in the short-run Static modelDynamic model Aggregate demand (AD) Dynamic Aggregate demand (DAD) Short-run aggregate supply (SAS) Short-run Phillips Curve (SPC) P and Y Inflation and unemployment Long-run aggregate supply (LAS) Long-run Phillips curve (LPC)

The Phillips Curve Aggregate supply: Rewrite: Subtract P -1 : Inflation

Okun’s law The deviation of output from its equilibrium level is inversely related to the deviation of unemployment from its equilibrium level 1 percentage point of unemployment gap = 2 percentage points of GDP gap.

Expected inflation Cyclical unemployment Random supply shocks Slope of the Phillips curve

U UNUN

Y P M up AD 0 AD 1 The static AD curve

Dynamic Aggregate demand (DAD) Growth in real money supply Dynamic multiplier

Use Okun’s Law Money growth Cyclical unemployment Slope of the DAD curve Demand shock

U UNUN

Long-run equilibrium Stable (constant) inflation. Expectations are fulfilled. No shocks. Steady state equilibrium

Characterization of long-run equilibrium The natural rate of unemployment u

Disinflation in the 80ies. Short-run analysis The model in action

U UNUN LPC A B C UBUB Dis-inflation in the beginning of the 1980s

u uNuN Time Fig

Inflation and unemployment in the UK is the early 1980s

Sacrifice ratio (SR) = the percentage points loss in a year’s GDP as a consequence of a one percentage point reduction in inflation. Inflation reduced from 20 to 5 percent in 6 years Suppose the natural rate is 3 percent. The unemployment gap is: =35 Okun’s Law suggests that this translated into a 70 percentage point accumulated loss over 6 years. SR = 70/15=4.6.

Defeating inflation In the long run, inflation will be low if the rate of money growth is low. The transition from high to low inflation may be painful if expectations are slow to adjust Adaptive expectations and the sacrifice ratio. Rational expectations and painless disinflation. Wage contracts take time to adjust Policy credibility may speed the adjustment process

What is next? The open economy