Inflation and Expectations Econ 102 2015 Spring. Phillips Curve Short-run Phillips Curve: In UK Phillips in 1958 Tradeoff between percentage change in.

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Presentation transcript:

Inflation and Expectations Econ Spring

Phillips Curve Short-run Phillips Curve: In UK Phillips in 1958 Tradeoff between percentage change in wages and unemployment rate.

SR Phillips Curve Wages changes usually lead to price changes hence we see a similar relationship between between percentage change in price level and Unemployment

SR Phillips Curve What type of policy recommendations does this indicate?

SR Phillips Curve Choose either Low inflation (high Unemp. rate) or High inflation (low (low Unemp. rate)

SR Phillips Curve Choose either Low inflation (high Unemp. rate) or High inflation (low (low Unemp. rate)

What is behind this trade off? AD policies or changes... P Y AD AS Y Potential E2 E3 E1

Supply shock two oil price increase by OPEC countries. Cost of production increased which can be seen as the following changes, P Y AD AS Y Potential AS2 E1 E2

Supply shock Result is both inflation and unemployment increase. Stagnation STAGNATION Inflation

Stagflation (inflation and unemployment) AD policies or changes... P Y AD AS Y Potential E2 E1 AS2

Expectations Consumer and Producers do not have static views, they look into the future and form ‘expectations’. They form expectations about future prices, or the rate of change of prices. In all their consumption, production and labor supply decisions they take the expected inflation rate into consideration. What is your expected rate of inflation today for the next year in Turkey?

What happened to Phillips Curve How do we form expectations? 1.Look back, from the past: Adaptive expectations. 2.Look at all the information and think rationally: Rational expectations

If you expect inflation? How will the firms decide on the price of their product? How will the workers decide for the wage Increases? What happens to the AS curve? How will borrowers and lenders be affected?

Borrowers and lenders 2013 Fusun borrowed from Ahmet 100 TL (if r= 8 %) If inflation rate is 60% Then P 2013 =100 Will Ahmet be happy? NO How should Ahmet be compensated? 2014 Fusun will pay to Ahmet 108 TL P 2014 =160 He wants to be compensated for inflation as well!

Interest rates under inflation

Wages continue to increase due to higher expected inflation... P Y AD AS Y Potential AS2 E1 E2 AS3 E3

Aggregate Demand responds with MS increases P Y AD AS Y Potential AS2 E1 E2 AS3 E3 AD2 AD3

Short-run and Long-run Phillips Curve Inflation rate Unemployment Rate Natural Rate of U LONG TUN PHILIPS CURVE SHORT_RUN PHILLIIPS CURVE

Monetarist view of best policy Quantity Theory of Money: M is Money Supply V is velocity –turn over rate of money P is price level Y is real output-real GDP.