Eco 200 – Principles of Macroeconomics Chapter 15: Macroeconomic Policy

The Phillips curve A.W. Phillips - study of relationship between rate of wage change and unemployment rate in England – strong and consistent inverse relationship Phillips curve studies in U.S. examined relationship between inflation and unemployment rates. similar inverse relationship found in 1950s and 1960s

U.S. Phillips curve 1960s

Later experience In the 1970s and early 1980s, higher inflation rates and higher unemployment rates occurred together. Phillips curve relationship seemed to be shifting over time and could not be used as a stable menu for policy choice.

Short-run and long-run Phillips curves

Expectations and the Phillips curve – initial equilibrium

AD rises – short-run effect

Long-run effect

Decrease in AD Process works in reverse: Short run price level is below expected level and output falls below potential GDP lower inflation and higher unemployment (movement along short-run Phillips curve) Long run inflationary expectations adapt downward AS shifts to the left – restoring potential GDP Phillips curve shifts – unemployment returns to the natural rate at a new lower anticipated (and realized) inflation rate

Slope of short-run Phillips curve Reasons for negative slope: wage expectations and unemployment inventory fluctuations and unemployment wage contracts and unemployment

Wage expectations and unemployment reservation wage strategy unexpected increase in inflation results in unexpectedly high wage offers and more job acceptances in short run requires money illusion

Inventory fluctuations and unemployment AD rises price level rises due to demand for more output inventories fall production and employment rises (and the unemployment rate falls)

Wage contracts and unemployment Wage contracts are fixed in the short run. As AD rises, firms hire more workers at the existing nominal wage. The increase in aggregate demand results in an increased price level and reduced unemployment. In the long run, nominal wages rise to restore the equilibrium real wage.

Adaptive and rational expectations Speed of adjustment to long-run equilibrium depends on how rapidly expectations change in response to new information. Adaptive expectations – expectations based solely on past outcomes for the variable that is being forecast. Rational expectations – expectations based on all available relevant information. Rational expectations forecasts are unbiased – i.e., there is no systematic tendency to either overestimate or underestimate the variable being forecast

Credibility and time inconsistency Fed announcements are credible if the public believes that the Fed will undertake the policies that it announces If changing economic conditions results in a situation in which the announced policy is not optimal, the original plans are said to be time inconsistent. Announcements of a low monetary growth policy, followed by more rapid monetary growth can provide short-term reductions in unemployment. The Fed may lose credibility if this happens.

Political business cycle

Government budget constraint

Monetary and fiscal policy linkage