Principles of Macroeconomics

Name: Principles of Macroeconomics
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Description: Principles of Macroeconomics

Principles of Macroeconomics
PowerPoint Presentations for Principles of Macroeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa

THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT
Chapter 16 Copyright © 2014 by Nelson Education Ltd.

THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT
This chapter will examine the tradeoff between inflation and unemployment. Copyright © 2014 by Nelson Education Ltd.

Origins of the Phillips Curve
In 1958, New Zealand economist A. W. Phillips published an article in the journal Economica that would make him famous. “The relationship between unemployment and the rate of change of money wages in the United Kingdom, ” The article showed a negative correlation between the rate of unemployment and the rate of inflation. Copyright © 2014 by Nelson Education Ltd.

Origins of the Phillips Curve
Two years later, Canadian economist Richard Lipsey confirmed and extended Phillips observations. At about the same time, two American economists, Samuelson and Solow, reasoned that the negative correlation between inflation and unemployment was associated with high aggregate demand and because high demand puts upward pressure on wages and prices. They dubbed the negative relationship the Phillips curve. They believed that the curve held important lessons for policy makers. Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.1: The Phillips Curve
Copyright © 2014 by Nelson Education Ltd.

Aggregate Demand, Aggregate Supply, and the Phillips Curve
The model of aggregate demand and aggregate supply provides an easy explanation for the menu of possible outcomes described by the Phillips curve. The Phillips curve simply shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve. Copyright © 2014 by Nelson Education Ltd.

Draw the Phillips curve. Use the model of aggregate demand and aggregate supply to show how policy can move the economy from a point on this curve with high inflation to a point with no inflation. Copyright © 2014 by Nelson Education Ltd.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS
Does the menu of possible inflation- unemployment outcomes remain the same over time? Copyright © 2014 by Nelson Education Ltd.

The Long-Run Phillips Curve
According to Milton Friedman, there is one thing that monetary policy cannot do and that is to pick a combination of inflation and unemployment on the Phillips. Phelps wrote a paper denying the existence of a long-run tradeoff between inflation and unemployment. In other words, they conclude that there is no reason to think the rate of inflation would, in the long-run, be related to the rate of unemployment. Policy makers therefore face a long-run Phillips curve that is vertical. Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.3: The Long-Run Phillips Curve

The Meaning of “Natural”
The natural rate of unemployment is the unemployment rate toward which the economy tends to gravitate in the long run. Not necessarily the socially desirable rate of unemployment Nor is it constant over time Monetary policy cannot influence the natural rate of unemployment. However, other types of policy can. A policy change that reduced the natural rate of unemployment would shift the long-run Phillips curve to the left. Copyright © 2014 by Nelson Education Ltd.

Reconciling Theory and Evidence
Why would anyone believe that policy makers faced a vertical Phillips curve when the world seemed to offer a downward slope? Friedman and Phelps (F & P) introduced a new variable into the analysis of the inflation-unemployment tradeoff: expected inflation. Copyright © 2014 by Nelson Education Ltd.

The Short-Run Phillips Curve
The analysis of F & P can be summarized in the following equation: According to F & P, it is dangerous to view the Phillips curve as a menu of options available to policy makers. Copyright © 2014 by Nelson Education Ltd.

Active Learning A Numerical Example Natural rate of unemployment = 5 percent Expected inflation = 2 percent In PC equation, a = 0.5 A. Plot the long-run Phillips curve. B. Find the u-rate for each of these values of actual inflation: 0 percent, 6 percent. Sketch the short-run PC. C. Suppose expected inflation rises to 4 percent. Repeat part B. D. Instead, suppose the natural rate falls to 4 percent. Draw the new long-run Phillips curve, then repeat part B. Copyright © 2014 by Nelson Education Ltd.

Active Learning Answers LRPCD PCB LRPCA An increase in expected inflation shifts PC to the right. PCD PCC A fall in the natural rate shifts both curves to the left. Copyright © 2014 by Nelson Education Ltd.

The Natural Experiment for the Natural Rate Hypothesis
Natural rate hypothesis: the claim that unemployment eventually returns to its normal, or natural rate, regardless of the rate of inflation Proof from the late 1960s: Government spending was rapidly increasing (expansionary fiscal policy). The Bank of Canada was increasing the money supply to keep interest rates low (expansionary monetary policy). Inflation remained high. As F & P predicted, unemployment did not stay low. Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.6: The Phillips Curve in the 1950s and 1960s

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS
Supply shock: an event that directly alters firms’ costs and prices, shifting the aggregate-supply curve and thus the Phillips curve Different source for the shifts in the short-run Phillips curve Example: Large increase in the price of oil Leads to a shift in the aggregate-supply curve and also the Phillips curve Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.7: The Breakdown of the Phillips Curve

FIGURE 16.8: An Adverse Shock to Aggregate Supply

FIGURE 16.9: The Supply Shocks of the 1970s

Given an example of a favourable shock to aggregate supply. Use the model of aggregate demand and aggregate supply to explain the effects of such a shock. How does it affect the Phillips curve? Copyright © 2014 by Nelson Education Ltd.

THE COST OF REDUCING INFLATION
After the 1979 increase in the price of oil, the Bank of Canada implemented a policy of disinflation. What would be the cost of this disinflation? Copyright © 2014 by Nelson Education Ltd.

The Sacrifice Ratio To reduce inflation, a contractionary monetary policy is required. Sacrifice ratio: the number of percentage points of one year’s output lost in the process of reducing inflation by one percentage point Okun’s law: the number of percentage points the unemployment rate increases when GDP falls by one percentage point Copyright © 2014 by Nelson Education Ltd.

Rational Expectations and the Possibility of Costless Disinflation
A new school of thought was emerging that started to question the sacrifice ratio. Rational expectations: the theory according to which people ultimately use all the information they have, including information about government policies, when focusing or forecasting the future Copyright © 2014 by Nelson Education Ltd.

Disinflation in the 1980s When the Bank of Canada was faced in the early 1980s with the prospect of reducing inflation, the economics profession offered two conflicting predictions. One group claimed that reducing inflation was going to be very costly and thus the sacrifice ratio was going to be high. The rational expectations proponents predicted that reducing inflation would be much less costly. Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.11: Disinflation in the 1980s

The Zero-Inflation Target
In 1988, John Crowe, the then Governor of the Bank of Canada, delivered the Hansen lecture. It his speech, he presented a clear statement defining the future direction of monetary policy in Canada. Achieve and maintain a stable price level and zero inflation Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.12: The Zero-Inflation Target

Anchored Expectations
The unexpected shift to the left of the aggregate-demand curve as a result of the recession in 2008 caused the economy to slide down the short-run aggregate-supply curve. Following this slide, the price level is lower and the level of output is below its natural rate. In terms of the Phillips curve, this movement is represented by a movement down the short- run Phillips curve to a lower inflation rate and a level of unemployment above the natural rate. arka38 / Shutterstock Copyright © 2014 by Nelson Education Ltd.

FIGURE 16.13: The Short-Run Phillips Curve, 1956–68 and 1989–99

FIGURE 16.14: The Quiet before the Storm

FIGURE 16.15: The 2008–09 Recession and Its Aftermath

LOOKING AHEAD Opinion is still divided among economists with regards to the cost of reducing inflation. Macroeconomists all agree, however, that having achieved low rates of inflation, the Bank of Canada should work hard to never again allow inflation to increase to the levels observed during the 1970s and 1980s. Thinkstock Copyright © 2014 by Nelson Education Ltd.

LOOKING AHEAD The evidence provided in this chapter also sheds light on two other macroeconomic issues: The increase in the 1970s, 1980s, and 1990s in the natural rate of unemployment was largely the result of badly designed government policies. External shocks such as the financial crisis of can have a powerful effect on the Canadian economy. Copyright © 2014 by Nelson Education Ltd.

LOOKING AHEAD Today we await the consequences of the choices that Canada’s fiscal and monetary policy makers made in response to the recession of It will be interesting to see if they succeeded in striking the right balance of trusting that people’s expectations will adjust to the implications of the financial crisis and so eventually lead the economy back toward full employment against implementing monetary and fiscal actions to speed that recovery. Copyright © 2014 by Nelson Education Ltd.

Classroom Activity Politics and Policy Find a current political proposal that would have economic implications. This can be a campaign promise by a candidate or a policy proposal by an office-holder. Name the politician and briefly describe the proposal. Consider the economic implications of this proposal. Is it more likely to affect aggregate demand or aggregate supply? Explain how this proposal would change the aggregate-demand curve—through consumption, investment, government spending, or net exports—or the aggregate-supply curve—through labour, capital, natural resources, or technology. Graph the impact of this proposal using aggregate demand and aggregate supply. Explain what happens to the price level and the level of output. Does this policy seem to be appropriate given the current economic conditions? Explain. Copyright © 2014 by Nelson Education Ltd.

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