1. Inflation, Deflation, and the Phillips Curve Inflation Perfection Deflation 1

2. 2

3. But first a little behavioral economics 3

4. 4

5. 5 With money illusion

6. Without money illusion 6

7. Macroeconomics up to now 7 IS-MP Y Potential output = AF(K,L) Y pot u ir

8. Now add inflation 8 IS-MP Y Potential output = AF(K,L) Y pot u πeπe π ir

9. 9 Inflation’s history in the US

10. 10

11. 11 How do we measure price indexes? Consumer price index: -Traditionally a Laspeyres price index (fixed weight index using early prices) -BLS has introduced an experimental index – the “chain CPI” – which is a superlative Törnqvist index. -As with output index, Laspeyres overstates inflation: g(Paasche) < g(Tornqvist), g(Fisher) < g(Laspeyres) National accounts price indexes -These are Fisher (superlative) indexes -Fed target uses personal consumption expenditures price index (Fisher) “Core Inflation” - removes volatile food and energy and is central target for monetary policy (personal consumption core price index)

12. 12 Paasche Laspeyres Superlative: Fisher, Tornqvist Remember this important set of relationships: Holds for output indexes and price indexes!

13. Does it make any difference? Yes, 0.5% per year over 1970-2012 13

14. 14 Major topics 1.Why do we care about inflation? 2.Modern inflation theory

15. Why do we care about inflation? Like temperature, we care mainly about the extremes: Hyperinflation (> 100% a month) Deflation (< 0) 15

16. 16 What are costs of inflation? Good discussion section 5-5 in Mankiw BASIC ELEMENTS: Distinguish anticipated from unanticipated inflation (ex ante v. ex post real interest rates) Redistribution: inflation redistributes wealth from creditors to debtors (mortgages, pensions). Inefficiencies of inflation: shoe leather, menu costs, taxes,... OVERALL: Overall, costs appear relatively small at low inflation rates. Hyperinflation can destroy price mechanism Deflation can produce low-level “bad equilibrium” of high real interest rates and the liquidity trap

17. 17 Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. ( JMK, Economic Consequences of the Peace, 1919; with many hyperinflations going on. ) Keynes On inflation (really on hyperinflation)

18. Now to inflation theory in the US 18

19. Natural (Goldilocks) rate of unemployment 19 Not too hot (inflationary) and not too cold (depressionary)

20. 20 The Expectations -Augmented Phillips Curve Fundamentals of theory: 1.Unemployment rate (u) determined by interaction of potential and actual Y by Okun’s Law 2.Inflation determined by labor/product market tightness (u relative to “natural rate of unemployment”*) and expected inflation (π e ) – Phillips curve 3.Expected inflation (π e ) determined by inflation history and forecasts of future inflation *natural rate of unemployment (Mankiw); sometimes called the NAIRU = “non-accelerating inflation rate of unemployment” = Goldilocks unemployment rate

21. 21 The Expectations -Augmented Phillips Curve In algebra: u - u* = λ (Y – Y P )/Y P π= π e - β (u - u*) π e determined by past inflation and expectations process

22. 22 The short-run P.C. Graph from Economic Report of the President 1969 This was relationship that led Keynesian to believe that P.C. was a good explanation for inflation (1960s) 1.(πe)

23. 23 Early Phillips Curve

24. 24 Early Phillips Curve

25. 25 Collapse of short-run P.C. This was relationship that led many new classical economists to conclude that Keynesian theories were “fatally flawed” (Lucas and Sargent. 1970s)

26. 26 Mainstream 2-equation inflation model (1)π(t) = π e (t) - β[u(t) - u*] + ε(t) [Note: corrected sign from class.] (2)π e (t) = π(t-1) Endogenous variables π = rate of price inflation π e = expected rate of inflation (or similar concept) u* = natural rate Exogenous variables u = actual unemployment rate (determined by policy and shocks) ε (t) = wage and price shocks (oil prices, exchange rates, globalization, decline of unions, immigration, etc...) t = time [Note: (2) is backward looking rather than rational expectations.]

27. 27 Simplest 1-equation inflation model Simplify by assuming no shocks and substituting: (3) π(t) = π(t-1) - β[u(t) - u*] (4) Δ π(t) = - β[u(t) - u*] which is the linear expectations-augmented P.C. model.

28. 28 u* = natural rate π 1 = π 1 e SRPC 1 Short-run Phillips curve 1

29. 29 u* = natural rate π 1 = π 1 e Moving up short-run Phillips curve 1 2 SRPC 1,2 π2π2

30. 30 u* = natural rate π 1 = π 1 e Short-run Phillips curve shifts upward with higher inflation expectations 1 2 π3e =π2π3e =π2 SRPC 1,2 SRPC 3

31. 31 u* = natural rate π 1 = π 1 e SRPC 1,2 SRPC 3 1 2 3 π 3 = π 3 e Now unemployment rate back to the natural rate

32. 32 u* = natural rate π 1 = π 1 e SRPC 1,2 LRPC SRPC 3 1 2 3 π3e =π2π3e =π2 u equals the natural rate in both periods 1 and 3, but the expected and actual inflation rates are higher in period 3. This diagram shows the way that the SRPC shifts as expected inflation adjusts to higher rate.

33. 33 u* = natural rate π 1 = π 1 e SRPC 1,2 LRPC SRPC 3 1 2 3 π3e =π2π3e =π2

34. 34 New synthesis of accelerationist PC Rough estimate of natural rate for 1960-2013 = 6 percent Δ π(t) = β[u(t) - u*] u* is u where Δ π(t) =0. This was the new synthesis developed by Phelps and Friedman (1967-68). It now forms the basis of mainstream macro for large open economies.

35. Recent Phillips curve 35

36. Phillips curve at low inflation 36 u* = natural rate Does Phillips curve bend because of nominal rigidity at zero inflation? Controversial, but probably yes. Why? Because of the downward nominal rigidity of wages! 1-2%

37. 37 Summary on The Expectations-Augmented Phillips Curve u and π are negatively related in short run no relation between u and π in the long run short-run PC adjusts up and down as economic agents adjust their inflation expectations to reality (combination of backward and forward looking expectations). Natural rate is u at which inflation tends neither to rise nor fall