1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-1 Chapter 14 Inflation

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-2 Learning Objectives Derive and examine the so-called Phillips curve. Discuss whether there is any apparent trade-off between unemployment and inflation. Examine the natural rate hypothesis and use it to analyse Australia’s experiences with stagflation.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-3 Learning Objectives (cont.) Explore the links between the Phillips curve model and our model of aggregate supply. Discuss demand-pull and cost-push inflation in light of our understanding of the Phillips curve.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-4 Phillips Curve: Introduction Previous lectures assumed that the economy could experience an inflationary gap or a recessionary gap but not both! Realistically both can occur as shown in the intermediate range of the AS curve Also we must now assume that AS can shift leftward

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-5 Phillips Curve An inverse relationship suggestive of a trade-off between inflation and the unemployment rate Generalisation: – the greater the rate of growth of AD, the greater the resulting inflation and GDP, and the lower the unemployment level – the slower the rate of growth of AD, the lower the resulting inflation and GDP, and the higher the unemployment level

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-6 Changes in AD, Real GDP and the Price Level 0 P0P0 Q0Q0 AD 0 AS Price Level Real GDP AS LR P1P1 Q1Q1 AD 1 P2P2 Q2Q2 AD 3

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-7 Phillips Curve (cont.) Evidence: – Empirical work by economists in the 1950s and 1960s Explanations: – Labour market imbalances  bottlenecks  structural problems – Market power of unions and big business

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-8 The Phillips Curve Concept Annual rate of inflation (per cent) Unemployment rate (per cent) 7654321076543210 1 2 3 4 5 6 7 unemployment increases as inflation declines...

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-9 Phillips Curve (cont.) Stabilisation policy dilemma: – Fiscal and monetary policies act on AD and not on labour market imbalances and market power Two complications: – Reversibility problem – Shift of AS curve Not a reliable basis for economic policy

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-10 Stagflation—A Shifting Phillips Curve Stagflation Simultaneous experience of both high and increasing unemployment and inflation Conflicts with the trade-offs embodied in the Phillips Curve

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-11 Stability of the Phillips Curve

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-12 Causes of Stagflation Aggregate supply shocks such as severe increases in fuel costs, and devaluations of the Australian dollar Productivity decline Inflationary expectations and wages – expectations about the likely future path and rate of increase of the general price level

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-13 Aggregate Supply Shocks 0 P1P1 AS 1 AD 1 AS 2 P2P2 P3P3 AS LR QFQF Price Level Real GDP AS 3 Q2Q2 Q3Q3 Q1Q1

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-14 Natural Rate Hypothesis Suggests that there is a unique level of unemployment around which observed unemployment will fluctuate LR stability corresponds with natural or full- employment rate of unemployment Two variants: – theory of adaptive expectations – rational expectations theory

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-15 Theory of Adaptive Expectations People form their expectation of future inflation based on previous and current rates of inflation Series of short-run Phillips curves – short-run trade-offs between inflation and unemployment Long-run vertical Phillips curve Can be employed to explain disinflation – reductions in or elimination of the rate of inflation

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-16 Rational Expectations Theory Increases in money wages lag behind increases in the price level, giving rise to temporary increases in profits and employment Argues that government measures to increase employment will only result in accelerating rates of inflation

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-17 Short-Run Aggregate Supply Short run: period in which input prices (especially wages) remain fixed in the presence of a change in the price level Constant input prices – lack of knowledge of existence of change – fixed-wage contracts

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-18 Long-Run Aggregate Supply Long run: period in which input prices including wages are fully flexible in the presence of changes in the price level Increasing input prices – Workers discover that prices have changed and demand higher nominal wages to restore their level of real wages

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-19 New Classical Policy Implications Price-level surprises – may create short-run macroeconomic instability – however, long-run stability occurs at full-employment level of output Long-run occurs either instantaneously or in a very short period Government intervention is not endorsed

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-20 Short-Run & Long-Run AS 0 P3P3 Q3Q3 P1P1 P2P2 Q1Q1 Q2Q2 AS 3 AS LR Price Level Real domestic output C1C1C1C1 AS 2 B1B1B1B1 AS 1 A3A3 A1A1 A2A2

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-21 Modern Keynesian Policy Implications Markets are not highly competitive – instantaneous adjustments do not occur Nominal wage adjustments are very slow Stabilisation policies are required to reduce the severe costs of unemployment or inflation

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-22 Demand-Pull Inflation Occurs when an increase in AD pulls up the price level Graphically: AD shifts rightward along a stable AS curve Short-run: increased prices and real output

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-23 AS 2 Demand-Pull Inflation (cont.) AD 2 0 AS 1 AS LR AD 1 Q1Q1 Price Level Real GDP P1P1 e1e1e1e1 P2P2 Q2Q2 e2e2e2e2 P3P3 e3e3e3e3

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-24 Demand-Pull Inflation (cont.) In the short run demand-pull inflation will drive up the price level and increase output In the long run, the increase in aggregate demand has only moved the economy along the vertical aggregate supply curve AS LR

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-25 Cost-Push Inflation Occurs when an increase in the cost of production at each price level shifts the AS curve leftward, resulting in increased prices Short run: increased prices and decreased real output (and more unemployment)

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-26 AD 2 Cost-Push Inflation (cont.) 0 AS 1 AS LR AD 1 Q1Q1 Price Level Real GDP AS 2 Q3Q3 P1P1 e′1e′1e′1e′1 P2P2 e′2e′2e′2e′2 Q2Q2 e′3e′3e′3e′3 P3P3 An attempt to increase AD will only further increase the price level

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-27 Cost-Push Inflation and Policy Dilemma Government intervention (AD): If government intervenes to increase AD, an inflationary spiral will result No government intervention (AD): If government does not intervene to increase AD, severe recession will result; however, nominal wages will eventually decline and restore AS to original position

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-28 Cost-Push Inflation: Non- Demand Management Options Two categories of non-demand management policies – Market policies – Wage–price (or incomes) policies

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 14-29 Next Chapter Aggregate Supply and the Labour Market