Download Week 20

ECON 100 Tutorial: Week 20
www.lancaster.ac.uk/postgrad/murphys4/
[email protected]
office: LUMS C85
Some notes for the last section of ECON 100
• You’ve had some experience with David
Peele’s questions – on Exam 4, I expect to see
similar style of questions from him, so practice
the maths that he is teaching.
• Gerry Steele doesn’t change his questions
much from year to year – so past exams are a
great resource for preparing for Exam 4.
(Past papers can be found on the student registry site; select
a year, select ECON 100, then look at approximately the last
10 questions on each year’s exam.)
• Gerry’s Tutorial Questions are also great for
preparing for Exam 4.
Question 1
What precisely did A.W. Phillips show on the vertical
axis in his original presentation of the ‘Phillips
curve’? (http://www.jstor.org/stable/2550759)
‘Rate of change of money wage rates, % per year’
Note: Some texts show inflation on the Y axis when
drawing the Phillips Curve. Gerry prefers to use this
notation instead. Question 2 looks at why he makes
this choice.
Question 2
How was ‘inflation’ irrelevant to the original
presentation of the ‘Phillips curve’?
‘Inflation’ was not the general experience of the UK
economy during the period of Phillip’s analysis
(1861-1957). Rather, for much of the 1920s and
1930s, prices were falling’ ’
Question 3
The Phillips inflation-unemployment relationship is
better described as “L-shaped” rather than a curve.
Explain.
ΔW/
Phillips’s explanation: ‘When the
demand for labour is high we should
expect employers to bid wage rates up
quite rapidly. On the other hand it
appears that workers are reluctant to
offer their services at less than
prevailing rates when the demand for
labour is low’
(Gerry covers this in lecture 1)
W
% unemployment
rate
Question 4 – Gerry’s solution
In the 1960s, ‘the Keynes-Phillips orthodoxy was sailing on smooth waters, the
object of much congratulation, rather like the liner Titanic prior to its collision with
the fateful iceberg’ (Edmund Phelps).
What is the nature of ‘the Keynes-Phillips orthodoxy’ and why was a collision
inevitable?
Steele’s suggested solution:
The Keynes-Phillips orthodoxy argues that inflation cannot occur with
large-scale unemployment:
‘ … an increase in the quantity of money will have no effect whatever on prices,
so long as there is any unemployment …’ (TGT: 295)
‘ … the general level of prices will not rise very much as output increases, so long
as there are available efficient unemployed resources of every type.’ (TGT: 300)
As subsequent analysis (the Friedman-Phelps expectations-augmented
Phillips curve) predicts, the co-existence of high inflation and high
unemployed is likely when monetary growth is excessive (i.e., when
ΔMS/MS > ΔMD/MD, demand-pull inflation is results)
Question 4 – another look
What is the nature of ‘the Keynes-Phillips orthodoxy’ and why was a collision inevitable?
Keynes-Phillips say that if you grow money supply (MS), you won’t have inflation if, at the same
time, you have unemployment.
Steele’s approach tells us:
The “inevitable collision” that Friedman-Phelps (expectations-augmented Phillips curve)
predicted is that:
If Monetary growth is excessive (i.e., ΔMS/MS > ΔMD/MD), then high inflation and high
unemployment can actually occur at the same time (i.e., Gerry calls it demand-pull inflation)
Usually (not Gerry’s method) cost-push and demand-pull inflation are presented using AS/AD.
The graph on the right shows the Phillips
Curve over time. (using US data)
• In the late 1960’s, we are on SPRC0, and it
looks like Phillips’ assessment is correct.
• By the late 1970’s and early ‘80’s, we see
both high unemployment and high
inflation (SRPC3). In this example, this
came about because high import prices
(particularly oil), rather than because of
excessive monetary growth, which is
what Friedman-Phelps were talking
about.
Cost-push inflation vs. Demand-pull inflation
1973: Price of oil ↑ OPEC oil embargo.
1979: Price of oil ↑ Iranian revolution.
Oil is a major factor of production,
so if P ↑ and consumption ↓then
production ↓, pushing aggregate supply
leftward.
This led to what is known as stagflation.
What kind of inflation is this?
The high inflation in the late 1970s is an
example of cost-push inflation.
Late 1960’s: G↑ due to the Vietnam war
1965: G↑ due to US’ War on Poverty.
Insufficient increases in taxation led to deficit
spending and a rightward shift in the aggregate
demand curve.
What kind of inflation is this?
The high inflation in the late 1960s relative to
the early 1960s is an example of demand-pull
inflation.
Cost-push inflation vs. Demand-pull inflation
1973: Price of oil ↑ OPEC oil embargo.
1979: Price of oil ↑ Iranian revolution.
Oil is a major factor of production,
so if P ↑ and consumption ↓then
production ↓, pushing aggregate supply
leftward.
Steele presents the idea that cost-push
inflation we’ve been describing is actually
price-inflation, not monetary inflation.
Some economists do not think that priceinflation should be included in the
definition of inflation.
Late 1960’s: G↑ due to the Vietnam war
1965: G↑ due to US’ War on Poverty.
Insufficient increases in taxation led to deficit
spending and a rightward shift in the aggregate
demand curve.
Steele notes that the late 1960’s and early
1970’s coincided with the end of the fixed
exchange rate and the beginning of new
expansionist policies in the central bank of
England. He thinks that this demand-pull
inflation continued to drive inflation in the
1970s.
Note: To properly understand Gerry’s materials, the best thing to do is review the lectures
and lecture slides as well as any reading material he puts up on Moodle.
Question 5(a)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Identify each of the variables:
ΔW/W
proportionate increase in wages
P
prices
U
percentage unemployment rate
(ΔP/P)e
expected proportionate increase in prices
Question 5(b)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What sign respectively would be expected for the
coefficients f and φ. Explain.
f
negative.
There is an inverse relationship between unemployment and Δmoney
wages. This is the same as in the original Phillips curve.
φ
positive
When workers accept employment contracts, they choose wages that
reflect anticipated price changes. This is expectations-augmented
part.
Question 5(c)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Which description is usually given for φ < 1. Explain.
money illusion
If the rate of increase in wages < the rate of increase in
prices, then, workers are being paid less in real terms.
The workers would be mistaken to accept this, but they
might due to money illusion.
Money illusion is the idea that if you’re paid more you
must be wealthier. You’re only wealthier if you’re paid
more relative to the price levels.
Question 5(d)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the ‘reservation wage’ in the analysis of job
search?
the minimum level of acceptable wage offer
Question 5(e)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the likely impact upon the reservation wage
as the duration of unemployment increases?
reservation wage falls
Question 5(f)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the likely impact upon unemployment if
unemployment benefits increase?
unemployment is likely to rise as job search is
extended
Question 5(g)
With the expectations-augmented Phillips curve represented
conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Explain the likely impact upon unemployment of (ΔP/P) > (ΔP/P)e.
So, we are asking, if the proportionate change in prices is greater
than the expected proportionate change in prices, what will be the
impact on unemployment. (Note, this is another way of saying if
inflation > expected inflation, or if we underestimate the inflation
rate)
The period of job search is likely to be curtailed (cut short), if the
inflation rate is underestimated.
Question 5(h)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Explain the likely impact upon unemployment of
(ΔP/P) = (ΔP/P)e.
unemployment finds its ‘natural rate’
Question 6
With prices rising at 4.0 percent annually, and wages rising at 3.5 percent per
annually, what would be the percentage reduction in real wages over a five year
period?
To answer this question, we need to the difference between future real wages and
the current period real wages.
To find the future period real wages, we have to calculate three things here:
real wages, and wages in a future period, and prices in a future period.
Here are the three equations we’ll need:
Real Wages = nominal wage ÷ prices
Wagefuture period = Wagecurrent period * (1 + growth ratewages)ΔT
Pricefuture period = Pricecurrent period * (1 + growth rateprices)ΔT
We can put it all together into the following equation:
Real Wagesfuture period =
Wagecurrent period*(1 + growth ratewages)ΔT ÷ Pricecurrent period*(1 + growth rateprices)ΔT
Question 6 ctd.
With prices rising at 4.0 percent annually, and
earnings rising at 3.5 percent per annually, what
would be the percentage reduction in real wages
over a five year period?
First, find Real Wages (R) in Year 5:
W5 W1 1.035 5
R5 =
=
= 0.9762 R1
5
P5 P1 (1.04)
Next, find the percentage change from Year 1 to 5:
(0.9762)R1
R5
Percentage Change = 1 - = 1 = 2.4%
R1
R1
The Phillips Curve
The following game is a fun way to look at the relationship
between unemployment and inflation (the Phillips Curve).
It allows you to pretend that you are the Central Bank and can
set interest rates as a tool to control inflation and
unemployment.
A high interest rate will attract people to purchasing bonds and
holding less money, restricting money supply and reducing
inflation.
A low interest rate will make investments more attractive.
People will invest in capital stock with a rate of return greater
than the return on bonds. Because the return on bonds is low,
this implies lots of capital investments will seem profitable.
These investments will create jobs and lower unemployment.
In summary:
IR↑ → inflation↓
IR↓ → unemployment↓
The game lasts 16 rounds (16 quarters = 4 years).
The overall goal is to keep the economy in good shape so that you get re-elected.
Remember:
IR↑ → inflation↓
IR↓ → unemployment↓
Inflation and unemployment don’t respond immediately, there are
some lags, so it’s good to start by slightly raising the interest rate.
We’ll divide the class into two groups:
Executive Branch
Federal Reserve Bank
Choose a:
President
Chairman
Goal:
keep unemployment low
keep inflation at/slightly below
near 5%
the target rate:
2%
Each round, both groups discuss their choices and the President makes a
recommendation to the Fed. The Fed has a few second to discuss and the Chairman
makes the final decision.
It’s not as easy as it sounds – let’s see how well you do:
http://sffed-education.org/chairman/
Next Week
Check Moodle for a tutorial worksheet and work
through it before coming to class.
I’ll try to add in some examples of past exam
multiple choice questions that relate to the
tutorial, if possible.
Note:
Tuesday’s Tutorial will move to 1:00 PM in County
Main SR 2 for the remainder of the term. If you
have a timetable problem, contact Sarah Ross.
Examples of Past Exam Multiple Choice
Questions that relate to this week’s tutorial
The original Phillips curve identified a
robust correlation between:
(a) unemployment and the rate of change of real
wage rates
(b) unemployment and the rate of change of
money wage rates
(c) wage levels and unemployment
(d) wage levels and inflation
2012 Exam Q3
Phillips Curve
• Inflation is
a change in
money
wages
The hypothesis of the expectationsaugmented Phillips curve holds that:
a) employment contracts fully accommodate the
rate of price inflation
b) job-seekers never make systematic errors
c) wage settlements are partially determined by
the expected rate of price inflation
d) reservation wages are determined by
minimum wage legislation
2010 Exam Q32
Expectations Augmented Phillips Curve
Initially, unemployment and
inflation are at point A.
Expansionist monetary policy
would increase consumption,
shifting to point B along the
Phillips curve
Unemployment is reduced but
there is a trade off; inflation.
After a short period, agents will
associate expansionist policies
with inflation and will push for
higher wages.
This will stop the consumption
stimulus and also de-incentivize
hiring. Agents will shift their
expectations curves to point C.
According to Friedman’s reinterpretation of the Phillips Curve, if
inflationary expectations rise, the
Phillips curve:
a) shifts down
b) shifts up
c) becomes flatter
d) becomes steeper
2011 Exam Q32
Expectations Augmented Phillips Curve
Initially, unemployment and
inflation are at point A.
Expansionist monetary policy
would increase consumption,
shifting to point B along the
Phillips curve
Unemployment is reduced but
there is a trade off; inflation.
After a short period, agents will
associate expansionist policies
with inflation and will push for
higher wages.
This will stop the consumption
stimulus and also de-incentivize
hiring. Agents will shift their
expectations curves to point C.
If job seekers under-estimate the rate of
inflation, the duration of the job-search:
(a) shortens, so that unemployment tends to rise
(b) lengthens, so that unemployment tends to fall
(c) shortens, so that unemployment tends to fall
(d) lengthens, so that unemployment tends to
rise
2012 Exam Q3
If job seekers under-estimate the rate
of inflation: (DP/P) > (DP/P)e
• Then they will over-estimate the value of an offered
wage contract
• And will accept a lower real wage more readily
• And thus will have a shorter period of
unemployment
• And unemployment will fall below the natural rate,
U < Un
If the causation is reversed, when actual inflation is
below the expected rate of inflation, (DP/P) < (DP/P)e
then unemployment will be above the natural
rate: U > Un
Identify the missing word(s): Goodhart’s
Law states ‘that any ____I____ will tend
to collapse once pressure is placed upon
it for control purposes.’
a)
b)
c)
d)
monetary target
observed statistical regularity
fiscal budgetary stance
structured investment
2010 Exam Q35
Goodhart’s Law
“Any observed statistical regularity will tend to
collapse once pressure is placed upon it for
control purposes.”
… an expansion of aggregate demand was expected to (increase
inflation and to) lower unemployment … but when the authorities
attempted to achieve this, the inflation -unemployment regularity
collapsed …
Suppose that national income (measured in
1990 prices) is £1000 billion. Suppose further
that prices have doubled since 1990 and that
the typical unit of money circulates around
the economy 20 times per year.
What is the money supply?
a)
b)
c)
d)
£50 billion
£100 billion
£150 billion
£200 billion
2010 Exam Q36
MV = QP
We know that:
V = 20
Q = 1000
P=2
So, solving for M:
MV=PQ
M = QP/V
M = 1000*2/20
M = 100