Download Inflation Expectations and SRPC

Inflation, Unemployment,
and Stabilization Policies:
Unemployment and the
Phillips Curve
AP Economics
Mr. Bordelon
Short-Run Phillips
Curve (SRPC)
SRPC shows the relationship
between inflation and
unemployment rates. Note that the
curve can cross 0.
Using the AD-AS model, we can
further elaborate on the relationship
between unemployment and
inflation rates.
When AD increases along SRAS,
unemployment rate decreases and
inflation rate increases.
Short-Run Phillips
Curve (SRPC)
Using the AD-AS model, we can
further elaborate on the relationship
between unemployment and
inflation rates. Note that a shift in
AD will cause a movement along the
SRPC.
When AD shifts right,
unemployment rate decreases and
inflation rate increases. On the
SRPC, this would be a movement
from A to B.
When AD shifts left, unemployment
rate increases and inflation rate
decreases. On the SRPC, this would
be a movement from A to B.
Short-Run Phillips
Curve (SRPC)
With shifts of SRAS, however, we
don’t see a movement along the
Phillips Curve, but rather a shift of
the entire Phillips Curve.
When SRAS shifts right, both
unemployment and inflation rates
decrease. This would cause a
downward shift of the SRPC.
When SRAS shifts left,
unemployment and inflation rate
increase. This would cause an
upward shift of the SRPC.
Inflation Expectations
and SRPC
The expected rate of inflation is the
rate of inflation that employers and
workers expect in the near future.
Changes in the expected rate of
inflation affect short-run relationship
between unemployment and inflation
and shift SRPC.
Inflation affects workers and
employers. If inflation is expected to
be high in coming months, wage
contracts reflect that expectation and
nominal wages will be increased. Both
workers and employers will factor
expected inflation into all wage and
price contracts because nobody wants
to lose purchasing power due to future
inflation.
Inflation Expectations
and SRPC
As a result, an increase in expected
inflation shifts SRPC upward. The
actual rate of inflation at any given
unemployment rate is higher when
the expected inflation rate is higher.
Macroeconomists believe that the
relationship between changes in
expected inflation and changes in
actual inflation is one-to-one. That is,
when the expected inflation rate
increases, the actual inflation rate at
any given unemployment rate will
increase by the same amount.
Why?
Inflation Expectations
and SRPC
Assume inflation has been near zero
for years, but people begin to expect
inflation of 3%. Nominal wages and
other contracts begin to reflect a
future increase of 3%. As these
wages and other resource prices rise
by 3%, actual inflation begins to rise
from 0% to 3%. In other words,
inflation expectations translate into
actual inflation rates.
Higher inflation expectations shift
SRPC upward. At any level of
unemployment, inflation will be that
much higher. The converse is also
true, lower inflation expectations
shift SRPC downward.
Inflation Expectations
and SRPC
In the graph, an increase in expected
inflation shifts SRPC upward.
SRPC0 is the initial SPRC with an
expected inflation rate of 0% at 6%
unemployment rate.
Assume an expected inflation rate of
2%. SRPC will shift upward by 2%.
Each additional percentage point of
expected inflation raises the actual
inflation rate at any given
unemployment rate by 1 percentage
point.
Ah, but I hear Tyler ask, wait, what
about the long run?
Inflation and Unemployment in the Long Run
Macroeconomists believe that there is no long-run
trade-off between lower unemployment rates and
higher inflation rates. That is, it is not possible to
achieve lower unemployment in the long run by
accepting higher inflation…but why?
LRPC
On this graph, SRPC0 is the SRPC when
expected inflation is at 0%. 6%
unemployment rate is the Non-accelerating
inflation rate of unemployment (NAIRU)—
more on this later.
At a 4% unemployment rate, the economy
is at point A with an actual inflation rate of
2%. The higher inflation rate will be
incorporated into expectations, and SRPC
will shift to SRPC2.
If policymakers decide to keep
unemployment at 4%, economy will be at
point B and the inflation rate will increase
by another 2% to 4%.
Inflationary expectations will be taken into
account again, and SRPC2 will shift to
SRPC4. At a 4% unemployment rate, the
economy will be at C and the actual
inflation rate will rise to 6%, und so
weiter…
LRPC
Okay, so what?
6% is the NAIRU, which is the
unemployment rate at which inflation
does not change over time.
As long as unemployment rate is at
NAIRU, the actual inflation rate will
match expectations and remain
constant.
An unemployment rate below 6%
requires ever-accelerating inflation.
LRPC, which passes through E0, E2,
and E4, as a result, is vertical.
No long-run trade-off between
unemployment and inflation exists.
Now, what about an unemployment
rate above 6%? In that case, we’d be
looking at disinflation.
LRPC
Disinflation. Process of bringing down
inflation that has become embedded in
expectations.
This is an extraordinarily painful process.
Gov’t’s must use contractionary
fiscal/monetary policy where the
unemployment rate is above NAIRU. This
would induce recession, and would decrease
inflation rate to the point where SRPC
shifts downward. The good news is that
once inflation is under control, the
economy can adjust back to the NAIRU,
but at the huge cost of high unemployment.
One final note on NAIRU. Recall the idea
of natural rate of unemployment (frictional
and structural). The natural rate is
unaffected by changes in the business cycle.
How does this relate to NAIRU?
NAIRU is another name for the natural
rate of unemployment, the level of
unemployment the economy needs in order
to avoid accelerating inflation is equal to
the natural rate of unemployment.
Deflation
First off, disinflation is a decrease in the inflation rate. Deflation
is the decrease in the aggregate price level.
Debt Deflation. Reduction in AD arising from increase in real
burden of outstanding debt caused by deflation.
The effects of deflation on borrowers and lenders can worsen an
economic slump. Deflation takes real resources away from
borrowers and redistributes them to lenders.
Borrowers, who lose from deflation, are short of cash, and will
be forced to cut their spending sharply when their debt burden
increases.
Lenders are less likely to increase spending sharply when value of
loans they own increase.
The overall effect is that deflation reduces AD, deepening the
economic slump, which in turn may lead to further deflation.
Deflation
Effects of Expected Deflation. Interest rates are affected by
inflation expectations, and to a certain extent expected deflation.
Nominal interest rate = real interest rate + expected inflation
Assume that the nominal interest rate is 4%, meaning the
expected inflation rate is 0%. If the expected inflation rate is 3% then the nominal interest rate will be 1%.
But what if the expected inflation rate was -5%, what then?
The nominal interest rate would be 0%, not -1%. Why?
If lenders lent money out at a nominal interest rate of -1%, this
would mean that they would be paying borrowers 1% interest on
the money borrowed. Somehow, I don’t think a bank would be
that generous.
Zero bound. The limit on nominal interest rates—it can not go
below zero.
Deflation
Effects of Expected Deflation
Deflation creates a situation where lenders receive
nominal interest rates that approach zero. If that’s the
case, we can predict that lending will stop.
If the economy is extremely depressed, which caused the
deflation in the first place, monetary policy becomes
completely ineffective. The Fed can not lower the
interest rate lower than 0%. This kind of deflation can
cause an economy to languish for a very long time.
Liquidity trap. Situation in which conventional
monetary policy is ineffective because the nominal
interest rates are up against the zero bound.
Deflation
Effects of Expected Deflation
Liquidity trap. Situation in which conventional monetary policy
is ineffective because the nominal interest rates are up against the
zero bound.
Example. Economy is depressed, with output below YP and
unemployment rate above natural rate. Central bank can
respond by cutting interest rates so as to increase AD.
“But wait,” said Chantal curiously, “if the nominal interest rate is
already at like zero, how can the Fed cut it even more?”
The answer is, it can’t. If the nominal interest rate is already zero,
no central bank can push it down further below zero.
Banks will refuse to lend and consumers and firms refuse to spend
because with a negative inflation rate and a 0% nominal interest
rate, holding cash yields a positive real rate of return.
Any further increases in the monetary base will either be held in
bank vaults or held as cash by individuals and firms, without being
spent.
This is the liquidity trap.
Question 1
Given the following scenarios, describe and graph what
happens to the SRPC.
Government spending increases.
The price of crude oil and most sources of energy
decreases.
Inflation expectations rise from 3% to 6%.
The Fed increases interest rates with contractionary
monetary policy.
Inflation expectations fall from 5% to 2%.
The government increases income taxes.