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Economic Modelling
Lecture 9
Stabilisation of Inflation and
Unemployment using Money Supply
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Needs for Stabilisation: Costs of Inflation
• Inflation distorts relative prices and makes the market system less
efficient as prices cannot signal relative scarcity.
• Inflation transfers resources from creditors to debtors
• Redistributes income from fixed income group to property holders.
• Taxes are not indexed for inflation, low income families are pushed
up to the tax threshold.
• Shoe leather and bookkeeping costs rise with inflation
• It creates uncertainty. Creates illusions, confusions and complicates
economic calculations.
• It is harmful for economic growth; reduces saving and investment
activities
• It create social tension
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Needs for Stabilisation: Costs of Unemployment
• Loss of output and income and utility
• Personal psychological costs
–
–
–
–
–
–
–
Unhappiness
Stress and tension
Discouragement and disappointment
Morale and motivation
Uncompetitive feeling
Dignity of human life
Insecurity
Loss of productive skills
productivity
Lack of learning by doing opportunity
Rise in social unrest and crimes
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Standard Measures of Stabilisation
(Such as Stability and Growth Pact)
• Control of Aggregate Demand
– Increase or decrease in money supply
– Control in the tax and spending programme
– Monetisation or contraction of the budget deficit
• Aggregate supply
– Wage renegotiations
– Efficiency enhancing measures
• Trade and Exchange Rates Measures
– Appreciation or depreciation of the currency
– Trade and exchange rate agreements
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Unemployment, Output and Inflation : Okun and Phillips Curves
Unemployment and Output gap (Okun’s Curve)


ut u  a g y,t  g y,n 
t 1


Rate of growth of output above the natural rate means lower
unemployment rate.
Inflation and unemployment gap (assuming adaptive expectation)
 t   but un 
t1
 te  
t 1
Link between rate of inflation and rates of growth money supply and
output
 t  gm,t  g y,t
Sacrifice ratio:
u  un 

1
t
sr 

 
t
t 1
b
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Inflation Reduction Programme:
Output, Inflation and Unemployment
Unemployment and output gap (Okun’s law)




ut u  a g y,t  g y,n
t 1




(1)
Phillip’s curve (expectation augmented):
 t 
t 1
 but un 
(2)
Relation between growth rates of money, output and inflation
g y,t  gm,t  t
(3)
g y,t is actual growth rate of output; g y,n is natural growth rate of
output
gm,t is growth rate of money supply
 t is inflation rate; ut is actual unemployment rate; un natural rate
of unemployment
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Stabilisation: Table 1
u t  u t 1  0.5g yt  2%   t   t 1  ut  3% ; g yt  g mt   t
Year
Inflation
Unemploy
ment rate
Growth
rate of
output
0
1
2
3
4
5
6
7
8
9
9
8
7
6
5
4
3
2
2
2
3
4
4
4
4
4
4
4
3
3
2
0
2
2
2
2
2
2
4
2
Growth
rate of
money
supply
11
8
9
8
7
6
5
4
6
4
7
A Smooth Inflation Reduction Programme
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4
pi
2
u
0
gy
gm
8
6
4
2
0
0
1
2
3
4
5
6
7
8
9
10
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Role of Expectation in An Economy
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Future is unknown and uncertain.
Some consumers and investors are more optimistic and confident about
the future the economy (about income, output and prices that affect their
decision to work and invest) than others.
These perceptions about the future affect all types of economic activities.
How do these expectations affect macroeconomic behaviour? It is obvious
from what we see in the markets.
Prosperity follows from good expectations. Recession arises with dim
expectations.
Confidence of consumers and producers, which itself is based in a set of
leading indicators of the economy, signals about the health of the
economy as is discussed almost every hour in the media, particularly in
case of highly integrated stocks and bonds markets around the globe.
There are three different ways of forming expectations about unknown
variables:
Perfect foresight;
Adaptive expectation and partial adjustment;
Rational expectation.
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Supply Shock and Stagflation
LAS
 
e
 
 
Stagflation
e
AS1
AS=f(w,pe)
 a y  y  


e
 t     or
 s
 bu  u 
n 

e
AD =f(M,G, T)
o
yy yy
u  un u  un u  un
y y
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Adaptive and Rational Expectation Views on a Positive
Demand Shock
LAS
SAS
c
P2
b
P1
P
P0
a
AD1
AD0
0
Reply to demand shock
Adaptive Expectation: a to b to c
Rational expectation: a to c
Yn
Y
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...............................
Policy Options
Actual inflation
Expected
inflation
Unemployment
rate
A
Low
Low
u = un
B
Low
High
u > un
C
High
Low
u < un
D
High
High
u = un
Pr ivate Sector

Government Sector  H
 L
L 
3,3
 5,3 0,0 
H
 3,0
Policy options and its outcome
LPC
Inflation  
PC2
Cooperative
solution A is better
but it is not stable.
H
PC1
C (3,-3)
L
 t   e  bu t  u n 
D (-3,0)
A(0,0)
uL
C is the most preferred and
B is the least wanted
scenario of the government.
Non cooperative Nash
Solution of this Game
is at point D with high
inflation and
Natural rat of unemploym
rate.
B(-5,-3)
un
Unemployment rate, u.
uH
Inflation Policy Game
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Lucas Critique of the IS-LM Model
Consumption:
Disposable income:
C  a bY d
Y d Y T
(1)
(2)
(3)
I r   I  qr
0
Demand for real balances: M  kY  r (4)
P
National income identity: Y  C  I  G
(5)
Investment:


r  1  kY  M 
P

a bT  I  qr  G
0
Y
(6)
1b


1 b Y  a  bT  I  G

Model I: IS curve:

0
r 
q
 

a bT  I q M  G
1
M



a bT  I  q  kY    G
Model II: ISLM
0
P
Y
0  
P 
q
1b  k
,
Y
1b
Households and firms already know the parameters like a, b, q, I0, k.
They fully anticipate and adjust their behaviour when G, T or M change.
Anticipated fiscal and monetary policies do no have any impacts in Y,
I or
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employment but only on prices and wages.
Rational Expectation
Conditional expectation about a variable X at time t+1
using all available information existing at time t

Et
X t 1

~
t  X t
Information set
t
It contains past values of endogenous and policy variables
and future predicted values of exogenous variables.
Three methods of forming rational expectation
1. Survey of opinion –asking people, economist, CEOs, consumers,
about the their opinion about a variable.
2. Using current value of variable as the best predictor of future.
3. Extrapolative model based forecasts
(Lucas (1976), Wallis (1977), Lee et.a. (2000)).
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References
•
•
Blanchard (9,23)
Bank of England (1999) The Transmission Mechanism of Monetary Policy
www.bankofengland.co.uk.
•
Blanchard, O.J. and L. Summers (1986), "Hysteresis and the European
Unemployment Problem," NBER Macroeconomics Annual, the MIT
Press.
Blanchard O.J.and Kiyotaki (1987) Monopolistic competition and the
effects of aggregate demand, American Economic Review, 77:
September, pp 647-66
Goodhart C.E.A. (1994) What should central banks do? What should be
their macroeconomic objective and operations?, Economic Journal, 104,
November, 1424-1436.
•
•
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Rogoff, K (1999) "International institutions for reducing global financial instability",
Journal of Economic Perspectives, 1999 or NBER WP 7265.
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