Download Talk: Stabilisation

Macroeconomic Analysis 2003
An Example of a Stabilisation Programme
Lecture 9
1
Contents
• Need for Stabilisation: Costs of Inflation and
Unemployment
• Review of Wage and Price Spiral and Inflation
• Output gap and Mark ups
• Stabilisation experience
• Phillips’ and Okun Curves
• Set up of the Stabilisation Programme
• Inflation reduction and Unemployment
• Growth rate of output, inflation and money supply
• Sacrifice Ratio
• inflation policy game between public and the
government: Rules or Discretion?
• Analysis of Stabilisation using AS-AD diagrams
Lecture 9
2
Movement of Economy Around the Trend: A Reminder

Y
Y  A K L
t
t t t
35 million unemployed
in the OECD
Boom
y y 0
yt  y 0 e
gt
Recession
y y 0
1992
1982
Lecture 9
2003
3
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 calculation
• It is harmful for economic growth; reduces saving and
investment activities
• It create social tension
Lecture 9
4
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
Lecture 9
5
 ,  =0.2 Main cause of Inflation: Wage Price Spiral
Time
Wage
Price
1
1.00
1.00
2
1.20
1.20
3
1.44
1.44
4
1.73
1.73
5
2.07
2.07
6
2.49
2.49
7
2.99
2.99
8
3.58
3.58
9
4.30
4.30
10
5.16
5.16
11
6.19
6.19
12
7.43
7.43
13
8.92
8.92
14
10.70
10.70
15
12.84
12.84
16
15.41
15.41
17
18.49
18.49
18
22.19
22.19
19
26.62
26.62
20
31.95
31.95
21
38.34
38.34
Modernisation or Negotiation?
Price Mark up by firms:
Pt  1   Wt
Price
(1)
Wage Mark up by unions
Wt  1   Pte
(2)
Price Wage Spiral
Pt  1   1   Pt

e

(3)
wage
Both mark-ups
and
increase in the boom
time and decrease in the slump.
    a y  y   bu  u 
Lecture 9
(4)
6
Price Level to Inflation Rate
Pt
Pte
 1   1   
Pt 1
Pt 1
1   t  1       1   
(5)

is the expected or the core inflation that firms and
unions use while settling the wage rate.
 t                 
(6)
Ignore these small numbers
Lecture 9
7
Inflation to Aggregate Supply or Expectation
Augmented Phillips Curve
t     
(7)
 t    a y  y 
Or
 t    bu  u 
(8)
 a y  y  


 t     or   s
 bu  u 


Lecture 9
(9)
8
Inflation, Output and Unemployment in the Short Run
LAS
 
e
 
 
e
AS=f(w,pe)
 a y  y  


e
 t     or   s
 bu  u 


e
AD =f(M,G, T)
o
yy yy
u  un u  un u  un
y y
Lecture 9
9
Supply Shock and Stagflation
LAS
 
e
 
 
Stagflation
e
AS1
AS=f(w,pe)
 a y  y  


e
 t     or   s
 bu  u 


e
AD =f(M,G, T)
o
yy yy
u  un u  un u  un
y y
Lecture 9
10
 t    but  un 
e
t
Inflation
t
ut  un 
Rational Expectation
t    0
e
t
t
Deflation
ut  un 
Time
ut  un 
Expectation die very slowly.
Lecture 9
11
Friedman (1966, 1968) and Phelps (1967) natural
rate of unemployment hypothesis
 t    ut  u   te where   0 (2)
N

where  t is the actual inflation,  e is the expected inflation u is
t
N
the natural rate of unemployment that is ground out by the
Walrasian system of the general equilibrium, and ut is the actual
unemployment rate.
Since  t  e  ut  u
t

N



and   0 the inverse relation
between unemployment and inflation implies
 t  te  ut  u N  yt  y*
 t   te  ut  u N  yt  y*
 t  te  ut  u N  yt Lecture
y* 9
(3)
12
Natural Rate of Unemployment Hypothesis
The natural rate of output and employment “ground out” by the
equilibrium in goods, labour and money markets (Friedman
(1968))
The economies converges to the natural rate in the long run.
Nothing in the economy guarantees that actual output and
employment do not deviate from such natural rates in the short
run.
When consumers and producers have good confidence about the
status of the economy they are likely to spend more and the
economic growth rate higher than the natural rate.
A reverse process operates in the downturn.
A smooth functioning of the economy requires stabilising the
economy around these natural rates.
Lecture 9
13
Four Main Theories of Natural Rate of Unemployment
1. Search cost and job
3. Efficiency wage theory
mismatch theory:
Firms pay higher wages to
s = job separation rate
workers to reduce hiring
and firing costs and to
f = job finding rate
reduce shirking and the
u = unemployment rate
monitoring costs or to
s
u
appear as an ideal employer
s f
but that makes others
2. Insider-Outsider theory:
unemployed
Inefficient Bargaining
4. Rigidity in the labour
between firms and
Market:
workers
Minimum wage laws
Members of the union
demand higher wages and
Entry deterrence and labour
non-member remain
market standards
Lecture 9
14
unemployed
Determination of the Natural Rate of Unemployment: An Example
Wage setting:
W  P e (1  au  z ) (1)
1
(1   )
Price Setting:
(2)
MPL
1
e
P

P
(1   )(1  au  z ) (3)
From (1) and (2):
MPL
In logs: (note log(1+x) = x )
P W
pt  pte    au t  z t  log( MPLt )
(4)
Subtract pt-1 from both sides:
pt  pt 1  pte  pt 1    au t  z t  log( MPLt )
Note pt  pt 1 
d log Pt
dPt 1

t
dt
dt Pt
 t   te    au t  z t  log( MPLt )
(5)
Natural rate of unemployment is a point
Actual and Expected Inflation are equal
z t    log( MPLt )
*
ut 
(6)
a
z includes:
 t   te
reservation wage, taxes, union bargaining power,
Lecture 9
upward pressure on wages by minimum wage laws,
benefits and efficiency wage arguments, Structural change
15
Recent Experience of Stabilisation in the UK
Lecture 9
16
Inflation is a Monetary Phenomenon
Inflation rate (% change in RPI) and Growth Rate of M4
30
25
inflation
m4growth
15
10
5
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
84
19
82
19
80
19
78
19
76
19
74
19
72
19
70
19
68
66
19
19
64
0
19
Percent
20
Lecture 9
17
Standard Measures of Stabilisation
• 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
Lecture 9
18
Unemployment and Output Gap: Okun’s Curve

Output Gap

ut u  a g y,t  g y,n 
t 1


Higher growth rate means
lower unemployment rate
Sacrifice ratio
Inflation gap
u  un 

1
t
sr 

 
t
t 1
 t 
t1
 but un 
b
Higher unemployment causes
wages and inflation to fall
Unemployment Gap
Lecture 9
19
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
Lecture 9
20
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
Lecture 9
Growth
rate of
money
supply
11
8
9
8
7
6
5
4
6
4
21
Basic Parameters for the Stabilisation Programme Model
Natural growth rate: g y,n  3% ;
Natural unemployment rate: un  5% ;
current  t =11%;
let target  *  2% ;
Inflation reduction rate each year:  t -
t 1
=2%;
Slope of the Okun’s curve a = 0.5;
Slope of the Phillips Curve: b = 0.5.
Growth rate of money supply, output and inflation
gm,t  g y,t t
Lecture 9
22
Disinflation (Stabilisation Program
u t  u t 1  0.5g yt  3%   t   t 1  0.5ut  5%
Year
Inflation
Unemploym
ent rate
Growth rate
of output
0
1
2
3
4
5
6
7
8
9
11
9
7
5
3
2
2
2
2
2
5
9
9
9
9
7
5
5
5
5
3
-1
3
3
3
8
8
3
3
3
Lecture 9
g yt  g mt   t
Growth rate
of money
supply
14
8
10
8
6
10
10
5
5
5
23
Parametric Specification and solution steps for
inflation reduction Programme
1.
Stick the current and past inflation rates
t
and 
t 1 in
equation (2) and solve that equation for actual unemployment
rate
ut . The current inflation rate t can be obtained using
information on
2.
3.

t 1
and desired decrease in the annual
inflation rate.
Use this unemployment rate in equation (1) and solve for the
actual growth rate, g y,t .
Use this growth rate of output in equation (3) to solve for
growth rate of money supply g m,t . Repeat this process
until target rate of inflation is achieved.
Lecture 9
24
Transitional path of output and money growth
and unemployment rate in the inflation reduction
g y,t  gm,t  t
programme
Time
pi
u
gy
gm
un  5%
0
14
5
3
17
 t =14%
1
12
9
-5
7
2
10
9
3
13
3
8
9
3
11
4
6
9
3
9
5
4
9
3
7
6
2
9
3
5
7
2
5
11
13
8
2
5
3
5
9
2
5
3
5
 t 
 0.5ut  un 
-t 
t 1
 2%
a = 0.5
b = 0.5
 *  2%
g y,n  3%
ut  u  0.5 g y,t  g y,n 
t 1


Lecture 9
t 1
25
20
18
16
14
12
10
8
6
4
2
0
-2
-4 0
-6
-8
Stabilisation Programme
pi
u
gy
gm
1
2
3
4
5
6
7
9
8
time periods
Lecture 9
26
Stabilisation: Table 2
uppose that inflation is 21%; natural growth rate of output is
3%; natural unemployment is 5%
b=1; a=1. Target inflation = 3%.
S
Year
Inflation
Unemploy
ment rate
Growth
rate of
output
0
1
2
3
4
5
6
7
8
21
18
15
12
9
6
3
3
3
5
8
8
8
8
8
8
5
5
3
0
3
3
3
3
3
6
3
Lecture 9
Growth
rate of
money
supply
24
18
18
15
12
9
6
9
6
27
Stabilisation: Table 3
Suppose that inflation is 21%; natural growth rate of output is
3%; natural unemployment is 5%
b=0.5; a=1. Target inflation = 3%.
Year
Inflation
Unemploy
ment rate
Growth
rate of
output
0
1
2
3
4
5
6
7
8
21
18
15
12
9
6
3
3
3
5
8
8
8
8
8
8
5
5
3
-3
3
3
3
3
3
9
3
Lecture 9
Growth
rate of
money
supply
24
15
18
15
12
9
6
12
6
28
Disinflation Path and the Steady State
Disinflation path
14%
Relation between growth rate of money
supply and output and unemployment
rate: in the medium run
(a)
  gm  g y
inflation
(b)

2%

 '  g 'm  g ' y
(c)
3%
4%
Un
Unemployment, u
Unemployment, u
Lecture 9
29
Another Set of Parameters for the Stabilisation Programme Model
Natural growth rate: g y,n  2% ;
Natural unemployment rate: un  3% ;
current  t =11%;
let target  *  2% ;
Inflation reduction rate each year:  t -
Slope of the Okun’s curve a = 0.5;
t 1
=1%;
Slope of the Phillips Curve: b = 1.
Growth rate of money supply, output and inflation
gm,t  g y,t t
Lecture 9
30
Transitional path of output and money growth
and unemployment rate in the inflation reduction programme
Time
0
1
2
3
4
5
6
7
8
9
10
11
12
pi
11
10
9
8
7
6
5
4
3
2
2
2
2
u
3
5
5
5
5
5
5
5
5
5
3
3
3
Lecture 9
gy
3
0
2
2
2
2
2
2
2
2
4
2
2
gm
14
10
11
10
9
8
7
6
5
4
6
4
4
31
A Smooth Inflation Reduction Programme
16
14
pi
In Percent
12
u
gy
10
gm
8
6
4
2
0
0
1
2
3
4
Lecture
5 9
6
7
8
9
10 32
11
Inflation Policy Game
...............................
Pr ivate Sector

Government Sector  H
 L
L 
3,3
 5,3 0,0 
H
 3,0
.
Policy options and its outcome
Policy Options
A
B
C
D
Actual inflation
Low
Low
High
High
Expected inflation
Low
High
Low
High
Lecture 9
Unemployment rate
u = un
u > un
u < un
u = un
33
Inflation Policy Game
LPC
Inflation  
PC2
H
PC1
C (3,-3)
L
A(0,0)
 t    bu t  u n 
e
D (-3,0)
uL
C is the most preferred and
B is the least wanted
scenario of the government
Non cooperative Game
may end at point D
with high inflation and
high unemployment
rate
B(-5,-3)
un
uH
Unemployment rate, u.
Lecture 9
34
Adaptive and Rational Expectation Views on a Positive
Demand Shock
LAS
SAS
c
P2
b
P1
P
a
P0
AD1
AD0
0
Reply to demand shock
Adaptive Expectation: a to b to c
Rational expectation: a to c
Yn
Lecture 9
Y
35
Movement of Aggregate Demand and Supply Around the Natural Rate
AS2
P2
Price Level
d
SA3
e
AS1
AS0
P3
c
P1
f
b
P0
AD3
a
AD1
AD0
0
YL Yn
Lecture 9
YH
36
Exercises
•
•
•
•
•
Okuns’ Curve
Phillips curve
Inflation reduction program
Sacrifice ratio
Money supply, inflation and economic
growth rate in the steady state
• Policy Game
Lecture 9
37