marco2 -750 or 800 words

dodo1995

Week3StudentSlidesTopic3TheInflation-UnemploymentTrade-OffMelb1.pptx

Home >Business & Finance homework help >Economics homework help >marco2 -750 or 800 words

The Inflation-Unemployment Trade-off

Topic 3

Inflation

Inflation is a sustained upward movement in the aggregate price level that is shared by most products

The price level is notated P

Inflation is notated p = %∆P

The Core Inflation Rate is the inflation rate for all products and services other than food and energy.

The Underlying Inflation is the inflation rate for the CPI basket excluding a particular set of volatile items such as fruit, vegetables and automotive fuel.

The Output Ratio and Inflation

The Output Ratio is the ratio of actual real GDP to natural real GDP (i.e. Y/YN).

If Y/YN = 100%, p is constant

If Y/YN > 100%, p is accelerating

If Y/YN < 100%, p is decelerating

What affects the output ratio?

A Demand Shock is a sustained acceleration or deceleration in AD, measured most directly as a sustained acceleration or deceleration in the growth of nominal GDP.

A Supply Shock is caused by a sharp change in the price of an important commodity (e.g. oil) that causes the inflation rate to rise or fall in the absence of demand shocks.

The Output Ratio and Unemployment

There also is an inverse relationship between the output ratio and unemployment:

(Y/YN)↑  U↓

This relationship is known as Okun’s Law, which explicitly states that there is a regular negative relationship between the output ratio (or output gap) and the gap between actual unemployment and the average rate of unemployment

A drop in the output ratio by 1 percentage points, would correspond to an increase in the unemployment rate of ½ percentage points.

Nominal GDP Growth and Inflation

Recall: Nominal GDP (X) is related to the price level (P) and real GDP (Y) as follows:

X = PY

(Note: Lower case letters represent the growth rates of the same variables)

Relationship between the growth rate of nominal GDP (x) and the inflation rate:

x ≡ p + y

When inflation is less than the growth rate of nominal GDP, real GDP must rise. When inflation is greater than the growth rate of nominal GDP, real GDP must fall.

Inflation, Output and Unemployment

What impact will a shift towards a more expansionary policy have on output and employment?

Can expansionary policies reduce the unemployment rate?

If so, how long can the lower unemployment rate be maintained, and at what cost?

The Gordon textbook examines the relationship between inflation and the output ratio for their Phillips Curve.

WE will adopt the standard approach for the Phillips Curve – the relationship between inflation and unemployment

Demand-Pull Inflation

AD0

RGDP

(trillions of dollars)

Price Level (P)

SAS (w=100)

100

102

$10

$10.4

AD1

UNE

Inflation rate

(p)

LAS

Which of the following factors could cause demand-pull inflation if the economy is currently operating at the natural rate of GDP?

an increase in exports

an increase in tax rates

a decrease in wage rates

a decrease in government spending

Check Your Knowledge

The Phillips Curve

The Short-Run Phillips (SP) Curve (also referred to as the expectations-augmented Phillips Curve) represents the negative short-run relationship between the unemployment rate and the inflation rate.

The PC relationship shows that when we:

decrease the inflation rate we increase unemployment rate.

decrease the unemployment rate we increase inflation rate.

Policy Implication:

offers policymakers a menu of possible economic outcomes. Policymakers could use monetary and fiscal policy to choose any point on the curve – a particular combination of inflation and unemployment.

Expectations and the SP

UNE

Inflation rate

(p)

SP0(pe=0%)

SP1(pe=2%)

pe represents the inflation rate that both workers and firms expected at the time of the last contract negotiation

The Long-Run Phillips Curve

The Long-Run Phillips (LP) Curve shows the relationship between the unemployment rate and the inflation rate after the adjustment of inflationary expectations.

Everywhere to the left of the LP, actual inflation is higher than expected, and the expected inflation rate increases. Everywhere to the right, actual inflation is lower than expected, and the expected inflation rate decreases.

Every point along the LP curve is consistent with the expected inflation rate (pe) equalling the actual inflation rate (p).

The Long-Run

AD0

RGDP

Price Level

LRAS

AD1

UNE

INF

LRPC

↑AD  ↑P thus ↑INF

Output remains at the potential level of output with the natural rate of unemployment.

The Long-Run

UNE

Inflation rate

(p)

SP0(pe=0%)

SP1(pe=2%)

LP(pe=p)

SP2(pe=4%)

Different Types of Expectations

The speed of adjustment of inflation expectations affects how long Y can be pushed beyond YN

Backward-looking Expectations use only information on the past behaviour of economic variables.

Adaptive Expectations base expectations for next period’s values on an average of actual values during previous periods.

Forward-looking Expectations attempt to predict the future behaviour of an economic variable using economic models

Rational Expectations argues that people will not consistently make the same mistake when forecasting inflationary expectations.

Adjustment

Attempts to keep the unemployment rate below the natural rate of unemployment will lead to ever-increasing rates of inflation.

AD1

RGDP

Price Index

(P)

SAS2

AD2

LAS

SAS1 (w=w1)

UNE

Inflation rate

(p)

SP2

SP1

(w=w2)

Policy Implications

Best way to stabilise the economy is to adopt policies to keep the output at potential RGDP – at the natural rate of unemployment.

How to Combat Inflation?

If the output is above potential (and the unemployment rate is below the natural rate), inflation is likely to accelerate. The appropriate response to adopt contractionary policies that reduce the output back to potential RGDP.

If the unemployment rate is above the natural rate - to the right of the LP line, policymakers should adopt expansionary policies.

Check Your Knowledge

In the short-run Phillips Curve, which of the following are being held constant?

the expected inflation rate

the natural unemployment rate

the AD curve

both A and B

The Cure for Inflation: Recession

Theoretically, if an increase in nominal GDP causes inflation, then a recession should do the opposite.

Disinflation is a marked deceleration in the inflation rate. To bring about disinflation restrictive monetary and tight fiscal policies are implemented.

How can disinflation be achieved?

The “Cold Turkey” approach to disinflation operates by implementing a sudden and permanent slowdown in nominal GDP growth.

The “gradualist approach” approach refers to a slow and steady return to natural RGDP.

The cost of disinflation is measured by the Sacrifice Ratio, which is the cumulative loss of output incurred during a disinflation divided by the permanent reduction in the inflation rate.

The Cure for Inflation: Recession

UNE

Inflation rate

(p)

SP1

SP2

International Perspective

Source: International Financial Statistics (IFS)

Demand vs. Supply Inflation

Demand Inflation is a sustained increase in prices that is preceded by a permanent acceleration of nominal GDP growth.

Supply Inflation is an increase in prices that stems from an increase in business costs not directly related to prior acceleration of nominal GDP growth.

Types of Supply Shocks – Cost-push Inflation

Changes in business input costs (like Poil and industrial relations)

Weather shocks that affect farm prices

Import price shocks due to fluctuating exchange rates – terms of trade and exchange rate shocks

If the value of the dollar falls, imported goods become more expensive.

Productivity growth shocks that change the amount workers can produce

Supply Shocks (Stagflation) and the SP

RGDP

Price Level

SRAS1

SRAS0

UNE

INF

SRPC0

SRPC1

Policy Responses to Supply Shocks

Following a supply shock, there are three possible policy responses:

Do nothing – allow the economy to self-correct over time.

An Accommodating Policy raises nominal GDP growth so as to maintain the original output ratio, ie a return to natural real GDP.

An Extinguishing Policy reduces nominal GDP growth so as to maintain the original inflation rate, ie reduction in the inflation rate.

Policy Responses

UNE

Inflation rate

(p)

SP0

SP1

Accommodating Policy

Extinguishing Policy

Cures for Inflation

Fundamental causes of inflation:

Excessive monetary growth

Excessive nominal GDP growth

Adverse supply shocks

Government approaches to cure inflation

Slow nominal GDP growth

Create beneficial supply shocks

Eliminate or weaken price- or cost-raising legislation

Creative tax and/or subsidy policies

Check Your Knowledge

At the macroeconomic level, demand-pull and cost-push inflation are different. Specifically cost-push inflation starts by

reducing GDP and reducing the price level.

reducing GDP and raising the price level.

raising GDP and raising the price level.

raising GDP and reducing the price level.