Econ 102 Discussion Section 10 (Chapter 17) Chapter 17: Inflation, Unemployment and Federal Reserve Policy The Philips Curve and AD/AS When we have discussed the AD-AS model in previous chapters, one fact we have discussed is that GDP and unemployment have an inverse relationship; that is, as output increases, unemployment decreases and vice versa. Given that we often focus on changes in AD when discussing recessions and expansions in the short run in the AD-AS model, this often means that prices and unemployment also employ an inverse relationship. However, this cannot be explicitly seen in the AD-AS model. In 1957, A.W. Philips plotted a curve illustrating short-run data on unemployment and prices that is now called the Philips Curve In the 1960’s, some economists believed that the Philip curve represented a structural, or unchanging, relationship in the economy. However, in the late 1960’s as economists began to agree that the LRAS was vertical, this contradicted the idea that the Philips curve represented an unchanging relationship between unemployment and inflation. In order to incorporate these seemingly disparate ideas, economists explained this by arguing that there is both a short run Philips curve (SRPC), and a long run Philips Curve (LRPC). The Short Run Philips Curve The SRPC illustrates the inverse relationship between prices and unemployment in the short run. The curve is downward sloping because workers and firms sometimes expect the inflation rate to be higher or lower than it actually is. If inflation is higher than workers and firms expect, real wages will end up being lower than expected and firms will hire more workers, and vice versa. If there is a persistent difference between expected and actual inflation over time, it can become embedded in the economy, meaning that firms will begin to take the new inflation rate as given in the future. This will cause the SRPC to shift to reflect these new expectations. In fact, there is a SRPC for every level of expected inflation, and each SRPC intersects with the LRPC at the expected inflation rate. The Long Run Philips Curve In the long run, there is no trade-off between unemployment and inflation, as workers and firms have the time to adjust their wages to the inflation rate. As a result, the LRPC is a vertical line at the natural rate of unemployment. The Philips Curve and Monetary Policy This has implications for the effectiveness of monetary policy in the long run. Suppose that the Fed uses expansionary monetary policy to reduce unemployment (by shifting the AD curve to the right) at the cost of higher inflation (note that this is equivalent to a movement along the SPRC). In the short run, if the inflation is unexpected, real wages will drop and unemployment will fall. However, over the long term, as workers and firms adjust to the higher prices, the SRAS shifts left to a long run equilibrium and the SRPC shifts up to reflect the new expectations of inflation (note that this means that a shift in the SRAS is equivalent to a shift of the SRPC). As a result, this means that only when unemployment is equal to the natural rate will the inflation rate be stable in the long run. Because of this, the natural rate of unemployment is sometimes referred to as the nonaccelerating inflation rate of unemployment, or NAIRU. This also means that the Fed can affect the inflation rate but not the unemployment rate in the long run Expectations of the Inflation Rate and Monetary Policy One key theme underlying all of these ideas is the difference between expected inflation and actual inflation. Now we want to understand how economic actors form those expectations. If economic actors have adaptive expectations, they assume that future inflation rates will mirror past patterns. In this case, monetary policy can be effective, as discussed above, in the short run. Under rational expectations, economic actors use all available information when forming expectations about future inflation. However, this could also include information about the effects of Federal Reserve policy. If this occurs, then monetary policy will not be effective in affecting unemployment, in both the short run and in the long run. Real Business Cycle Models If individuals have rational expectations, and monetary policy is ineffective in changing GDP in the short run, how do we explain fluctuations in GDP? Robert Lucas, one of the first economists to discuss rational expectations, explained this by suggesting that fluctuations in GDP were caused by unexpected changes in monetary policy. On the other hand, Finn Kydland and Edward Prescott argue that changes in real variables, particularly technology shocks, instead of monetary policy, lead to shifts in GDP (remember that shifts in SRAS are equivalent to shifts of the SRPC. The challenge of pursuing disinflation In August 1979, Paul Voekler became the chairman of the Fed. To reduce the rate of inflation (called disinflation), he began reducing the growth rate of the money supply. This accomplished the goal of reducing inflation, but at the cost of higher unemployment due to reduced demand. Over time, as workers and firms adjusted their expectations of inflation, the SRPC began to shift down, until it was possible for the Fed to pursue expansionary monetary policy while still maintaining the desired inflation rate. However, this took a time period of 10 years, during which unemployment rose to nearly 10% at times. This illustrates the challenges of attempting to reduce inflation over an extended period of time. Practice Problems Figure 17-1 1. Refer to Figure 17-1. What should the Federal Reserve do if it wants to move from point A to point B in the short-run Phillips curve depicted in the figure above? A) sell treasury bills B) lower the discount rate C) increase the money supply D) lower taxes 2. According to the short-run Phillips curve, if unemployment is 3.2% and inflation is 1.3%, an increase in the inflation rate might result in which of the following? A) an increase in the unemployment rate to 3.4% B) a decrease in the unemployment rate to 3.0% C) a decrease in the demand for labor in the economy D) a return to the original inflation rate of 1.3% 3. If the Phillips curve represents a "structural relationship," then A) the trade-off between unemployment and inflation is permanent. B) the trade-off between unemployment and inflation holds only for the short run. C) the trade-off between unemployment and inflation holds in the long run, but not in the short run. D) the Phillips curve will be vertical in the long run. 4. In the long run, the Phillips curve is a ________ at ________. A) horizontal line; 0% inflation B) negatively sloped line; the intersection of AD and SRAS C) vertical line; the natural rate of unemployment D) vertical line; the expected rate of inflation 5. If actual inflation is less than expected inflation, actual real wages will be ________ expected real wages and unemployment will ________. A) greater than; rise B) greater than; fall C) less than; rise D) less than; fall 6. If workers and firms raise their inflation expectations, A) unemployment will fall. B) actual inflation will fall to match expected inflation. C) the short-run Phillips curve will be vertical. D) the short-run Phillips curve will shift upward. Figure 17-‐‑2 7. Refer to Figure 17-2. Suppose the economy is at point B in the figure above. Which of the following is true? A) The expected rate of inflation is 3%. B) The natural rate of unemployment is 3.8%. C) The current unemployment rate is 5%. D) The economy is producing at potential GDP. 8. What impact does monetary policy have on the long-run Phillips curve? A) Monetary policy can only shift the long-run Phillips curve to the left. B) Monetary policy shifts the long-run Phillips curve to the right or left, depending on whether monetary policy is expansionary or contractionary. C) Monetary policy can only shift the long-run Phillips curve to the right. D) Monetary policy has no impact on the long-run Phillips curve. 9. If workers and firms know that the Federal Reserve is following an expansionary monetary policy, workers and firms will expect inflation to ________ and will adjust wages so that the real wage ________. A) increase; increases B) increase; remains unchanged C) decrease; decreases D) increase; decreases 10. If firms and workers have rational expectations, including knowledge of the policy being used by the Federal Reserve, the short-run Phillips curve will be A) negatively sloped. B) positively sloped. C) vertical. D) flatter in the long run than it is in the short run 11. Which of the following could increase unemployment and inflation simultaneously? A) an increase in oil prices B) expansionary monetary policy C) contractionary monetary policy D) a decrease in the real wage Answer: 1. A) 2. B) 7. A) 8. D) 3. A) 9. B) 4. C) 5. A) 6. D) 10. C) 11. A)