SGPE Summer School: Macroeconomics Lecture 9 · Macroeconomics Lecture 9 •In the IS-LM model, we assumed that prices were given ... and price inflation: Inflation is determined

SGPE Summer School:

Macroeconomics

Lecture 9

• In the IS-LM model, we assumed that prices were given

in the short run

• But prices are not constant. We need a theory for how

wages and prices adjust in the short run

• In the long run, production and employment should go

back to the equilibrium levels found in Lectures 2 and 6

• Analysis of wage and price adjustment ties the short

and the long run together

Wage and price adjustment in the short run (Chapter 9)

2

Wage and price adjustment: Introduction

Questions:

• What factors determine short run wage and price

adjustment?

• Is there a choice between low inflation and low

unemployment?

3

Wage and price adjustment: The Phillips curve

The wage-setting equation:

If unemployment is lower (higher)

than the equilibrium level, companies

want to raise wages more (less) than

the average rate of wage growth

DWt

d

Wt-1

=DW

t

Wt-1

-b ut-un( )

4


Wage-setting in the short run:

• Share of companies set wages at the end of the previous year

• Share of companies that have flexible wages:

• Average rate of wage increase in the economy:

Wage increase in firms Wage increase in firmsthat can adjust wages that can’t adjust wagesduring the period during the period

1-l

l

W r

W x

DWt

Wt-1

= lDW

t

x

Wt-1

+ 1-l( )DW

t

r

Wt-1

5


• Wage-setting in companies that can adjust wages:

these firms set their desired wage

• Wage-setting in companies that cannot adjust wages:

these firms set wages based on theirexpectations about average wage development

Intuition: If they were to set any other wage, they would be

consciously setting the wrong wage! Those who are flexible set the

wage correctly given the labour market situation

DWt

x

Wt-1

=DW

t

Wt-1

-b ut-un( )

DWt

r

Wt-1

=DW

t

e

Wt-1

6


Average rate of wage increase in the economy:

where The Phillips curve

DWt

Wt-1

= lDW

t

x

Wt-1

+ 1-l( )DW

t

r

Wt-1

= lDW

t

Wt-1

-b ut-un( )

é

ëê

ù

ûú+ 1-l( )

DWt

e

Wt-1

DWt

Wt-1

=DW

t

e

Wt-1

-lb

1-lut-un( )

DWt

Wt-1

(1-l) = (1-l)DW

t

e

Wt-1

-lb ut-un( )

DWt

Wt-1

=DW

t

e

Wt-1

- b ut-un( )

b =

lb

1-l

7


The Phillips curve:

where DWt

Wt-1

=DW

t

e

Wt-1

- b ut-un( ) b =

lb

1-l

8


The slope of the Phillips curve is determined by:

• The parameter

How much unemployment influences the company’s wage-

setting decisions

• The parameter

What percentage of companies can adjust wages freely

If and are large, the Phillips curve has a steep slope

and vice-versa

b

l

b l

9


Definition of inflation:

To analyse short run wage and price adjustment, we

simplify the production function and set :

Price-setting:

Inflation:

Expected inflation:

Y = EN Þ MPL = APL =Y

N= E

P = (1+m)MC = (1+m)W

MPL= (1+m)

W

E

p =DW

W-DE

E

pt=Pt- P

t-1

Pt-1

p e =DW e

W-DEe

E

a = 0

10


We can write the Phillips curve in terms of unemployment

and price inflation:

Inflation is determined by:

• expected inflation

• unemployment

• unexpected changes in productivity

p =DW

W-DE

E=DW e

W- b u-un( )-

DE

E

p = p e +DEe

E- b u-un( )-

DE

E= p e - b u-un( )-

DE

E-DEe

E

æ

èç

ö

ø÷

11


The Phillips curve in terms of unemployment and

inflation:

To simplify, we write:

where z represents unexpected changes in productivity

and also changes in cost or taxes that affect prices when

wages have been set

p = p e - b u-un( )-DE

E-DEe

E

æ

èç

ö

ø÷

p = p e - b u-un( )+ z

12


• Definition, unemployment:

• Production function:

•

When production is above the natural level,

unemployment is below the natural level

• Definition, output gap:

• The Phillips curve: where

u =L- N

L

Y = EN

u-un =L-N

L-L-N n

L= -N -N n

L= -Y / E -Y n / E

L= -Y n

EL

Y -Y n

Y n

Y =Y -Y n

Y n

p =p e +bY + z b = bY n

EL=lb

1-l

Y n

EL

Y n = EN n

13


p =p e +bY + z

14


Inflation is determined by:

• Expected inflation

• Output gap

• Unexpected shocks to productivity and non-wage costs

such as energy prices

p =p e +bY + z

15


Adjustment is probably slower for several reasons:

• Many wage agreements are multi-year agreements

• Those who set wages and prices have imperfect

information about the economic situation and it takes

time to react

• Changes in wages and prices are not synchronised

All these factors influence the speed of wage and price

adjustment and hence the slope of the Phillips curve

16

Expectations: Introduction

Question: The position of the Phillips

curve depends on expected

inflation, but how are

expectations about inflation

formed and what are the

consequences for the relation

between inflation and

production/employment?

17

Expectations: Introduction

Three cases:

The price level is expected to be the same as last year

Inflation is expected to be the same as last year

Inflation is expected to equal the inflation target

p e = 0

p e = p Ä

p te = p t-1

18

Expectations: Price level the same

Phillips curve:

What happens if the money supply increases more

quickly?

The effect of increasing M will be higher inflation and

higher production and employment.

There is a trade-off between inflation and unemployment

p = bY + z

(p e = 0)

19

Expectations: Inflation the same

But if inflation is higher, people should realise that sooner

or later. An alternative Phillips curve is

pt= p

t-1+bY

t+ z

t

(p e = p-1)

20


What happens if the money supply increases faster?

Phillips curve is not stable: when expectations haveadjusted, the effect of a faster increase of M is higherinflation but no effect on unemployment

p = p-1+bY + z

21


• Phillips curve:

• Subtraction of yields

• If production is kept above the equilibrium level, inflation will accelerate and vice-versa

• Equilibrium unemployment is sometimes called the non-accelerating-inflation rate of unemployment (NAIRU)

• The vertical line at the equilibrium level of production (or unemployment rate) is sometimes called the long-run Phillips curve (LRPC)

p = p-1+bY + z

p-1 Dp = bY + z

22


• In the long run there is no real choice between inflation and unemployment

• It is costly to keep production above the natural level: the result will be permanently higher inflation

• If inflation is high, it can be worthwhile to try to reduce it even if it is costly in terms of production and employment in the short run. The result is permanently lower inflation

23

Expectations: A strict and credible inflation target

Phillips curve: What happens if the money supply increases faster?

The effect of increased M is higher inflation andproduction. The Phillips curve is not affected as long asthe target remains credible

p =p Ä +bY + z

(p e = p Ä )

24

Relation between economic activity and inflation

25


Why is there no clear relation – no stable Phillips curve?

• When inflation has increased to a high level, it tends to

remain high because expected inflation is higher

• Equilibrium unemployment can change over time

On the other hand there is a fairly strong relation

between the output gap and the change in inflation,

which supports the Phillips curve with

that is p = p-1+bY + z

p e = p-1

Dp = bY + z

26


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SGPE Summer School: Macroeconomics Lecture 9 · Macroeconomics Lecture 9 •In the IS-LM model, we assumed that prices were given ... and price inflation: Inflation is determined