20121125 mankiw economics chapter35

Principles of Economics

Chap35 The short-‐run trade off between Infla7on and Unemployment

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What we have learned in macroeconomics

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Chap 25

Chap 26 Chap 27

Chap 28

Chap 29 Chap 30

The level and growth of productivity and real GDP

How the financial system works and How the real interest rate adjusts to balance saving and investment

Why there is always some unemployment in the economy

The monetary system and how changes in the money supply affect the price level,the inflation rate, and the nominal interest rate

Chap 31 Chap 32

Extension of this analysis to open economies to explain the trade balance and the exchange rate.

GDP

Financial system

Unemployment

Monetary system

Open Economy

Chapter Key words Contents

Chap 33 .Discussing some of the important facts about short run fluctuations in economic activity and introducing a basic model to explain those fluctuations.

Aggregate demand and aggregate supply

Chap 34 ・How monetary policy influences aggregate demand. ・How fiscal policy influences aggregate demand

Aggregate demand and aggregate supply

The long run determinants of unemployment rate and infla7on

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Unemployment Inflation

Labor Makers -minimum wage laws -the market power of union -the role of efficiency wages

Monetary Markets -growth in the money supply -a nation’s central bank controls

Largely unrelated problems in the long run

Ten Principles of Economics

Ⅰ.How People Make Decisions. 1:People Face Trade-offs. 2:The Cost of Something Is What You Give Up to Get It. 3:Rational People Think at the Margin. 4:People Respond to Incentives. Ⅱ.How People Interact. 5:Trade Can Make Everyone Better Off. 6:Markets Are Usually a Goodway to Organize Economic Activity. 7:Governments Can Sometimes Improve Market Outcomes. Ⅲ.How the Economy as a Whole Works 8:A Country's Standard of Living Depends on its Ability to Produce Goods and

Services. 9:Prices Rise When the Government Prints Too Much Money. 10:Society Faces a Short-Run Trade-off between Inflation and Unemployment.

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Probably the single most important macroeconomics relationship is the Phillips curve

Origins of the Phillips Curve

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p  Phillips showed the negative correlation between the rate of unemployment and the rate of inflation based on date for the United Kingdom through publishing article in 1958.

p  Paul Samuelson and Robert Solow also showed a similar negative correlation between the rate of unemployment and the rate of inflation in data for United States.

p  According to Samuelson and Solow, policy makers face a trade off between inflation and unemployment, and the Phillips curve illustrates that trade-off.

Unemployment rate(%)

Inflation rate (% year)

4% 7%

6%

2%

Aggregate demand and aggregate supply, and the Phillips Curve

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p  The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve.

p  Because monetary and fiscal policy can shifts the aggregate demand curve, they can move an economy along the Phillips curve.

p  The Phillips curve offers policymakers a menu of combination of inflation and unemployment.



Quantity of output

Price level

7% 4%

6%

2%

A

B 106

102

Unemployment Is 7%

Unemployment Is 4%

The Phillips Curve The model of aggregate demand and aggregate supply

The Phillips curve seems to offer policy maker a menu of possible infla7on unemployment outcome. But does this menu of choices remain the same over7me?

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The long-‐run Phillips curve

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p  According to Friedman and Phelps, there is no trade-off between inflation and unemployment in the long run.

p Growth in the money supply determines inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical.



Quantity Of output

Price level

Natural rate Of return

B

A

B

A

P2

P1


How to reduce natural rate of unemployment

•  Policy makers should look to policies that improve the func7oning of the labor market – Minimum wage laws – Collec7ve bargaining laws – Unemployment insurance –  Job training program

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The short run Phillips curve

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Unemployment rate =

Natural rat of Unemployment

a Actual inflation

Expected inflation

In the short-‐run

In the long-‐run People come to expect whatever infla7on the Fed produces , so actual infla7on equals expected infla7on , and unemployment is at its natural rate.

Expected infla7on is given, so higher actual infla7on rate is associated with lower unemployment rate

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The natural experiment for the Natural-‐rate hypothesis

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p  Friedman and Phelps had made a bold prediction in 1968.

p  If policy maker try to take advantage of the Phillips curve by choosing higher inflation to reduce unemployment, they will succeed at reducing unemployment only temporarily.

Natural rate of unemployment

B

A

C

The long run Phillips Curve

[case]data from 1961 to 1968 The Phillips curve in the 1960s

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p This figure uses annual data from 1961 to 1968 on the employment rate and on the inflation to show the negative relationship between inflation and unemployment.

[case]data from 1961 to 1973 The break down of the Phillips curve

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p  The Phillips curve of the 1960s breaks down in the early 1970s, just as Friedman and Phelps had predicted.

p  Notice that the points labeled A, B, and C in this figure correspond roughly to the points in figure of page 12.

Shi[ in the Phillips curve The role of supply shock

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Quantity Of output

Price level



B

A

P2

P1

B

A

AS1

AS2

p In 1974, OPEC began to exert its market power as a cartel in the world oil market to increase its member’s profits.

p A large increase in the world price of oil is an example of oil is an example of a supply shock. A supply shock is an event that directly affects firm’s costs of production and thus the prices they charge; it shifts the economy’s aggregate supply curve and, as a result the Phillips curve.

p Confronted with such an adverse shifts in the Phillips curve, policy makers face a difficult choice between fighting inflation and unemployment further.

p Faced with such an adverse shifts in the Phillips curve, policy makers will ask whether the shift is temporary or permanent. The answer depends on how people adjust their expectations of inflation.

Y1 Y2


[case] data from 1972 to 1981 the period 1973-‐1975 and 1978-‐1981

The supply shock of the 1970s

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p  In the period 1973-1975 and 1978-1981, increases in world oil prices led to higher inflation and higher unemployment.

Disinfla7onary monetary policy in the short run and long run

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Long run Phillips Curve

A

C

B

Natural rate of Unemployment

Short run Phillips curve with high expected infla7on.

Short run Phillips curve with low expected infla7on.

p  If a nation wants to reduce inflation, it must endure a period of high unemployment and low input.

p  When the Fed pursues contractionary monetary policy to reduce inflation, the economy moves along a short run Phillips curve from point A to B.

p  Over time ,expected inflation falls, and the short run Phillips curve shifts downward. p  When the economy reaches point C, unemployment is back at its natural rate.

Sacrifice ra7o

•  The sacrifice ra7o is the number of percentage points if annual output lost in the process of reducing infla7on by 1% point.

•  A typical es7mate of sacrifice ra7o is 5.

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[case]from 1979 to 1987 The Volcker disinfla7on

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p The reduction in inflation during this period came at the cost of very high unemployment in 1982 and 1983.

p Note that the points labeled A, B, and C in this figure correspond roughly to the the points in page 17.

[case] data from 1984 to 2005 The Greenspan Era

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p During most of this period, Alan Greenspan was chairman of the Federal Reserve.

p Fluctuations in inflation and unemployment were relatively small.

[case]data from 2006 to 2009 The Phillips curve during the financial crisis

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p A financial crisis caused aggregate demand to plummet, leading to much higher unemployment and pushing inflation down to a very low level.

Economy & Finance

20121125 mankiw economics chapter35