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Learning Objectives
Understand the theory of the Phillips curve, which shows
that there is a trade-off between unemployment and
inflation.
Recognise that the trade-off is different in the short run and
the long run, and the transition between short and long run
is governed by the way expectations are formed and the
degree of flexibility in wages and prices.
Analyse the policy choices while considering the costs of
unemployment and inflation.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Learning Objectives
Explain how monetary policy can be used to control the
rate of inflation, and how the Phillips Curve framework is
used to formulate monetary policy.
Recognise how the importance of monetary policy has
grown as policy makers place an increasing emphasis on
the control of inflation.
Investigate the reasons behind the recent trend for making
central banks independent and analyse the time
inconsistency problem
Cover the concepts of seignorage and hyper-inflation
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Monetary policy
Monetary policy refers to the control of either the quantity
or the price of money. The importance of monetary policy
has grown as policy makers place a growing emphasis on
the control of inflation.
The traditional goal of full employment has been
supplanted by target of economic stability, and as a result,
the tools the government uses to control the economy have
shifted away from fiscal (demand management) to
monetary policy.
The theory of the Phillips curve is very useful here, as it can
explain how monetary policy could be used to control the
rate of inflation.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
The level of inflation refers to the rate at which prices are changing:
Theories of Unemployment
There are two important concepts of labour market
equilibrium, but both share similar foundations, that is,
wages will move in the same direction as the difference
between demand and supply pressures in the labour market.
The natural rate of unemployment is essentially the level
of unemployment that results when the labour market is in
equilibrium.
Under competitive conditions, the labour market is in
equilibrium when the demand and supply of labour are
equal to each other.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
unr U L
Nd N s U U
When prices are set equal to marginal costs price inflation is equal to
wage inflation, so the Phillips curve can be written as:
P
unr u
P
The Phillips curve implies that inflation will be negatively related to the
difference between unemployment and the natural rate.
NAIRU
In this set up, unions set wages and firms set prices.
W P Z u
e
NAIRU
The bargained real wage is downward sloping with respect
to unemployment, implying that unions will moderate wage
demands when unemployment is high, but in times of a
tight labour market, will be more ambitious about what can
be achieved.
The price-setting relationship, also known as the Feasible
Real Wage (FRW), describes the way that firms set prices.
Essentially, these are just a mark up over costs, which are in
turn defined by the ratio of wages to labour productivity
(LP):
W
P 1
LP
NAIRU
In terms of the real wage, the FRW is unrelated to the level of
unemployment and is just determined by product market
conditions (mark up) and productivity.
The NAIRU is found at the intersection of the price-setting
(FRW) and wage-setting (BRW) schedules.
Again, prices will change as a result of disequilibrium. If
unemployment is below the NAIRU, then the BRW is above
the FRW. Consequently, high wage demands by workers will
lead to higher prices. Correspondingly, when unemployment
is above the NAIRU, moderating wage demands will put
downward pressure on prices. Again, the rate at which prices
change is assumed to be proportionally related to the size of
the disequilibrium.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
NAIRU
Phillips curve
As the change in nominal wages reflects the
difference between unemployment and the
NAIRU, then we can once again generate a
Phillips curve type relationship:
W
g u un
W
u un
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
P W
P
W
Empirical Evidence
In general, wage inflation
lies above price inflation,
although both clearly
follow similar trends.
The difference is mainly
accounted for by a positive
growth in productivity,
which allows the real wage
to grow over time in line
with living standards.
Inflation
Although the trade-off between unemployment and
inflation started out as an empirical observation, the Phillips
curve has played a central role in policy making for more
than 30 years. The Phillips curve was seen as a trade-off
frontier for policy makers. Lower unemployment can be
bought with higher inflation and vice versa. The role of
economic policy is to choose the preferred point on this
frontier.
In making these policy choices, the government is
effectively trying to reach the lowest level of misery
neither inflation nor unemployment is desirable. The
theory of choice is therefore not about utility maximisation
but the minimisation of disutility.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Costs of Unemployment
The costs associated with unemployment can be divided
into two sorts: social and economic.
Social Costs: Poverty, crime, social/personal esteem.
Economic Costs: There are two main economic costs
associated with unemployment.
Efficiency
Budgetary
Costs of Inflation
The costs associated with rising prices can be split,
depending on whether inflation is anticipated or
unanticipated.
Anticipated: Menu and shoe leather costs
Unanticipated:
Redistribution
Instability: Probably, the main concern for
maintaining low and stable inflation is that it
creates conditions which are amenable for long
term investment.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Benefits of Inflation
If there are costs to inflation, should policy makers
aim to achieve zero inflation? In fact, should we go
further and actually target a negative rate of
inflation? This would imply falling prices known as
deflation.
The answers to these questions are:
Policy makers tend to prefer a low positive rate
of inflation rather than zero inflation.
Deflation is regarded as being just as bad, if not
worse, than high inflation.
Global Applications 10.2 Japan
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
U U , u
Policy Choices
An indifference curve plots the combinations of inflation
and unemployment that give the same level of (dis)utility.
Each level of (dis)utility will be synonymous with a
different indifference curve.
As both inflation and unemployment are bads, the lower
the indifference curve, the better.
The policy maker is made better off as he moves from
I1 I 2 I3 .
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Policy Choices
Policy Choices
The indifference curves are concave to the origin, which
implies that policy makers prefer averages to extremes.
This suggests that if unemployment is high, the policy
maker would be preferred to trade off a higher increase in
inflation to reduce unemployment than if unemployment
were low. The same would apply to inflation. The policy
maker will act to minimise the total amount of disutility that
is suffered.
The Phillips curve represents the menu of inflationunemployment outcomes from which the policy maker can
choose. The rational choice is the lowest indifference curve
that is consistent with a position on the Phillips curve. This
is where the two curves are tangential to each other.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Optimal unemployment-inflation
combination
Policy Choices
In this framework, the combination of unemployment and
inflation that the economy ends up with will reflect the
preferences of the policy maker.
If the policy maker is very adverse to high unemployment,
then he is now more willing to trade off higher inflation for
lower unemployment, the indifference curves are skewed
towards verticality.
If the policy maker is highly adverse to inflation, then he
would be prepare to trade off higher levels of unemployment
for lower inflation. The indifferences curves reflecting these
preferences are flatter and the economy ends up in a position
where unemployment is higher and inflation is lower.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
un u
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
W P e Z u
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
P 1
LP
LP
Therefore:
P e W P
e
P
W
P
te te1 1 t 1
Adaptive Expectations
Adaptive Expectations
Suppose the economy starts of with unemployment at the
natural rate, and actual and expected inflation equal to one
another at point a.
The government, however, decides that the current rate of
unemployment is too high and unleashes an expansionary
policy (fiscal or monetary) with the aim of reducing
unemployment. As the expected price level rises, the
Phillips curve will shift upwards to point b.
However, because the expected price level lags behind the
actual price level, the expected real wage will still exceed
the equilibrium level. There will be further upward pressure
on prices and the economy moves to point c.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Adaptive Expectations
Over time, the expected level of inflation will eventually
catch up with the actual level of inflation and the economy
will return to is long run equilibrium position.
This exercise demonstrates that under the adaptive
expectations framework, policy changes will only be able to
exploit a short run trade-off between unemployment and
inflation. In the long run, when expectations fully adjust, it
will be the case that policy can have no effect on the level
of unemployment, only on inflation which has risen
permanently to a higher level representing a higher point on
the long run Phillips curve, point d.
Rational Expectations
The major criticism levelled at adaptive
expectations is that it only makes use of past
information. Forming expectations using only a
subset of information available is deemed to be
sub-optimal and irrational behaviour.
Expectations which are formed rationally use all
available information: e E I
t
Rational Expectations
Rational Expectations
Rational expectations was a revolutionary concept, arguing
that the short run trade-off between unemployment and
inflation no longer existed.
When expectations are formed rationally, changes in policy
will not influence the level of unemployment at all, not even
in the short run. Agents in the private sector are fully aware
of the consequences of the policy action and will immediately
adjust their expectations of inflation. Consequentially, wages
will stay in tune with prices. If the real wage does not change,
the rate of unemployment will not deviate from the NAIRU.
Rational expectations and the vertical long run Phillips curve
are very important in monetary policy.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Supply Shocks
Supply side shocks can lead to a change in the equilibrium
level of unemployment. These have been explained
previously and principally fall into two categories.
First, there are factors which impact upon labour
productivity, which leads to shifts in the price-setting or
feasible real wage schedule.
Second, anything which affects the bargaining power of
labour will also influence the equilibrium level of
unemployment via movements in the wage-setting or
bargained real wage schedule. These might include labour
market legislation, trade union power, and the replacement
ratio, amongst others.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Supply Shocks
Policy Neutrality
The important implication of the NAIRU concept
is that in the long run, the unemployment rate can
only change as a result of a change in the NAIRU.
This has a strong bearing on policy makers. If
unemployment is to be tackled in the long term,
then policies should concentrate on the supply
rather than the demand side.
Hysteresis
In the long run, the Phillips curve is vertical at the
equilibrium rate of unemployment, indicating that no tradeoff exists between unemployment and inflation. However,
this does not rule out the possibility that the equilibrium
rate of unemployment is open to change.
The NAIRU has been found to have changed over time and
the evidence suggests that there is a close relationship
between the NAIRU and the actual rate of unemployment.
Hysteresis refers to the notion that short run changes in
unemployment can influence the NAIRU. In this case,
short run changes in unemployment can become
remarkably persistent.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Hysteresis
Hysteresis
The concept of hysteresis is of growing importance in
economics. This is due to a new interest in what is defined as
the medium run.
As the short run can effectively be a considerable period of
time, the medium run is used to describe situations where
there are fairly persistent, but not necessarily permanent,
movements in a series such as unemployment.
This might be one reason why estimates of the NAIRU tend
to track the actual rate of unemployment.
One important example of hysteresis is the rise in
unemployment in Europe.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Why is hysteresis
empirically most
applicable to the
economies of
continental Europe?
Hysteresis Mechanisms
How do short run movements in the
unemployment rate become permanent?
Several different types of hysteresis
mechanisms have been proposed:
Insider-Outsider Mechanisms
Long run unemployment
Insider-Outsider Mechanisms
P v Y M
P v Y M
P M
P
M
So,
Monetary Targeting
The expectations augmented Phillips curve highlights the
important role that expectations of inflation play in
establishing the actual rate of inflation in an economy.
If the government considered the current level of inflation
to be too high, it could simply reduce the money supply.
When expectations are formed adaptively, the level of
output will rise above the natural rate and there will be
downward pressure on prices. Eventually, as expectations
catch up with the actual rate of inflation, the economy will
settle at the equilibrium rate of unemployment, but also at a
lower actual and expected rate of inflation.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Monetary Targeting
Monetary Targeting
Inflation targeting
Continued financial deregulation means that monetary
authorities are unlikely to exert complete control over the
domestic money supply. This was described as trying to
control without controls.
The policy of targeting the money supply is aimed at
achieving a target inflation rate. The solution to the
problems might be to target the inflation rate directly.
Inflation is likely to arise when the economy deviates form
the NAIRU. Therefore, maintaining an inflation target
requires the economy to be maintained at this level. As the
interest rate is likely to control domestic activity, it can be
used in keep the economy at its NAIRU.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
S gM
L Y , r
S g M L Y , rreal g M
Seignorage revenue
Hyper-inflation
In the short run, an increase in the growth rate of the money
supply may lead to little change in real money balances.
However, over time as prices adjust, the government will
find the same rate of money growth yields lower seignorage
revenue. Therefore, in order to fund persistent deficits, it
will have to continuously increase the growth of its money
supply. If there was no lag between money growth and the
updating of inflation expectations, then the demand for
money would fall immediately when the money growth rate
was increased.
Therefore, hyper-inflation requires the acceleration in the
growth of money to stay one step ahead of the updating of
expectations. Ever increasing growth in the money stock
will generate an increase in seignorage revenues.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Hyper-inflation
Hyper-inflation usually starts when a government faces a
large budget deficit that requires painful policy measures to
offset. Seignorage is then seen as an easy way out.
Hyper-inflations do not blow themselves out; inflation will
continue to accelerate and can only be stopped by
intervention:
A credible commitment to reducing the budget deficit
through tax increases or reductions in government
spending.
A credible commitment from the monetary authorities to
stop printing money for the purposes of paying the debt.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Summary
The control of unemployment and inflation has been a
longstanding preoccupation of macroeconomists. We
covered the theory of the Phillips curve, which shows that
there is a trade-off between the two.
We saw that there is ample evidence to suggest that the
trade-off is different in the short run and the long run, and
the transition between short and long run is governed by the
way expectations are formed and the degree of flexibility in
wages and prices.
Policy makers face a dilemma in trading off unemployment
and inflation. They use policy to make the trade-off based
on their preferences between unemployment and inflation.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Summary
The theory of the Phillips curve is very useful here, as it can
be used to explain how monetary policy can be used to
control the rate of inflation. More than this, it is the
framework that is generally used to formulate monetary
policy.
The importance of monetary policy has grown as policy
makers place an increasing emphasis on the control of
inflation. Also, the traditional goal of full employment has
been supplanted by target of economic stability, and as a
result, the tools the government uses to control the economy
have shifted away from fiscal (demand management) to
monetary policy.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning
Summary
The reasons behind the recent trend for making
central banks independent can be described using
the Phillips curve theory. In particular, the time
inconsistency problem can be understood.
Solving the time inconsistency problem involves
delegation of monetary policy and the creation of
an independent central bank, among others.
Finally, seignorage and hyper-inflation were
covered as interesting episodes.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
2006 Cengage Learning