Macroeconomics

Session 12 & 13

6-1
• The price-output relation along the aggregate supply
curve is built up from the links among wages, prices,
employment, and output.
• The link between unemployment (on the Phillips curve)
and inflation is called the Phillips curve.
• Examine the dynamic adjustment process that carries us
from the short run to the long run.
• the numbers we see every day are the unemployment rate
and the inflation rate.
• The Phillips curve uses these more convenient measures.
• Unemployment: gap b/w actual and potential output; inflation:?
6-2
• All modern models, however different their starting
points, tend to reach a similar result: that in the short run
the aggregate supply curve is flat, but in the long run it is
vertical.

• Demonstrate the translation between the aggregate supply

curve and the Phillips curve.
• GDP connects to unemployment; potential GDP connects to the
natural rate of unemployment; the price level connects to the
inflation rate.

6-3
 Output and Unemployment
• Figure shows U.S. unemployment
from 1959 to 2014
• Several periods of high
unemployment: early 1960s, mid
1970’s, early-mid 1980’s, early
1990s, 2000s
• Several periods of low
unemployment: late 1960’s, early
2000
• A link between falling output and
unemployment

6-4
Demand Vs Supply Side Inflation

6-5
 Unemployment and Inflation in US
• In US in 2017
• U = 4.5%, I = 2%
• Had aggregate demand
grown faster, inflation
would have been higher and
unemployment would have
been lower.
• had aggregate demand
grown more slowly than it
actually did, unemployment
would have been higher and
inflation lower

6-6
 The Phillips Curve
•• In 1958 A.W. Phillips [Insert Figure 6.2 here]
published a study of wage
behavior in the U.K. between
1861 and 1957
•The main findings are
summarized
 There in the Figure
is an inverse relationship
 between
There is the
an inverse
rate of relationship
between the rateand
unemployment of the rate of
unemployment
increase in moneyandwages
the rate of
increase
 From in money wages
a policymaker’s
From a policymaker’s
 perspective, there is a tradeoff
perspective,
between wagethere is a tradeoff
inflation and
between wage inflation and
unemployment
unemployment

6-7
 AS

D A
112 12
Price level

C B
108 8
C
B
AD4

Inflation Rate
104 4
A D
AD3
100 0
AD2
AD1 PC

6.0 6.2 6.4 Y* = 6.6 2 4 6 8

Real GDP Unemployment Rate

6-8
 Explaining the Phillips curve

“If fluctuations in economic activity are caused primarily

by variations in the rate at which the aggregate demand
curve shifts outward from year to year, then the data should
show an inverse relationship between unemployment and
inflation.”

6-9
A Phillips Curve for the United States,
1954–1969

6-10
• Changes in the growth rate of aggregate demand caused:
• Economic fluctuations in Great Britain between 1861 and 1913
• In United States between 1954 and 1969

• The simple model of demand-side inflation really does

seem to describe what happened.

6-11
 The Policy Tradeoff
• PC quickly became a
cornerstone of macroeconomic
policy analysis since it
suggests that policy makers
could choose different
combinations of u and  rates
• Can choose low u if willing to
accept high  (late 1960’s)
• Can maintain low  by having
high u (early 1960’s)

6-12
 PC for the United States (1970-84)???
• Given the unemployment
rates in each of the years,
inflation was astonishingly
high by past standards.
• Something went badly
wrong with the old view
of the Phillips curve

6-13
 PC for the United States (1970-84)???
• Supply side Inflation
during 1970-84
• crop failures -1972–1973
• oil price increases-1973–74
and again in 1979–80.
• In case of supply shock:
• output declines (or grows
more slowly) and prices rise
• Thus, inflation and
unemployment rise
together
6-14
 One Explanation

“If fluctuations in economic activity emanate from the

supply side, higher rates of inflation will be associated with
higher rates of unemployment, and lower rates of inflation
will be associated with lower rates of unemployment.”

6-15
 Another Explanation - Self-correcting
Mechanism
• Policymakers misinterpreted the Phillips curve and tried to
pick combinations of inflation and unemployment that
were unsustainable in the long run.
• Self-correcting mechanism cures both inflations and
recessions eventually, even if the government does nothing.
• If economy is far from normal full-employment level of
unemployment
• many combinations of output and prices cannot be maintained
indefinitely. Some will self-destruct.
• forces will be set in motion that tend to erode the inflationary or
recessionary gap.

6-16
 Self-correcting Mechanism
(Recessionary Gap)
• AS intersects DD at A
• the economy has unused
industrial capacity and
unsold output, so inflation
will likely be falling.
• availability of unemployed
workers limits the wage
rates to push up.
• Wages and costs decline –
stimulate production
• AS shifts – S0 to S1
(Economy moves - Point B)
6-17
• Point a here corresponds
to point A in previous fig
• The adjustment path from
A to C previously appears
here as a movement
toward less inflation and
less unemployment—point
a to c

6-18
 Inflationary Gap
• Inflationary gap – point d
• Low unemployment >
higher wages and prices >
low real money supply>
high interest rates> low
consumer spending > low
production > high
unemployment
• unemployment and
inflation both rise (point f)

6-19
 “Neither points corresponding to an inflationary gap (like
point d) nor points corresponding to a recessionary gap
(like point a) can be maintained indefinitely. Inflationary
gaps lead to rising unemployment and rising inflation.
Recessionary gaps lead to falling inflation and falling
unemployment”

•All the points that are sustainable in the long run (such as
c, e, and f ) correspond to the same rate of unemployment,
which is, therefore, called the natural rate of
unemployment - “full-employment” unemployment rate.
6-20
 Short vs. Long run
• PC connecting points d, e,
and a is not a menu of
policy choices at all.
• AD stimulus may move
economy from e to d
• d not sustainable -
unemployment may not be
kept so low indefinitely
• policymakers must choose
from among points such as
c, e, and f
6-21
 Short vs. Long run
• In the short run, it is
possible to “ride up/down
the Phillips curve” toward
lower/higher levels of
unemployment by
stimulating aggregate
demand (d/a) – short run
trade-off.
• No such trade-off in the
long run

6-22
• The self-correcting mechanism ensures that
unemployment will eventually return to the natural rate
no matter what happens to aggregate demand.
• In the long run, faster growth of demand leads only to
higher inflation, not to lower unemployment; and
• Slower growth of demand leads only to lower inflation,
not to higher unemployment.

6-23
 Policies for Fighting Unemployment

Should the government use its ability to manage aggregate

demand through fiscal and monetary policy to combat
unemployment? And if so, how?

6-24
• In US, before GFC –
Unemployment rate – 5%
• Gradually unemployment
went up to 10% (from e to
a) – recessionary gap
• SCM would have self-
corrected (reaching c)
• Low inflation and
unemployment – Good?
• How much time period for
adjustment??
6-25
• Instead, Fed started cutting
interest rates aggressively
in 2008
• Tax cut and fiscal stimulus
• Large doses to push the
economy from a towards e
• Strong policy responses
leading to a faster recovery
• But with a higher inflation
rate

6-26
 What should be done?
• SCM (c) and expansionary
policies (e) worked
simultaneously
• The net result was an
intermediate path (g)
• Economy started to return
slowly to full employment
in 2010 and after, growth
resumed and inflation was
relatively stable.

6-27
 Short Run and Long Run Philips Curve

LR Philips Curve

F
12 G
D
9 E

6 C
B
Inflation Rate

3
A SRPC3

SRPC2

SRPC1

2 4 6 - NRU

Unemployment Rate

6-28
 AD-AS Model and Macro Principles
• Macro policies impact AS

economic outcomes with a 8

lag 6 B

• Policies that only A

Inflation
4

increases AD result in AD2

2
• short term output growth
and long term high inflation AD1

• Increase in revenue exp. > 6.0 6.2 6.4 6.5

increased AD > inflation > Real GDP

increased interest rates >

reduced investment >
reduced output growth
6-29
 AD-AS Model and Macro Principles
• Policies that increases AS1 AS2

both AD and AS result in 8

• long term output growth 6

without high inflation

Inflation
A
4 B
• Increase in capital
exp./structural reforms > 2
AD2

increased AD and AS > AD1

stable prices >
6.0
accommodative monetary 6.2 6.4 6.6

Real GDP
policy > increased
investment > increased
output growth

6-30
 AD-AS Model and Macro Principles
• Revenue exp is myopic policymaking while capex is far
sighted policymaking
• No multiplier effect of revenue exp. (Rs. 100 exp. > Rs. 98-99
spending) – enhances demand temporarily
• Capital Exp. Multiplier – 2.45 in first year and 4.85 in later years
• Enhances supply, keeps inflation low

• Capex increases both demand and supply while revenue

only increases demand
• Capex creates assets increasing the AS; also increases AD by
creating jobs in formal and informal sectors

6-31
 AD-AS Model and Macro Principles
• Capex “crowds in” private investment while revenue exp
“crowds out” private investment
• Capex - Construction activity has linkages with steel and cement
where private investment increases – income as well as the pool
of savings increases
• Revenue exp – Income and pool of savings does not increase

6-32
 India’s response to GFC
• Increased RE (27%) but decreased CE (4.83%) in 2008-
09 – lead to triple whammy of high FD-Inflation-CAD
• Investment (% of GDP) decreased from 35.8% in 2007 to 31.3%
in 2013.
• Fiscal deficit was 2.5% in 2007; remained above 4.5% for each
year from 2008-13 with peak of 6.5% in 2009
• Increase in AD without much increase in AS lead sharp rise in
inflation from 6.37% in 2007 to 8.34-10.9-12-8.8-9.3-10.9 in
2013
• Increased AD without AS deteriorated CAD from 1% in 2006 to
4.8% in 2012
• No structural reforms carried out during and post-GFC
6-33
 Covid-19 Pandemic
• Policy Response to Covid
AS2
Shock (2019-20 to 2021-
AS1
22): B
6.3 A
• Increase in Capex – 29%

Inflation
5
• Increase in Revenue Exp.
(12%)
AD1
AD2

Y2 Y3

Real GDP

6-34
 Mid Term Questions
Q1. Imagine a world with two large economies. In the first
economy, Derekland, savings, investment and consumption
decisions are governed by the following two equations (the
subscript d and p denote the name of the two countries):
Sd= 450 + 1000r; Id = 550 − 1500r
In the other economy, Pabstania, the same decisions are
governed by : Sp = 900 + 1000r; Ip = 950 − 1400r
Furthermore, both governments spend an equal amount of
Gd = Gp = 400 and production is slightly higher in
Derekland with Yd = 2000 while Yp = 1950 in Pabstania.

6-35
 Mid Term Questions
A. Assume the marginal propensity to consume is 0.6 in
both countries. An election occurs at the same time in each
country, so governments give tax breaks of 100 to
consumers (while government spending remains the same).
In Derekland, consumers anticipate an increase in future
taxation for the 100 spent by the government. In Pabstania,
consumers do not anticipate changes in future tax rates (or
do not care about it) and thus they see this tax break as an
increase in their income. How does the reaction of
consumers differ in the two countries? Find the equilibrium
interest rate. (Hint: the savings function change)

6-36
 Mid Term Questions
• In Derekland, consumers anticipate future taxation to pay
for the 100 spent and thus, they do not change their
consumption behavior. Hence they save all their tax
break, which compensates the loss of government
savings.
• Sd = 450 + 100 − 100 + 1000r = 450 + 1000r
• In Pabstania, tax break is seen as an increase in income
and is split according to their MPC (0.6), eg, 60
consumption and 40 savings, while the government
decreases savings by 100. New savings functions:
• Sp = 900 + 40 − 100 + 1000r = 840 + 1000r
6-37
 Mid Term Questions
• In both cases, we must have that savings equals
investment demand :
• For Derekland: 450 + 1000r = 550 − 1500rd
• ⇔ 2500rd = 100 ⇔ rd = 0.04
• For Pabstania: : 840 + 1000r = 950 − 1400rp
• ⇔ 2400rp = 110 ⇔ rp = 0.045

6-38
• Q.2 A. The public is less sensitive to changes in interest
rates on their willingness to hold money.

• The LM curve will become steeper, while maintaining

the same intercept on the income axis. The interest
rate will rise causing investment and consumption to
decrease, and bond prices to fall unless the money
supply is increased.

6-39
• Q.2 B. What is likely to happen to interest rates if a fiscal
policy deficit occurs and the RBI does not act to change
the money supply?

• Under normal IS and LM slopes, a fiscal policy deficit

shifts the IS curve to the right increasing income and
the interest rate. Without more money, the interest
rate rises to partially crowd out public spending by
reduced investment spending.

6-40