Inflation, Unemployment and Monetary Policy

Mankiw 14.2

Learning Objectives

1. Understand the relationship between inflation and unemployment (the Philips Curve)

2. Understand what is the optimal level of inflation

3. Understand the modern prescription for independent central banks

Phillips Curve

• The Philips Curve relates Unemployment to inflation

• Similar to AS curve• Unemployment and inflation are of direct

interest• Also Prices are usually rising so makes

more sense to talk of declining inflation than declining prices

• The Philips Curve mirrors the AS curve– Price level replaced by inflation– Output replaces unemployment– Natural rate of unemployment replaces

potential output

• In the SR there is a trade-off between inflation and unemployment– this is only for fixed expectations

• In the LR there is no trade off

SRPC(e)

LRPC

UU*

tte

tt uu )( *

Sources of Inflation

• The Phillips curve tells us three sources of inflation– Expectations– Unemployment gap (demand pull)– Supply shocks (cost push)

• First expectations:– If people expect inflation then actual inflation

will occur– Self-fulfilling prophecy

• How does it work?– Expect price increases

– Demand higher wages

– Need higher prices to pay for the wages

– Same mechanism as before

• Supply shocks– e.g. increase in price of oil

– Feeds through to increase all other prices

– Workers demand increase in wages to compensate

– General inflation

• Unemployment gap– Suppose increases AD to reduce unemployment (eg G

rises)– Prices are driven up– Demand for labour shifts up– Workers revise expectations (else real wage would fall)– Expect inflation so actual wages are bid up (Labour

Supply curve shifts up)– Output/employment doesn’t change

• LR at “natural level”

– Prices/inflation rise

• Note when inflation is at it expected level, unemployment is the natural rate

Accelerationist Phillips Curve

• How are expectations formed?– Assume e=t-1

– Can also model inertia

• Inflation is constant when Unemployment is equal to the natural rate– NAIRU

• Allows us to look at the effect of policy over time• Suppose start at A

– NAIRU=6, and zero inflation

• Government decides to expand AD to reduce U– Unemployment falls and economy moves to point B

– Inflation has risen to (say) 6%• Higher prices needed to get firms to produce more

• Point B cannot be long run eqm– Inflation is 6% but workers expect it to be 0%– This means real wage is falling– Workers revise there expectations after one

period and demand higher wages– New SRPC where e=6

• We are now at point C– Inflation is now 12%– Still not LR eqm

SRPC(e=12)

LRPC

U

tttt uu )( *1

SRPC(e =)

SRPC(e =)A

B

C

U*

• If gov persists in keeping unemployment below natural rate– Get ever increasing inflation– Accelerating prices

• Cannot achieve LR eqm unless unemployment is equal to its natural rate– Achieve temporary reduction in U– Permanent increase in inflation– Potential for hyperinflation

Implications

• There exists only a SR trade off between inflation and unemployment

• Attempt to use this trade off for a longer period– Ever increasing inflation– Hyperinflation

• How long is the Short Run?– For as long as it take expectations to adjust– My example was one period

• Leaves open possibility of stabilization policy

• Note how all this relates to AS and Labour Market

Disinflation

• We can use the PC to analyse the issue of deflation– i.e. how do we lower inflation without causing (much)

unemployment

• This is the flip-side of what we just looked at– What happens when we try to reduce unemployment

• We already know part of the answer– LR there is no trade-off

• No LR increase in unemployment

– SR there is a trade off• Reducing inflation will mean higher U

– Expectations play a role

SRPC(e=12)

LRPC

U

tttt uu )( *1

SRPC(e =)

SRPC(e =)

A

B

C

• Suppose we are at A– Unemployment equals its natural rate (6%)– Inflation is 12%– Too high want to reduce it

• Reduce AD (increase interest rates)– Unemployment rises: 8% > 6%– Move down the SRPC to B– Actual inflation falls

• B cannot be LR eqm (why?)– Actual Inflation (9%) is lower than expected (12%)– Real wages higher than expected– Expectations adjust down – – New SRPC

• New SR eqm at C– Still not a LR equilibrium– Inflation will keep falling for as long as U is

kept above the natural rate

• When the gov. is satisfied with the level of inflation, – allow unemployment to return to the natural

rate– Inflation stable

Sacrifice Ratio

• Disinflation achieved at a cost• U>U* for several years• Sacrifice ratio

– The increase in unemployment (above the natural rate) needed to reduce inflation by one percentage point in one year.

– My example: 0.66

Volker Disinflation Again

• Inflation fell by 6.7% over 4 years (1982-85)

• Unemployment was 9.5%, 9,5%, 7.4% and 7.1%

• Natural rate was 6%• Sacrifice ratio 1.4

Painless Disinflation• Previous example assumed

• In reality expectations could adjust a lot quicker

• Think of extreme case– Expectations adjust fully and immediately– Full immediate fall in inflation without any

increase in unemployment– Sacrifice ration of zero

CB Independence

• What is required for this?– Policy must be announced– Policy must be credible– Willing to cause pain

• Intermediate case is more realistic– More credible policy maker faces a lower sacrifice

ratio– This is the justification for independent central

bank• Bank can be mean in a way democratic

politicians would find difficult

Independence• How independent should CB be?

– How “political” or “accountable”– Varies: ECB to UK to Singapore

• Empirical evidence that independence lowers inflation– Beware of missing variables

• Theory suggests independence might matter

• Policy makers have a bias towards inflation– Would like to reduce unemployment – Works in the short run– Leads to inflation in long run

• Better to prevent yourself from using the trade-off– insulate the CB from political process– ECB

• Also can help affect expectations through credibility

Mandate of Central Banks

• Whether independent or not what should a CB seek to do?

• Most central banks are required to achieve low inflation and low unemployment

• Federal Reserve – Humphrey-Hawkins Act 1978– Maximum employment and stable prices

• ECB – Maastricht Treaty– Stable prices

• In practice the fed takes “Max employment” to mean unemployment at the natural rate

• Both Central banks take “stable” prices to mean inflation at 2% or so– Quality issues– Preferences– Boskin Commission

• See Mankiw 15.1• John Taylor proposed a rule for Central

Banks: Set rates to respond to– the gap between actual inflation and some

target inflation rate – the gap between actual unemployment and the

“natural” rate

Or– The gap between output and its natural rate

Taylor Rule

The Rule

• i* = + r* + ( – *) + log(Y/Y*)

• The monetary authorities set i*, where i* = r + and r* is the LR eqm interest rate

Using the Rule• Suppose

– r* = 0.03– Y = Y* so (Y/Y*) = 1, * = 0.02 = 0.06; = = 0.5

• then: i* = 0.06 + 0.03 + 0.5(0.06 – 0.02) = 0.11

• Short-term nominal interest rate is 0.11 or 11%

The rule in a Recession

• But suppose (Y/Y*) = 0.9 i.e. recession• then: i* = 0.06 + 0.03 + 0.5(0.06 – 0.02)

+ 0.5 log(0.9) = 0.11 – 0.5(0.046) 0.085 or 8.5%

• So rule will lead the central bank to lower interest rates in a recession

• Do Central Banks follow a Taylor Rule?

EUROZONE MMR* ACTUAL V TAYLOR RULE 1999 - 2007

FEDERAL RESERVE FFR* ACTUAL V TAYLOR RULE 1999 - 2007

Optimal Rate of Inflation• Why have the optimal rate at (or close to)

zero?– Hyperinflation costly – money ceases to

function – Moderate Inflation has Costs and Benefits

• Erode value of money

• Shoe leather costs – “trip to bank”– Electronic banking reduce a lot

• Tax Distortions– Taxed on nominal prices/income– Higher tax when inflation higher– Bracket creep– e.g. VAT, Cap Gains tax (US)– Tax system could be indexed

• Money Illusion– people think nominal increase represents a real

increase– e.g. Wages in AS-AD diagram– Other prices also– Agents make the wrong decision– Akerloff book looks at this

• Volatility– Changes in inflation imply greater risks in the

future– Inflation that is higher on average tends also

too be more volatile

• Seignorage– Benefit of inflation– Government gets to print more money– Alternative to other taxes– Inflation can be viewed as a tax– Important in cases of hyper-inflation

• Money Illusion (again!)– Could view as benefit– Think of adjustment to to a shock– Need real wages to go down– Nominal wages wont go down– Can get real wages down if nominal wages

increase by less than inflation– May not be illusion

• Negative real interest rates– Real interest rate=nominal – inflation– Reflects the true return on an investment– With inflation can get negative real interest

rates– Raise output– Japan

• Why not index?

• What is the optimal rate of inflation?– Anything between zero and 5%

Why Monetary policy?• Stabilization

• Suppose there is a shock– Economy will eventually recover– But could help it along

• Fiscal policy slower– Long and variable lags– In Europe it is not centralised

Standard Prescription

• Independent CB

• Focuses on low inflation (not zero)

• And keeping u=u*

• Fiscal Policy should focus on longer term– Not stabliztion – Public services– Infrastructure– Pensions (big deal now)

Conclusions

1. Philips curve– SR trade-off of U and inflation dependent on

expectations2. Understand what is the optimal level of

inflation– Costs of low inflation are probably small

3. Understand the modern prescription for independent central banks

– Independent CB seeks to stablise economy in general and secure low inflation (c2%)

What’s Missing?

• Philips curve was really just a reformulation of the AS curve

• We still haven't said where unemployment comes from

• We also need to more explicit about how interest rates can affect parts of AD e.g. consumption and investment