Aggregate Supply & Phillips Curve PDF

AG G R E G AT E S U P P LY & T H E P H I L L I P S C U RV E Week 7 V I VA L D O MENDES I NSTITUTO UNIVERSITÁRIO DE LISBOA – ISCTE-IUL [email protected] O CTOBER 2024 1/29 1. T h e P h i l l i p s C u rv e...

AG G R E G AT E S U P P LY & T H E P H I L L I P S C U RV E Week 7 V I VA L D O MENDES I NSTITUTO UNIVERSITÁRIO DE LISBOA – ISCTE-IUL [email protected] O CTOBER 2024 1/29 1. T h e P h i l l i p s C u rv e 2/29 T h e Pa i n s o f F i g h t i n g I n f l at i o n Fed Funds Rate Inflation "We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t." Jay Powel, Chair of the Fed, 21 Sept. 2022 3/29 T h e P h i l l i p s C u rv e ( P C ) Almarin Phillips discovered in the 1950s the kind of pain we have to suffer from reducing inflation. The PC shows how much more unemployment we will get (U ), to reduce the inflation rate (π). The PC was easily confirmed in the 1960s. 4/29 T h e P h i l l i p s C u rv e i n t h e 1 9 7 0 s In the 1970s, the PC begins to display a strange configuration: it seems to move constantly, looping around. 5/29 T h e P h i l l i p s C u rv e i n t h e 1 9 8 0 s In the 1980s, the PC seems to have different slopes. 6/29 T h e F r i e d m a n - P h e l p s P C C u rv e In the late 1960s, Milton Friedman and Edmund Phelps showed that if inflation expectations (π e ) were added to the original PC, we could explain those strange behaviors. According to them, the expectations-augmented Phillips Curve should be: π = π e − ω (U − Un ) (1) π inflation rate π e expected inflation rate U unemployment rate Un natural unemployment rate (U − Un ) cyclical unemployment rate ω is a parameter 7/29 Oil Prices Shocks Large shocks in oil prices have been a recurrent major characteristic of the world economy since the early 1970s. 8/29 T h e P C w i t h S u p p ly S h o c k s Shocks in oil prices affect production costs and as such they interfere in the relationship between inflation and unemployment. For example, if oil prices increase a lot, production costs will also rise substantially, and inflation goes up, for every level of unemployment. The Covid19 pandemic has been a colossal shock on the supply side. The Phillips Curve can easily accommodate these kind of shocks: π = π e − ω (U − Un ) + ρ (2) where ρ represent the external shocks that hit the production side of the economy. 9/29 T h e P C w i t h A da p t i v e E x p e c tat i o n s The PC we will work with in this course includes three major ingredients: 1. Adaptive expectations: contracts involving wages and prices are linked to past inflation, so inflation expectations adjust slowly to new circumstances: π e = π−1 2. Cyclical unemployment: U − Un 3. Shocks: ρ Therefore: π = π−1 − ω (U − Un ) + ρ (3) 10/29 T h e P h i l l i p s C u rv e : g r a p h i c a l r e p r e s e n tat i o n If we want a lower unemployment rate, we have to accept a higher inflation rate; assuming everything else constant (Un , π e , ρ). 11/29 2. S h i f t s i n t h e P h i l l i p s C u rv e 12/29 Shifts in the PC The PC will move to the right (higher inflation rate for a given unemployment rate) if any of the following facts occur: Inflation expectations go up: ↑ π e The natural rate of unemployment goes up: ↑ Un A negative supply shock: ↑ ρ – Oil prices go up – A war cuts the supply of products – A pandemic disrupts supply chains 13/29 H i g h e r πe s h i f t s t h e P C t o t h e R i g h t π = π e − ω (U − Un ) , ω = 1.5, πte = πt−1 14/29 T h e S h o rt / L o n g Ru n P h i l l i p s C u rv e s Shifts in the PC show a new concept: the Long Run Phillips Curve (LRPC). 15/29 L ow e r π e s h i f t s t h e P C t o t h e l e f t π = π e − ω (U − Un ) , ω = 1.5, πte = πt−1 16/29 T h e S h o rt / L o n g Ru n P h i l l i p s C u rv e s A deflationary process caused by lower π e 17/29 3. T h e O k u n ’ s L aw 18/29 T h e O k u n ’ s L aw Arthur Okun showed in the early 1960s that there is a negative relationship between cyclical unemployment and the output-gap: = −θ × Y − Y P
U − Un (4) | {z } | {z } Cyclical unemployment Output-gap where θ is a parameter, usually θ ' 0.5 for the USA economy. Arthur M. Okun (1962). "Potential GNP: Its Measurement and Significance". Reprinted as Cowles Foundation Paper 190. 19/29 T h e O k u n ’ s L aw f o r t h e U S A The slope of the curve is −0.441392 for the period 1960-2019. 20/29 4. T h e Ag g r e g at e S u p p ly F u n c t i o n ( A S ) 21/29 T h e S h o rt Ru n A S C u rv e : D e r i vat i o n The short-run Aggregate Supply curve (AS) is obtained by inserting the Okun’s law into the Phillips Curve (PC) π = π e − ω (U − Un ) + ρ U − Un = −θ × Y − Y P
Therefore: π = π e − ω × −θ Y − Y P +ρ 
 (5) | {z } =U −Un To simplify notation we will use: γ = ωθ. So, the short-run AS curve is given by: π = πe + γ Y − Y P + ρ
(6) 22/29 T h e S h o rt Ru n A S F u n c t i o n : R e p r e s e n tat i o n 23/29 T h e L o n g Ru n A S F u n c t i o n : D e r i vat i o n Suppose there are no shocks: ρ = 0 Suppose inflation expectations are anchored, that is, they are stable: π = π e = π−1 If we insert these two assumptions in the AS curve π = πe + γ Y − Y P + ρ
We will obtain: Y =YP That is, the PC has to be vertical in the long-run. 24/29 T h e L o n g Ru n A S F u n c t i o n : R e p r e s e n tat i o n 25/29 S h i f t s i n t h e S h o rt Ru n A S ↑ πe , ↑ ρ 26/29 S h i f t s i n t h e L o n g Ru n A S ↑ K , ↑ L , or ↑ Technology 27/29 5. Readings 28/29 Readings Read Chapter 11 of the adopted textbook: Frederic S. Mishkin (2015). Macroeconomics: Policy & Practice, Second Edition, Pearson Editors. 29/29