ECON 201 Lecture 22 Fall 2024 PDF

Lecture 22: Phillips Curve Applications Fall 2024 Jonas Jin November 18, 2024 Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 1 / 28 Outli...

Lecture 22: Phillips Curve Applications Fall 2024 Jonas Jin November 18, 2024 Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 1 / 28 Outline 1 Recap: Phillips Curve 2 Phillips Curve Applications Volcker Disinflation The Greenspan Era The Great Recession The Pandemic Fed Credibility: Inflation Target Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 2 / 28 Phillips Curve Model The Phillips Curve Model depicts the relationship between inflation (π) and unemployment (u): Inflation π LRPC πe SRPC (given inflation expectations π e ) Natural Rate of Unemployment u Unemployment u ∗ Short-Run Phillips Curve (SRPC ): negative relationship between unemployment and inflation in short run, given inflation expectations π e Long-Run Phillips Curve (LRPC ): no relationship between unemployment and inflation in long run (tend back to natural rate of unemployment) Actual inflation π = π e at LRPC Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 3 / 28 Policy Shocks in AD/AS and Phillips Curve Model LRAS P π LRPC AD2 2 C π2 AD1 C B 2 B π1 1 SRAS2 A SRPC2 A (π e = π2 ) 1 SRAS1 SRPC1 (π e =π ) Y u∗ u 1 Suppose the economy starts at long-run equilibrium A and AD shifts rightwards (e.g. from a positive demand shock or expansionary policy) 1 With fixed π e , move along SRPC1 from A → B: higher inflation, lower unemployment 2 Expectations adjust to the new (higher) actual inflation until π e = π2 , shifting SRPC ▶ Changing inflation expectations synonymous with self-correction Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 4 / 28 Rational vs. Adaptive Expectations Rational vs. adaptive expectations refers to the speed at which expectations adjust: Rational expectations: individuals are “fully rational” and perfectly predict inflation → expectations immediately adjust to actual inflation (SRPC shifts immediately) Adaptive expectations: individuals take time to adjust expectations to actual inflation (SRPC shifts slowly) Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 5 / 28 Rational vs. Adaptive Expectations: Rightward Shift in AD Start at equilibrium A, and suppose AD shifts right (positive AD shock or expansionary policy) LRAS π LRPC P AE2 AD2 C π2 B AD1 C AE 2 RE1 AE1 SRPC2 RE 1 B π1 A (π e = π2 ) SRAS2 AE 1 A SRPC1 (π e = π1 ) SRAS1 u∗ u Y Adaptive expectations: Rational expectations: 1 Actual inflation changes to π2 , 1 Since policy was perfectly anticipated, expectations stay fixed: move along expectations change simultaneously with SRPC1 from A → B actual inflation: SRPC1 → SRPC2 , A → C 2 Expectations adjust to new inflation π2 : → Increase in inflation without temporary SRPC1 → SRPC2 , B → C decrease in unemployment! → Temporary decrease in unemployment for higher short- and long-run inflation Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 6 / 28 Rational vs. Adaptive Expectations: Leftward Shift in AD Start at equilibrium A, and suppose AD shifts left (negative AD shock or contractionary policy) LRAS π LRPC P AD1 A π1 AE 1 AD2 A AE 1 RE 1 B SRPC1 B RE 1 π2 C (π e = π1 ) SRAS1 AE 2 AE 2 C SRPC2 (π e = π2 ) SRAS2 u∗ u Y Adaptive expectations: Rational expectations: 1 AD1 → AD2 : Actual inflation changes to 1 Since policy was perfectly anticipated, π2 , expectations stay fixed: move along expectations change simultaneously with SRPC1 from A → B actual inflation: A → C 2 Expectations adjust to new inflation π2 : → Costless deflation: decrease in inflation SRPC1 → SRPC2 , B → C without increase in unemployment! → Temporary increase in unemployment for lower long-run inflation Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 7 / 28 Phillips Curve Applications Let’s take a look at a few policy episodes and see how the Phillips Curve applies: Volcker disinflation (1980 - 1987) The Greenspan Era (1987 - 2005) The Great Recession (2007 - 2009) The Pandemic (2020 - 2021) All of these are in the textbook; we are just adding graphs to them Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 8 / 28 Caveats For the next slides, remember that our models are approximations! We will draw things as if: The Phillips Curve is linear Only specific curves shift, while others are held equal (“all else equal”) Economy either starts or ends at long-run equilibrium, unless otherwise specified We know exact magnitudes of shifts In real life, many things could be simultaneously changing In general, AD and AS typically grow over time along with LRAS, and π e and π move simultaneously That becomes artistically difficult to depict cleanly ▶ But try to line up the Phillips Curve movements in the theory with the actual Phillips Curves in the data! Art is not my passion Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 9 / 28 Sacrifice Ratio The sacrifice ratio tells us about the magnitude of the effect of changing inflation on output: Percentage point change in output Sacrifice ratio = Percentage point change in inflation The typical sacrifice ratio is 5, meaning we must decrease output by 5 percentage points (through increasing unemployment) to decrease inflation by 1 percentage point. Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 10 / 28 Volcker Disinflation Faced with 10% inflation in the 1970s, Federal Reserve Chairman Paul Volcker attempted to lower inflation (to say, 4%) with contractionary monetary policy. Sacrifice ratio of 5 =⇒ have to give up (10 − 4) × 5 = 30 percentage points of output What happened? Lower inflation came at cost of high unemployment from 1981-1983 → somewhat refuted rational expectations However, loss in output not as high as predicted based on presumed sacrifice ratio → expectations adjusted faster than predicted Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 11 / 28 Volcker Disinflation: Theory and Data π LRPC π0 A π1 C B π2 SRPC2 SRPC1 (π e = π2 ) (π e = π0 ) u1 u2 u Starting from a recession at A, and assuming inflation expectations start fixed and we end up at long-run equilibrium: Contractionary monetary policy increases unemployment and decreases inflation (A → B along SRPC1 ) Inflation expectations adjust from π0 to π2 (SRPC1 → SRPC2 , B → C ) Compare movement in theory and data! Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 12 / 28 The Greenspan Era (1987 - 2005) 1986: positive supply shock from OPEC removing oil supply restrictions 1989-1990: fall in unemployment and increase in inflation led to contractionary monetary policy, which generated small recession (overshot) 1990s: technological boom (not covered here, but perhaps in problem set) 2001: expansionary monetary and fiscal policy used to recover from recession after 9/11 and corporate accounting scandal Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 13 / 28 Greenspan Phillips Curve Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 14 / 28 Greenspan Era: Positive Supply Shock 1984-1986: Positive supply shock from oil-exporting countries lifting export restrictions LRAS π LRPC P SRAS1 π1 SRAS2 A A π2 SRPC1 B (π e = π1 ) B AD SRPC2 (π e = π2 ) u∗ u1 u Y Positive supply shock, assuming we end at long-run equilibrium: → Shifted AS right, decreasing price level and unemployment (A → B) → People lowered inflation expectations from π1 → π2 → No further shift since we’re at long-run equilibrium → Shifted SRPC1 → SRPC2 Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 15 / 28 Greenspan Era: Overshooting the Target? 1989 - 1990: low unemployment and high inflation led to contractionary monetary policy, which generated a small recession from 1990-1992 P LRAS SRAS π LRPC A A π1 B AD1 π2 B SRPC AD2 Y u1 u ∗ u2 u Assuming expectations fixed: → Contractionary policy: leftward shift in AD → Decrease in AD leads to higher unemployment, lower inflation (A → B along SRPC ) (What would happen in the long run?) Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 16 / 28 Post-2001 Recovery 2001: expansionary monetary and fiscal policy used to recover from recession after 9/11 and corporate accounting scandal from 2002 - 2005 P LRAS SRAS π LRPC B B π2 A AD2 π1 A SRPC (π e = π2 ) AD1 Y u∗ u1 u Assuming expectations fixed and we end at long-run equilibrium: Expansionary policy: rightward shift in AD Increase in AD leads to lower unemployment, higher inflation (A → B along SRPC ) Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 17 / 28 The Great Recession Ben Bernanke was nominated to replace Greenspan by Bush in 2005, and was reappointed by Obama in 2009: “My first priority will be to maintain continuity with the policies and policy strategies established during the Greenspan years.” Housing market boom hit by financial crisis leading to steep decline in AD Recovery involved aggressive expansionary monetary policy (quantitative easing) No sizeable shifts in short-run Phillips curve due to stable inflation expectations Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 18 / 28 The Great Recession: Phillips Curve Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 19 / 28 The Great Recession: Drop in AD From 2007 to 2010, decline in AD raised unemployment from 5 to 10%, and reduced inflation from 3 to 1%: P LRAS SRAS π LRPC A A 3% B AD1 B 1% SRPC AD2 Y ∗ u = 5% 10% u Assume we start at long-run equilibrium and expectations are fixed: Negative AD shock: leftward shift in AD Decrease in AD leads to lower inflation, higher unemployment (A → B along SRPC ) Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 20 / 28 The Great Recession: Recovery Recovery involved aggressive expansionary monetary policy (quantitative easing) from 2010 - 2014 P LRAS SRAS π LRPC B B π2 A AD2 A π1 SRPC (π e = π2 ) AD1 Y u∗ u1 u Assume we start at long-run equilibrium and expectations are fixed: Positive AD shock: leftward shift in AD Decrease in AD leads to lower inflation, higher unemployment (A → B along SRPC ) Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 21 / 28 The Pandemic Coronavirus drove decrease in both SRAS and AD AD recovered quickly due to expansionary monetary and fiscal policy as well as relaxation of restrictions, but SRAS took longer to recover (people reluctant to go back to work, supply chain issues) Large monetary and fiscal expansion may have been excessive, generating inflation ▶ Recovery would then depend on how inflation expectations changed Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 22 / 28 Pandemic Phillips Curve Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 23 / 28 Pandemic: Negative Shocks to AD and SRAS 2021-2021: Coronavirus drove decrease (leftward shift) in both SRAS and AD (A → B): LRAS π LRPC P AS shock AD1 AD2 B A π1 A B SRAS2 AD SRPC2 sh o ck SRAS1 SRPC1 u∗ u1 u Y Assuming we start at long-run equilibrium: Negative AD and AS shocks: leftward shifts in AD and AS Decrease in AD leads to lower inflation, higher unemployment Decrease in AS leads to higher inflation expectations (SRPC1 → SRPC2 ) Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 24 / 28 The Pandemic: Recovery in AD/Expansionary Policy 2021-2022: AD recovered quickly, but SRAS took longer to recover (drawn as if SRAS is constant); large monetary and fiscal expansion may have been excessive, generating inflation: P LRAS π LRPC SRAS π3 B3 B3 B2 π2 B2 A π1 A AD3 SRPC AD2 AD1 Y u3 u ∗ u2 u1 u How excessive was recovery/policy? ▶ Did we exceed Potential GDP and drive high inflation (A → B3 ) or stop short (A → B2 )? Future will depend on changes in inflation expectations ▶ Based on observed Phillips curve since 2022, it appears that inflation expectations have since decreased Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 25 / 28 Inflation Target The Phillips Curve implies that inflation expectations affect the tradeoff between inflation and unemployment. If we could change expectations, it would give us pretty good control over unemployment and inflation! In learning about the Federal Reserve, we discussed the interest rate target: the interest rate the Fed aims to hit through manipulation of money supply. Starting in 2012, the Fed has also announced a long-run inflation target (2%) What is the Fed really trying to do? Control inflation expectations! Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 26 / 28 Fed Credibility Being able to control expectations relies on the Fed’s credibility : can we believe that the Fed will achieve their goal? Has the Fed achieved this long run goal in the past? How confident are we that they can continue to do so in the future? Success in fighting inflation under Volcker may have provided Fed with strong credibility. Is it ever in the Fed’s best interest to use their credibility to “lie” about the inflation target?? Potentially - problem set 4! (Sort of) suggests tradeoff between policy control and credibility Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 27 / 28 Japan’s Phillips Curve Japan’s Phillips Curve Looks Like Japan Jonas Jin (Northwestern University) ECON 201 Lecture 22 November 18, 2024 28 / 28