Session 12. Aggregate Supply: The Phillips curve. Credibility

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1 Session 12. Aggregate Supply: The Phillips curve. Credibility v Potential Output and v Okun s law v The Role of Expectations and the Phillips Curve v Oil Prices and v US Monetary Policy and World Real interest rate Potential output and inflation Changes in the economic environment lead to changes in demand. In the short run demand determines output. If demand is below potential, the economy is in a recession, if demand is above potential the economy is in an expansion. Long-run aggregate supply Recession Overheating Y potential Output 1

2 Okun s Law, or How to Estimate Potential Output? v Estimates of potential output can be done by measuring the factors of production (capital, labor) and their productivity. v A simpler (although not as accurate) approach to estimating potential output is to use the Okun s law. The Okun s law is an empirical regularity that postulates a relationship between unemployment and the output gap. Okun s law in the US: and Using the relationship between the output gap and unemployment (Okun s Law) we can think about the relationship between unemployment, as a measure of slack in the economy, and inflation (the Phillips Curve). Overheating and increasing inflation Recession and Decreasing Phillips Curve (short run) Natural Rate of = Full Employment 2

3 and : US in the 1960s and : (US)

4 and : and v The Phillips curve is anchored by two long-run parameters: the natural rate of unemployment and the inflation targeted by the central bank. If they change, the curve shifts. v The only reason why sometimes there is a negative relationship between inflation and unemployment is because there is change in regime and it takes time for inflation to change. There is, therefore, an element of surprise in this negative relationship. Expectations and Credibility are crucial v Example: Anticipated Expansionary Monetary Policy Money supply growing at a 10% rate for a while Firms expect this to continue for the next year => Firms increase prices by 10% today; no effect on output or employment 4

5 Disinflation: Trading off and 12.1% In 1979/1980 the newly elected chairman of the U.S. Federal Reserve, sets as a goal to bring inflation below 4%. Tight monetary policy will be the tool to achieve this low inflation. The consequence is high unemployment for several years 5.4% 3.3% Phillips Curve (short run) Natural Rate of (6%) 7.2% 7.1% 9.7% The Role of Expectations v What makes unemployment go down from 1983 to 1985 without increasing inflation? v From 1980 to 1983 the decrease in inflation has effects on relative (real) prices because v Contracts are written in nominal terms (e.g. wages) and are not modifiable in the short run v Even if contracts get changed, expectations (forecasts) of inflation take time to adjust. The length depends on the credibility of the policy maker. v After 1983, policy becomes credible and contracts adjust. This adjustment gets reflected in lower unemployment and a return to potential (trend) output. v Notice that the economy does not return to its original position because inflation will now be lower forever (until the next change in policy) 5

6 and Phillips Curve (long run) Every short run Phillips curve corresponds to specific inflation target (which is credible). target (expected ) Phillips Curve (short run) Natural Rate of and Phillips Curve (long run) Target Phillips Curve (short run) New Target Decrease in expected inflation Natural Rate of 6

7 The Cost of Reducing The impact of low inflation on growth? But even those who concede that New Zealand's performance in keeping inflation low and stable has been good often argue that the cost of achieving this, in terms of economic growth and employment foregone, has been too high, and that perhaps something more moderate, or "less obsessive" in the words of some of our critics, would have been more desirable. There is not much doubt that the process of reducing inflation from around 15 per cent per annum in the mid-eighties to below 2 per cent in 1991 had an adverse impact on growth and employment during that period. I have often acknowledged that point, and indeed I know of no central banker who would claim with any confidence that inflation can be reduced from a high level to a low level without at least some, temporary, impact on growth and employment. The reasons for this are now widely understood and relate to the way in which a policy to reduce inflation interacts with expectations that inflation will continue at its previous pace. But shortly after inflation was first reduced to the 0 to 2 per cent target in 1991, the economy began to grow again and unemployment began to fall. Donald T Brash, Governor of the Reserve Bank of New Zealand (February 2000) The Cost of Reducing As a result, if inflation accelerates to higher levels as it did during and , tighter monetary policy (higher interest rates) would be needed to bring inflation down again, and that such tightening is initially likely to be accompanied by slower economic growth and concomitantly rising unemployment. A shortrun pain for a long-run gain! Dr Monde Mnyande, Chief Economist, South African Reserve Bank (Central Bank), January 28,

8 The Role of Expectations One of the key characteristics of the expectations formation process is the level of inertia. There is a significant inertia in expectations. In particular, one can look at the persistence in economic forecasts around the point where policy is reversed. Anchoring of Expectations is Linked to Credibility A credible central bank anchors inflation expectations in a way that temporary changes in inflation do not translate into wage and price decisions by workers and firms. Euro area inflation forecasts 8

9 Anchoring of Expectations is Linked to Credibility A comparison of inflation rates of goods with flexible prices and those with sticky prices in the US shows that since the early 80 s inflation expectations are much more anchored (i.e. temporary changes in inflation do not change medium-term expectations of inflation because the public believes that inflation will go back to normal) Annual M1 1972M1 1976M1 1980M1 1984M1 1988M1 1992M1 1996M1 2000M1 2004M1 2008M Flexible Sticky Core Versus Headline Another way to think about credibility of long-term expectations is to look at the volatility of core inflation (excluding volatile items). Core inflation is a good measure of long-term inflation. Headline inflation (includes all items) fluctuates around core inflation Annual Core Headline 9

10 Management of Expectations In the last years and as a result of falling inflation expectations, a series of statements by the Chairman of the Federal Reserve as well as different rounds of quantitative easing and Operation Twist brought inflation expectations back to normal. Building credibility, anchoring inflation expectations and avoiding political interference in central bank decisions To minimize the impact of politicians on monetary policy policy, many economists have suggested two alternatives: Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. Examples: constant money growth, fixed exchange rate (monetary policy), balanced budget amendment, 3% limits on budget deficits (fiscal policy). Policy conducted by independent institutions: Allow for discretion but remove the decision from those who have the wrong incentives. This is today the case for most central banks in advanced economies and in a growing number of emerging markets. Is fiscal policy next? 10

11 Central Bank Independence Giving independence to central banks has proven to be the best way to keep inflation low and stable. Average inflation Spain New Zealand Italy United Kingdom Australia Denmark France/Norway/Sweden 5 4 Belgium J apan Canada Ne therlands United States 3 S witzerl and Ge rmany Source: See Alesina and Summers (1993) Index of central bank independence What about oil prices? Aren t they a cause of inflation? In 1973 and 1979 the price of oil grew by about 60% and put upward pressure on prices in countries that were dependent on oil as a source of energy Price of Oiil (nominal) Oil Price (annual %) Price of Oil Oil Price 11

12 Stagflation and Oil Price shocks Although all countries faced the same increase in the price of oil. behaved very differently depending on the response of monetary policy Germany Japan United Kingdom United States Stagflation and Oil Price shocks The differences in the response of monetary policy did not result in significant differences in GDP growth rates. Some of the countries that let inflation go up by a larger amount then had to deal with deeper recessions when inflation had to be brought back to normal levels (as in the case of the United Kingdom). 10 Real GDP Growth Germany Japan United Kingdom United States 12

13 Relative versus Absolute Prices v There are two goods in the world Oil and Computers. The relative price of each of them is determined by the pace of technological progress in each of the two sectors. Because of fast technological progress in computers we see price of oil expressed in terms of computers will increase over the coming years. v Their ABSOLUTE price and how fast it changes is determined by monetary policy. v Assume equal weight for both of them. An inflation of 2% can be achieved with v 25% increase in the price of oil and -21% fall in computers prices or v 12% increase in the price of oil and -8% fall in computers prices. US Monetary Policy and World Is the US Federal Reserve policy responsible for inflation in other countries? The most important development globally is that the world is growing more quickly, particularly in emerging markets, Bernanke said in response to a question after his speech at the National Press Club... I think it s entirely unfair to attribute excess demand in emerging markets to U.S. monetary policy, Bernanke said. Those nations can use their own monetary policy and adjust exchange rates to deal with their inflation problems, he said. It s really up to emerging markets to find appropriate tools to balance their own growth. February

14 Session 12. Summary v In the short run, there is a trade off between inflation and unemployment. The big lesson from the 1970s is that there is no permanent trade-off between inflation and unemployment. Any attempt to exploit the short-run relationship will change expectations of inflation and force the economy to return back to equilibrium. v The management of inflation expectations is key to monetary policy. v To ensure that policies are not abused by politicians, several countries have required that monetary policy be conducted by rules and the central bank be given legal independence from the government. Appendix: Stagflation and Oil Price shocks 1. We can think about an oil price shock as a shift of the long-run aggregate supply to the left. Long-run aggregate supply Real interest rate Equilibrium Real interest rate IS LM 2. What are the policy options? Y LR Output 14

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