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Econ 100b

Created 4/30/1996
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Lecture Fourteen

The Short-Run Inflation-Unemployment Tradeoff, and the Sacrifice Ratio
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 23, 1996


Administration
Accelerating Inflation
The Sacrifice Ratio
"Hysteresis"
Disinflation and the "Sacrifice Ratio"
Anti-Recession Policy, Cyclical Unemployment, and Structural Unemployment


Administration

Make-up exam to be given on March 15, 2-3 PM
Talk about lecture schedule; next year how much effort should be devoted to making this a TTh (or a MW) course?

Sidelight

New Federal Reserve nominees; Larry Meyer; Alice Rivlin

Accelerating Inflation

Consider the options that the Phillips curve gives to someone trying to nudge the economy to full employment with monetary and fiscal policy. At any single moment, expected inflation and supply shocks are outside of control. Yet changing aggregate demand alters output, unemployment, and inflation. Expanding aggregate demand is close to guaranteed to produce higher output, lower unemployment, and higher inflation Contracting aggregate demand is all but guaranteed to raise unemployment and lower inflation.

Almost every time Alan Greenspan appears in front of Congress, he says something like that this short-run tradeoff is "ephemeral and unusable". Why? Because the past generation's experience strongly suggests that any systematic attempt to run a high-pressure economy--to have a little bit lower unemployment and a little bit higher inflation--is doomed to failure, because expectations of inflation will adjust upward. And when they do you have a less favorable short-run tradeoff.

Thus in the long run, we are back where we were at the start of the course: chapter 3. Output (and employment) are determined by "fundamentals": productivity and factor supplies, if we are in a situation in which all expectations are satisfied.

How long is the long run? Probably more than five years.

The Sacrifice Ratio

In the late 1970s the U.S. economy had an "expected" and an actual inflation rate somewhere near 8 percent per year (pushed up, temporarily, at the end of the end of the 1970s by supply shocks). Suppose--for the sake of argument--that when Paul Volcker was named to the Federal Resrve, that unemployment was at its "natural rate", that Volcker sought to reduce inflation and expected inflation from around 8 percent per year to around 3 percent, and that he had asked you to tell him what was going to happen as he pursued this policy.

How do we think about this?

We have the result of our IS-LM apparatus:

(1) Y = Y(r)

If we think of the Federal Reserve as controlling interest rates. We have our short-run Phillips curve:

(2) p = E(p) + (1/a)(Y-Y*)

But this is not enough; we need to know how expectations of inflation adjust over time.

One possibility is that people are pretty sophisticated in forming expectations of inflation. They take a look at the economy as a whole--including a look at the monetary and fiscal policies in effect--try to estimate how those policies are going to affect the economy, and so form their expectations of inflation.

This possibility would suggest that the location of the short-term Phillips curve is easy to shift--for good or for ill--that if a central bank or a government tries to expand employment and keep it above "natural rates" the Phillips curve will shift upward rapidly; conversely, the mere announcement of a change in policy could shift the short-run Phillips curve: all you have to do is say "we are going to be tough on inflation; and you find the Phillips curve shifting).

There is something to this:

But there is another approach--one that says that this "rational expectations" vision is hopelessly naive:
People don't trust announcements of policies
People don't trust economic models
Hence, "show me"
This approach implies that reducing inflation will be much more painful; the only way to push inflation down is to produce enough unemployment that you can show that inflation has fallen.

How to influence expected inflation?

Clearly the first two are to be preferred, if they work...
Clearly people are likely to be suspicious of the first two; naivete of the first; perversity of the second (people react to incomes policies by raising their expectations of what will happen after the end of the program): Nixon: these policies will do a lot less damage as implemented by us, who don't believe in them, than if implemented by true believers.
Importance of "credibility": Thatcher and the MTFS; Reagan and the hope for painless disinflation in the early 1980s.

So: once again: Suppose--for the sake of argument--that when Paul Volcker was named to the Federal Resrve, that unemployment was at its "natural rate", that Volcker sought to reduce inflation and expected inflation from around 8 percent per year to around 3 percent, and that he had asked you to tell him what was going to happen as he pursued this policy.

Suppose that expected inflation equals last year's inflation:

(3) pt = pt-1 + (1/a)(Yt - Y*t)

and suppose that you want to accomplish the reduction in inflation over a period of five years. Then:

(4) p5 = p4 + (1/a)(Y5 - Y*5)

(5) p5 = p3 + (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4)

Keep substituting in; and eventually we have:

(6) p5 - p0 = (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4) + (1/a)(Y3 - Y*3) + (1/a)(Y2 - Y*2) + (1/a)(Y1 - Y*1)

or

Lost Production (relative to potential output Y*) = a(p5 - p0)

Where a is the inverse slope of the Phillips curve.

Use Okun's Law to express this in terms of unemployment...

Between 1981 and 1985, 9.5 percentage point-years of cyclical unemployment; inflation down by five percentage points. "Sacrifice ratio" of 1.9 for unemployment (or 3.8 for output). Reducing inflation thus very expensive....

Tempted to leave inflation bouncing around in the 5-10 percent range. But (a) voters hated inflation; (b) fear that permanent moderate inflation is a contradiction in terms...


"Hysteresis"

An extremely ugly word. Comes from study of magnetism. Attempt by Larry Summers and Olivier Blanchard to create an intellectual movement to study peculiar problems of European unemployment.

Brief history of European unemployment; unemployment rises a lot in recessions; it does not fall much in booms

Natural rate hypothesis...

But recessions can shift the natural rate of unemployment as well; transformation of cyclical into structural unemployment:

"Hysteresis" raises the sacrifice ratio: makes it infinite, in fact; most of the attraction of disinflation is that you incur several bad years for something--lower inflation--of permanent benefit. But in Europe over the past generation this has not been true.


The Macroeconomic Policy Debate

Mankiw, chapter 12.

Lecture 14 Equations

(1) Y = Y(r)
(2) p = E(p) + (1/a)(Y-Y*)
(3) pt = pt-1 + (1/a)(Yt - Y*t)
(4) p5 = p4 + (1/a)(Y5 - Y*5)
(5) p5 = p3 + (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4)
(6) p5 - p0 = (1/a)(Y5 - Y*5) + (1/a)(Y4 - Y*4) + (1/a)(Y3 - Y*3) + (1/a)(Y2 - Y*2) + (1/a)(Y1 - Y*1)

Lost Production (relative to potential output Y*) = a(p5 - p0)



>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/