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Econ 100b

Created 4/30/1996
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Lecture Thirteen

Inflation, Unemployment, and the Phillips Curve
(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 21, 1996


Models of Aggregate Supply
What Do We Think of These Models?
From Aggregate Supply to the Phillips Curve
Disinflation and the "Sacrifice Ratio"
Anti-Recession Policy, Cyclical Unemployment, and Structural Unemployment


Models of Aggregate Supply

The goal is, ultimately, to get to an aggregate supply equation of the form:

(1) Y = Y* + a(P - E(P))

Where "E" denotes "expectation"--that when the actual price level P is below what people had expected it to be, output (and employment) is depressed.

Now why do shocks to spending show up as shifts in prices and rather than as shifts in prices alone? The first part of Greg Mankiw's chapter 11 gives four possible answers:

Sticky Wages
The first is that nominal wages are sticky. Adjust with a substantial lag. Typical labor contract has wages fixed (for a while), and employment variable (employment at will).

Why structure labor contracts this way? Why not make employment status fixed and wages variable? Incentive compatibility: employer loses something if he or she fires workers for no good reason. Employer loses nothing if reduces wages of workers for no good reason. Hence employers' self-interest cannot be relied on to check desire to reduce wages.

Once you have a sticky nominal wage, then firm profit maximization says that the higher the price level, the higher employment and output--and we have arrived at equation (1).

Worker Misperceptions
Workers do not really "know" the general price level. They estimate their real wage by dividing their nominal wage by what the think the price level is. A positive boost to prices and wages raises workers' perceived (although not their actual) real wage; increases the labor force; raises employment.

Imperfect Information
Everyone confuses changes in relative prices with changes in the absolute price level. If relative prices change, the right response is to increase or decrease production. This confusion leads production and employment to be correlated with unanticipated shifts in the price level.

Sticky Prices/Small Menu Costs
Changing prices is somewhat expensive, and is done relatively rarely. Firms want to keep their customers happy by not changing their prices too much (or too far), and by not having to tell customers that their goods are out of stock.

Staggering of Wages and Prices

Aggregate Demand Externalities (under monopolistic competition)/Recessions as coordination failures


What Do We Think of These Models?

Well, they are all at work out there in the real world. Prices are sticky; information about which shifts in demand are shifts in relative demand and which are shifts in aggregate demand is imperfect; workers do misperceive the general price level; wages are sticky and employment--bodies and hours--is variable.

A mistake to think that there is the model of aggregate supply which is the truth. Complicated world. Lots of things going on...

Nevertheless, note that worker misperceptions, imperfect information, and sticky prices all imply that people are--or should be--unhappy with booms. Worker misperceptions imply that, after a prolonged boom, people are unhappy because they look back at the real wages they actually received and think "they weren't worth the extra hours (or the extra jobs)". Imperfect information implies that businesses look back after a boom and say "we shouldn't have produced all that stuff". Sticky prices implies that businesses during a boom are saying "we shouldn't be producing so much; our marginal costs are too high".

Even the sticky wages model is uneasy with the implication that people are happy in a boom. Aggregate demand externalities and recessions as coordination failures are the only possible models that conform to reality...

Greg calls this an "active area of research"; and it is the area where he spends most of his time (and also where economists' models are perhaps least satisfactory).

From Aggregate Supply to the Phillips Curve

Recall equation (1):

(1) Y = Y* + a(P - E(P))

and let's divide everything by a and move the price level P to the left-hand side:

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

Now subtract last year's price level from both sides:

(3) P - P-1 = E(P) - P-1 + (1/a)(Y - Y*)

and notice that:

(4) Inflation = Expected Inflation + (1/a)(Y - Y*)

or, from Okun's Law:

(5) Inflation = Expected Inflation - B(u - u*) + e

Supply shocks; oil price increases; price controls and their relaxation.



1961-1970: Expectations of inflation low; as unemployment falls from 1961-1970, the inflation rate rises as we produce a "high pressure economy"

1971-1975: Expectations of inflation rising rapidly as people note the loss of the economy's commitment to stable prices; oil shocks; outward shift of the "Beveridge Curve" as labor market seems to work less well...

1976-1980: Expectations of inflation more-or-less stable at 7-8% per year or so; as unemployment falls, inflation rises; 1961-1970, but with less favorable inflation expectations.

1981-1984: Another supply shock; fear that expectations are moving in a very unfavorable direction; Volcker disinflation--not only raise unemployment high enough to push inflation down, but keep unemployment high enough long enough to convince people that inflation will remain low.

1985-1995: Expectations of inflation low (but a bit higher than in 1960s). As unemployment falls and rises, inflation rises and falls; some sign of further adjustment of expectations/inward movement of Beveridge Curve in recent years.

Disinflation and the "Sacrifice Ratio"

How to influence expected inflation?

Clearly the first two are to be preferred...
Clearly people are likely to be suspicious of the first two...
Importance of "credibility": Thatcher; Reagan...


Anti-Recession Policy, Cyclical Unemployment, and Structural Unemployment


>

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/