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Lecture 9 1
Macroeconomic Analysis 2003
An Example of a Stabilisation Programme
Lecture 9 2
Contents• Need for Stabilisation: Costs of Inflation and
Unemployment• Review of Wage and Price Spiral and Inflation • Output gap and Mark ups• Stabilisation experience• Phillips’ and Okun Curves • Set up of the Stabilisation Programme• Inflation reduction and Unemployment• Growth rate of output, inflation and money supply• Sacrifice Ratio• inflation policy game between public and the
government: Rules or Discretion?• Analysis of Stabilisation using AS-AD diagrams
Lecture 9 3
gtt eyy 0
2003
Y
Movement of Economy Around the Trend: A Reminder
1982 1992
t
Lt
Kt
At
Y
0 yy
0 yy
35 million unemployed in the OECD
Recession
Boom
Lecture 9 4
Needs for Stabilisation: Costs of Inflation• Inflation distorts relative prices and makes the market system
less efficient as prices cannot signal relative scarcity• Inflation transfers resources from creditors to debtors• Redistributes income from fixed income group to property
holders• Taxes are not indexed for inflation, low income families are
pushed up to the tax threshold• Shoe leather and bookkeeping costs rise with inflation• It creates uncertainty. Creates illusions, confusions and
complicates economic calculation• It is harmful for economic growth; reduces saving and
investment activities• It create social tension
Lecture 9 5
Needs for Stabilisation: Costs of Unemployment
• Loss of output and income and utility
• Personal psychological costs– Unhappiness
– Stress and tension
– Discouragement and disappointment
– Morale and motivation
– Uncompetitive feeling
– Dignity of human life
– Insecurity
Loss of productive skills
productivity
Lack of learning by doing opportunity
Rise in social unrest and crimes
Lecture 9 6
Price Mark up by firms:
tt WP 1 (1) Wage Mark up by unions
ett PW 1 (2)
Price Wage Spiral
ett PP 11 (3)
Both mark-ups and
increase in the boom time and decrease in the slump.
uubyya (4)
Main cause of Inflation: Wage Price Spiral Modernisation or Negotiation?
wage
Price
Time Wage Price
1 1.00 1.00
2 1.20 1.20
3 1.44 1.44
4 1.73 1.73
5 2.07 2.07
6 2.49 2.49
7 2.99 2.99
8 3.58 3.58
9 4.30 4.30
10 5.16 5.16
11 6.19 6.19
12 7.43 7.43
13 8.92 8.92
14 10.70 10.70
15 12.84 12.84
16 15.41 15.41
17 18.49 18.49
18 22.19 22.19
19 26.62 26.62
20 31.95 31.95
21 38.34 38.34
=0.2,
Lecture 9 7
11
11
t
et
t
t
P
P
P
P
111 t (5)
is the expected or the core inflation that firms and unions use while settling the wage rate.
t (6)
Price Level to Inflation Rate
Ignore these small numbers
Lecture 9 8
t (7)
yyat Or
uubt (8)
s
uub
or
yya
t
(9)
Inflation to Aggregate Supply or Expectation Augmented Phillips Curve
Lecture 9 9
s
uub
or
yyae
t
AS=f(w,pe)e
e
e
yy yy yy o
LAS
Inflation, Output and Unemployment in the Short Run
nuu nuu nuu
AD =f(M,G, T)
Lecture 9 10
s
uub
or
yyae
t
AS=f(w,pe)e
e
e
yy yy yy o
LAS
Supply Shock and Stagflation
nuu nuu nuu
AD =f(M,G, T)
Stagflation
AS1
Lecture 9 11
ntett uub
Time0 e
tt Rational Expectation
nt uu
nt uu
nt uu
t
t
Inflation
Deflation
Expectation die very slowly.
Lecture 9 12
Friedman (1966, 1968) and Phelps (1967) natural rate of unemployment hypothesis
etNutut
where 0 (2)
where t is the actual inflation, et is the expected inflation Nu is
the natural rate of unemployment that is ground out by the Walrasian system of the general equilibrium, and tu is the actual
unemployment rate.
Since
Nutuett and 0 the inverse relation
between unemployment and inflation implies
*
*
*
yty
yty
yty
Nutuett
Nutuett
Nutuett
(3)
Lecture 9 13
Natural Rate of Unemployment Hypothesis
The natural rate of output and employment “ground out” by theequilibrium in goods, labour and money markets (Friedman(1968))
The economies converges to the natural rate in the long run.
Nothing in the economy guarantees that actual output andemployment do not deviate from such natural rates in the shortrun.
When consumers and producers have good confidence about thestatus of the economy they are likely to spend more and theeconomic growth rate higher than the natural rate.
A reverse process operates in the downturn.
A smooth functioning of the economy requires stabilising theeconomy around these natural rates.
Lecture 9 14
Four Main Theories of Natural Rate of Unemployment
1. Search cost and job mismatch theory:
s = job separation rate
f = job finding rate
u = unemployment rate
fs
su
2. Insider-Outsider theory: Inefficient Bargaining between firms and workers
Members of the union demand higher wages and non-member remain unemployed
4. Rigidity in the labour Market:
Minimum wage laws
Entry deterrence and labour market standards
3. Efficiency wage theoryFirms pay higher wages to workers to reduce hiring and firing costs and to reduce shirking and the monitoring costs or to appear as an ideal employer but that makes others unemployed
Lecture 9 15
Wage setting: )1( zauPW e (1)
Price Setting: )1(1
MPLWP (2)
From (1) and (2): )1)(1(1
zauMPL
PP e (3)
In logs: (note log(1+x) = x )
)log( tttett MPLzaupp (4)
Subtract pt-1 from both sides: )log(11 tttt
ettt MPLzaupppp
Note tt
tttt Pdt
dP
dt
Pdpp
1log1
)log( tttett MPLzau (5)
Natural rate of unemployment is a point
Actual and Expected Inflation are equal ett
a
MPLzu tt
t
)log(*
(6)
z includes: reservation wage, taxes, union bargaining power, upward pressure on wages by minimum wage laws, benefits and efficiency wage arguments, Structural change
Determination of the Natural Rate of Unemployment: An Example
Lecture 9 16
Recent Experience of Stabilisation in the UK
Inflation, Unemployment Rate and Growth Rates of Output and Money Supply(www.HM-Treasury.co.uk)
-5.0
0.0
5.0
10.0
15.0
20.0
1981
Per
cent
rpimsurategdp
Lecture 9 17
Inflation rate (% change in RPI) and Growth Rate of M4
0
5
10
15
20
25
30
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Per
cent
inflationm4growth
Inflation is a Monetary Phenomenon
Lecture 9 18
Standard Measures of Stabilisation• Control of Aggregate Demand
– Increase or decrease in money supply– Control in the tax and spending programme– Monetisation or contraction of the budget deficit
• Aggregate supply– Wage renegotiations– Efficiency enhancing measures
• Trade and Exchange Rates Measures– Appreciation or depreciation of the currency– Trade and exchange rate agreements
Lecture 9 19
Unemployment and Output Gap: Okun’s Curve
Output Gap
nygtygatutu ,,1
Unemployment Gap
nutubtt 1Inflation gap
Higher growth rate means lower unemployment rate
Higher unemployment causes wages and inflation to fall
b
tt
nutusr 1
1
Sacrifice ratio
Lecture 9 20
Inflation Reduction Programme:Output, Inflation and Unemployment
Unemployment and output gap (Okun’s law)
nygtygatutu ,,1 (1)
Phillip’s curve (expectation augmented):
nutubtt 1 (2)
Relation between growth rates of money, output and inflation
ttmgtyg ,, (3)
tyg , is actual growth rate of output; nyg , is natural growth rate of
output
tmg , is growth rate of money supply
t is inflation rate; tu is actual unemployment rate; nu natural rate
of unemployment
Lecture 9 21
%25.01 yttt guu %31 ttt u ; tmtyt gg Year Inflation Unemploy
ment rate Growth rate of output
Growth rate of money supply
0 9 3 2 11 1 8 4 0 8 2 7 4 2 9 3 6 4 2 8 4 5 4 2 7 5 4 4 2 6 6 3 4 2 5 7 2 4 2 4 8 2 3 4 6 9 2 3 2 4
Stabilisation: Table 1
Lecture 9 22
Natural growth rate: %3, nyg ;
Natural unemployment rate: %5nu ;
current t =11%; let target %2* ;
Inflation reduction rate each year: t - 1t =2%;
Slope of the Okun’s curve a = 0.5; Slope of the Phillips Curve: b = 0.5. Growth rate of money supply, output and inflation
ttygtmg ,,
Basic Parameters for the Stabilisation Programme Model
Lecture 9 23
Year Inflation Unemployment rate
Growth rate of output
Growth rate of money
supply 0 11 5 3 14 1 9 9 -1 8 2 7 9 3 10 3 5 9 3 8 4 3 9 3 6 5 2 7 8 10 6 2 5 8 10 7 2 5 3 5 8 2 5 3 5 9 2 5 3 5
%35.01 yttt guu %55.01 ttt u tmtyt gg
Disinflation (Stabilisation Program
Lecture 9 24
Parametric Specification and solution steps for inflation reduction Programme
1. Stick the current and past inflation rates t and 1t in
equation (2) and solve that equation for actual unemployment
rate tu . The current inflation rate t can be obtained using
information on 1t and desired decrease in the annual
inflation rate. 2. Use this unemployment rate in equation (1) and solve for the
actual growth rate, tyg , .
3. Use this growth rate of output in equation (3) to solve for
growth rate of money supply tmg , . Repeat this process
until target rate of inflation is achieved.
Lecture 9 25
Transitional path of output and money growthand unemployment rate in the inflation reduction
programmeTime pi u gy gm
0 14 5 3 17
1 12 9 -5 7
2 10 9 3 13
3 8 9 3 11
4 6 9 3 9
5 4 9 3 7
6 2 9 3 5
7 2 5 11 13
8 2 5 3 5
9 2 5 3 5
nygtygt
utu ,,5.01
nutu
tt 5.01
ttmgtyg ,,
%5nu
t =14%
- %21
tt
a = 0.5
b = 0.5
%2* %3, nyg
Lecture 9 26
Stabilisation Programme
-8-6-4-202468
101214161820
0 1 2 3 4 5 6 7 8 9
time periods
pi
u
gy
gm
Lecture 9 27
Suppose that inflation is 21%; natural growth rate of output is 3%; natural unemployment is 5% b=1; a=1. Target inflation = 3%.
Year Inflation Unemployment rate
Growth rate of output
Growth rate of money supply
0 21 5 3 24 1 18 8 0 18 2 15 8 3 18 3 12 8 3 15 4 9 8 3 12 5 6 8 3 9 6 3 8 3 6 7 3 5 6 9 8 3 5 3 6
Stabilisation: Table 2
Lecture 9 28
Suppose that inflation is 21%; natural growth rate of output is 3%; natural unemployment is 5% b=0.5; a=1. Target inflation = 3%.
Year Inflation Unemployment rate
Growth rate of output
Growth rate of money supply
0 21 5 3 24 1 18 8 -3 15 2 15 8 3 18 3 12 8 3 15 4 9 8 3 12 5 6 8 3 9 6 3 8 3 6 7 3 5 9 12 8 3 5 3 6
Stabilisation: Table 3
Lecture 9 29
Disinflation Path and the Steady State
Disinflation path 14% (a) inflation (b) 2% (c) 3% 4% Unemployment, u
Relation between growth rate of money supply and output and unemployment rate: in the medium run ym gg
ym gg '''
Un Unemployment, u
Lecture 9 30
Natural growth rate: %2, nyg ;
Natural unemployment rate: %3nu ;
current t =11%; let target %2* ;
Inflation reduction rate each year: t - 1t =1%;
Slope of the Okun’s curve a = 0.5; Slope of the Phillips Curve: b = 1. Growth rate of money supply, output and inflation
ttygtmg ,,
Another Set of Parameters for the Stabilisation Programme Model
Lecture 9 31
Time pi u gy gm0 11 3 3 141 10 5 0 102 9 5 2 113 8 5 2 104 7 5 2 95 6 5 2 86 5 5 2 77 4 5 2 68 3 5 2 59 2 5 2 410 2 3 4 611 2 3 2 412 2 3 2 4
Transitional path of output and money growthand unemployment rate in the inflation reduction programme
Lecture 9 32
A Smooth Inflation Reduction Programme
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7 8 9 10 11 12
In P
erce
nt
pi
u
gy
gm
Lecture 9 33
Inflation Policy Game
0,03,5
3,30,3
Pr...............................
L
H
LH
SectorGovernment
Sectorivate
.
Policy options and its outcome
Policy Options Actual inflation Expected inflation Unemployment rate A Low Low u = un B Low High u > un C High Low u < un D High High u = un
Lecture 9 34
Inflation Policy Game
LPC Inflation PC2 PC1 C (3,-3) D (-3,0) A(0,0) B(-5,-3) un
nte
t uub Unemployment rate, u.
C is the most preferred and B is the least wantedscenario of the government
uL
L
H
uH
Non cooperative Game may end at point Dwith high inflation and high unemploymentrate
Lecture 9 35
P
YYn
AD0
AD1
LAS SAS
a
b
c
0Reply to demand shockAdaptive Expectation: a to b to cRational expectation: a to c
Adaptive and Rational Expectation Views on a Positive Demand Shock
P0
P2
P1
Lecture 9 36
a
b
c
d e
AD0
AD1AD3
f
Yn
Price LevelAS0
AS1AS2
SA3
YL YH
P0
P1
P2
P3
Movement of Aggregate Demand and Supply Around the Natural Rate
0
Lecture 9 37
Exercises• Okuns’ Curve
• Phillips curve
• Inflation reduction program
• Sacrifice ratio
• Money supply, inflation and economic growth rate in the steady state
• Policy Game
