WS 2006/07 1 U. van Suntum Konjunktur und Beschäftigung

7. Expectations and the Phillips Curve

• Exogenous business cycle explanation

• rational expectations • resulted from critique of Phillips curve

• extreme results in theory

• substantial impact on economic thought

U. van Suntum KuB 6 1U van Suntum, Lecture KuB 1

WS 2006/07 2 U. van Suntum Konjunktur und Beschäftigung

Phillipscurve and Expectations

termedisturbanc u

level price expectedp

output mequilibriu Walras

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Robert E. Lucas jr.• born 1937

• Nobelprize 1995

U. van Suntum KuB 6 2

Lucas supply function:*)

U van Suntum, Lecture KuB 2

WS 2006/07 3 U. van Suntum Konjunktur und Beschäftigung

Business cycle modell with Lucas supply function

up

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U. van Suntum KuB 6 3

ubY

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• With p = pe and u = 0 => Yreal = Yreal*

• p endogenous, dependent on pe

U van Suntum, Lecture KuB 3

WS 2006/07 4 U. van Suntum Konjunktur und Beschäftigung

Three versions of expectations:

a) static (Keynesian version ):

b) adaptive (monetaristic version):

c) rational (new classical version):

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With it follows:

U. van Suntum KuB 6 4U van Suntum, Lecture KuB 4

WS 2006/07 5 U. van Suntum Konjunktur und Beschäftigung

Nine possible combinations with monetary policy (six are relevant):

Additional money supply

a) static expectations b) adaptive expectations

c) rational expectations

A) One off increase (prevailing)

Aa

B) Increase by constant rate in every period

Ba Bb

C) Increase by accelerating rate in every period

Cb Cc

=> Keynesian Phillipscurve

=> Monetaristic Phillipscurve

=> New classical Phillipscurve

U. van Suntum KuB 6 5U van Suntum, Lecture KuB 5

WS 2006/07 6 U. van Suntum Konjunktur und Beschäftigung

Additional money supply

a) static expectations b) adaptiv expectations

c) rational expectations

A) One-off increase (prevailing)

B) Increase by constant rate in every period

C) Increase by accelerating rate in every period

=> Keynesian Phillipscurve

=> Monetaristic Phillipscurve

=> New classical Phillipscurve

U. van Suntum KuB 6 6U van Suntum, Lecture KuB 6

WS 2006/07 7 U. van Suntum Konjunktur und Beschäftigung

Numerical example model Ab: one-off increase of M with adaptive expectations*)

Wachstumsrate M 0,00% Mo 800ALG* 80,00% y* 800Parameter a (v) 0,5 PP 1000Parameter b (y) 1adaptive Erwartungen:

0 1 2 3 4________________________ __________ __________ __________ __________ __________Preisniveau t-1 1,00 1,00 1,05 1,12 1,16Infl.Rate t-1 0,00% 0,00% 5,00% 6,19% 3,95%=> erw. Preisniveau pe 1,00 1,00 1,10 1,18 1,20Geldmenge M 800,00 880,00 880,00 880,00 880,00* Umlaufsgeschw. v 1,00 1,00 1,03 1,03 1,02= nom. Sozialprodukt Y 800,00 880,00 902,00 907,24 897,38/ Preisniveau p 1,00 1,05 1,12 1,16 1,16= reales Sozialprodukt y 800,00 838,10 808,97 782,75 771,43=> ALG 80,00% 83,81% 80,90% 78,28% 77,14%Inflationsrate 0,00% 5,00% 6,19% 3,95% 0,36%nachrichtl: 1-ALG 20,00% 16,19% 19,10% 21,72% 22,86%

1*)

U. van Suntum KuB 6 7

Neuklassisches Konjunkturmodell.xls

U van Suntum, Lecture KuB 7

WS 2006/07 8

Einmalige Geldmengenerhöhung und adaptive Erwartungen

-5,00%

0,00%

5,00%

10,00%

0,00% 5,00% 10,00% 15,00% 20,00% 25,00%

Unterauslastung (1-ALG)

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ionsr

ate

Phillipskurve

U. van Suntum Konjunktur und Beschäftigung

Phillipscurve in model Ab:

U. van Suntum KuB 6 8U van Suntum, Lecture KuB 8

WS 2006/07 9 U. van Suntum Konjunktur und Beschäftigung

Wachstumsrate M 10,00% Mo 800ALG* 80,00% y* 800Parameter a (v) 0,5 PP 1000Parameter b (y) 1adaptive Erwartungen:

0 1 2 3 4________________________ __________ __________ __________ __________ __________Preisniveau t-1 1,00 1,00 1,05 1,17 1,36Infl.Rate t-1 0,00% 0,00% 5,00% 11,56% 15,88%=> erw. Preisniveau pe 1,00 1,00 1,10 1,31 1,57Geldmenge M 800,00 880,00 968,00 1064,80 1171,28* Umlaufsgeschw. v 1,00 1,00 1,03 1,06 1,08= nom. Sozialprodukt Y 800,00 880,00 992,20 1126,34 1264,26/ Preisniveau p 1,00 1,05 1,17 1,36 1,58= reales Sozialprodukt y 800,00 838,10 847,04 829,81 801,89=> ALG 80,00% 83,81% 84,70% 82,98% 80,19%Inflationsrate 0,00% 5,00% 11,56% 15,88% 16,15%nachrichtl: 1-ALG 20,00% 16,19% 15,30% 17,02% 19,81%

1:* Assumption

U. van Suntum KuB 6 9

Neuklassisches Konjunkturmodell.xls

Numerical example model Ab: constant growth rate of M with adaptive expectations*

U van Suntum, Lecture KuB 9

WS 2006/07 10 U. van Suntum Konjunktur und Beschäftigung

Konstante Geldmengenerhöhung und adaptive Erwartungen

0,00%

5,00%

10,00%

15,00%

20,00%

0,00% 5,00% 10,00% 15,00% 20,00% 25,00%

Unterauslastung (1-ALG)

Infla

tions

rate Phillipskurve

Phillipscurve in model Bb:

U. van Suntum KuB 6 10U van Suntum, Lecture KuB 10

WS 2006/07 11 U. van Suntum Konjunktur und Beschäftigung

Phillipskurve Deutschland 1973 - 2001(ALQ bis 1991 West-D, ab 1992 Gesamt-D)

-2

0

2

4

6

8

10

12

14

73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

Jahr

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Inflationsrate

Arbeitslosenquote

U. van Suntum KuB 6 11

Phillipscurve in Germany 1973 – 2001(I)

Inflation rateUnemployment rate

year

U van Suntum, Lecture KuB 11

WS 2006/07 12 U. van Suntum Konjunktur und Beschäftigung

Phillipskurve Westdeutschland 1973 - 1991

9190 89

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83

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79

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7776

75

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2

3

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0 1 2 3 4 5 6 7 8 9 10

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U. van Suntum KuB 6 12

Phillipscurve in Germany 1973 – 2001 (II)

Unemployment rate

infl

atio

n ra

te

U van Suntum, Lecture KuB 12

WS 2006/07 13 U. van Suntum Konjunktur und Beschäftigung

Phillipskurve Deutschland 1973 - 2001(ab 1992: Gesamtdeutschland)

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U. van Suntum KuB 6 13

Phillipscurve in Germany 1973 – 2001 (III)

Unemployment rate

infl

atio

n ra

te

U van Suntum, Lecture KuB 13

WS 2006/07 14

Phillipskurve Deutschland 1973 - 2001(ab 1992: Gesamtdeutschland)

99 98979695

94

9392

9190 89

888786

8584

83

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80

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75

7473

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0 2 4 6 8 10 12 14

Arbeitslosenquote

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U. van Suntum Konjunktur und Beschäftigung

1970s 1980s 1990s

U. van Suntum KuB 6 14

Phillipscurve in Germany 1973 – 2001 (IV)

Unemployment rate

infl

atio

n ra

te

U van Suntum, Lecture KuB 14

WS 2006/07 15 U. van Suntum Konjunktur und Beschäftigung

Criticism of new classical theory

Strengths:

• Role of expectations is highlighted

• Different versions of Phillips curve can be explained

• Simultanous explanation of inflation and business cycle

Weaknesses:

• Rational expectations not a realistic assumption

• Money supply exongenous?• One-sided

U. van Suntum KuB 6 15U van Suntum, Lecture KuB 15

WS 2006/07 16 U. van Suntum Konjunktur und Beschäftigung

Learning goals/Questions

• What is a Lucas supply function?

• What kinds of expectations can be distiguished?

• What is the impact of different combinations of monetary policy and expectations on the Phillips curve?

• What are the key drivers for fluctuations in new classical theory?

U. van Suntum KuB 6 16U van Suntum, Lecture KuB 16