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ECN 253---Inflation, Unemployment, and Federal Reserve Policy

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Yuanyuan Chen

on 14 November 2012

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Transcript of ECN 253---Inflation, Unemployment, and Federal Reserve Policy

Inflation, Unemployment, and Federal Reserve Policy Catherine Chen, Ph.D. Structure of this Chapter Short-Run Trade-off between Unemployment and Inflation Philips Curve (Long-run and Short-run) Inflation Rate and Monetary Policy Federal Reserve Policy The Discovery of the Short-Run Trade-off between Unemployment and Inflation There is a short-run trade-off between unemployment and inflation. In the late 1950s by New Zealand economist A. W. Phillips as an inverse relationship between unemployment and inflation, exists in the short run—a period that may be as long as several years—but disappears in the long run. Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate. Is the Phillips Curve a Policy Menu? Structural relationship A relationship that depends on the basic behavior of consumers and firms and that remains unchanged over long periods. Because many economists and policymakers in the 1960s viewed the Phillips curve as a structural relationship, they believed it represented a permanent trade-off between unemployment and inflation. Is the Short-Run Phillips Curve Stable? During the 1960s, the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation. Then in 1968, Milton Friedman argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation because a vertical long-run aggregate supply curve is inconsistent with a downward sloping long-run Phillips curve. The Long-Run Phillips Curve Remember Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP. Friedman concluded that the long-run aggregate supply curve is a vertical line at potential real GDP, and the long-run Phillips curve is a vertical line at the natural rate of unemployment. The Role of Expectations of Future Inflation If the long-run Phillips curve is a vertical line, no trade-off exists between unemployment and inflation in the long run. Differences between the expected inflation rate and the actual inflation rate could lead the unemployment rate to rise above or dip below the natural rate. Example: The Short-Run and Long-Run Phillips Curves Shifts in the Short-Run P-Curve & How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy? In the long run, there is no trade-off between unemployment and inflation. In the long run, the unemployment rate always returns to the natural rate, no matter what the inflation rate is. Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease. In the long run, the Federal Reserve can affect the inflation rate but not the unemployment rate. Expectations of the Inflation Rate and Monetary Policy how workers and firms adjust their expectations of inflation • Low inflation. When the inflation rate is low, as it was during most of the 1950s, the early 1960s, the 1990s, and the 2000s, workers and firms tend to ignore it. • Moderate but stable inflation. For the four-year period from 1968 to 1971, the inflation rate in the United States stayed in the narrow range between 4 and 5 percent, which workers and firms could not ignore without seeing their real wages and profits decline. • High and unstable inflation. Although it has been rare in U.S. history during peacetime, the inflation rate was above 5 percent every year from 1973 through 1982. People are said to have adaptive expectations of inflation if they assume that future inflation rates will follow the pattern of recent inflation rates. Rational expectations Expectations formed by using all available information about an economic variable. The Effect of Rational Expectations on Monetary Policy Is the Short-Run Phillips Curve Really Vertical? Lucas and Sargent argued that the apparent short-run trade-off was actually the result of unexpected changes in monetary policy. Many economists have remained skeptical of the argument that the short-run Phillips curve is vertical.
The two main objections raised are that
(1) Workers and firms actually may not have rational expectations.
(2) The rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place. Real Business Cycle Models Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP. During the 1980s, some economists argued that fluctuations in “real” factors, particularly technology shocks, which are changes to the economy that make it possible to produce either more output—a positive shock—or less output—a negative shock—with the same number of inputs, explain deviations of real GDP above or below its previous potential level. Federal Reserve Policy from the 1970s to the Present A Supply Shock Shifts the SRAS and the Short-Run Phillips Curve Paul Volcker and Disinflation Disinflation A significant reduction in the inflation rate. Alan Greenspan, Ben Bernanke, and the Crisis in Monetary Policy • Deemphasizing the money supply. Greenspan’s term was notable for the Fed’s continued movement away from using the money supply as a monetary policy target. Instead of the Fed setting targets for M1 and M2, the Federal Open Market Committee (FOMC) has relied on setting targets for the federal funds rate to meet its goals of price stability and high employment. The importance of Fed credibility. Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective. The Decision to Intervene in the Failure of Long-Term Capital Management During 2008, the Fed decided to help save the hedge fund Long-Term Capital Management (LTCM), which had suffered heavy losses on several of its investments.Although some critics see the Fed’s actions in the case of LTCM as encouraging the excessive risk taking that helped result in the financial crisis of 2007–2009, other observers doubt that the behavior of managers of financial firms were much affected by the Fed’s actions. The Decision to Keep the Target for the Federal Funds Rate at 1 Percent from June 2003 to June 2004 The Fed lowered the target for the federal funds rate from 6.5 percent in May 2000 to 1 percent in June 2003. At the time, the FOMC argued that although the recession of 2001 was mild,the very low inflation rates of late 2001 and 2002 raised the possibility that the U.S. economy could slip into a period of deflation. Fun time: Short Review http://www.econreview.com/phillips/us.php Follow
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