Macroeconomics

1
Macroeconomics

• Lecture 5
• Inflation and unemployment

2
Outline

• Empirical facts
• The dynamic AD-AS model (the Phillips Curve
  Model).
• Using the Phillips Curve Model to make sense of
  the 70ies, 80ies and 90ies.

3
Unemployment as a of the labour force, United
Kingdom, 1960-1997
70s
80s
OECE, Main indicators.
4
Inflation, GDP deflator (annual, ) United
Kingdom, 1961-96
OECD. Main indicators.
5
Inflation and unemployment in the UK is the early
1980s
6
Inflation and unemployment inthe short-run
Static model
Dynamic model
Inflation and unemployment
P and Y
Dynamic Aggregate demand (DAD)
Aggregate demand (AD)
Short-run aggregate supply (SAS)
Short-run Phillips Curve (SPC)
Long-run aggregate supply (LAC)
Long-run Phillips curve (LAC)
7
The Phillips Curve
Aggregate supply
Rewrite
Subtract P-1
Inflation
8
Okuns law
The deviation of output from its equilibrium
level is inversely related to the deviation of
unemployment from its equilibrium level
9
Slope of the Phillips curve
Random supply shocks
Expected inflation
Cyclical unemployment
10
U
UN
11
The static AD curve
P
M up
(G - T) up
AD1
AD0
Y
12
Dynamic Aggregate demand (DAD)
Growth in government deficit (G-T)
Growth in real money supply
Dynamic multipliers
13
Use Okuns Law
Slope of the DAD curve
Growth of government deficit
Money growth
Demand shock
Cyclical unemployment
14
U
UN
15
Long-run equilibrium
Steady state equilibrium

• Stable (constant) inflation.
• Expectations are fulfilled.
• The growth of the deficit is zero.
• No shocks.

16
Characterization of long-runequilibrium
Real rigidity
Non-accelerating inflation rate of unemployment
(NAIRU)
the structural rate of unemployment
Nominal rigidity
The natural rate of unemployment
17
Characterization of long-runequilibrium
18
Short-run analysis
The model in action

• Stagflation in the 70ies (high inflation and
  unemployment in response to supply shocks).
• Disinflation in the 80ies.
• Central bank independence in the 90ies.

19
LPC
A
Long-run equilibrium
U
UN
20

• Negative supply shock leading to stagflation in
  the 70ies

• Accommodating economics policy

d
LPC
C
B
A
U
u1
UN
21
Dis-inflation in the beginning of the 1980s
d
LPC
C
B
C
U
UB
UN
22
u
uN
Time
Fig
Time
23
The cost of disinflation
Adjustment speed
Credibility

• Does the private sector believe the government
  will go through with the plan.
• Institutions and ideology

• How fast do expectations adjust (rational versus
  adaptive expectations)?
• How fast do changes in expectations get locked
  into nominal wage contracts?

24
What is next?

• Stabilization policy in a closed economy.
• Fiscal and monetary policy.