Inflation, Deflation, and the Phillips Curve
Inflation
Deflation
1
Macroeconomics up to now
2
IS-MP
Y
Potential output = AF(K,L)
Ypot
u
i r
Now add inflation
3
IS-MP
Y
Potential output = AF(K,L)
Ypot
u
πe
π
i r
4
Inflation’s history in the US
50
100
150
200250
350
500
1000
15002000
00 25 50 75 00 25 50 75 00
CPI Price index of GDP
Pri
ce (
1865
-191
4 =
100
)
Gold-silverstandardperiod
5
1
2
3
4
5
6
7
8
9
10
1980 1985 1990 1995 2000 2005 2010 2015
Core inflation and Fed inflation target rate
Inflation target = 2%
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How do we measure price indexes?
Consumer price index:- Traditionally a Laspeyres price index (fixed weight
index using early prices)- BLS has introduced an experimental index – the
“chain CPI” – which is a superlative Törnqvist index.
- As with output index, Laspeyres overstates inflation:g(Paasche) < g(Tornqvist), g(Fisher) <
g(Laspeyres)National accounts price indexes
- These are Fisher (superlative) indexes- Fed target uses personal consumption expenditures
price index (Fisher)“Core Inflation”
- removes volatile food and energy and is central target for monetary policy (personal consumption core price index)
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Paasche
Laspeyres
Superlative: Fisher, Tornqvist
Does it make any difference?Yes, 0.5% per year over 1970-2012
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0.96
1.00
1.04
1.08
1.12
1.16
1.20
1.24
1970 1975 1980 1985 1990 1995 2000 2005 2010
CPI/Price of PCE[Laspeyres/Fisher]
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Major topics
1. Why do we care about inflation?2. Modern inflation theory
Why do we care about inflation?
Like temperature, we care mainly about the extremes:
Hyperinflation (> 100% a month)
Deflation (< 0)
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What are costs of inflation?
– Redistribution: inflation redistributes wealth from creditors to debtors (mortgages, pensions).
– Inefficiencies of inflation: shoe leather, menu costs, taxes,...
– Distinguish anticipated from unanticipated inflation (ex ante v. ex post real interest rates)
– Overall, costs appear relatively small at low inflation rates.
– Hyperinflation can destroy price mechanism– Deflation can produce low-level equilibrium
Now to inflation theory in the US
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The Expectations -Augmented Phillips Curve
Fundamentals of theory:1. Unemployment rate (u) determined by interaction of
potential and actual Y by Okun’s Law2. Inflation determined by labor/product market
tightness (u relative to “natural rate of unemployment”*) and expected inflation (πe) – Phillips curve
3. Expected inflation (πe) determined by inflation history and forecasts of future inflation
*natural rate of unemployment (Jones); sometimes called the NAIRU = “non-accelerating inflation rate of unemployment” = Goldilocks unemployment rate
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The Expectations -Augmented Phillips Curve
In algebra:
u - u* = λ (Y – YP)/YP
π= πe - β (u - u*)πe determined by past inflation and expectations process
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The short-run P.C.
Graph from Economic Report of the President 1969
This was relationship that led Keynesian to believe that P.C. was a good explanation for inflation (1960s)
1. (πe)
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0
1
2
3
4
5
6
2 3 4 5 6 7 8
Unemployment rate
CP
I in
flatio
n ra
te
1961
1969
Early Phillips Curve
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Collapse of short-run P.C.
0
2
4
6
8
10
12
14
2 3 4 5 6 7 8 9 10
U
Pi
1961
1995
1980 This was relationship that led many new classical economists to conclude that Keynesian theories were “fatally flawed” (Lucas and Sargent. 1970s)
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Mainstream 2-equation inflation model
(1)π(t) = πe(t) + β[u(t) - u*] + ε(t)
(2)πe(t) = π(t-1)
Endogenous variablesπ = rate of price inflationπe = expected rate of inflation (or similar concept)u* = natural rate
Exogenous variablesu = actual unemployment rate (determined by policy and shocks)ε(t) = wage and price shocks (oil prices, exchange rates, globalization, decline of unions, immigration, etc...)t = time
[Note: (2) is backward looking rather than rational expectations.]
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Simplest 1-equation inflation modelSimplify by assuming no shocks and substituting:
(3) π(t) = π(t-1) - β[u(t) - u*]
(4) Δ π(t) = - β[u(t) - u*]
which is the linear expectations-augmented P.C. model.
20u* = natural rate
π1 = π1e
SRPC1
Short-run Phillips curve
1
21u* = natural rate
π1 = π1e
Moving up short-run Phillips curve
1
2
SRPC1,2
π2
22u* = natural rate
π1 = π1e
Short-run Phillips curve shifts upward with higher inflation expectations
1
2π3
e =π2
SRPC1,2
SRPC3
23u* = natural rate
π1 = π1e
SRPC1,2
SRPC3
1
2
3π3 = π3
e
Now unemployment rate back to the natural rate
24u* = natural rate
π1 = π1e
SRPC1,2
LRPC
SRPC3
1
2
3π3
e =π2
u equals the natural rate in both periods 1 and 3, but the expected and actual inflation rates are higher in period 3.
This diagram shows the way that the SRPC shifts as expected inflation adjusts to higher rate.
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-3
-2
-1
0
1
2
3
3 4 5 6 7 8 9 10
Unemployment rate
Ch
an
ge
in c
ore
infla
tion
ra
te
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New synthesis of accelerationist PCRough estimate of natural rate for 1960-2012 = 6 percent
Δ π(t) = β[u(t) - u*]u* is u where Δ π(t) =0.
This was the new synthesis developed by Phelps and Friedman (1967-68). It now forms the basis of mainstream macro for large open economies.
Phillips curve at low inflation
26 26u* = natural rate
Does Phillips curve bend because of nominal rigidity at zero inflation?
Controversial, but probably yes.
1-2%
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Summary onThe Expectations-Augmented Phillips Curve
• u and π are negatively related in short run • no relation between u and π in the long run • short-run PC adjusts up and down as economic agents
adjust their inflation expectations to reality (combination of backward and forward looking expectations).
• Natural rate is u at which inflation tends neither to rise nor fall
Deflation
Deflation = falling price levelThis seldom occurs in modern economy, but sometimes
have near-zero inflation (Japan for two decades, US today).
Problems:- If full-employment interest rate < 0, have liquidity trap- Unstable dynamics: since r = i – π, as π falls have higher real interest rate, lower I, lower Y, and “low-level trap”
Some of the issues involved are discussed in Bullard, Seven Faces. Very interesting discussion!
But this is uncharted territory in modern macro!
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