7. MP/FP/EP and Philips curve

Question 1

What are demand driven economic fluctuations?

Answer 1

Contraction in AD:
- Pessimism, stock market bust, drop in exports
- Demand driven contraction - output falls, price level falls
Over time, the SRAS curve shifts right, output reverts to natural rate as price levels adjust downwards

Shown graphically pretty simply:

• actual prices drop below expected levels
• Over time, as expected price level adjusts, SRAS curve shifts right and economy reaches new point where new AD curve crosses the LRAS
• Output returns to natural rate Y1 and price level falls to P3
• Note with demand driven contraction we expect prices to fall = deflationary

Question 2

uWhat are supply driven fluctuations

Answer 2

Contraction in AS:
- INcrease in prodcution costs, increase price expectations
- AS driven contraction - output falls, price levels increase
-Stagflation - inflation rate high, economic growth rate slows and unemployment remains high

With time, SRAS shifts back right, output reverts to natural rate as price level falls

Graphically:
- Events increase costs, SRAS curve shifts left from AS1 to AS2. Economy moves left up the AD curve resulting in stagflation - output falls, price levels rise

Question 3

What are examples of AD/AS driven recession/expansion

Answer 3

Great depression:
- Real GDP fell 27%
- Unemployment rose from 3% to 25%
- Prices fell 22%
- Money supply fell 28% - low AD

Expansion - early 1940 wartime expenditure
- Unemployment fell from 17% to 1%
- Prices rose 20%
Also occured post pandemic

AS contraction - oil crisis in 70s
AS expansion - new technology driving expansion in 90s

Question 4

What was the impact of the pandemic on fluctuation

Answer 4

Market shut down completely - AS shock, AD drifted to far right due to policies
- Inflation and shifted AD left, CB raised interest rates

Graphically:
- Shifts left in SRAS - lead to staglation
- Over time, output reverts to natural rate, prices drop back down
- To counter policy makers elect to shift AD curve right so output returns quickly to natural state
- Causes higher inflation

Question 5

What is the effect of monetary policy

Answer 5

CHange in money supply shifts AD curve
- Increase in money lowers interest, expansionary
- Decrease raises interest, contractive (AD left)

Effect shown on page 28

Question 6

What are tools used for monetary policy

Answer 6

Adjusting refinancing rate

Conducting Open Market Operations to change interest rates

• To ensure 2& CB bond traders supply enough money to ensure met
• Changing money supply and hcnaging interest rate amounts to same outcome

Question 7

What is the effect of fiscal policy?

Answer 7

Changes in G or taxation
- DIrectly shifts AD

A £1 increase in spending may be worth more than £1 dependingon:

Multiplier effect - amplifies effect on AD

Crowding out - diminishes effect on AD

Question 8

WHat is the multiplier effect?

Answer 8

Consumers respond to an injection of money, firms increase investment and consumers spend more
- Leads to a further shift to the right in AD, which gradually diminishes

Spending multiplier depends on:

MPC - marginal propensity to consume
- Larger MPC, larger multiplier
- If income increases for people likely to spend it, multiplier higher

As a result of multiplier effect £1 increase in spending leads to a greater than £1 increase in AD

Question 9

What are some of the calculus for multiplier

Answer 9

MPW = MPS + MPT + MPI

MPW = 1-MPC

Multiplier = 1/MPW
OR
= 1/1-MPC

Question 10

What is the effect of crowding out

Answer 10

An increase in G causes AD to shift right
- Increase income increases demand for money
- Increased interest rates and so reduction in investment spending

As a result AD curve shifts back towards the left
- Crowding out happens in long run if governments continuously run deficit

Effect on page 28

Since the government expenditure increases, money supply increases raising demand and raising interest rates

Question 11

What is active stabilisation policy? What is the Keynesian view?

Answer 11

Both MP and FP used to stabilise econom yin face of shocks
- Objective to ensure YFE and stable inflation

Keynesian:
- Key role of AD explaining fluctuations - state should stimulate AD to maintain production at full employment level to avoid unemployment

Question 12

What is the argument against active stabilisation policy?

Answer 12

-AD hard to control - long and variable lags
- Unreliable forecasts - leads to mistakes - overheating, bubbles, runaway inflation
- Corruption -> waste
- Better to leave economy alone and let market mechanisms deal with short run fluctuations

Question 13

What was the effect of the 2008 recession

Answer 13

• Large contractionary shift in AD
  -Real GDP fell sharp - 4% between Q4 2007 and Q2 2009
• Employment fell sharply - unemployment rose 4.4% may 2007 to 10% october 2009

Question 14

What were the 2008 policy actions

Answer 14

CB cut targets for repo rate - espcailly to about zero in late 2008
- Bought bonds, mortgage backed securities and private loans in market open market operations, providing banks with additional funds

October 2008 - Congress appropriated $700bn in the US
- For treasury to rescue financial system, stem financial crisi on Wall St, make loans easier to obtain and inject equity into banks
- UK and US temporarily part owner of some banks

Jan 2009 - Obamna increased government spending - $787bn stimulus bill in febuary
- Arguably worked but we dont know impact if didnt happen

Question 15

What are automatic stabilisers?

Answer 15

Automatic chnage sin spending that stimulate AD when economy goes into recession

Operates through taxes and transfers

In recession less tax collected, reduction in AD. More unemployment benefits paid out in recession - raises AD

(opposite happens during a boom)

However, not sufficiently strong to prevent business cycles completely
- size depends on public sector size relative to GDP
- Without them, output and employment much more volatile

Question 16

Why does the classical dichotomy break down in AD/AS model in the short run? how does it differ in long run

Answer 16

In long run - inflation depends only on growth in money supply
- Unemployment tends to natural rate - depends on NMW, unions, efficiency wages, search, etc.

Short run:
- Classical dichotomy breaks down
- Inflation and output related - expansionary policy increases output and inflation

Question 17

What does the phillips curve show? How does it differ for low/high levels of AD? What happens as you move down it

Answer 17

The trade off between inflation and unemployment in the short run
- Negative sloping curve correlation between the two

High AD:
- high output and prices - low unemployment and high inflation

Low AD;
- Low output and price level - high unemployment and low ifnlation

Moving down:
If AD shifts right, lower AD curve would be further along curve whilst higher AD curve would be closer to the y axis

Question 18

How does AD and AS respond to philips curve? What does the phillips curve look like in the long run?

Answer 18

AS curve slopes upward due to actual prices differing from expected prices
- Thus philips curve slopes downward only when actual inflation is different from expected inflation

When actual = expected inflation, philips curve will be verticalq

Long run:
- Unemploymen ttends towards natural rate
- Doesnt depend on money growth and inflation in the long run (classical dichotomy)

Question 19

What is the effect of MP on inflation? (GRAPHICALLY)

Answer 19

Genereates a surprise/unexpected inflation - if not AS curve would be vertical and be no change in Y/unemployment

Monetary expansion creates price increase, raising output
- In long run, people come to expect higher inflation to persist and expectations catch up with expectation - causes a move up the long run phillips curve (illustrated on 28)

Higher expected rate means higher short run trade off between inflation and unemployment is at its natural rate
- If then MP expansionary, economy moves up in the short run
- Expected inflation still low at point B, but actual inflation high

Unemployment below natural rate - in long run, expected inflation rises, economy moves to point C
- Expected inflation and actual inflation both high; unemployment back to natural rate

Question 20

What were Friedmand and Phelps’ theory?

Answer 20

Unemployment rate = natural rate of unemployment - a(Actual inflation - expected inflation)

(a is a parameter measuring how much unemployment responds to unexpected inflation)
- Similar to SRAS equation

If actual > expected, unemployment lower than natural rate

Question 21

What causes shifts in the philips curve

Answer 21

Changes in expected inflation

e.g. oil price shocks made inflationary pressures intolerable, policy focus on fighting inflation in early 80s by contractionary MP
- AD contracts, reduces inflation and moves down PC - also leads to lower unemployment which is costly

However ver time, short run philips curve shifts left, returning unemployment to its natural rate but now with a lower rate of inflation: graphed again on 28

Explanation:
- Contractionary monetary policy reduces inflation, economy moves along SRPC from A to B
- Over time expectations fall, so short run curve shifts downwards - when C is reached, unemployment at natural rate

Question 22

What is the sacrifice ratio

Answer 22

• % of annual output lost in process of reducing inflation by 1%
• Typically about 3 to 5%

For each $ inflation reduced, 3 to 5% of annual output sacrificed in transition
- In early 1980s inflation over 20% - to reduce to 5% lost 40% annual output

Question 23

WHat are rational expectations

Answer 23

• People optimally use all information when forecasting future - including policy information

If people belief CB will fight inflation, may lower inflation expectations, disinflation may cost less

Question 24

How is it possible for costless disinflation

Answer 24

Rational expectation implies a much smaller sacrifice ratio (maybe even 0)

Government must credibly commit to policy of low inflation so:
- People lower expectations
- When actual inflation decreases sharply, so does expected inflation
- We can stay of the long run philips curve

Question 25

What was thatcher disinflation and sacrifice ratio

Answer 25

In 1980s - peak inflation 20% was reduced to 5% in 1983

This turned out to not be costless though:
- High unemployment - 11% 1982 and 1983 decrease in output
- Not a decrease by 40% so not as bad as predicted

With Volker and Thatcher disinflations:
- Cost not as large as predicted but still high - maybe rational expectations hypothesis wrong - maybe instead mean public did not react how they estimated when announced the reduction of inflation