EC2B3 Topic 5: Inflation and the Phillips Curve Flashcards
What is inflation?
The rate at which the general level of prices for goods and services is rising, eroding purchasing power.
What does the Phillips Curve illustrate?
The inverse relationship between the rate of unemployment and the rate of inflation.
True or False: According to the Phillips Curve, lower unemployment leads to higher inflation.
True
Fill in the blank: The Phillips Curve suggests that there is a trade-off between _______ and inflation.
unemployment
What can cause a shift in the Phillips Curve?
Changes in inflation expectations, supply shocks, or policy changes.
What is meant by ‘stagflation’?
A situation characterized by stagnant economic growth, high unemployment, and high inflation.
What happens to the Phillips Curve in the long run?
It is vertical at the natural rate of unemployment, indicating no trade-off between inflation and unemployment.
Fill in the blank: The natural rate of unemployment is the level of unemployment that exists when the economy is _______.
at full capacity
What are supply shocks?
Unexpected events that affect supply, leading to changes in prices and inflation.
How do inflation expectations affect the Phillips Curve?
If expectations of inflation rise, the curve shifts upward, indicating higher inflation at any given level of unemployment.
What is the short-run Phillips Curve?
A downward-sloping curve that shows the trade-off between inflation and unemployment in the short term.
True or False: The long-run Phillips Curve suggests a stable trade-off between unemployment and inflation.
False
What is the impact of monetary policy on the Phillips Curve?
Monetary policy can influence inflation and unemployment, shifting the Phillips Curve in the short run.
Fill in the blank: The concept of the Phillips Curve originated from the work of economist _______.
A.W. Phillips
What is the cyclical relationship of inflation with real GDP
- Procyclical (not stable over time)
- Less volatile than GDP
- Slightly lagging
Mid way between new keynesian model and full price flexibility
Partial price adjustment model
diff between big W and little w
W is wage in money terms
w is wage in real terms
w = W/P
With imperfect competition. what does labour demand equal
Firm charge a price above MC –> labour demand MRPn = w = W/P
MRPn below MPn –> gap is profit margin
What to do if MRPn < w or MRPn > w
If MRPn < w then price is too low
raise price and sell less
If MRPn > w then price is too high
lower price and sell more
What are the links between real GDP and desired price changes
HIgher AD –> more workers –> pushes up w –> move alaong Ns curve –> dimishing returns to labour so MPn and MRPn decline –> marginal costs rise, eroding profit margins
Relationship between outgaps and MRPn being > or < w
If Y< Y * then MRPn > w so price cut needed (deflation in recession)
If Y>Y * then MRPn < w so a price rise is desired (inflation in boom)
Larger gap between Y and Y * ; larger desired price change
How does a price adjustment lead to a Phillips Curve
- Positiive rs between inflation and output gap
Thus there is an upward sloping PC when plotting π against Y
–> downward sloping if plotted against UE
What causes PC to shift
- If natural output level rises and falls
- Inflation expectations change
Why does inflation expectations lead to higher current inflation
Any firm adjusting its prices in current period will choose a price increase when expectations higher
How can inflation be controlled using monetary policy if inflation is controlled by the Phillips curve
- Influence people’s expectations
- Move along PC by affecting demand; use transmission mechanism
Transmission mechanism
Nominal IR up –> real IR up –> AD down –> output gap (Y - Y * ) down –> inflation down (PC)
CB should adjust IR in response to fluctuations in inflation
Taylor rule
Rule of thumb for how CB should set IR
Desireable features of the Taylor rule
- Positive b is systematic stabilising response to business cycles
–> cut IR in recessions, raise IR in booms
Stabilise inflation through a>1; more than one for one reaction of nominal IR to inflation. Known as the ‘Taylor Principle’
Why is the ‘Taylor Principle’
Failure to do this means rising inflation actually reduces real interest rate causing demand to rise and stoking more inflationary pressure
MM line in response to Real GDP Y and inflation
MP response to real GDP Y makes MM line upward sloping (+ve correlation)
MP response to inflation shifts the MM line when π changes (+ve correlation)
How do you summarise the Y(d) curve and monetary policy
Summarise with a single line in the same diagram as the Phillips Curve (Yd - MM)
Draw the Yd - MM line
Yd - MM represents combination of output demand Yd and stance of monetary policy
- shifts for same reasons as Yd does and in same direction
- Shifts with expectations
- Shifts with change in monetary policy reaction
What does the intersection of PC and Yd-MM line determine
Inflation (π) and GDP Y
How do expectations impact Yd - MM
If taylor principle satisfied:
- larger i so r and MM shift up
- so Yd - MM shifts left, reducing Y and π along Phillips curve
if taylor principle not satisfied:
- effect on Yd - MM is the opposite
Higher expected future growth shifts Yd and Yd-MM to the right
How do demand shocks helps us observe a stable PC
If policy doesn’t offset the shocks, Yd-MM line shifts, tracing out a PC in the data
PC plays role of supply, stable position due to temp. nature
Draw temporary supply shocks
Draw the permanent shift in demand/monetary policy, with adjustment of inflation expectations
Supply shocks move the PC around due to Y * changing
Passes through inflation expectation.
Y * down , PC inwards
Y * up, PC outwards
inflation counteracted and you see no rs between output and inflation
why is inflation bad for real GDP and other reasons
Real GDP:
- PC implies volatality in inflation destabilises the real economy
- Control of inflation helps to manage the business cycle
Other:
- long term planning is difficult
- price out of line sith supply demand
- tax distortions
Redistribution:
- Arbitrary gains or losses for creditors or debtors, workers or firms
Analyse strict inflation targetting
if π = 0
- Firms happy w price –> w = MRPn –> employment on Ys curve –> at Y * so no output gap
Policy replicates flexible price equilibrium
R must shadow R * (need i = r = r * )
Draw strict inflation targetting
Why does aiming for π = 0 lead to inefficient output
Real GDP Y = Y * (as if prices were fully flexible but still imperfect competition)
Implies MRPn = w * = MRS (l,c) which implies –> MPn > MRS (l,c) as MPn > MRPn
How do supply shocks interact with strict inflation targetting
Causes real GDP fluctuations too much
Draw a negative supply shock in rigid wages.
Show the difference in flexible and strict inflation targetting
if strict inflation targetting; N is where MRPn = wage
Core inflation?
Inflation excl food and energy
Why should CB focus on core inflation
Costs of inflation is where greatest nominal rigidity, while energy and food is v flexible
CB mitigate nominal rigidity by targeting inflation where prices would be slower to adjust
