Föreläsning 14-15 Flashcards
Whats the difference for price levels, production and employment in the short and long run?
Short term (IS-LM model): We have taken the price level as given, and production is determined by demand. Therefore, production is not necessarily at its natural level
Long term: Prices are flexible. Production is determined by production factors (capital, labor, technology). Production and employment return to their natural long term equilibrium levels.
Which are the three versions of the Philips curve?
Unemployment and the rate of wage increase
Unemployment and inflation
Output gap and inflation
What does the wage setting equation state?
The wage setting equation states that the desired rate of wage increase depends on the average rate of wage increase and the cyclical unemployment rate.
If unemployment is higher than the equilibrium level, firms want to increase wages less than the average rate of wage increase and vice versa
Firms set wages to best balance the cost of:
Direct wage costs
Turnover costs
Whats the differnce between firms having flexible wages and rigid wages for the unemployement?
The more firms have flexible wages, the more unemployment affects the average wage increase because they adjust their wages immediately when labor market condition change
The more firms have rigid wages, the more significant role expected wage increases will play in the average wage increase.
The position of the Phillips curve depends on inflation expectations
To understand how the trade-off between 𝜋 and u changes over time, we need to understand how expectations are formed
What are the three theories of expectation formation?
Constant price level: Prices are expected to remain the same as last year: 𝜋e = 0
Constant inflation: Price changes are expected to be the same as last year: 𝜋e = 𝜋t-1
Anchored expectations: Inflation is expected to be equal to the inflation target: 𝜋e=𝜋⊗
What does stabilization policy do?
Measures aimed at dampening economic fluctuations, maintaining stable inflation, and low unemployment
What is monetary and fiscal policy
Monetary policy: The central bank uses, among other thing, the policy rate
Fiscal Policy: Public investments and consumption, taxes, subsidies
What is the goal of monetary policy?
Price stability: interpreted as low and stable inflation
However, it can also allow temporary deviations in inflation to achieve other goals:
High and stable production and employment
Well-functioning financial markets: payment systems, access to credit
…but price stability is often the primary mandate
How should the central bank react to a demand shock?
If CB changes the interest rate: Using stabilization policy, CB raises the interest rate to, counteract the increase in AD, thereby stabilizing production and inflation
How should the central bank react if an unexpected increase in oil prices leads to a cost shock for business (z > 0)?
When z increases, business costs increase, and inflation rises, shifting the PC upward
If CB does not change the interest rate: inflation increases (𝜋 > 𝜋⊗) because the PC has shifted up. Assuming 𝜋e = 𝜋⊗, the increase is temporary. When the shock subsidies (z = 0), the PC shifts back: 𝜋 = 𝜋⊗
If CB changes the interest rate:
Inflation remains at the target (𝜋 = 𝜋⊗) despite the upward shift in the PC, but production decreases (Y < Yn). When the shock subsidies (z = 0), the PC shifts back, and production returns (Y = Yn)
… CB faces a trade-off between 𝜋 and Ŷ
𝜋e = 𝜋⊗: prioritize Y
𝜋e = 𝜋t-1: prioritize 𝜋
How should the central bank react if, for example, the inflation target loses credibility so that 𝜋e increases above the target, i.e., 𝜋e > 𝜋⊗?
When 𝜋e increases, the IS curve shifts out, and the Phillips curve shifts upward
IS: Shifts because an increase in 𝜋e for a given interest rate means lower r. As r decreases, aggregate demand (AD) increases, causing the IS curve to shift out
PC: shifts out because the rate of expected wage increase rises. Firms want to match expected wage increases so that their employees do not choose to leave for another firm willing to pay higher wages
If CB does not change the interest rate
PC shifts up when 𝜋e increases (direct effect on 𝜋: 𝜋⊗ → 𝜋e´)
IS shifts out since real interest rates decrease (𝜋e increased but i remains constant), increasing AD and thus production (Yn → Y´). This reduces unemployment (u), creating pressure for wage and price increases: 𝜋 increases (indirect effect on 𝜋: 𝜋e´ →𝜋1)
If CB changes the interest rate:
Increase the interest rate by the same amount as the increase in 𝜋e. At i = i1, Ŷ = 0 but 𝜋 > 𝜋⊗
Increase the interest rate more than the increase in 𝜋e. At i = i2, 𝜋 = 𝜋⊗, but Ŷ < 0
… CB faces a trade-off between 𝜋⊗ and Ŷ
Prioritize Ŷ = 0: △i = △𝜋e so that i = i1
Prioritize 𝜋⊗ (Taylor’s principle): △i > △𝜋e so that i = i2
