SR Fluctuations/Phillips Curve Flashcards
What is a short-run fluctuation? How can Central Banks change this?
- SR fluctuations; variations in inflation and output
- Potential Output cannot be changed, so Central Banks can use interest rates to influence Actual Output to close the gap
- However, shocks can harm growth rates
Explain the Spike in Oil Prices in 1973 and the subsequent issues and actions in the US
- The spike in Oil prices via OPEC embargoes led to inflation in USA
- US adopts an ‘average price level targeting’; meaning that there could be inflation if it evens out overall
- Core inflations aims to remove highly fluctuating items unlike CPI
- Federal Reserves often decompose CPI in both sticky and flexible prices, which helps to tell the inflation rate’s nature
- US gives weighting to sticky prices (about 90%)
How do firms set prices?
- Expected inflation
- Demand
- Output
- Supply Shocks
- Firm adjust their nominal prices to maintain their own relative profits
What is the Phillips Curve? What is the equation for this phenomenon?
- π = π(-1) + α(Y-Ȳ)
- The Phillips Curve is the relationship between unemployment/output and inflation
- This is related by Okun’s Law
- Shows that in a boom (GDP increases), inflation also rises
- π(-1) = Last year’s inflation
- (Y-Ȳ) = Output Gap
- α = The responsiveness of prices to AD, which is affected by competition
What is the difference between rational and adaptive expectations?
- Rational expectations: Inflationary expectations based on good forecasts
- Adaptive expectations:
Inflationary expectations based on past information
What are Supply-Side shocks? How do they relate to the Phillips Curve?
- Supply-Side shocks (v) are events that cause major changes in firms production cost, impacting output and prices in the Short-Run
- Can be adverse or beneficial
- Some shocks include raw material costs, wages, exchange rate movement
- This meant that the formula becomes :
- π = π(-1) + α(Y-Ȳ) + v
What are the determinants of Aggregate Expenditure
- Consumption
- Investment
- Government Spending
- Net exports
- Private Consumption accounts for 70% of total expenditure
What is the role of the interest rate on Aggregate expenditure
- Interest rate here is the forecasted real interest rate
- r = i - Eπ
- There is a negative relationship between r and AE
What are expenditure shocks? What factors affect this?
- Shifts in the Aggregate Expenditure line
- Government Spending, Tax, Consumer confidence Technological changes, Bank lending, Credit crunches and foreign business cycles all effect expenditure
Explain a shift outward of AE
- AE1 to AE2
- Potential is at Y1 and r1, so moving from Y1 to Y3 means that output is greater than potential
- To remain at Y1, the Central Bank raise interest trates
What is the difference between an Expenditure Shock and Supply-Side shock (impact on PC)?
- Expenditure Shocks: Shift in AE, movement on PC
- Supply-Side Shocks: If Central Bank does nothing to deal with inflation, PC shifts
What are some dilemmas when a central bank is deciding whether to act
- Inflation Vs Output
- Accommodative Vs Non-Accommodative (Exp. Vs Cont.)
- Depends on the stance
- Permenant boom
What is the difference between Accommodative and Non-Accommodative?
- Accommodative monetary policy = allows a supply shock to raise inflation permanently, even after the shock ends, since the positive change in inflation increases the level of inflation into the future (EXPANSIONARY)
- Non-Accommodative policy = keeps inflation constant and the fall in output is temporary as only a temporary increase in the interest rate is needed to keep inflation constant (CONTRACTIONARY)
What is Monetary Neutrality?
- Lr Monetary Neutrality is the principle that monetary policy cannot affect real variables
- Can impact inflation and nominal variables (ONLY SR)
- LR unemployment (NRU) undetermined
