Term 2 Week 3: The Phillips Curve Flashcards
What is constant inflation equilibrium (2)
-Modern economies are characterized by a low, positive rate of inflation
-At the WS-PS intersection, the real wage is constant, meaning nominal wages and prices rise at the same rate
How will the WS-PS model adjust to an AD shock (4)
-If there is a positive AD shock, the economy will no longer be in medium run equilibrium, as output and employment will rise before wages and prices
-An AD shock will lead to nominal wages changing in the next wage round (people ask for more nominal wages to cover the price increase + to reflect the output gap, which takes their real wage up to the point on the WS curve at higher employment)
-This then leads to firms, experiencing a rise in costs, raising prices in the next round to keep markup fixed
-Assuming productivity is fixed, this wage inflation = price inflation
How will the WS-PS model adjust to an AD shock in equation form (3)
-(ΔW/W)t = (ΔP/P)t-1 + a(yt - ye)
-(ΔP/P)t = (ΔW/W)t - (Δλ/λ)t
-Assuming λ = constant, (ΔP/P)t = (ΔP/P)t-1 + a(y1-ye)
-(The change in wages in period 1t= change in prices in period t-1 + output gap)
-(Change in prices in period t = change in wages in period t - change in productivity)
-(assuming productivity change = 0, change in prices in period t = change in prices in period t-1 + output gap
What is the Non-Accelerating Inflation Rate of Unemployment (2)
-The Non-Accelerating Inflation Rate of Unemployment is an estimate of the unemployment rate at which inflation would be constant
-This is much less volatile than actual unemployment, due to business cycle fluctuations
How to draw the Phillips curve (2,1)
-Output (y) on the x axis, inflation (π) on the y axis
-The Phillips curve is then an upwards sloping curve
-Could also draw it downwards sloping with unemployment on the x axis, especially if using historical data
How do we model inflation when deriving the Phillips curves (3)
-Wage setters are increased in the real wage, so when setting the nominal wage increase, they use the previous CPI to predict how it’ll progress
-In modelling inflation/Phillips curve, it is usual to express the role of lagged inflation in terms of expectations (π^et = π(t-1) in equilibrium)
-When we model wage setters behaviour, we say they have adaptive expectations (they update their expectations based on previous data)
How can we derive the Phillips curve in equation form (3)
-πt = π^Et + a (yt - ye)
-Under adaptive expectations, we can also say πt = πt-1 + a (yt - ye)
-Current inflation = lagged inflation + output gap
How does the Phillips curve diagram shift to a positive AD shock (6,1)
-Assume the IS curve shifts outwards, due to a positive AD shock (investment boom of 2%)
-This causes disequilibrium and a positive output gap (2%), as there is now a gap between ye and y1
-This output gap can thus be seen on the WS-PS graph, where there is now the output gap between the WS and PS curve, due to the OG causing bargaining power (2%) and rises in wages
-This thus leads to an expansion on the PC in period t, as the wage rises cause prices to rise by 4% (inflation was 2%, OG = 2%)
-In period t+1, the PC shifts upwards to represent the higher level of expected inflation (4% vs 2%), thus causing actual inflation to rise to 6% (4% inf + 2% og)
-This is a cyclical process why the output gap remains, the PC continually shifting up
-In a world without stabilisation policy, a positive demand shock is associated with higher employment and rising inflation
