Inflation and Expectations
Econ 102
2015 Spring
Phillips Curve
• Short-run Phillips
Curve:
• In UK Phillips in
1958
Tradeoff between
percentage change in
wages and
unemployment rate.
Wt+1 - Wt
= -e (m - m * )
Wt
SR Phillips Curve
• Wages changes usually
lead to price changes
hence we see a similar
relationship between
between percentage
change in price level
and Unemployment
Pt+1 - Pt
= -e (m - m * )
Pt
SR Phillips Curve
• What type of policy
recommendations
does this indicate?
SR Phillips Curve
Choose either
• Low inflation
(high Unemp. rate)
or
• High inflation (low
(low Unemp. rate)
SR Phillips Curve
Choose either
• Low inflation
(high Unemp. rate)
or
• High inflation (low
(low Unemp. rate)
What is behind this trade off?
• AD policies or changes...
P
AD
AS
E3
E2
E1
Y Potential
Y
Supply shock
• 1973-1979 two oil price increase by OPEC
countries. Cost of production increased which
can be seen as the following changes,
AS2
P
AD
AS
E2
E1
Y Potential
Y
Supply shock
• Result is both inflation and unemployment
increase.
Stagnation
STAGNATION
Inflation
Stagflation
(inflation and unemployment)
• AD policies or changes...
AS2
P
AD
AS
E2
E1
Y Potential
Y
Expectations
• Consumer and Producers do not have static
views, they look into the future and form
‘expectations’.
• They form expectations about future prices, or
the rate of change of prices.
• In all their consumption, production and labor
supply decisions they take the expected inflation
rate into consideration.
• What is your expected rate of inflation today for
the next year in Turkey?
What happened to Phillips Curve
• How do we form expectations?
1. Look back, from the past:
Adaptive expectations.
2. Look at all the information and think
rationally:
Rational expectations
If you expect inflation?
• How will the firms decide on the price of their
product?
• How will the workers decide for the wage
Increases?
What happens to the AS curve?
• How will borrowers and lenders be affected?
Borrowers and lenders
2013
Fusun borrowed from Ahmet
100 TL
(if r= 8 %)
2014
Fusun will pay to Ahmet
108 TL
If inflation rate is 60%
Then P2013=100
P2014=160
Will Ahmet be happy? NO
How should Ahmet be
compensated?
He wants to be compensated
for inflation as well!
Interest rates under inflation
Nominal interest rates = real interest rates + expected inflation rate
i = r + expected inflation rate
68% = 8% + 60%
Wages continue to increase due to
higher expected inflation...
•
P
AS3
AS2
E3
AS
E2
E1
AD
Y Potential
Y
Aggregate Demand responds with
MS increases
•
P
E3
AS3
AS2
E2
AS
E1
AD3
AD
Y Potential
AD2
Y
Short-run and Long-run Phillips Curve
•
Inflation
rate
LONG TUN PHILIPS CURVE
SHORT_RUN PHILLIIPS CURVE
Natural Rate of U
Unemployment
Rate
Monetarist view of best policy
• Quantity Theory of Money:
M is Money Supply
V is velocity –turn over rate of money
P is price level
Y is real output-real GDP.