X unemployment and Inflation

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Figure X.13 Short- and Long-Run Phillips Curves

You can now see why economists who became captive of this framework were interested in the value of . For Keynesians, a value of less than one maintained their policy position that the government could use expansionary fiscal and monetary policy to reduce the unemployment rate should they consider the current rate to be too high.

For Monetarists, a value of = 1, was consistent with their claims that the Keynesian aggregate demand management framework was flawed and would only cause inflation should the government try to push the unemployment rate below the natural rate, which was established when inflationary expectations were equal to the actual inflation rate.

Thus, at the time, the focus of the macroeconomic debate was on the value of .

To see the way the natural rate of unemployment emerges out of this framework, we can solve Equation (X.11) for the long-run unemployment rate. After the relevant algebraic manipulation we get:

(X.12) U* = -

Which shows there is still a trade-off in the long-run between unemployment and inflation as long as ≠ 1. Once, = 1, the long-run unemployment rate becomes Friedman’s natural rate and the equation representing that case is written as:

(X.13) U* =

This means that in the Friedman natural rate hypothesis, there are only two factors which influence the long-run or natural rate of unemployment: (a) the rate of growth of productivity captured in the α term; and (b) the short-run responsiveness of wage inflation to movements in the unemployment rate (β). Note that given β is assumed to be negative, the sign on the term -(α/β) is positive.

As a result, the higher is the growth in productivity, other things equal, the lower will be the natural rate. The Monetarists assumed that productivity growth was a structural phenomenon and invariant to aggregate demand policies.

It is clear, that in the Expectations-Augmented Phillips Curve framework, the government could only achieve temporary reductions in the unemployment rate below the natural rate as long as it could drive a wedge between the expected inflation rate and the actual inflation rate, Once the workers’ inflationary expectations adjusted, then the trade-off disappeared and the economy would return to the natural rate of unemployment, albeit with higher inflation.

Continued attempts at driving down the unemployment rate below the natural rate would, according to the Monetarists, just result in accelerating inflation.

The introduction of the role of inflationary expectations in the Phillips curve focused attention on how such expectations were formed. What behavioural models could be invoked to capture expectations. There were two main theories advanced by economists: (a) adaptive expectations, and later; (b) rational expectations.

Both theories considered the formation of expectations to be endogenous to the economic system. That is, developments within the system conditioned the way in which workers (and firms) formed views about the future course of inflation.

We consider the implications of these two theories in the Advanced material box – Inflationary Expectations.

Advanced Material – The Adaptive Expectations Hypothesis

The assumption that workers formed their expectations of inflation in an adaptive manner allowed the Monetarists to conclude the government attempts to reduce the unemployment rate would only cause accelerating inflation and that the economy would always tend back to the natural rate of unemployment.

The only way the government could sustain an unemployment rate below the natural rate using aggregate demand stimulus would be if they continually drove the price level ahead of the money wage level and forced the workers to continually misperceive the true inflation rate.

The Adaptive Expectations hypothesis is expressed in terms of the past history of the inflation rate. The assertion is that the workers adapt their expectations of inflation as a result of learning from their past forecasting errors.

The following model expresses this idea:

(X.14) = t + t - ) 0 < λ < 1

The left-hand side of Equation 12A is the expected inflation rate in the next period (t + 1) formed by workers in period t. Equation 12A has to components on the right-hand side. First, t is the actual inflation rate in the current period. Thus, workers use the current inflation rate as a baseline to what they think the inflation rate in the next period will be.

Second, the term λ(t) captures the forecast error from the previous period. was the inflation expectation that workers formed in period t-1 of inflation in period t. The difference between that expectation and the actual rate than occurred is the size of their forecast error. The coefficient λ measures the strength of adaption to error. The higher is λ, the more responsive workers will be to actual conditions.


Unemployment and Inflation – Part 10

Posted on Friday, March 22, 2013 by bill

Advanced Material – The Rational Expectations Hypothesis

An extreme form of Monetarism, which became known as New Classical Economics posits that no policy intervention from government can be successful because so-called economic agents (for example, household and firms) form expectations in a rational manner.

This literature, which evolved in the late 1970s claimed that government policy attempts to stimulate aggregate demand would be ineffective in real terms but highly inflationary.

The theory claimed that as economic agents formed their expectations rationally, they were able to anticipate any government policy action and its intended outcome and change their behaviour accordingly, which would undermine the policy impact.

For example, individuals might anticipate a rise in government spending and predict that taxes would rise in the future to pay back the deficit. As a result the private individuals will reduce their own spending to save for the higher taxes and that action thwarts the expansionary impact o the public spending increase.

Recall that under adaptive expectations, economic agents are playing catch-up all the time. They adopt to their past forecasting errors by revising their current expectations of inflation accordingly.

In this context, Monetarists like Milton Friedman claimed that the government could exploit a short-run Phillips curve for a time with expansionary policy by tricking workers into thinking their real wages had risen when in fact their money wage increases were lagging behind the inflation rate.

But Monetarists considered the unanticipated inflation would induce the workers to supply a higher quantity of labour than would be forthcoming at the so-called natural rate of output (defined in terms of a natural rate of unemployment).

Under adaptive expectations, the workers take some time to catch up with the actual inflation rate. Once they adjust to the actual inflation rate and realise that their real wage has actually fallen, they withdraw their labour back to the natural level.

The use of adaptive expectations to represent the way workers adjusted to changing circumstances was criticised because it implied an irrationality that could not be explained or appear reasonable. In a period of continually rising prices, workers would never catch up. Why wouldn’t they realise after a few periods of errors that they were under-forecasting and seek to compensate by overshooting the next period?

The theory of rational expectations was developed, in part, to meet these objections. Economic agents, when forming their expectations were considered to act in a rational manner consistent with the assumptions in mainstream microeconomics pertaining to Homus Economicus.

This required that economic agents used all the information that was available and relevant at the time when forming their views of the future.

What information do they possess? The rational expectations (RATEX) hypothesis claims that individuals essentially know the true economic model that is driving economic outcomes and make accurate predictions of these outcomes. Any forecasting errors are random. The proponents of RATEX said that predictions derived from rational expectations are on average accurate.

Proponents of the rational expectations (RATEX) hypothesis assumed that all people understood the economic model that policy makers use to formulate their policy interventions. The most uneducated person is assumed to command highly sophisticated knowledge of the structural specification of the economy that treasury and central banks deploy in their policy-making processes.

Further, people are assumed to be able to perfectly predict how policy makers will respond (in both direction and quantum) to past policy forecast errors. According the RATEX hypothesis, people are able to anticipate both policy changes and their impacts.

As a result, any “pre-announced” policy expansions or contractions will have no effect on the real economy. For example, if the government announces it will be expanding the deficit and adding new high powered money, we will also assume immediately that it will be inflationary and will not alter our real demands or supply (so real outcomes remain fixed). Our response will be to simply increase the value of all nominal contracts and thus generate the inflation we predict via our expectations.

The government can thus never trick the private sector. The introduction of rational expectations into the debate, thus, went a step further than the Monetarists who conceded that governments could shift the economy from the “natural level” by introducing unanticipated policy changes.

The New Classical Economics denied that governments could alter the course of the real economy at all. In other words, there was not even the possibility of a short-run trade-off between inflation and the unemployment rate. Workers would always know the future inflation rate and build it fully into each round of money wage bargaining.

The economy would thus always stay on the long-run Phillips curve.

While there are some very sophisticated theoretical critiques of the RATEX hypothesis (for example, the Sonnenschein-Mantel-Debreu theorem) which extend the notion of the fallacy of composition where what might be valid at the individual level will not hold at the aggregate level, some simple reflection suggests that the informational requirements necessary for the hypothesis to be valid are beyond the scope of individuals.

A relatively new field of study called behavioural economics has attempted to examine how people make decisions and form views about the future. The starting point is that individuals have what are known as cognitive biases which constrain our capacity to make rational decisions.

RATEX-based models have failed to account for even the most elemental macroeconomic outcomes over the last several decades. They categorically fail to predict movements in financial, currency and commodity markets.

The 2008-09 Global Financial Crisis was not the first time that models employing rational expectations categorically failed to predict major events.

Rational expectations imposes a mechanical forecasting rule on to individual decision-making when, in fact, these individuals exist in an environment of endemic uncertainty where the future is unknowable.

As we will see in later Chapters, endemic uncertainty is a major problem facing decision-makers at all levels and of all types in a capitalist monetary economy. The existence of uncertainty gives money, the most liquid of all assets, a special capacity to span the uncertainty of time.

In the real world, people have imperfect knowledge of what information is necessary for forecasting and even less knowledge of how this choice of information will impact on future outcomes. We also do not know how we will react to changing circumstances until we are confronted with them. The nature of endemic uncertainty is that we cannot know the full range of options that might be presented to us at some time in the future.

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