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.

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Unemployment and Inflation – Part 10

Posted on Friday, March 22, 2013 by bill