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Panel a shows the standard LM curve (which graphs the equation
M/P=L(r,Y) together with a horizontal line representing the world
interest rate r*. The intersection of these two curves determines the
level of income, regardless of the exchange rate, therefore as panel B
shows the LM* curve is vertical.
Equilibrium of the small open economy
According to the Mundell Fleming model, a small open economy with
perfect capital mobility can be described by two equations.
The first describes equilibrium in the goods market
The second describes equilibrium in the money market
The exogenous variables are fiscal policy G and T, Monetary policy
M, the price level P, and the World interest rates r*. The endogenous
variables are income Y and the exchange rate.
The two relationships are illustrated together below
* .......... .......... .......... .......... .......... *, /
* . .......... .......... *
LM Y r L P M
IS e NX G r I T Y C Y
The graph plots the goods market equilibrium condition IS* and the
money market equilibrium LM*. Both curves are drawn holding
interest rates constant at the world interest rates . The intersection of
these two curves show the level of income and the exchange rate
that satisfy equilibrium both in the goods and in the money market.
Private reading
Give hand out on the open economy
Exchange rates and how policies affect the real exchange rates.
Mankiw pg 205-214
The Philliphs curve
Two goals of policy
-Low inflation
-Low Unemployment
These goals are often in conflict
Suppose government were to use expansionary fiscal and monetary
policies to boost demand
Economy would move to higher demand and higher prices.
Higher output means higher unemployment
Higher price levels given previous prices may mean inflation
This trade off between inflation and unemployment is called the
philliphs Curve.
The philliphs curve is a reflection of the short run aggregate supply
curve: As policy makers move the economy along the aggregate
supply curve, unemployment and inflation move in opposite
directions.
The philliphs curve states that the inflation rate depends on 3 forces
-Expected inflation
-The deviation of unemployment from the natural rate called cyclical
unemployment
-Supply shocks
Inflation=Expected Inflation- ( *cyclical unemployment) +supply
shocks
Is a parameter measuring the response of inflation to cyclical
unemployment.
The minus sign before cyclical unemployment term implies that high
unemployment reduces inflation
The equation therefore summarizes the relationship between inflation
and unemployment.
Deriving The philliphs curve from aggregate supply curve
The Philliphs curve could be derived from the equation for aggregate
supply
Recall aggregate supply equation is written as follows
Add to the right hand side of the equation a supply shock V to
represent exogenous event that alter the price level and shift the
aggregate supply curve
To go from price level to inflation subtract last years price level P
-1
from both sides of the equation to obtain
The term on the left hand side (P-P
-1
) Is the difference between the
current price level and last years price level which is inflation. The
term on the right hand side (P
e
-P
-1
) is the difference between the
v u u
n e
Y Y P P
e
/ 1
V Y Y P P
e
/ 1
V Y Y P P P P
e
/ 1
1 1
expected price level and last years price level which is expected
inflation
Hence we have
Okuns law states that the deviation of output from its natural rate is
inversely related to the deviation of unemployment from its natural
rate
That is when output is higher than its natural rate unemployment is
lower from its natural rate . This can be rewritten as
We can substitute (u-un) for (1/)(Y-Y) In the previous equation to
obtain:
Thus the short run aggregate supply equation and the philliphs curve
represent the essentially the same macroeconomic ideas.
According to the short run aggregate supply equation, output is
related to unexpected movements in the price level.
According to the Philliphs curve unemployment is related to
unexpected movements in the inflation rate.
The aggregate supply curve is more convenient when studying output
and prices while the philliphs curve is more convenient when studying
inflation and unemployment.
Hence the philliphs curve and the aggregate supply curve are two
sides of the same coin.
Adaptive expectations and inflation inertia
People may form their expectations about inflation adaptively:
For example if people expect this years inflation to be like last years
inflation then
In this case we can rewrite the Philliphs curve as
v Y Y
e
/ 1
) ( / 1
n
u u Y Y
v u u
n e
1
e
v u u
n
1
I.e. inflation depends on past inflation, cyclical unemployment and a
supply shock.
The past term implies that inflation has inertia. It keeps going unless
something acts to stop it.
In particular if inflation is at its natural rate and if there are no supply
shocks, the price level will continue to rise the same way it has been
rising
In a model of aggregate supply and aggregate demand inflation
inertia is interpreted as upward shift of both supply and aggregate
demand curve.
This will continue until something like a recession or a supply shock
will change expectations about inflation it
Aggregate demand curve will also shift upward. Most often the
continued rise in aggregate demand is due to persistent growth in
money supply.
If money supply was to be halted, aggregate demand would stabilize
causing a recession.
High unemployment during recession would reduce inflation and
expected inflation thus causing inflation inertia to subside.
Causes of rising and falling inflation
The second and third term of the philliphs curve equation show the
two forces that can change the rate of inflation
The second term
Shows that cyclical unemployment (deviation of unemployment from
its natural rate) exerts upwards or downward pressure on inflation.
Low unemployment pulls the inflation rate up: This is demand pull
inflation
The parameter beta measures how responsive inflation is to cyclical
unemployment
The third term v, also shows that inflation also rises and falls due to
supply shock.
n
u u
Supply shocks are thus either beneficial or negative.
Negative supply shocks cause cost push inflation
Beneficial supply shocks ease inflation
Short run trade off between inflation and unemployment
Consider the options the philliphs curve offers the policy maker.
By changing aggregate demand the policy maker can alter output
unemployment and inflation.
The following figure plots the phillips curve and shows the short run
trade off (mankiw pg 370.
In the short run there is a negative relationship between inflation and
unemployment
At any point in time a policy maker who controls aggregate demand
can choose a combination of inflation and unemployment on the short
run philliphs curve.
Expectations shift the Philliphs curve.
The curve is higher when expected inflation is high
Disinflation and the sacrifice ratio
Imagine an economy in which unemployment is at its natural rate and
inflation is running at 6%.
What would happen to unemployment and output if a policy to reduce
inflation to 2% was pursued?
The Philliphs curve shows that in the absence of a beneficial shock,
lowering inflation requires a period of high unemployment and
reduced output.
Before deciding whether to reduce inflation, policy makers must know
how much output would be lost during the transition to lower inflation
This is called the sacrifice ratio:- The percentage of a years GDP that
must be forgone to reduce inflation by 1%.
Rational expectations and the possibility of painless disinflation
Suppose expectations were to be formed rationally
People use all available information including government policies:
Lessens inflation inertia
Hence options of the philliphs curve may not capture all options
available to policy makers.
If policy makers were committed to lowering inflation, rational people
will understand the commitment and will quickly lower their
expectations of inflation
Disinflation will thus be less painful.
A painless disinflation has 2 requirements:
-The plan to reduce inflation must be announced to workers and firms
who form expectations about inflation
-The workers and firms must believe the announcement and the
government commitment
If both requirements are met, the announcment will immediately shift
the short run trade off between unemployment and inflation
downward permitting a lower rate of inflation without unemployment.
.