Monetary EconomicsPhillips curve and AS curve

Seyed Ali Madanizadeh

Sharif University of Technology

November 14, 2016

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Introduction

If prices (output price, wages, interest rates, ...) are flexible, thenthere is no relationship.

Any frictions in labor or goods market can result in a positiverelationship between price and output in the short run.

In the long run, prices adjust and theeconomy returns to its naturalrate of output.

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Supply Side

Labor market: Wages are sticky

P ↑⇒ wP↓⇒ Nd ↑⇒ N ↑⇒ Y ↑

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Aggregate Supply

Y

P

LRAS

AS

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Phillips Curve

A trade-off between inflation and unemployment

Unemployment

Inflation

LR PC

PC

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Aggregate Supply

Y

P

Keynesian

Neoclassic or new Keynesian

Classic

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Aggregate Supply

Wage and price stickiness (Keynesian): Demand fall

Flexible prices (Classic): Perfect Market

Wage stickiness but flexible prices: (Neoclassical or new Keynesian)

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Data (Phillips Curve)

Inflation and Unemployment in the United States, 1950—1969 and1970—2010

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New AS curve

Modern macroeconomics with micro-foundation (Friedman, Phleps,Lucas, ...)

Role of ExpectationsSpecify the sources of frictions

InformationPrice stickinessWage stickinessSearch frictions....

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Aggregate Supply Curve

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Shifts in Aggregate Supply Curves

The long-run aggregate supply curve shifts to the right from whenthere is

an increase in the total amount of capital in the economyan increase in the total amount of labor supplied in the economyan increase in the available technologya decline in the natural rate of unemployment

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Shift in the Long-Run Aggregate Supply Curve

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Shifts in the Short-Run Aggregate Supply Curve

expected inflation

price shocks

a persistent output gap

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Equilibrium in Aggregate Demand and Supply Analysis

General Equilibrium: All market in equilibriumAS=AD

Short run equilibrium

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Adjustments to long run equilibrium

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Self-Correcting Mechanism

Regardless of where output is initially, it returns eventually to thenatural rate

Slow

Wages are inflexible, particularly downwardNeed for active government policy

Rapid

Wages and prices are flexibleLess need for government intervention

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Changes in Equilibrium: Aggregate Demand ShockAnalysis

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The Volcker Disinflation

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Changes in Equilibrium: Aggregate Supply (Price) Shocks

The aggregate supply curve can shift

from temporary supply (price) shocks in which the long-run aggregatesupply curve does not shift, orfrom permanent supply shocks in which the long-run aggregate supplycurve does shift

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Changes in Equilibrium: Aggregate Supply (Price) Shocks

Temporary Supply Shocks

When the temporary shock involves a restriction in supply, we refer tothis type of supply shock as a negative (or unfavorable) supply shock,and it results in a rise in commodity pricesA temporary positive supply shock shifts the short-run aggregate supplycurve downward and to the right, leading initially to a fall in inflationand a rise in output. In the long run, however, output and inflation willbe unchanged (holding the aggregate demand curve constant)

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Changes in Equilibrium: Temporary Supply Shocks

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Changes in Equilibrium: Permanent Aggregate SupplyShock

Real Business Cycle Theory

A permanent negative supply shock– such as an increase in ill-advisedregulations that causes the economy to be less effi cient, therebyreducing supply– would decrease potential output and shift thelong-run aggregate supply curve to the leftBecause the permanent supply shock will result in higher prices, therewill be an immediate rise in inflation and so the short-run aggregatesupply curve will shift up and to the leftOne group of economists, led by Edward Prescott of Arizona StateUniversity, believe that business cycle fluctuations result frompermanent supply shocks alone and their theory of aggregate economicfluctuations is called real business cycle theory

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Changes in Equilibrium: Permanent Aggregate SupplyShock

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Positive Supply Shocks, 1995—1999

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Okun’s Law

Okun’s law describes the negative relationship between theunemployment gap and the output gap

Okun’s law states that for each percentage point that output is abovepotential, the unemployment rate is one-half of a percentage pointbelow the natural rate of unemployment. Alternatively, for everypercentage point that unemployment is above its natural rate, outputis two percentage points below potential output

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Okun’s Law 1960-2010

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Phillips Curve

Inflation and Unemployment in the United States, 1950—1969 and1970—2010

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The Short- and Long-Run Phillips Curve

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Short run effects of Money Supply Injections / Shifts ofMoney Demand

Signal extraction problem: Is is real or is it nominal? Lucas (1996),Lucas (1972), Wallace (1992), McCallum (1984).

Open Market Operations and Liquidity Effects with Segmented AssetMarkets

Classics: Grossman and Weiss (1983), Rotemberg (1984), Lucas(1990).Output Effects Fuerst (1992), Christiano and Eichenbaum (1992).Variations: Alvarez, Lucas, and Weber (2001), Alvarez, Atkeson, andKehoe (2002), Occhino (2004), Edmond and Weill (2009), Alvarez andLippi (2011).

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Short run effects of Money Supply Injections / Shifts ofMoney Demand

Nominal Rigidities: sticky prices

One Period Prices Set in Advance: Blanchard and Kiyotaki (1987)Calvo-type dynamics: Yun (1996), Gali (2001). Revisiting LiquidityEffects.Revisiting the Friedman Rule: optimality of stable price level: Khan,King, and Wolman (2003), Yun (2005).

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Short run effects of Money Supply Injections / Shifts ofMoney Demand

Nominal Rigidities: Real effect on (s S) models

Warm up: sS without aggregate shocks, Sheshinski and Weiss (1977),Benabou and Konieczny (1994)Money Neutrality : “elevator coming up”aggregation Caplin andSpulber (1987)Phillips Curve: “elevator in a shaft”: Caplin and Leahy (1991, 1997)also Chap 12 Stokey (2009)Phillips Curve with constant prob. changes price: Danziger (1999)Quantitative Examples: Golosov and Lucas (2007), Midrigan (2009).

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Conclusions

A shift in the aggregate demand curve affects output only in the shortrun and has no effect in the long run

A temporary supply shock affects output and inflation only in theshort run and has no effect in the long run (holding the aggregatedemand curve constant)

A permanent supply shock affects output and inflation both in theshort and the long run

The economy has a self-correcting mechanism that returns it topotential output and the natural rate of unemployment over time

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Conclusions

There are two types of Phillips curves, long run and short run

There is no long-run trade-off between unemployment and inflation

There is a short-run trade-off between unemployment and inflation

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