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.

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

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

Y

ADAS

Y Potential

E2

E3

E1

Supply shock • 1973-1979 two oil price increase by OPEC

countries. Cost of production increased which can be seen as the following changes,

P

Y

ADAS

Y Potential

AS2

E1

E2

Supply shock

• Result is both inflation and unemployment increase.

Stagnation STAGNATION

Inflation

Stagflation (inflation and unemployment)

• AD policies or changes...P

Y

ADAS

Y Potential

E2

E1

AS2

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

2013Fusun borrowed from Ahmet

100 TL (if r= 8 %)

If inflation rate is 60%Then P2013=100

Will Ahmet be happy? NO

How should Ahmet be compensated?

2014Fusun will pay to Ahmet

108 TL

P2014=160

He wants to be compensated for inflation as well!

Interest rates under inflation

Wages continue to increase due to higher expected inflation...

• P

Y

AD

AS

Y Potential

AS2

E1

E2

AS3

E3

Aggregate Demand responds withMS increases

• P

Y

AD

AS

Y Potential

AS2

E1

E2

AS3E3

AD2

AD3

Short-run and Long-run Phillips Curve

• Inflation rate

Unemployment Rate Natural Rate of U

LONG TUN PHILIPS CURVE

SHORT_RUN PHILLIIPS CURVE

Monetarist view of best policy

• Quantity Theory of Money:

M is Money SupplyV is velocity –turn over rate of moneyP is price level Y is real output-real GDP.