Inflation, Deflation, and the Phillips Curve

Inflation

Perfection Deflation

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2

But first a little behavioral economics

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4

5

With money illusion

0

400

800

1,200

1,600

2,000

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

S&P stock prices

Without money illusion

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20

30

40

50

60

70

80

90

100

110

1925 1930 1995 2000 2005 2010

Real stock prices

Depression Recent period

Macroeconomics up to now

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IS-MP

Y

Potential output = AF(K,L)

Ypot

u

i r

Now add inflation

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IS-MP

Y

Potential output = AF(K,L)

Ypot

u

πe

π

i r

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Inflation’s history in the US

50

100

150200250

350

500

1000

15002000

00 25 50 75 00 25 50 75 00

CPI Price index of GDP

Pric

e (1

865-

1914

= 1

00) Gold-silver

standardperiod

10

1

2

3

4

5

6

7

8

9

10

1980 1985 1990 1995 2000 2005 2010 2015

Core inflation and Fed inflation target rate

Inflation target = 2%

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How do we measure price indexes?Consumer price index:

- Traditionally a Laspeyres price index (fixed weight index using early prices)

- BLS has introduced an experimental index – the “chain CPI” – which is a superlative Törnqvist index.

- As with output index, Laspeyres overstates inflation:g(Paasche) < g(Tornqvist), g(Fisher) <

g(Laspeyres)National accounts price indexes

- These are Fisher (superlative) indexes- Fed target uses personal consumption expenditures

price index (Fisher)“Core Inflation”

- removes volatile food and energy and is central target for monetary policy (personal consumption core price index)

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Paasche

Laspeyres

Superlative: Fisher, Tornqvist

Remember this important set of relationships:

Holds for output indexes and price indexes!

Does it make any difference?Yes, 0.5% per year over 1970-2012

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0.96

1.00

1.04

1.08

1.12

1.16

1.20

1.24

1970 1975 1980 1985 1990 1995 2000 2005 2010

CPI/Price of PCE[Laspeyres/Fisher]

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Major topics

1. Why do we care about inflation?2. Modern inflation theory

Why do we care about inflation?Like temperature, we care mainly about the

extremes:

Hyperinflation (> 100% a month)

Deflation (< 0)

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What are costs of inflation?

Good discussion section 5-5 in MankiwBASIC ELEMENTS:

– Distinguish anticipated from unanticipated inflation (ex ante v. ex post real interest rates)

– Redistribution: inflation redistributes wealth from creditors to debtors (mortgages, pensions).

– Inefficiencies of inflation: shoe leather, menu costs, taxes,...

OVERALL:– Overall, costs appear relatively small at low

inflation rates.– Hyperinflation can destroy price mechanism– Deflation can produce low-level “bad equilibrium”

of high real interest rates and the liquidity trap

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Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

(JMK, Economic Consequences of the Peace, 1919; with many hyperinflations going on.)

Keynes On inflation (really on hyperinflation)

Now to inflation theory in the US

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Natural (Goldilocks) rate of unemployment

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Not too hot (inflationary) and not too cold (depressionary)

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The Expectations -Augmented Phillips Curve

Fundamentals of theory:1. Unemployment rate (u) determined by interaction of

potential and actual Y by Okun’s Law2. Inflation determined by labor/product market

tightness (u relative to “natural rate of unemployment”*) and expected inflation (πe) – Phillips curve

3. Expected inflation (πe) determined by inflation history and forecasts of future inflation

*natural rate of unemployment (Mankiw); sometimes called the NAIRU = “non-accelerating inflation rate of unemployment” = Goldilocks unemployment rate

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The Expectations -Augmented Phillips Curve

In algebra:

u - u* = λ (Y – YP)/YP

π= πe - β (u - u*)πe determined by past inflation and expectations process

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The short-run P.C.

Graph from Economic Report of the President 1969

This was relationship that led Keynesian to believe that P.C. was a good explanation for inflation (1960s)

1. (πe)

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0

1

2

3

4

5

6

2 3 4 5 6 7 8

Unemployment rate

CP

I inf

latio

n ra

te

1961

1969

Early Phillips Curve

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0

1

2

3

4

5

6

2 3 4 5 6 7 8

Unemployment rate

CP

I inf

latio

n ra

te

1961

1969

Early Phillips Curve

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Collapse of short-run P.C.

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2

4

6

8

10

12

14

2 3 4 5 6 7 8 9 10

U

Pi

1961

1995

1980 This was relationship that led many new classical economists to conclude that Keynesian theories were “fatally flawed” (Lucas and Sargent. 1970s)

0

1

2

3

4

5

6

2 3 4 5 6 7 8

Unemployment rate

CPI in

flatio

n rate

1961

1969

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Mainstream 2-equation inflation model

(1)π(t) = πe(t) - β[u(t) - u*] + ε(t) [Note: corrected sign from class.]

(2)πe(t) = π(t-1)

Endogenous variablesπ = rate of price inflationπe = expected rate of inflation (or similar concept)u* = natural rate

Exogenous variablesu = actual unemployment rate (determined by policy and shocks)ε(t) = wage and price shocks (oil prices, exchange rates, globalization, decline of unions, immigration, etc...)t = time

[Note: (2) is backward looking rather than rational expectations.]

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Simplest 1-equation inflation modelSimplify by assuming no shocks and substituting:

(3) π(t) = π(t-1) - β[u(t) - u*]

(4) Δ π(t) = - β[u(t) - u*]

which is the linear expectations-augmented P.C. model.

28u* = natural rate

π1 = π1e

SRPC1

Short-run Phillips curve

1

29u* = natural rate

π1 = π1e

Moving up short-run Phillips curve

1

2

SRPC1,2

π2

30u* = natural rate

π1 = π1e

Short-run Phillips curve shifts upward with higher inflation expectations

1

2π3

e =π2

SRPC1,2

SRPC3

31u* = natural rate

π1 = π1e

SRPC1,2

SRPC3

1

2

3π3 = π3

e

Now unemployment rate back to the natural rate

32u* = natural rate

π1 = π1e

SRPC1,2

LRPC

SRPC3

1

2

3π3

e =π2

u equals the natural rate in both periods 1 and 3, but the expected and actual inflation rates are higher in period 3.

This diagram shows the way that the SRPC shifts as expected inflation adjusts to higher rate.

33u* = natural rate

π1 = π1e

SRPC1,2

LRPC

SRPC3

1

2

3π3

e =π2

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-3

-2

-1

0

1

2

3

3 4 5 6 7 8 9 10

Unemployment rate

Cha

nge

in c

ore

infla

tion

rate

3434

New synthesis of accelerationist PCRough estimate of natural rate for 1960-2013 = 6 percent

Δ π(t) = β[u(t) - u*]u* is u where Δ π(t) =0.

This was the new synthesis developed by Phelps and Friedman (1967-68). It now forms the basis of mainstream macro for large open economies.

Recent Phillips curve

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0

2

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6

8

10

0 2 4 6 8 10 12

Unemployment rate

Ave

rage

hou

ry e

arni

ngs

grow

th (n

omin

al)

Phillips curve at low inflation

36 36u* = natural rate

Does Phillips curve bend because of nominal rigidity at zero inflation?

Controversial, but probably yes.

Why?

Because of the downward nominal rigidity of wages!

1-2%

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Summary onThe Expectations-Augmented Phillips Curve

• u and π are negatively related in short run • no relation between u and π in the long run • short-run PC adjusts up and down as economic agents

adjust their inflation expectations to reality (combination of backward and forward looking expectations).

• Natural rate is u at which inflation tends neither to rise nor fall