copyright 1998, r. h. rasche macroeconomic models ii: supply side
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Copyright 1998, R. H. Rasche
Macroeconomic Models II:Supply Side
Copyright 1998, R. H. Rasche
Macroeconomy - Supply Side
Supply side of Macroeconomy consists of:
– Aggregate Production function relating output produced to inputs of labor and capital (machines and equipment)
– Supply and demand curves in Labor Market
– Labor Market equilibrium condition
Short-cut to summarize all these pieces:
– Expectations Augmented Phillips Curve
Copyright 1998, R. H. Rasche
Expectations Augmented Phillips Curve
Phillips thought there was a single, fixed relationship between the unemployment rate and inflation… but...
The relationship between Inflation and Unemployment is not stable! It shifts up and down as expected rate of inflation changes
pt = t-1pt + g(Ut - UNt)
» pt = Actual Inflation
» t-1pt = Current Expected Inflation Rate
» UNt = “natural unemployment rate”
Copyright 1998, R. H. Rasche
Expectations Augmented Phillips Curve: Slope
In expectational equilibrium pt = t-1pt. Hence U- UN = 0, regardless of the value of the inflation rate.
– in expectational equilibrium Phillips curve is vertical. (Long-run Phillips Curve (LP))
Holding t-1pt fixed, changes in unemployment rate produce changes in inflation in opposite direction (g < 0)
– Short-run Phillips curve (SP) is negatively sloped)
Copyright 1998, R. H. Rasche
Long-run -- Short-run Phillips Curves
p
UUN
LP
SPt-1pt
Long-run and Short-Run Phillips Curves intersect when actual inflation is equal to expected rate of inflation.
Copyright 1998, R. H. Rasche
Actual and Forecast (AR[1]) Annual Inflation: 1877-1994
Actual and Expected Annual Inflation AR(1),patterns
1877 1890 1903 1916 1929 1942 1955 1968 1981 1994-15
-10
-5
0
5
10
15
20
25
Copyright 1998, R. H. Rasche
Unexpected Inflation vs Unemployment: 1877-1994
Annual Unexpected Inflation vs Unemployment
0 5 10 15 20 25 30
-25
-20
-15
-10
-5
0
5
10
15
20
Copyright 1998, R. H. Rasche
Long-run & Short-run Phillips Curves in terms of Output (Y)
p
YYN
LP
SP
t-1pt
p
UUN
LP
SP
t-1pt
or
Copyright 1998, R. H. Rasche
Changes in Expected Inflation Shift SP Curve
p
YYN
LPSP
t-1pt’
Long-run and Short-Run Phillips Curves intersect when actualinflation is equal to expected rate of inflation.
When expectedrate of inflation changes, the height of the SP curve at YN
is increased or decreased
SP’t-1pt
Copyright 1998, R. H. Rasche
Supply Shocks Think of changes in YN as “Supply Shocks”
– These can result from anything that changes productivity
– Also result from shifts in labor supply function
Shocks to Yn affect both LP and SP curves
Copyright 1998, R. H. Rasche
Changes in YN Shift Both LP and SP Curves
p
Y
t-1pt
With no change in expected inflation, both SP and LP must shift when YN changes.
SPLP
YN YN’
LP’
SP’
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