financial system, the federal reserve bank, and the phillips curve chapters 12, 13, 14, and 15

Financial System, the Federal Reserve Bank, and the Phillips Curve

Chapters 12, 13, 14, and 15

Macro Unit IV: Money, Monetary Policy, and Economic Stability

• The financial system matches one person’s saving with another person’s investment.

• It moves the economy’s scarce resources from savers to borrowers.

• We must have savers in order to borrow

The Financial System

• The financial system is made up of financial institutions that coordinate the actions of savers and borrowers.– Helps address 3 problems

• Transaction costs– Makes it easier for savers to find borrowers

• Risk– Reduces risk by making it easier to diversify

• Provides liquidity– Provides access to cash for borrowers

• Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.

FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY

Financial MarketsStock MarketBond Market

Financial IntermediariesBanksMutual Funds


Financial markets are the institutions through which savers can directly provide funds to borrowers.

Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.


• The Bond Market– A bond is a certificate of indebtedness that

specifies obligations of the borrower to the holder of the bond.

– Characteristics of a Bond• Term: The length of time until the bond matures.• Credit Risk: The probability that the borrower will

fail to pay some of the interest or principal.• Tax Treatment: The way in which the tax laws

treat the interest on the bond.– Municipal bonds are federal tax exempt.

Financial Markets IOU

• The Stock Market– Stock represents a claim to partial ownership

in a firm and is therefore, a claim to the profits that the firm makes.

– The sale of stock to raise money is called equity financing.

• Compared to bonds, stocks offer both higher risk and potentially higher returns.

– The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.

Financial Markets

• Banks– take deposits from people who want to save

and use the deposits to make loans to people who want to borrow.

– pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.

– Banks help create a medium of exchange by allowing people to write checks against their deposits.

• A medium of exchanges is an item that people can easily use to engage in transactions.

Financial Intermediaries

Mutual FundsA mutual fund is an institution that sells shares

to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both.They allow people with small amounts of money to

easily diversify.


Other Financial Institutions Credit unionsPension fundsInsurance companiesLoan sharks


• Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:

Y = C + I + G + NX

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS

• Assume a closed economy – one that does not engage in international trade:

Y = C + I + G

Some Important Identities

• Now, subtract C and G from both sides of the equation:

Y – C – G =I• The left side of the equation is the total

income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).


• Substituting S for Y - C - G, the equation can be written as:

S = I


• National saving, or saving, is equal to:S = I

S = Y – C – G S = (Y – T – C) + (T – G)


• National Saving– National saving is the total income in the economy that

remains after paying for consumption and government purchases.

National saving = Public + Private • Private Saving

– Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.

Private saving = (Y – T – C) • Public Saving

– Public saving is the amount of tax revenue that the government has left after paying for its spending.

Public saving = (T – G)

The Meaning of Saving and Investment

Surplus and DeficitIf T > G, the government runs a budget surplus

because it receives more money than it spends.The surplus of T - G represents public saving.If G > T, the government runs a budget deficit

because it spends more money than it receives in tax revenue.


• For the economy as a whole, saving must be equal to investment.

S = I


• Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

• The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

• Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

THE MARKET FOR LOANABLE FUNDS

The supply of loanable funds comes from people who have extra income they want to save and lend out.

The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Supply and Demand for Loanable Funds

The interest rate is the price of the loan.It represents the amount that borrowers pay

for loans and the amount that lenders receive on their saving.

The equilibrium of the supply and demand for loanable funds determines the real interest rate.


The Market for Loanable Funds

Loanable Funds(in billions of dollars)

0

InterestRate

Supply

Demand

5%

$1,200

Copyright©2004 South-Western

Real

Government Policies That Affect Saving and InvestmentTaxes and savingTaxes and investmentGovernment budget deficits


Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Policy 1: Saving Incentives

A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the

right.The equilibrium interest rate decreases.The quantity demanded for loanable funds

increases.


An Increase in the Supply of Loanable Funds


0

InterestRate

Supply, S1 S2

2. . . . whichreduces theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

1. Tax incentives forsaving increase thesupply of loanablefunds . . .

5%

$1,200

4%

$1,600


Real

If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.


An investment tax credit increases the incentive to borrow.Increases the demand for loanable funds.Shifts the demand curve to the right.Results in a higher interest rate and a greater

quantity saved.

Policy 2: Investment Incentives

If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

Policy 2: Investment Incentives

An Increase in the Demand for Loanable Funds


0

InterestRate 1. An investment

tax creditincreases thedemand for loanable funds . . .

2. . . . whichraises theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Supply

Demand, D1

D2

5%

$1,200

6%

$1,400


Real

When the government spends more than it receives in tax revenues, the short fall is called the budget deficit.

The accumulation of past budget deficits is called the government debt.

Policy 3: Government Budget Deficits and Surpluses

Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms.

This fall in investment is referred to as crowding out.The deficit borrowing crowds out private

borrowers who are trying to finance investments.


A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate.Reduces the equilibrium quantity of loanable

funds.


The Effect of a Government Budget Deficit


0

InterestRate

3. . . . and reduces the equilibriumquantity of loanable funds.

S2

2. . . . whichraises theequilibriuminterest rate . . .

Supply, S1

Demand

$1,200

5%

$800

6% 1. A budget deficitdecreases thesupply of loanablefunds . . .


Real

When government reduces national saving by running a deficit, the interest rate rises and investment falls.


A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.


The U.S. Government Debt

Percentof GDP

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

RevolutionaryWar

2010

CivilWar World War I

World War II

0

20

40

60

80

100

120


Financial System, the Federal Reserve Bank, and the Phillips Curve

Chapters 12, 13, 14, and 15

Macro Unit IV: Money, Monetary Policy, and Economic Stability

Money is the set of assets in an economy that people regularly use to buy goods and services from other people.Three functions

Medium of exchangeUnit of accountStore of value

THE MEANING OF MONEY

• Functions of Money– A medium of exchange is an item that buyers

give to sellers when they want to purchase goods and services.

• A medium of exchange is anything that is readily acceptable as payment.

– A store of value is an item that people can use to transfer purchasing power from the present to the future.

– A unit of account is the yardstick people use to post prices and record debts.

The Functions of Money

LiquidityLiquidity is the ease with which an asset can be

converted into the economy’s medium of exchange.

The Functions of Money

Commodity money takes the form of a commodity with intrinsic value.Examples: Gold, silver, cigarettes.

Fiat money is used as money because of government decree.It does not have intrinsic value.Examples: Coins, currency, check deposits.

The Kinds of Money

• M0– Currency is the paper bills and coins in the hands of the

public.• M1

– M0 + Demand Deposits, passbook savings, and traveler’s checks

– Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

• M2– M1 + Small time savings deposits and money market shares

• M3– M2 + Large time deposits (over $100,000)

• As you go down the list, the money becomes less liquid, so it is harder to convert to cash.

• We cannot account for all the money in the economy– Illegal activities, foreign markets

Money in the U.S. Economy

Money in the U.S. Economy

Copyright©2003 Southwestern/Thomson Learning

Billionsof Dollars

• Currency (M0)

• Demand deposits• Traveler’s checks• Other checkable deposits

• Everything in M1

• Savings deposits• Small time deposits• Money market mutual funds• A few minor categories

0

M1

M2

http://www.federalreserve.gov/releases/h6/current/H6.pdf

http://www.federalreserve.gov/releases/h6/current/H6.pdf

The Federal Reserve (Fed) serves as the nation’s central bank.Created in 1914 after a series of bank failures

convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system.

It is designed to oversee the banking system.It regulates the quantity of money in the

economy.

THE FEDERAL RESERVE SYSTEM

The Structure of the Federal Reserve System:The primary elements in the Federal Reserve

System are:1) The Board of Governors2) The Regional Federal Reserve Banks3) The Federal Open Market Committee4) The Federal Advisory Council

THE FEDERAL RESERVE SYSTEM

The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate.

Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides

over board meetings, and testifies about Fed policy in front of Congress.Current Chairman: Janet Yellen

The Fed’s Organization

The Board of GovernorsSeven members Appointed by the president Confirmed by the SenateServe staggered 14-year terms so that one

comes vacant every two years.President appoints a member as chairman to

serve a four-year term.


• The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks.– Decentralized to limit power and make it more

responsive to local needs– 12 Regional Banks

• The New York Fed implements some of the Fed’s most important policy decisions.

• Nine directors– Three appointed by the Board of Governors.– Six are elected by the commercial banks in the district.

• The directors appoint the district president, which is approved by the Board of Governors.


The Federal Reserve System

Copyright©2003 Southwestern/Thomson Learning

The Federal Open Market Committee (FOMC)Serves as the main policy-making organ of the

Federal Reserve System.Meets approximately every six weeks to review

the economy.Can meet if there is an economic emergency at any

timeSeptember 11, 2001Lehman Brothers collapse in 2008

Always important when they meet.


The Federal Open Market Committee (FOMC) is made up of the following voting members:The chairman and the other six members of the

Board of Governors.The president of the Federal Reserve Bank of

New York.The presidents of the other regional Federal

Reserve banks (four vote on a yearly rotating basis).


Monetary policy is conducted by the Federal Open Market Committee.Monetary policy is the setting of the money

supply by policymakers in the central bankThe money supply refers to the quantity of

money available in the economy.


Federal Advisory Council12 members appointed by the 12 regional

banksOffer advice on the overall health of the

economy


Primary Functions of the FedRegulates banks to ensure they follow federal

laws intended to promote safe and sound banking practices.

Acts as a banker’s bank, making loans to banks and as a lender of last resort.

It is the US governments bankConducts monetary policy by controlling the

money supply.

The Federal Open Market Committee

Banks can influence the quantity of demand deposits in the economy and the money supply.

BANKS AND THE MONEY SUPPLY

Reserves are deposits that banks have received but have not loaned out.

In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.Started as a reaction to the Great Depression


• Reserve Ratio– The reserve ratio is the fraction of deposits that

banks hold as reserves.• Reserve Requirement

– % set by the Fed that all banks must meet.• Paying Interest on Reserves

– New policy began in during the financial crisis of 2008

• Fed pays interest on Reserves held by banks at the Fed– Raise Rate would raise reserve ratio– Lower Rate would lower reserve ratio

• Read about it here…


http://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves

When a bank makes a loan from its reserves, the money supply increases.

The money supply is affected by the amount deposited in banks and the amount that banks loan.Deposits into a bank are recorded as both assets

and liabilities.The fraction of total deposits that a bank has to

keep as reserves is called the reserve ratio.Loans become an asset to the bank.

Money Creation with Fractional-Reserve Banking

This T-Account shows a bank that…accepts deposits,keeps a portion

as reserves, and lends out

the rest. It assumes a

reserve ratio of 10%.


Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Prepare to have your mind blown…When one bank loans money, that money is

generally deposited into another bank.This creates more deposits and more reserves

to be lent out. When a bank makes a loan from its reserves,

the money supply increases.Therefore, the more loans given out, the faster the

money supply grows.


How much money is eventually created in this economy?The money multiplier is the amount of money

the banking system generates with each dollar of reserves.

The Money Multiplier


Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00


Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00


Money Supply = $190.00!

The money multiplier is the reciprocal of the reserve ratio:

M = 1/RWith a reserve requirement, R = 20% or 1/5,The multiplier is 5.


The Fed has three tools in its monetary toolbox to manipulate the money supply:Open-market operationsChanging the reserve requirementChanging the discount rate

The Fed’s Tools of Monetary Control

Open-Market OperationsThe primary way in which the Fed changes the

money supply is through open-market operations.

The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:When the Fed buys government bonds, the money

supply increases.The money supply decreases when the Fed sells

government bonds.


Reserve RequirementsThe Fed also influences the money supply with

reserve requirements.Reserve requirements are regulations on the

minimum amount of reserves that banks must hold against deposits.


Changing the Reserve RequirementThe reserve requirement is the amount (%) of a

bank’s total reserves that may not be loaned out.Increasing the reserve requirement decreases the

money supply. Decreasing the reserve requirement increases the

money supply.


Changing the Discount Rate and The discount rate is the interest rate the Fed

charges banks for loans.Increasing the discount rate decreases the money

supply. Decreasing the discount rate increases the money

supply.


• Expansionary Money Policy (Increasing the Money Supply and Inflation)– Buy Bonds– Lower Reserve Requirement– Lower Discount Rate

• Contractionary Money Policy (Decreasing the Money Supply and Inflation)– Sell Bonds– Raise Reserve Requirement– Raise Discount Rate

Summary

• The Fed’s control of the money supply is not precise.

• The Fed must wrestle with two problems that arise due to fractional-reserve banking.– The Fed does not control the amount of money

that households choose to hold as deposits in banks.

• Currency Drains– Withdrawing deposits to hold as cash

– The Fed does not control the amount of money that bankers choose to lend.

Problems in Controlling the Money Supply

• Time value of money– Money loses value over time due to inflation

• This means that when you loan out money, you want to get paid back a value, at minimum, equal to the loan

• Money lent is money you cannot spend, so you give up some satisfaction or utility you could have gained by spending it as consumption or invested it otherwise

– The opportunity cost of a loan is reflected in interest rates

– Present value refers to the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money.

Future vs. Present Value of Money

• The concept of present value demonstrates the following:

• Receiving a given sum of money in the present is preferred to receiving the same sum in the future.

• In order to compare values at different points in time, compare their present values.

• Firms undertake investment projects if the present value of the project exceeds the cost.

PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY

• Interest paid on savings and interest charged on borrowing is designed to equate the value of dollars today with the value of future dollars

• FV = PV x (1 + r)n

– The future value of $1 invested one year from now is $1 x (1 + r)1

• PV = FV / (1 + r)n

– The present value of $1 received one year from now is $1 / (1 + r)1

Future vs. Present Value of Money

The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

When the overall price level rises, the value of money falls.

THE CLASSICAL THEORY OF INFLATION

The money supply is a policy variable that is controlled by the Fed.Through instruments such as open-market

operations, the Fed directly controls the quantity of money supplied.

Money Supply, Money Demand, and Monetary Equilibrium

Money demand has several determinants, including interest rates and the average level of prices in the economy.


People hold money because it is the medium of exchange.The amount of money people choose to hold

depends on the prices of goods and services.Opportunity cost of holding money: forgone

interest potentially earned on the money in an interest-bearing asset


Demand for money also dependent on price level, level of real GDP, and level of real incomeIf prices double, a person will need twice as

much money to buy groceries or other goods and services.

People are most concerned with the real value of income: what the income can buy or its purchasing power.

As income rises, the demand for money increases.


In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.


Money Supply, Money Demand, and the Equilibrium Price Level

Copyright © 2004 South-Western

Quantity ofMoney

Nominal Interest Rate

Quantity fixedby the Fed

Money supply

0

Equilibriumvalue ofmoney

Moneydemand

The Effects of Monetary Injection


Quantity ofMoney

Moneydemand

0 M1

MS1

M2

MS2

The Quantity Theory of MoneyHow the price level is determined and why it

might change over time is called the quantity theory of money.The quantity of money available in the economy

determines the value of money.The primary cause of inflation is the growth in the

quantity of money.

THE CLASSICAL THEORY OF INFLATION

The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Velocity and the Quantity Equation

V = (P Y)/M

Where: V = velocityP = the price levelY (or Q) = the quantity of outputM = the quantity of money in circulation


• Rewriting the equation gives the quantity equation:

M V = P Y


The quantity equation relates the quantity of money (M) to the nominal value of output (P Y).Nominal value of output = nominal GDP


The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:the price level must rise,the quantity of output must rise, orthe velocity of money must fall.


Nominal GDP, the Quantity of Money, and the Velocity of Money


Indexes(1960 = 100)

2,000

1,000

500

0

1,500

1960 1965 1970 1975 1980 1985 1990 1995 2000

Nominal GDP

Velocity

M2

• The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money – The velocity of money is relatively stable over

time.– When the Fed changes the quantity of money, it

causes proportionate changes in the nominal value of output (P Y).

– Changes in the money supply affect nominal variables but not real variables.

• The irrelevance of monetary changes for real variables is called monetary neutrality.

• Because money is neutral, money does not affect output.


Whip Inflation Now (WIN)Created by the Ford Administration in 1974Attempt to lower Velocity to stop inflation

Encouraged people to save money by changing personal habits

Really bad idea…total failureAlan Greenspan’s thoughts when he originally

heard the idea: “This is unbelievably stupid”

Case Study: WIN Campaign

http://en.wikipedia.org/wiki/File:Plastic_%22WIN%22_sign.jpg

• Society faces a short-run tradeoff between unemployment and inflation.

• If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.

• If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

• The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.– Think MV = PQ

Unemployment and Inflation

Nominal Interest Rate versus Real Interest RateNominal Interest Rate: rate that appears on

the financial pages of newspapers and on the signs and ads of financial institutions

Real Interest Rate: increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future

INTEREST RATES AND MONETARY POLICY IN SHORT AND LONG RUN

Two relationships between real and nominal interest rates:Ex ante real interest rate: the expected interest

rate; equals the nominal interest rate minus the expected inflation rate

Ex poste real interest rate: the real interest rate actually received; equals the nominal interest rate minus the actual rate of inflation

Nominal vs. Real Interest Rates

The ex poste real interest rate will equal the ex ante interest rate if people accurately anticipate the inflation rateKnown as the Fisher Equation

Nominal vs. Real Interest Rates

Looking at the equation of exchange, we see that changes in the money supply – holding velocity and real output constant – lead to changes in the price level

These changes in the price level change the nominal interest rate once they’ve been anticipated.

Fisher Effect

Expansionary monetary policies are often referred to as easy money

Contractionary monetary policy is often called tight money

Something I forgot…

How do changes in money supply affect aggregate demand and aggregate supply?

Changes in money supply result in changes in price level, but not output

Remember, monetary policy is neutral…

The Phillips curve illustrates the short-run relationship between inflation and unemployment.

THE PHILLIPS CURVE

The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2


The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.

A higher level of output results in a lower level of unemployment.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply


0

InflationRate

(percentper year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregate

demand

Highaggregate demand

(output is8,000)

B

4

6

(output is7,500)

A

7

2

8,000(unemployment

is 4%)

106 B

(unemploymentis 7%)

7,500

102 A


The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS

In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.As a result, the long-run Phillips curve is

vertical at the natural rate of unemployment.Monetary policy could be effective in the short

run but not in the long run.

The Long-Run Phillips Curve

The Long-Run Phillips Curve

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

BHighinflation

Lowinflation

A

2. . . . but unemploymentremains at its natural ratein the long run.

1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .


How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

Natural rateof output

Natural rate ofunemployment

0

PriceLevel

P

Aggregatedemand, AD

Long-run aggregatesupply

Long-run Phillipscurve


UnemploymentRate

0

InflationRate


2. . . . raisesthe pricelevel . . .

1. An increase in the money supplyincreases aggregatedemand . . .

AAD2

B

A

4. . . . but leaves output and unemploymentat their natural rates.

3. . . . andincreases theinflation rate . . .

P2B


• Expected inflation measures how much people expect the overall price level to change.

• In the long run, expected inflation adjusts to changes in actual inflation.

• The Fed’s ability to create unexpected inflation exists only in the short run.– Once people anticipate inflation, the only way to

get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

• WHY???

Expectations and the Short-Run Phillips Curve

How Expected Inflation Shifts the Short-Run Phillips Curve

UnemploymentRate


InflationRate Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.

CB

A


The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.

Historical observations support the natural-rate hypothesis.

The Natural Experiment for the Natural-Rate Hypothesis

The concept of a stable Phillips curve broke down in the in the early ’70s.Stagflation

During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

The Natural Experiment for the Natural Rate Hypothesis

The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

1968

1966

19611962

1963

1967

19651964


The Breakdown of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1973

1966

1972

1971

19611962

1963

1967

19681969 1970

19651964


• The short-run Phillips curve can shift due to changes in expectations.

• The short-run Phillips curve also shifts because of shocks to aggregate supply. – Major adverse changes in aggregate supply

can worsen the short-run tradeoff between unemployment and inflation.

– An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge.

This shifts the economy’s aggregate supply curve. . .

. . . and as a result, the Phillips curve.


An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregatedemand


UnemploymentRate

0

InflationRate


3. . . . andraises the price level . . .

AS2 Aggregatesupply, AS

A

1. An adverseshift in aggregate supply . . .

4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum.Fight the unemployment battle by expanding

aggregate demand and accelerate inflation.Fight inflation by contracting aggregate

demand and endure even higher unemployment.


The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1972

19751981

1976

1978

1979

1980

1973

1974

1977


• To reduce inflation, the Fed has to pursue contractionary monetary policy.

• When the Fed slows the rate of money growth, it contracts aggregate demand.

• This reduces the quantity of goods and services that firms produce.

• This leads to a rise in unemployment.

THE COST OF REDUCING INFLATION

Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate


InflationRate

Long-runPhillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.

BC

A


To reduce inflation, an economy must endure a period of high unemployment and low output.When the Fed combats inflation, the economy

moves down the short-run Phillips curve.The economy experiences lower inflation but at

the cost of higher unemployment.


The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.An estimate of the sacrifice ratio is five.To reduce inflation from about 10% in 1979-

1981 to 4% would have required an estimated sacrifice of 30% of annual output!


The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

Rational Expectations and the Possibility of Costless Disinflation

Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run.

How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.


The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.


When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the nation’s foremost problems.

Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).

The Volcker Disinflation

Figure 11 The Volcker Disinflation

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Alan Greenspan’s term as Fed chairman began with a favorable supply shock. In 1986, OPEC members abandoned their

agreement to restrict supply.This led to falling inflation and falling

unemployment.

The Greenspan Era

The Greenspan Era

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financial system, the federal reserve bank, and the phillips curve chapters 12, 13, 14, and 15

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