Inflation, Deflation, and the Phillips Curve Inflation Deflation 1

Inflation, Deflation, and the Phillips Curve

Inflation

Deflation

1

Macroeconomics up to now

2

IS-MP

Y

Potential output = AF(K,L)

Ypot

u

i r

Now add inflation

3

IS-MP

Y

Potential output = AF(K,L)

Ypot

u

πe

π

i r

4

Inflation’s history in the US

50

100

150

200250

350

500

1000

15002000

00 25 50 75 00 25 50 75 00

CPI Price index of GDP

Pri

ce (

1865

-191

4 =

100

)

Gold-silverstandardperiod

5

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

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?

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

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

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

– Overall, costs appear relatively small at low inflation rates.

– Hyperinflation can destroy price mechanism– Deflation can produce low-level equilibrium

Now to inflation theory in the US

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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 (Jones); 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 in

flatio

n ra

te

1961

1969

Early Phillips Curve

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Collapse of short-run P.C.

0

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)

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Mainstream 2-equation inflation model

(1)π(t) = πe(t) + β[u(t) - u*] + ε(t)

(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.

20u* = natural rate

π1 = π1e

SRPC1

Short-run Phillips curve

1

21u* = natural rate

π1 = π1e

Moving up short-run Phillips curve

1

2

SRPC1,2

π2

22u* = natural rate

π1 = π1e

Short-run Phillips curve shifts upward with higher inflation expectations

1

2π3

e =π2

SRPC1,2

SRPC3

23u* = natural rate

π1 = π1e

SRPC1,2

SRPC3

1

2

3π3 = π3

e

Now unemployment rate back to the natural rate

24u* = 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.

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-3

-2

-1

0

1

2

3

3 4 5 6 7 8 9 10

Unemployment rate

Ch

an

ge

in c

ore

infla

tion

ra

te

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New synthesis of accelerationist PCRough estimate of natural rate for 1960-2012 = 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.

Phillips curve at low inflation

26 26u* = natural rate

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

Controversial, but probably yes.

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

Deflation

Deflation = falling price levelThis seldom occurs in modern economy, but sometimes

have near-zero inflation (Japan for two decades, US today).

Problems:- If full-employment interest rate < 0, have liquidity trap- Unstable dynamics: since r = i – π, as π falls have higher real interest rate, lower I, lower Y, and “low-level trap”

Some of the issues involved are discussed in Bullard, Seven Faces. Very interesting discussion!

But this is uncharted territory in modern macro!

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