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# 13 the phillips curve and expectations theory

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### 13 the phillips curve and expectations theory

1. 1. Chapter 27The Phillips Curve andExpectations Theory • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
2. 2. In this chapter, you will learn to solve these economic puzzles: If the might expansionary Fed is independent, Why wearing a button Can economic theory why would the moneyfiscal reduce inflation? and monetary policies explain pop quizzes? supply increase beforerun? be useless in the long the presidential election? 2
3. 3. What is the Phillips Curve?A curve showing an inverse relationship between the inflation rate and the unemployment rate 3
4. 4. Increase in Aggregate Demand AS116 Price Level D112 C108 AD4 B104 AD3 A Full Employment100 Real GDPAD1 AD2 5.8 6.0 6.2 6.4 6.6 6.8 4
5. 5. Movement along the Phillips Curve16% D Phillips Curve12% Inflation Rate C8% B4% A 0 Unemployment Rate 2% 4% 6% 8% 10% 12% 5
6. 6. What is the Conclusionof the Phillips Curve?The opportunity cost of more employment is more inflation and vice versa 6
7. 7. The Phillips Curve U.S., 1960’s7%6% Inflation Rate 695%4% 683% 67 64 60 662% 63 65 611% Unemployment Rate 62 1% 2% 3% 4% 5% 6% 7% 7
8. 8. The Phillips Curve U.S., 1970 - 1998 14% 13% 80 12% 79 11% 74 81Inflation Rate 10% 9% 75 8% 78 7% 73 77 82 6% 70 90 76 5% 84 89 71 4% 88 87 85 83 3% 72 97 96 94 92 2% 98 86 1% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Unemployment Rate 8
9. 9. What does the Long-runPhillips Curve look likeaccording to the Natural Rate Hypothesis? It is a vertical line at the natural rate of unemployment 9
10. 10. The Short-run and Long-run Phillips Curves Long-run Inflation Rate15% F G12% Short-run9% D E Phillips curves B PC36% C PC2 Natural rate A PC 4% 1 Unemployment Rate 2% 4% 6% 8% 10% 10
11. 11. Short-runadaptive Unemployment rate risesexpectationstheory Inflation rate rises, real wages fall, and profits riseAggregate demandincreases 11
12. 12. Long-run Unemployment rateadaptive is restored to full employmentexpectationstheory Inflation rate is constant at higher rate, workers’ nominal wage rate rises, and profits fall 12
13. 13. Rational Inflation rate rises on vertical expectations line at full theory employment Inflation rate rises and nominal wages adjust quickly equal to inflation rateAggregate demandincreases 13
14. 14. What two versions ofExpectations Theoryexplain the Natural Rate Model?Adaptive expectationsRational expectations 14
15. 15. What is the AdaptiveExpectations Theory?People believe the best indicator of the future is recent information 15
16. 16. What is the conclusion of the Adaptive Theory?Expansionary monetary and fiscal policies to reduce unemployment are useless in the long-run 16
17. 17. Why are Monetary andFiscal Polices useless in the Long-run?After a short-run reduction in unemployment, the economy will self-correct to the natural rate of unemployment, but at a higher inflation rate 17
18. 18. What is the RationalExpectations Theory?People will use all available information to predict the future, including future monetary and fiscal policies 18
19. 19. What is the conclusion ofRational Expectations?Systematic and predictable macroeconomic policies can be negated when businesses and workers anticipate the effects of these policies 19
20. 20. According to the RationalExpectations Theory, can Macroeconomic Policies make things worse? People acting on their expectations of expansionary monetary and fiscal policies that are predictable can cause inflation 20
21. 21. What happens ifMacroeconomic Policies are not Predictable?The economy’s self- correction mechanism will restore the economy to full employment 21
22. 22. What is the best way to lower Inflation?Preannounced, stable policies to achieve a low and constant money supply growth and a balanced federal budget 22
23. 23. How can a Distinctionbe made between the Two Theories?By analyzing the aggregate demand and supply model 23
24. 24. Adaptive Expectations Theory LRAS Price Level E3 SRAS1110105 E2 AD2100 Natural Rate E1 AD1 Real GDP 5.0 5.5 6.0 6.5 7.0 7.5 24
25. 25. Rational Expectations Theory LRAS Price Level SRAS2 E3 SRAS1110105 AD2100 Natural Rate E1 AD1 Real GDP 5.0 5.5 6.0 6.5 7.0 7.5 25
26. 26. What is an AlternativeWay to fight Inflation? Use incomes policies 26
27. 27. What are Incomes Policies?Federal government policies designed to affect the real incomes of workers by controlling nominal wages and prices 27
28. 28. What are examples of Incomes Policies?• Jawboning• Wage and price guidelines• Wage and price controls 28
29. 29. What is Jawboning?Oratory intended to pressure unions and businesses to reduce wage and price increases 29
30. 30. What are Wage and Price Guidelines?Voluntary standards set by the government for “permissible” wage and price increases 30
31. 31. What are Wage and Price Controls?Legal restrictions on wage and price increases. Violations can result in fines and imprisonment 31
32. 32. How do different macroeconomicmodels cure inflation? 32
33. 33. MonetarismMonetarists see the cause of inflation as “too much money chasing too few goods,” based on the quantity of money theory (MV = PQ). To cure inflation, they would cut the money supply and force the Fed to stick to a fixed money supply growth rate. In the short run, the unemployment rate will rise, but in the long-run, it self- corrects to the natural rate. 33
34. 34. KeynesianismKeynesians believe in using contractionary fiscal and monetary policies to cool an overheated economy. To decrease aggregate demand, they advocate that the government use tax hikes and/or spending cuts. The Fed should reduce the money supply and cause the rate of interest to rise. The opportunity cost of reducing inflation is greater unemployment. Keynesians also believe that incomes policies are effective. 34
35. 35. Supply-Side EconomicsSupply-siders view the cause of inflation as “not enough goods.” Their approach is to increase aggregate supply by cuts in marginal tax rates. Government regulations, and import barriers. The effect provides incentives to work, invest, and expand production capacity. Thus, both the inflation rate and the unemployment rate fall. 35
36. 36. New Classical SchoolThe theory of rational expectations asserts that the public must be convinced that policy-makers will stick to restrictive and persistent fiscal and monetary policies. If policy-makers have credibility, the inflation rate will be anticipated and quickly fall without a rise in unemployment. 36
37. 37. Key Concepts 37
38. 38. Key Concepts• What is the Phillips Curve?• What is the Conclusion of the Phillips Curve?• What two versions of Expectations Theory expla• What is the Adaptive Expectations Theory?• What is the Rational Expectations Theory? 38
39. 39. Key Concepts cont.• How can a Distinction be made between the Tw• What are Incomes Policies?• What are examples of Incomes Policies?• What is Jawboning?• What are Wage and Price Guidelines?• What are Wage and Price Controls? 39
40. 40. Summary 40
41. 41. The Phillips curve shows a stableinverse relationship between theinflation rate and the unemploymentrate. If policy-makers reduce inflation,unemployment increases, and viceversa. During the 1960s, the curveclosely fitted inflation andunemployment rates in the UnitedStates. Since 1970, the Phillips curvehas not conformed to the stableinflation-unemployment trade-offpattern of the 1960s . 41
42. 42. The natural rate hypothesis arguesthat the economy self-corrects to thenatural rate of unemployment. Overtime, changes in the rate of inflation arefully anticipated, and prices and wagesrise or fall proportionately. As a result,the long-run Phillips curve is a verticalline at the natural rate of unemployment.Thus, Keynesian demand-managementpolicies ultimately cause only higher orlower inflation, and the natural rate ofunemployment remains unchanged. 42
43. 43. Adaptive expectations theory is theproposition that people base theirforecasts on recent past information,rather than future information. Once thegovernment causes the inflation rate torise or fall, people adapt theirinflationary expectations to the currentinflation rate. The result is a short-runPhillips curve that intersects the verticallong-run Phillips curve. Over time, theeconomy self-corrects to the natural rateof unemployment. 43
44. 44. The political business cycle is abusiness cycle is created by theincentive for politicians to manipulatethe economy to get re-elected. Usingexpansionary policies, officeholderscan stimulate the economy before theelection. Unemployment falls, and theprice level rises. After the election, thestrategy is to contract the economy tofight inflation and unemployment rises. 44
45. 45. Rational expectations theoryargues that it is naïve to believe thatpeople change their inflationaryexpectations based only on the currentinflation rate. Rational expectationistsbelong to the new classical school. 45
46. 46. The rational expectation theory isbased on people’s expectations. Forexample, if government policies arepredictable, people immediatelyanticipate higher or lower inflation.Workers quickly change their nominalwages as businesses change prices.Consequently, inflation worsens orimproves, and unemployment remainsunchanged at the natural rate. Thus,there is no short-run Phillips curve, andthe vertical long-run Phillips curve isidentical to adaptive expectations 46
47. 47. Incomes policies are a variety offederal government programs aimed atdirectly controlling wages and prices.Incomes policies include jawboning,wage-price guidelines, and wage-pricecontrols. Over time, incomes policiestend to be ineffective. 47
48. 48. Wage and price controls are legalrestrictions on wages and prices. Mosteconomists do not favor wage andprice controls in peacetime. Suchcontrols are expensive to administer,destroy efficiency, and intrude oneconomic freedom. 48
49. 49. Chapter 27 Quiz ©2000 South-Western College Publishing 49
50. 50. 1. The Phillips curve depicts the relationship between the a. unemployment rate and the change in GDP. b. inflation rate and the interest rate. c. level of investment spending and the interest rate. d. inflation rate and the unemployment rate. D. The Phillips curve is a theory developed by A. W. Phillip in 1958. 50
51. 51. 2. A difficulty in using the Phillips curve as a policy menu is the a. fact that the natural rate of unemployment does not exist. b. fact that the curve would not remain in one position. c. difficulty deciding between monetary and fiscal policies. d. fact that Democrats choose one point on the curve and Republicans choose another point.B. The Phillips curve is a theory based on the assumption that it is stationary. 51
52. 52. 3. Since the 1970’s, the a. Phillips curve has not been stable. b. inflation rate and the unemployment rate have been about equal. c. Phillips curve has proven to be a reliable model to guide public policy. d. relationship between the inflation rate and the unemployment rate moves in a counterclockwise direction. A. During 1960-69, the Phillips curve appeared stable. Since the 1970’s, the Phillips curve has not been stable. 52
53. 53. The Phillips Curve U.S., 1960’s7%6% Inflation Rate 695%4% 683% 67 64 60 662% 63 65 611% Unemployment Rate 62 1% 2% 3% 4% 5% 6% 7% 53
54. 54. The Phillips Curve U.S., 1970 - 1998 14% 13% 80 12% 79 11% 74 81Inflation Rate 10% 9% 75 8% 78 7% 73 77 82 6% 70 90 76 5% 84 89 71 4% 88 87 85 83 3% 72 97 96 94 92 2% 98 86 1% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Unemployment Rate 54
55. 55. 4. According to natural rate hypothesis theory, a. the Phillips curve is quite flat, so that a large reduction in employment can be achieved without inflation. b. workers only adapt their wage demands to inflation after a considerable time lag. c. the Phillips curve is vertical in the long run at full employment. d. workers cannot anticipate the inflationary effects of expansionary public policies. C. Natural rate hypothesis argues that the economy will self-correct to the full- employment unemployment rate. 55
56. 56. 5. Adaptive expectations theory a. argues that the best indicator of the future is recent information. b. underestimates inflation when it is accelerating. c. overestimates inflation when it is slowing down. d. none of the above. e. all of the above. E. According to adaptive expectations theory, expansionary monetary and fiscal policies to reduce the unemployment rate are useless in the long run. 56
57. 57. 6. The conclusion of adaptive expectations theory is that expansionary monetary and fiscal policies intended to reduce the unemployment rate are a. effective in the long-run. b. effective in the short-run. c. unnecessary and cause inflation in the long-run. d. necessary and reduce inflation in the long-run.C. This theory believes, after a short-run reduction in unemployment, that the economy self-corrects to the natural rate of unemployment, but at a higher inflation rate. 57
58. 58. 7. Most macroeconomic policy changes, say the rational expectations theorists, are a. unpredictable. b. predictable. c. slow to take place. d. irrational.B. Rational expectations theory argues that people are intelligent and informed. They not only consider past changes, but also use all available information to predict the future, including future monetary and fiscal policies. 58
59. 59. 8. Rational expectations theorists advise the federal government to a. change policy often. b. pursue stable policies. c. do the opposite of what the public expects. d. ignore future economic predictions.C. Rational expectations argues that systematic and predictable expansionary monetary and fiscal policies are not only useless, but also harmful because the only result is higher inflation. 59
60. 60. Exhibit 10The Short-run and Long-run Phillips Curves Long-run Inflation Rate15% Phillips curve12%9% E16% D Short-run Natural rate Phillips curve3% Unemployment Rate 2% 4% 6% 8% 10% 60
61. 61. 9. Suppose the government shown in Exhibit 10 uses contractionary monetary policy to reduce inflation from 9 to 6 percent. If people have adaptive expectations, then a. the economy will remain stuck at point E 1 b. the natural rate will permanently increase to 8 percent. c. unemployment will rise to 8 percent in the short run. d. unemployment will remain at 6 percent as the inflation rate falls.C. The unemployment rate will rise to 8% as people adapt their inflationary expectations to the current inflation rate. Over time, however, the economy self- corrects to the natural unemployment rate. 61
62. 62. 10. Suppose the government shown in Exhibit 10 uses contractionary monetary policy to reduce inflation from 9 to 6 percent. If people have rational expectations, then a. the economy will remain stuck at point E 1. b. the natural rate will permanently increase to 8 percent. c. unemployment will rise to 8 percent in the short run. d. unemployment will remain at 6 percent as the inflation rate falls.D. Assuming the impact of government policy is predictable, people immediately anticipate higher of lower inflation. Workers quickly change their nominal wages and businesses change prices. The price level changes but the unemployment remains unchanged 62 the natural at
63. 63. 11. Voluntary wage-price restraints are known as a. wage-price controls. b. price rollbacks. c. wage-price guidelines. d. anti-inflation commitments.C. Wage-price guidelines are voluntary standards set by government rather than wage-price controls which are legal restrictions. 63
64. 64. 12. Which of the following government policies is an incomes policy? a. A reduction in welfare expenditures. b. The publication of a list of guidelines suggesting maximum wage and price increases. c. An increase in the money supply. d. All of the above answers are correct. B. Income policies include presidential jawboning, wage-price guidelines, and wage-price controls. 64
65. 65. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 65
66. 66. END 66