Advanced Macroeconomics: The Phillips Curve, Inflation Expectations, and Federal Reserve Policy

Theoretical Foundations of the Phillips Curve and Inflation Expectations

• Conceptual Definition of Phillips Curve Lines: Each line on a Phillips curve diagram represents a specific level of expected inflation.

• Dynamics of Expectations vs. Reality: The relationship between expectation and reality determines the specific point on the curve.     * The Phillips curve is only ‘real’ or accurate at the single point where the expected inflation rate and the actual inflation rate meet.     * Across the curve, the reality of inflation can vary, but the curve itself is anchored by a specific expectation (e.g., a curve for a $3\%$ expectation vs. a curve for a $5\%$ expectation).

• Scenario A: Actual inflation is $5\%$; Expected inflation is $3\%$:     * The economy is positioned on the lower curve (representing the $3\%$ expectation).     * Because the actual inflation ($5\%$) exceeds the expectation ($3\%$), the point moves up and to the left along that specific curve, resulting in lower unemployment but higher inflation than expected.

• Scenario B: Actual inflation is $3\%$; Expected inflation is $5\%$:     * The economy is positioned on the upper curve (representing the $5\%$ expectation).     * The point is located to the right side of the curve because actual inflation is lower than expected, leading to higher unemployment.

• Scenario C: Actual inflation is $5\%$; Expected inflation is $5\%$:     * The point is located in the middle of the upper curve, exactly where it intersects the Long-Run Phillips Curve (LRPC).

• Scenario D: Actual inflation is $3\%$; Expected inflation is $3\%$:     * The point is located in the middle of the lower curve, intersecting the LRPC at the natural rate of unemployment.

Impact of Structural Changes on Long-Run and Short-Run Phillips Curves

• Shift in the Natural Rate of Unemployment: If there is a rise in the natural rate of unemployment—for example, due to a minimum wage increase to $\$20$ per hour—the Long-Run Phillips Curve (LRPC) shifts to the right.

• Interdependence of Curves: Whenever the Long-Run Phillips Curve shifts, the Short-Run Phillips Curve (SRPC) must shift with it. However, the SRPC can shift independently without moving the LRPC.

• Effect on Inflation: In a scenario where the natural rate of unemployment ticks up, the inflation rate may remain unchanged initially, but the baseline level of unemployment in the economy increases.

Supply Shocks and Historical Case Studies (OPEC)

• Positive Supply Shocks (1975–1976): A rare example of a positive supply shock occurred when OPEC effectively ‘fell apart,’ pumping more oil and causing prices to drop.     * This moved the economy to a ‘whole new lower Phillips curve.’     * Trade-offs became more attractive: the economy could achieve lower unemployment and lower inflation simultaneously compared to the $1975$ data points.

• Negative Supply Shocks: Conversely, a negative supply shock (e.g., oil prices jumping from $\$3.99$ to $\$4.40$ in a single day due to a conflict such as a war in Iran) shifts the SRPC upward and to the right.     * This results in stagflation: a ‘crappier’ set of trade-offs where both inflation and unemployment are higher.

Aggregate Demand, Government Spending, and Sliding vs. Shifting

• Distinguishing Between Demand and Supply Issues:     * Demand Changes: Cause a movement (sliding) along the existing Short-Run Phillips Curve.     * Supply Changes/Shocks: Cause the entire Short-Run Phillips Curve to shift to a new position.

• Rise in Government Spending: This increases Aggregate Demand (shifting from $AD_1$ to $AD_2$).     * On an Aggregate Supply/Aggregate Demand (AS/AD) graph, this is a slide up the Short-Run Aggregate Supply (SRAS) curve.     * On a Phillips curve diagram, this is equivalent to sliding up and to the left along the SRPC.     * Variable Equivalence: Rising prices and output in AS/AD correspond exactly to rising inflation and falling unemployment on the Phillips curve.

Recessions and the Correction of Expectations

• Recessionary Mechanism: A fall in consumer spending causes a recession, shifting Aggregate Demand left.     * Initial Move (Point A to Point B): Inflation drops and unemployment rises as the economy slides down the SRPC.

• Correction Process: Over time, expectations of inflation adjust to meet the new, lower actual inflation.     * When expectations drop (e.g., from $5\%$ to $3\%$), the entire Short-Run Phillips Curve shifts downward.     * Resulting Point (Point H): The economy eventually returns to the natural rate of unemployment but at a much lower inflation rate.

• The ‘Benefit’ of Recessions: While painful due to high unemployment during the transition, a recession can result in a more attractive set of trade-offs (a better Phillips curve) once expectations reset.

• Government Accommodation (The Alternative): If the government ‘juices’ the economy with expansionary policy during the recession to lower unemployment quickly, the economy slides back to the original point, forfeiting the opportunity to move to a lower inflation Phillips curve.

Economic Perspectives on Disinflation Policy

• Case: Reducing Inflation from $10\%$ to $5\%$:     * Economist Milton: Argues that expectations change quickly. Proposed contractionary policy would be ‘costless’ or low-cost, with a quick snap down to $5\%$ inflation and minimal impact on output.     * Economist James: Argues that expectations are ‘sluggish.’ He suggests the cost is high, potentially causing a $30\%$ drop in output that could last years.

• Policy Implications: A Board of Governors is more likely to pursue contractionary monetary policy if they subscribe to Milton’s view of rapid expectation adjustment.

Errors in Estimating the Natural Rate of Unemployment

• Scenario: The Fed believes the natural rate is $4\%$ when it is actually $5\%$.

• The Inflationary Spiral:     1. The Fed sees $5\%$ unemployment and assumes it is too high relative to their expected $4\%$.     2. They implement expansionary monetary policy (loosening money supply).     3. This moves the economy to a point of higher inflation.     4. Workers adjust their expectations to the new inflation, and the SRPC shifts up, moving unemployment back to the real natural rate of $5\%$.     5. The Fed, still believing the rate should be $4\%$, stimulates again.     6. This creates a cycle of ever-increasing inflation without any long-term gain in employment.

• Historical Context: This mirrors the economic conditions of the $1970s$, where the Fed continually stimulated an economy with a high natural rate (roughly $6\%$ or $7\%$), leading to runaway inflation.

Factors Influencing the Severity of Disinflation (The Volcker Era)

• Background: Paul Volcker (early $1980s$) used contractionary policy to fight high inflation ($12\%$).

• Wage Contract Duration:     * Short Duration: Beneficial (Thumbs Up). Allows employers to renegotiate labor costs quickly as inflation drops.     * Long Duration: Problematic. If a contract mandates a $13\%$ raise (to match old inflation) while actual inflation is only $8\%$, employers will stop hiring or lay off workers.

• Fed Credibility: If there is little confidence in the Fed’s determination, expectations will not change. People will continue to demand high raises, keeping the economy on a high-inflation Phillips curve.

• Quick Adjustment: If expectations adjust quickly to reality, the economy experiences ‘costless disinflation,’ where inflation drops without a major spike in unemployment.

Case Study: 2008 Housing and Financial Crisis

• The Double Shock:     1. Demand Shock: Decrease in Aggregate Demand (AD) from the housing/financial collapse.     2. Supply Shock: Decrease in Short-Run Aggregate Supply (SRAS) from rising commodity prices.

• Combined Effects:     * Output ($Y$): Experienced a massive fall.     * Unemployment ($U$): Experienced a significant rise ($U_1$ to $U_3$).     * Price Level/Inflation: Impact was ambiguous; the demand shock pushed prices down while the supply shock pushed prices up. The net result depends on which shock was larger.

• Fed Response: The Fed intervened aggressively (lowering interest rates to $0\%$, bank recapitalization, stimulus checks) to shift Aggregate Demand back to the right and reach Point C.

• Risks of Intervention: The primary reason for the Fed to hesitate would be the fear of causing excessive inflation, though the actual recovery from $2008$ saw a relatively costless reduction in inflation from peaks of $9\%$ back toward $3\%$ or $4\%$.

Questions & Discussion

• Jerome Powell and the FOMC: There was mention of Jerome Powell’s recent activity. On the Federal Open Market Committee (FOMC), $3$ of the $12$ members were recently dissenters, favoring lower interest rates due to concerns about creeping unemployment and dropping output.

• Historical Fed Mandates: Mentioned that the last time a Fed chairman stayed on after a term without reappointment was in $1948$. The speaker predicts Powell may stay for a few months until the political situation in Washington clarifies.

• Logistics: The next test is scheduled for next Friday, consisting of $14$ multiple-choice questions and $3$ open-ended questions. Reviews will be held on the Monday and Wednesday prior.

• Teacher/Staff Mentions: Mr. Hillman (supplies) and Ms. Martinique (signature stamp email).