Macroeconomics subject For undergraduate students (semester 2)

1. Phillips curve
Meeting 5

2. 1. shift in the Philips curve
2. the role of expectation
3. the cost of reducing inflation

3. Shift in the Philips curve

4. The Phillips Curve

5. The Phillips Curve
• The slope of the Phillips curve
depends on how sticky prices and
wages are
– the stickier are wages and prices, the
smaller is parameter , and the flatter is
the Phillips curve
• When the Phillips curve is flat, even
large changes in the unemployment
rate have little effect on the price
level

6. The Phillips Curve
• Whenever unemployment is equal to
its natural rate, inflation is equal to
expected inflation
– the position of the Phillips curve can be
determined if we know the natural rate of
unemployment and the expected inflation
rate

7. The Phillips Curve
• The Phillips curve shifts if either
expected inflation or the natural rate
of unemployment changes or if a
supply shock occurs
– a higher natural rate moves the Phillips
curve to the right
– higher expected inflation moves the
Phillips curve up
– adverse supply shocks move the Phillips
curve up

8. Shifts in the Phillips Curve

9. The role of expectation

10. Expected Inflation
• The natural rate of unemployment and expected
inflation together determine the position of the
Phillips curve
– higher expected inflation moves the Phillips curve upward

11. Expected Inflation
• There are three basic scenarios for
how inflation expectations are formed
– static expectations
• prevail when people ignore the fact that
inflation can change
– adaptive expectations
• prevail when people assume the future will be
like the recent past
– rational expectations
• prevail when people use all the information
they have as best they can

12. The Phillips Curve under Static
Expectations
• If inflation expectations are static,
expected inflation never changes
– the trade-off between inflation and
unemployment will not change from year
to year
• If inflation has been low and stable,
businesses will probably hold static
inflation expectations

13. Static Expectations of Inflation

14. The Phillips Curve under Adaptive
Expectations
• If the inflation rate varies too much
for workers and businesses to ignore
it and if last year’s inflation rate is a
good guide to inflation this year,
individuals are likely to hold adaptive
expectations
– inflation will be forecasted by assuming
that this year will be like last year
– forecast will be good only if inflation
changes slowly

15. The Phillips Curve under Adaptive
Expectations
• The Phillips curve can be written
s
t
*
tt1-tt )u-(u- 
• The Phillips curve will shift up and
down depending on whether last
year’s inflation was higher or lower
than the previous year’s
– inflation accelerates when unemployment
is less than the natural rate

16. Adaptive Expectations
• Example
– the government pushes the
unemployment rate down 2 percentage
points below the natural rate
– =1/2
– last year’s inflation rate = 4%
2-1-tt 
This year’s inflation rate = 4+1/22=5
Next year’s inflation rate = 5+1/22=6
And so on

17. The Phillips Curve under Rational
Expectations
• If the economy is changing rapidly
enough that adaptive expectations
lead to large errors, individuals will
switch to rational expectations
– People form their forecasts of future
inflation not by looking backward but by
looking forward
• they look at what current and expected
government policies tell us about what
inflation will be

18. The Phillips Curve under Rational
Expectations
• The Phillips curve will shift as rapidly
as changes in economic policy that
affect aggregate demand
• Anticipated changes in economic
policy turn out to have no effect on
the level of production or employment

19. What Kind of Expectations Do We
Have?
• If inflation is low and stable,
expectations are probably static
• If inflation is moderate and fluctuates
slowly, expectations are probably
adaptive
• When shifts in inflation are clearly
related to changes in monetary policy,
swift to occur, and large enough to
seriously affect profitability,
expectations are probably rational

20. Chapter Summary
• The principal determinant of the
expected rate of inflation is the past
behavior of inflation
– if inflation has been low and steady,
expectations are probably static
– if inflation has been variable but
moderate, expectations are probably
adaptive
– if inflation has been high or has varied
rapidly, expectations are probably
rational

21. The cost of reducing inflation

22. Do the long-term benefits of reducing inflation
outweigh the short-term costs?
• expectations play a key role in economic well-being
• expectations matter and that inflation can be successfully managed
• some economists have argued that inflation can be reduced with minimal
short-term costs if policymakers are able to change the public's
expectations about inflation
• If policymakers credibly commit to reducing inflation, the public will believe
them and inflation will fall without a dramatic slowing of the economy
• Economists have been so focused on measuring the costs that they have
not asked whether the gain that results from lower inflation justifies the
pain required to reduce it

23. Reducing inflation
• Using the stock market to gauge the net effects:
• In a well-functioning and rational stock market, changes in stock prices
reflect expectations about both future corporate profits and interest rates.
• Measures taken to stabilize inflation may raise interest rates and reduce
profits in the short run-which is bad for the stock market
• However, the reduction in inflation may increase future profits and reduce
interest rates - which is good for the market
• Therefore, the stock market response to the announcement of a policy
directed at reducing inflation measures whether the good effects of
reducing inflation outweigh the bad

24. Reducing inflation
• When countries tried to stabilize high inflation, the stock market
increased by 24 percent on average
• In other words, reducing high inflation has a large positive effect on
the stock market
• In contrast, reducing moderate inflation had no significant effect on
the stock market
• A positive stock market response to inflation stabilization predicts
lower inflation and faster economic growth in the future and vice
versa

25. Reducing inflation
• Reducing high inflation has different implications for the economy
than reducing moderate inflation
• People seem to believe that there will be large long-run benefits of
reducing high inflation and virtually no short-run costs
• With respect to reducing moderate inflation, the expectation seems
to be that the benefits will not outweigh the costs
• High inflation and moderate inflation present very different policy
challenges.

26. The costs of inflation
• menu costs
• shoe leather costs
• loss of purchasing power
• the redistribution of wealth

27. Menu Costs
• Is the cost to a firm resulting from changing its prices
• The name stems from the cost of restaurants literally printing new
menus
• But economists use it to refer to the costs of changing nominal prices
in general
• With high inflation, firms must change their prices often

28. Shoe leather costs
• refers to the cost of time and effort that people spend trying to
counteract the effects of inflation, such as holding less cash, investing
in different currencies with lower levels of inflation, and having to
make additional trips to the bank.
• The term comes from the fact that more walking is required
(historically, although the rise of the Internet has reduced it) to go to
the bank and get cash and spend it, thus wearing out shoes more
quickly.
• A significant cost of reducing money holdings is the additional time
and convenience that must be sacrificed to keep less money on hand
than would be required if there were less or no inflation.

29. Loss of purchasing power
• inflation causes the value of an individual dollar to decrease over
time.
• Each dollar has less purchasing power with inflation.
• Thus, individuals who have the same wage next year as this year will
be able to purchase less.
• Purchasing power can be maintained if wages increase exactly at the
rate of inflation, but this is not always the case. When wages increase
less than the rate of inflation, people lose purchasing power.

30. Redistribution of wealth
• The effect of inflation is not distributed evenly in the economy, and as a
consequence there are hidden costs to some and benefits to others from
this decrease in the purchasing power of money.
• For example, with inflation, those segments in society which own physical
assets (e.g. property or stocks) benefit from the price of their holdings
going up, while those who seek to acquire them will need to pay more for
them.
• Their ability to do so will depend on the degree to which their income is
fixed. For example, increases in payments to workers and pensioners often
lag behind inflation, and for some people income is fixed.

31. Hyperinflation in Zimbabwe

32. 1012

33. ? name
10100

34. • Zimbabwe's peak month of inflation is estimated at 79.6 billion percent in
mid-November 2008
• In 2009, Zimbabwe stopped printing its currency, with currencies from
other countries being used
• In mid-2015, Zimbabwe announced plans to have completely switched to
the United States dollar by the end of 2015
• The government did not attempt to fight inflation with fiscal and monetary
policy. In 2006, before hyperinflation reached its peak, the bank announced
it would print larger bills to buy foreign currencies.
• The Reserve Bank printed a Z$21 trillion bill to pay off debts owed to the
International Monetary Fund.

35. • The head of the Central Bank of Zimbabwe Gideon Gono announced that on August 1, 2008, the
Zimbabwe dollar will be denominated 10,000,000,000 times.
• So 1 new ZWD equals 10 billion. In addition, the circulation of US dollars and euros is allowed.
• On January 16, 2009, a denomination of 100,000,000,000,000 (100 trillion) Zimbabwean dollars
was issued.
• On February 2, 2009, the Central Bank of Zimbabwe conducted another denomination, removing
12 zeros from banknotes, thus 1 trillion ZWD turned into 1, the rate of which was 0.25 US dollars.
• In these conditions, the authorities of Zimbabwe refused to issue the national currency and
switched to the US dollar, which allowed to bring down the level of inflation and stabilize the
situation in the economy

36. • A monetarist view is that a general increase in the prices of things is
less a commentary on the worth of those things than on the worth of
the money. This has objective and subjective components:
• Objectively, that the money has no firm basis to give it a value.
• Subjectively, that the people holding the money lack confidence in its
ability to retain its value.