Macroeconomic Analysis 2003

1. Macroeconomic Analysis 2003 An Example of a Stabilisation Programme Lecture 9

2. Contents • Need for Stabilisation: Costs of Inflation and Unemployment • Review of Wage and Price Spiral and Inflation • Output gap and Mark ups • Stabilisation experience • Phillips’ and Okun Curves • Set up of the Stabilisation Programme • Inflation reduction and Unemployment • Growth rate of output, inflation and money supply • Sacrifice Ratio • inflation policy game between public and the government: Rules or Discretion? • Analysis of Stabilisation using AS-AD diagrams Lecture 9

3. Movement of Economy Around the Trend: A Reminder 35 million unemployed in the OECD Y Boom Recession 1992 1982 2003 Lecture 9

4. Needs for Stabilisation: Costs of Inflation • Inflation distorts relative prices and makes the market system less efficient as prices cannot signal relative scarcity • Inflation transfers resources from creditors to debtors • Redistributes income from fixed income group to property holders • Taxes are not indexed for inflation, low income families are pushed up to the tax threshold • Shoe leather and bookkeeping costs rise with inflation • It creates uncertainty. Creates illusions, confusions and complicates economic calculation • It is harmful for economic growth; reduces saving and investment activities • It create social tension Lecture 9

5. Needs for Stabilisation: Costs of Unemployment • Loss of output and income and utility • Personal psychological costs • Unhappiness • Stress and tension • Discouragement and disappointment • Morale and motivation • Uncompetitive feeling • Dignity of human life • Insecurity Loss of productive skills productivity Lack of learning by doing opportunity Rise in social unrest and crimes Lecture 9

6. Main cause of Inflation: Wage Price Spiral Modernisation or Negotiation? , =0.2 Price wage Lecture 9

7. Price Level to Inflation Rate Ignore these small numbers Lecture 9

8. Inflation to Aggregate Supply or Expectation Augmented Phillips Curve Lecture 9

9. Inflation, Output and Unemployment in the Short Run LAS AS=f(w,pe) AD =f(M,G, T) o Lecture 9

10. Supply Shock and Stagflation LAS AS1 AS=f(w,pe) Stagflation AD =f(M,G, T) o Lecture 9

11. Inflation Rational Expectation Time Deflation Expectation die very slowly. Lecture 9

12. Friedman (1966, 1968) and Phelps (1967) natural rate of unemployment hypothesis Lecture 9

13. Natural Rate of Unemployment Hypothesis Lecture 9

14. Four Main Theories of Natural Rate of Unemployment 1. Search cost and job mismatch theory: s = job separation rate f = job finding rate u = unemployment rate 2. Insider-Outsider theory: Inefficient Bargaining between firms and workers Members of the union demand higher wages and non-member remain unemployed 4. Rigidity in the labour Market: Minimum wage laws Entry deterrence and labour market standards 3. Efficiency wage theory Firms pay higher wages to workers to reduce hiring and firing costs and to reduce shirking and the monitoring costs or to appear as an ideal employer but that makes others unemployed Lecture 9

15. Determination of the Natural Rate of Unemployment: An Example Lecture 9

16. Recent Experience of Stabilisation in the UK Lecture 9

17. Inflation is a Monetary Phenomenon Lecture 9

18. Standard Measures of Stabilisation • Control of Aggregate Demand • Increase or decrease in money supply • Control in the tax and spending programme • Monetisation or contraction of the budget deficit • Aggregate supply • Wage renegotiations • Efficiency enhancing measures • Trade and Exchange Rates Measures • Appreciation or depreciation of the currency • Trade and exchange rate agreements Lecture 9

19. Unemployment and Output Gap: Okun’s Curve Output Gap Higher growth rate means lower unemployment rate Sacrifice ratio Inflation gap Higher unemployment causes wages and inflation to fall Unemployment Gap Lecture 9

20. Inflation Reduction Programme:Output, Inflation and Unemployment Lecture 9

21. Stabilisation: Table 1 Lecture 9

22. Basic Parameters for the Stabilisation Programme Model Lecture 9

23. Disinflation (Stabilisation Program Lecture 9

24. Parametric Specification and solution steps for inflation reduction Programme Lecture 9

25. Transitional path of output and money growthand unemployment rate in the inflation reduction programme =14% - a = 0.5 b = 0.5 Lecture 9

26. Lecture 9

27. Stabilisation: Table 2 Lecture 9

28. Stabilisation: Table 3 Lecture 9

29. Disinflation Path and the Steady State Lecture 9

30. Another Set of Parameters for the Stabilisation Programme Model Lecture 9

31. Transitional path of output and money growthand unemployment rate in the inflation reduction programme Lecture 9

32. Lecture 9

33. Inflation Policy Game Lecture 9

34. Inflation Policy Game C is the most preferred and B is the least wanted scenario of the government Non cooperative Game may end at point D with high inflation and high unemployment rate uL uH Lecture 9

35. Adaptive and Rational Expectation Views on a Positive Demand Shock LAS SAS c P2 b P1 P a P0 AD1 AD0 0 Yn Reply to demand shock Adaptive Expectation: a to b to c Rational expectation: a to c Y Lecture 9

36. Movement of Aggregate Demand and Supply Around the Natural Rate AS2 SA3 AS1 P2 d e AS0 P3 Price Level c P1 f b P0 AD3 AD1 a AD0 0 YL Yn YH Lecture 9

37. Exercises • Okuns’ Curve • Phillips curve • Inflation reduction program • Sacrifice ratio • Money supply, inflation and economic growth rate in the steady state • Policy Game Lecture 9