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Principles of Economics Macroeconomics Inflation, Unemployment, Output, and Prices. J. Bradford DeLong U.C. Berkeley. Interest Rates and Spending. Y = μ[c 0 + (G - c y T) + (c w W + I + X)(r)]; r: the real interest rate:

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principles of economics macroeconomics inflation unemployment output and prices
Principles of EconomicsMacroeconomicsInflation, Unemployment, Output, and Prices

J. Bradford DeLong

U.C. Berkeley

interest rates and spending
Interest Rates and Spending
  • Y = μ[c0 + (G - cyT) + (cwW + I + X)(r)]; r: the real interest rate:
    • r = i (the current interest rate) + E(Δi) (expected change in interest rates) + ρ (the risk premium) - E(π) (expected inflation)
  • Rule of thumb: in the U.S. today, boost the (risky) real interest rate r by 1%-point: reduces exports by $50 billion/year; reduces household consumption spending by $50 billion/year; and reduces business investment spending by $200 billion/year
  • The “Liquidity Trap”
aggregate supply
Aggregate Supply
  • Where is the aggregate supply curve?
    • Full employment
    • Last year’s prices
    • Expected inflation
suppose we were to slip a derivative
Suppose We Were to Slip a Derivative?
  • In some ways a better diagram to draw—we aren’t continually having to draw our curves higher and higher on the graph…
the phillips curve
The Phillips Curve
  • When unemployment is high AD is to the left—and we should see inflation less than expected inflation plus supply shocks
  • When unemployment is low AD is to the right—and we should see inflation less than expected inflation plus supply shocks
the phillips curve ii
The Phillips Curve II
  • When unemployment rises, inflation tends to fall
  • A relationship called the “Phillips Curve”
  • But not something you can count on…
the phillips curve iii
The Phillips Curve III
  • And what inflation rate corresponds to a given unemployment rate has varied a lot over the past half century…
the phillips curve iv
The Phillips Curve IV
  • And what inflation rate corresponds to a given unemployment rate has varied a lot over the past half century…
  • The “new economy” of the 1960s…
  • The 1973 oil shock…
  • Whip Inflation Now!
  • The Iranian Revolution
  • The “Great Moderation”
    • The Volcker Disinflation
    • Opportunistic Disinflation
    • Greenspan Stability
    • Bernanke
  • Inflation Expectations and supply shocks
what drives inflation expectations
What Drives Inflation Expectations?
  • Last year’s inflation
  • Economic slack
  • Jawboning?
  • What’s just happened to gasoline prices
    • Oil shocks more generally
slipping a derivative
Slipping a Derivative
  • In some ways a better diagram to draw—we aren’t continually having to draw our curves higher and higher on the graph…
okun s law
Okun’s Law
  • Production (relative to the full-employment “potential output” level)
  • Unemployment (relative to the natural rate)
  • A 2-to-1 relationship
suppose we were to substitute unemployment for production
Suppose We Were to Substitute Unemployment for Production?
  • This should move up or down depending on how expected inflation changes
and suppose we were willing to assume that inflation expectations were adaptive
And Suppose We Were Willing to Assume That Inflation Expectations Were Adaptive?
  • Then we slip another
  • derivative
how well does this do
How Well Does This Do?
  • Since 2000 (black) there has been very little change in inflation
  • In the 1990s periods of unemployment < 5% see inflation creep up; periods of unemployment > 7% see inflation ebb
  • In the 1980s (green) we see substantial deceleration of inflation when unemployment > 7%
  • The 1970s (red) are all over the place
breaks down in the 1970s and post 2009
Breaks Down in the 1970s and Post-2009
  • In the 1970s big supply shocks shift expected inflation and disrupt the “adaptive” Phillips Curve
  • After 2009 inflation does not fall (much) even when unemployment is very high
  • In between we have:
    • π = -β(u-u*) + E(π)
    • π = -β(u-u*) + π-1
will the adaptive phillips curve come back
Will the “Adaptive” Phillips Curve Come Back?
  • Who knows?
    • Supply shocks
    • Adaptive expectations
    • Static expectations (expectations “well anchored”)
    • Inflation lower bound
    • “Rational” expectations