Lecture 20 Phillips Curve Price Stickiness. Noah Williams

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1 Lecture 20 Phillips Curve Price Stickiness Noah Williams University of Wisconsin - Madison Economics 702

2 Expectations-Augmented Phillips Curve Then money supply surprises affect labor supply and with it total output. As output increases above expected level, unemployment decreases. Get an expectations-augmented Phillips curve. There is a fundamental natural unemployment rate ū in the economy, depending on labor market institutions. (More on this later in class.) Idea dates to Friedman (1968) and Phelps (1968): The cyclical unemployment rate u ū depends on unanticipated inflation: π π e = h(u ū) When π = π e, u = ū. When π > π e, u < ū.

3 Shifting Phillips Curve The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment. Relationship between π and u isn t stable when ū or π e change: - Higher π e implies a higher Phillips curve. - Higher ū shifts Phillips curve to the right. A fall in TFP increases both expected inflation and the natural rate of unemployment. Shifts the Phillips curve up and to the right. Phillips curve unstable in periods with large TFP shocks.

6 Historical Shifts in Phillips Curve US in 1960s: expected inflation and the natural rate of unemployment are approximately constant. Stable Phillips curve. After 1970: expected inflation rate and the natural rate of unemployment varied considerably. Oil price shocks in and Changes in labor force raising the natural rate of unemployment. Monetary policy was expansionary in the 1970s, leading to high and volatile inflation. Relationship of unemployment and inflation broke down, but fairly stable relationship with unanticipated inflation.

7 Changes in Natural Rate of Unemployment Figure 5 NAIRU From Wage Phillips Curve 12 Unemployment Rate 10 8 ± 2 SE Bands for NAIRU NAIRU Estimate Percent 6 4 Trend Unemployment Year

8 Phillips Curve, Phillips Curve: Inflation Mean Unemployment Mean

9 Expectational Phillips Curve, Expectational Phillips Curve: Change in Inflation Unemployment Mean

10 Expectational Phillips Curve, Expectational Phillips Curve: Change in Inflation Unemployment Mean

11 Expectational Phillips Curve, Expectational Phillips Curve: Change in Inflation Unemployment Mean

12 Expectational Phillips Curve, Expectational Phillips Curve: Change in Inflation Unemployment Mean

13 Policy Implications Monetary policy can have real effects... but only by surprising the public. Expected changes in monetary policy have no real effects. If people are rational, systematic misperceptions are impossible. In any case, surprising the public is not desirable. Conclusion: monetary policy should be transparent.

14 Implications & Critiques of the Model If most shocks are monetary: The price level is procyclical. (Counter to data.) Real wages are countercyclical. (Counter to data.) But if most shocks are real, The price level is countercyclical. (As in data.) Real wages are procyclical. (As in data.) How realistic is it to assume that prices or money are unobservable? Persistence problem: Effects of unexpected money supply only last short time (until realized).

15 An Example Problem Suppose that problems in the banking sector lead to an unanticipated reduction in the money supply. In each of the following scenarios consider the effects of this shock on output and real interest rates. In addition, suppose that one option to respond to this shock would be to increase government spending temporarily, without raising current taxes (but increasing them in the future). If the policy goal is to stabilize output, is this fiscal policy response a good idea? 1 Use the cash in advance model. 2 Use the Lucas-type misperceptions model.

16 Solution to #1 In the cash in advance model with flexible prices the only effect of a change in the money supply is a change in the price level. Thus there is no effect of this change on output or interest rates. A temporary increase in government spending would increase output and interest rates, as it would shift the output demand curve more than the output supply curve. But this response is unnecessary here, and so not a good idea.

17 Solution to #2 In this model, an unanticipated fall in the money supply is interpreted by households as at least partly a reduction in total factor productivity. Labor supply and hence output supply fall, leading to a reduction in output and an increase in the real interest rate. The effects are just the opposite direction of the following figure. Figure 11.1 The Effects of an Unanticipated Increase in the Money Supply in the Money Surprise Model Copyright 2005 Pearson Addison-Wesley. All rights reserved. 11-2

18 Solution to #2 The response of the economy to an increase in government spending is just the same as in the cash in advance model above, with output and interest rates increasing. If the goal is to stabilize output, this policy response would be a good idea, as it could offset the negative shock to output supply. Interest rates would increase even further in comparison to the original equilibrium. (While fiscal policy may help stabilize output, it may not increase welfare, as the government spending leads to lower private consumption and less leisure.)

19 Money, prices, and nominal rigidities Flexible price models share a common property the inverse of the aggregate price level, 1/P t, behaves like a speculative asset price. Yet this seems at odds with the evidence. Many researchers accept that some degree of nominal rigidity in prices and/or wages is necessary if a dynamic general equilibrium model is going to have any chance of matching macro time series data and be useful for policy exercises.

20 Price Stickiness Tendency of prices to adjust slowly in economy. Sources: Monopolistic competition and menu costs. Under perfect competition, market forces prices to adjust rapidly. But in many markets, sellers produce differentiated goods with some market power: monopolistic competition. Sellers set prices. Menu costs: costs of changing prices may lead to price stickiness. Even small costs like these may prevent sellers from changing prices often. Since competition isn t perfect, having the wrong price temporarily won t affect the seller s profits much. The firm will change prices when demand or costs of production change enough to warrant the price change.

21 Empirical Evidence on Price Stickiness Industrial changed more often the more competitive is the industry (Carlton). Catalog prices don t seem to change much from one issue to the next. Menu costs may not be cause of stickiness (Kashyap). Bils-Klenow (2004): Half of all goods prices last more that 5.5 months. Varies dramatically over types of goods, amount of competition in industry. Steinsson-Nakamura (2008): Excluding sales, frequency of price changes is 9-12 % per month. Median duration regular prices is 8-11 months. Levy-Young (2004): The price of 6.5 ounce Coca-Cola was 5 cents from

22 Table 2 Monthly Frequency of Price Changes for Selected Categories % of Price Quotes with Price Changes % of Price Quotes with Price Changes, excluding observations with item substitutions All goods and services 26.1 (1.0) 23.6 (1.0) Durable Goods 29.8 (2.5) 23.6 (2.5) Nondurable Goods 29.9 (1.5) 27.5 (1.5) Services 20.7 (1.5) 19.3 (1.6) Food 25.3 (1.8) 24.1 (1.9) Home Furnishings 26.4 (1.8) 24.2 (1.8) Apparel 29.2 (3.0) 22.7 (3.1) Transportation 39.4 (1.8) 35.8 (1.9) Medical Care 9.4 (3.2) 8.3 (3.3) Entertainment 11.3 (3.5) 8.5 (3.6) Other 11.0 (3.3) 10.0 (3.3) Raw Goods 54.3 (1.9) 53.7 (1.7) Processed Goods 20.5 (0.8) 17.6 (0.7) Notes: Frequencies are weighted means of category components. Standard errors are in parentheses. Durables, Nondurables and Services coincide with U.S. National Income and Product Account classifications. Housing (reduced to home furnishings in our data), apparel, transportation, medical care, entertainment, and other are BLS Major Groups for the CPI. Raw goods include gasoline, motor oil and coolants, fuel oil and other fuels, electricity, natural gas, meats, fish, eggs, fresh fruits, fresh vegetables, and fresh milk and cream. Data Source: U.S. Department of Labor (1997).

23 Coke Cost a Nickel (5 cents) for 70+ Years

24 Williams 46 Economics 702 FIGURE 3: PRICE OF TRISCUIT 9.5 oz IN DOMINICK S FINER FOODS SUPERMARKET IN CHICAGO Figure Triscuit 9.5 oz price week Source: Chevalier, Kashyap and Rossi (2000)

28 Adding nominal rigidities Objectives: 1 To examine how the introduction of nominal rigidity affects analysis of macro issues. 2 To see how models employed in policy analysis can be derived when some degree of nominal rigidity is introduced into the dynamic general equilibrium models examined so far. We will first study an (old) Keynesian model where prices (or wages) are fixed, derive predictions. Will also discuss other sources of real and nominal rigidities. Later we will study a New Keynesian model where firms set prices rationally with stickiness, knowing that the price they choose will prevail for some time.

29 The Keynesian Model John Maynard Keynes (1936) The General Theory of Employment, Interest, and Money. Interpreted by Hicks (1937). Original theory NOT general equilibrium. In particular viewed unemployment in the Great Depression as resulting from excess labor supply, due to rigid nominal wages. Reconciled (at least somewhat) with classical theory by Samuelson and Tobin in 1950s-1960s. Predominant view in macroeconomics through the 1960s. Challenged by Friedman and monetarists in 1960s, later by rational expectations models (Lucas, Kydland-Prescott). Later work in 1970s and 1980s incorporating micro-foundations and building general equilibrium models with real and/or nominal rigidities: New Keynesian economics.

30 The Basic Keynesian Setup Premise: Some prices or wages are fixed in the short-run. Implies that some markets need not clear. Money market: reacts quickly to information. Assume it always clears. Goods market: reacts somewhat more slowly, but assume able to change production so it clears. Labor market: reacts most slowly. When economy out of general equilibrium, assume labor supply not equal to labor demand. Rigid nominal wage W = wp. Employment determined by labor demand. May have excess supply of labor, hence unemployment.

32 The IS-LM-FE Model Depict relationship between output and real interest rate via three curves. IS (investment=savings) represents goods market equilibrium. Re-labelling of output demand curve. LM (liquidity=money) represents money market equilibrium for a given price. Assume expected inflation constant, so R r. FE (full-employment) represents labor market equilibrium. Re-labelling of output supply curve. In short run with fixed prices/nominal wages, output determined by intersection of IS and LM. In long run, prices/wages adjust so reach general equilibrium at intersection of IS-LM-FE.

34 r IS LM r* Y* Y Short-run equilibrium in the Keynesian Model

35 r IS FE LM r* Y* Y Long-run equilibrium in the Keynesian Model

38 r IS FE LM(P) LM (P) M increase r* r Y* Y Y Short-run Effect of Increase in Money Supply

39 r IS LM(P)=LM(P ) FE LM (P) M increase P increase r* r Y* Y Y Long-run Effect of Increase in Money Supply: Money is neutral in the long-run.