Lecture 10. The Dynamic AD–AS Model and the Phillips Curve
Recommended reading : 【Macroeconomics】 Macroeconomics Table of Contents
1. Inflation
2. The Dynamic Aggregate Demand–Aggregate Supply Model
3. The Phillips Curve
4. Monetary and Financial Policy
1. Inflation
⑴ Inflation (inflation)
① Definition: A phenomenon in which the price level rises continuously over multiple periods, causing the value of money to fall (↔ deflation)
② Effects of inflation
○ Efficiency harms: Overinvestment in real assets; disruption of long-term lending/borrowing contracts
○ Equity harms: Transfers wealth from creditors holding monetary assets to debtors with monetary liabilities
○ Sometimes, it also transfers wealth from the private sector holding cash and government bonds to the government that issues them
③ Inflation rate
④ Expected inflation rate: Reflects economic agents’ expectations about changes in the price level
⑤ Type 1. Demand-pull inflation
○ Price increases driven by higher aggregate demand: National income and prices rise simultaneously
○ Keynesian school: ΔG ↑ → IS shifts right → AD shifts right○ Continuous increases in government spending are impossible
○ If inflation is excessive, they argue that contractionary policy should be implemented to restrain aggregate demand
○ Monetarist school: M ↑ → LM shifts right → AD shifts right
○ Unlike government spending, the money supply can be expanded without bound
⑥ Type 2. Cost-push inflation
○ Price increases driven by a fall in aggregate supply: National income falls while prices rise, producing stagflation (stagflation)
⑦ Type 2-1. Wage-push inflation: When workers demand wage increases that exceed the growth rate of labor productivity
⑧ Type 2-2. Supply-shock inflation: Arises from oil-price hikes, raw material price increases, etc.
⑨ Type 3. Mixed inflation
○ Prices rise sharply
⑵ Social costs of inflation
① Redistribution of wealth
○ Inflation shifts wealth from monetary assets to real assets
○ Real interest rates and real wages fall, harming creditors and workers
○ Fixed-income earners are harmed because nominal income is unchanged while real income falls
○ In general, the government may intentionally use inflation to obtain tax revenue from the private sector
② Higher tax burdens under a progressive tax system
○ Because nominal income rises, the tax burden increases
③ Shoe-leather costs
○ Transaction costs of exchanging/holding money rise
④ Menu costs
○ If menu costs are excessive, firms cannot adjust prices immediately
○ Relative prices change, causing inefficiencies in market resource allocation
⑤ Reduced economic growth
○ People prefer real assets, reducing financial savings: real estate is favored while deposits and stocks are avoided
○ In the long run, this can hinder growth by reducing funds available for investment
⑥ Balance of payments
○ If prices of domestically produced goods rise, international competitiveness falls, exports decline, and imports rise: deterioration in the balance of payments
⑦ Greater economic uncertainty
⑶ (Reference) Hyperinflation (hyperinflation)
① Definition: When the inflation rate reaches thousands or tens of thousands of percent
② Historically, this occurred in Germany after its defeat in World War I
③ Cause: Because the government tries to obtain tax revenue by printing money○ Money issuance → prices rise → more money issuance due to higher prices → prices rise further → ···
⑷ (Reference) Deflation
① Definition: A phenomenon in which the aggregate demand curve shifts left, leading to lower prices and lower national income
② Causes○ Japan’s deflation in the 1990s and the Great Depression in the 1930s were caused by collapses in asset prices
③ Effects
○ Falling prices increase the real burden of debt, reducing households’ disposable income
○ Lower disposable income reduces consumption and weakens financial institutions
○ As deflation pushes nominal interest rates toward 0, the economy can fall into a liquidity trap
: Refer to the Fisher equation below
⑸ (Reference) Goldilocks (goldilocks)
① Definition: A state in which the economy achieves high growth without rising prices
② Named after the British folktale “Goldilocks and the Three Bears”
2. The Dynamic Aggregate Demand–Aggregate Supply Model
⑴ Overview
① Explains short-run fluctuations of dynamic economic variables
② That is, variables are expressed in terms of rates of change
⑵ The dynamic aggregate demand curve (Note: endogenous variables are now distinguished as nominal and real interest rates)
① Fisher equation (Fisher equation)
○ Nominal interest rate (Rt): Interest rate measured in monetary units
○ Real interest rate (rt): Interest rate expressed in real goods
○ Ex post real interest rate
○ Ex ante real interest rate
○ (Reference) Darby effect: Even if expected inflation is fully reflected in the nominal interest rate, creditors may still lose once the tax system is considered
② Nominal interest rate vs. real interest rate
○ Nominal interest rate: Determines money demand. (Reference) An increase in money demand reduces real money supply
○ Real interest rate: Determines investment demand, because investment in construction, equipment, inventories, etc. is real investment
③ Dynamic aggregate demand curve
Figure. 1. Dynamic aggregate demand curve]
○ Movement along the curve: A fall in inflation (π0 → π1) increases real money supply, shifting the LM curve right
○ Increase in real money supply: (Note) This likely means that money is not being used up by rising prices, indirectly increasing effective money supply
○ Shift of the curve: A rise in expected inflation → lower real interest rate → higher investment → AD shifts right (Mundell–Tobin effect)
○ In the real interest rate–income diagram, LM shifts right: real interest rate falls, income rises
○ In the nominal interest rate–income diagram, IS shifts right: nominal interest rate rises, income rises
○ | rise in nominal interest rate | + | fall in real interest rate | = rise in expected inflation
⑶ The dynamic aggregate supply curve
① Labor supply: If expected inflation rises, labor supply decreases (∵ expected decline in real wages) (i.e., expectation-related)
② Labor demand: If inflation rises, labor demand increases (∵ real wages fall) (i.e., actual-outcome-related)
③ Dynamic aggregate supply curveFigure. 2. Dynamic aggregate supply curve]
○ Movement along the curve: Inflation rises (π0 → π1) → real wages fall → labor demand increases
○ Shift of the curve: Expected inflation rises → nominal wage growth costs rise → labor supply falls → AS shifts left○ Nominal wage growth cost: W’ - πe (i.e., workers believe they lose by πe)
○ An increase in nominal wage growth cost is equivalent to a fall in the expected real wage
④ Okun’s law (Okun’s law)
○ Employment growth and the unemployment rate are inversely related: empirically, a 1% increase in the unemployment gap reduces output by 2.5%
○ un: the natural rate of unemployment. The long-run equilibrium unemployment rate corresponding to full-employment output
⑤ Conclusion: Derivation of the Phillips curve
⑷ Equilibrium in dynamic aggregate demand and supply (Assume there is an unanticipated increase in the money growth rate)
Figure. 3. Equilibrium in dynamic AD and AS]
① 1st. Initially, the economy is in long-run equilibrium with output at the full-employment level
② 2nd. An unanticipated increase in money growth reduces money demand: LM shifts right; IS unchanged○ Because private expected inflation (π0e) is fixed in the short run, IS does not move
③ 3rd. Given expected inflation (π0e), AD shifts right
④ 4th. Liquidity effect of monetary/financial policy (liquidity effect): nominal interest rate falls, real interest rate falls, output rises○ Real interest rate falls because it equals nominal interest rate minus expected inflation (fixed), so it moves with the nominal rate
⑤ 5th. As equilibrium inflation rises, real money supply falls, so LM shifts slightly left
⑥ 6th. In the long run, expected inflation is revised upward to match actual inflation
⑦ 7th. Higher expected inflation lowers the real interest rate, shifting AD right
⑧ 8th. Higher expected inflation increases nominal wage growth, shifting AS left
⑨ 9th. As output returns to full employment, real money supply falls and LM shifts left
⑩ 10th. In the long run, an increase in the money supply does not affect output or the real interest rate○ Because the dynamic AD–AS model is based on classical assumptions, output equals potential output in the long run
○ From Y = C + I + G and Y = Y, we can see that I is constant, implying the real interest rate returns to its initial level
○ The nominal interest rate rises by the amount of inflation
○ This is called the expected inflation effect *(expected inflation effect) or the Fisher effect (Fisher effect)
3. The Phillips Curve (Phillips curve)
⑴ The Phillips curve under static expectations (also called the classical Phillips curve)
① Reinterprets the positive relationship between output and inflation as an inverse relationship (trade-off) between unemployment and inflation
Figure. 4. Classical Phillips curve
② Policy implication: Price stability and full employment cannot be achieved simultaneously
③ Limitation 1. The classical Phillips curve focuses on nominal wages, but workers and firms actually focus on real wages○ Lipsey studied the relationship between nominal wage growth and unemployment
○ Nominal wage increases → (money illusion) labor supply increases → real wages fall → labor demand increases and unemployment falls
○ It assumes excess demand (supply) in the labor market raises (lowers) nominal wages④ Limitation 2. Stagflation in the 1970s: inflation and unemployment rose together, so the Y–π curve had a negative slope
○ In other words, stagflation demonstrated the instability of the Phillips curve
⑵ Adaptive expectations and the Phillips curve (also called the natural rate of unemployment hypothesis; proposed in 1970)
Figure. 5. Phillips curve under adaptive expectations]
① Overview
○ Friedman and Phelps: unlike Lipsey, they argued that labor supply is determined not by nominal wage growth but by expected real wage growth
○ Friedman was among the first to emphasize the role of expectations
○ This led to the concept of expected inflation
○ It became possible to explain stagflation
○ The classical Phillips curve mainly explains the inflation–unemployment relationship driven by aggregate demand fluctuations
○ Stagflation was caused by aggregate supply shocks, interpreted as an upward shift of the Phillips curve
○ Inflation in the 1970s was largely cost-push inflation driven by supply shocks② Phillips curve
○ πe: expected future inflation under adaptive expectations
○ Past observed outcomes are incorporated into expectations: persistent errors occur when inflation keeps rising
○ un: natural rate of unemployment
○ Short run: downward-sloping Phillips curve
○ Long run: vertical Phillips curve③ Interpretation under adaptive expectations
○ Under adaptive expectations, if the central bank raises the inflation rate, an effect appears in the short run even if only briefly
○ Short run: downward-sloping Phillips curve; a choice can be made between inflation and unemployment (∵ money illusion)
○ Long run: workers’ expected inflation matches actual inflation, and unemployment returns to the natural rate④ Natural rate hypothesis (natural rate hypothesis): proposed by the Keynesian school
○ Definition
○ The long-run Phillips curve is vertical at the natural rate of unemployment
○ The natural rate can be used as a benchmark indicator for monetary/financial policy
○ It can be used to assess whether policy stance is consistent with resolving labor-market imbalances
○ NAIRU (non-accelerating inflation rate of unemployment): the unemployment rate at which inflation can remain stable without accelerating or decelerating
○ Case 1. Unemployment < natural rate: inflation accelerates
○ Case 2. Unemployment > natural rate: disinflation accelerates⑤ Limitations of the natural rate hypothesis: why monetary policy should not be decided by relying solely on the Phillips curve
○ Limitation 1. The natural rate is difficult to estimate (a technical problem)
○ Limitation 2. Effects of monetary policy appear with a lag of 2–3 years, creating uncertainty○ That is, economic conditions can change over 2–3 years
○ Limitation 3. Assumes adaptive expectations: with rational expectations, policy ineffectiveness can arise
○ This is why many economists are skeptical about immediate policy responses
⑶ Rational expectations and the Phillips curve (proposed by Lucas of the New Classical school)
① Interpretation under rational expectations
○ Agents use not only past and current realized inflation but also all information such as policy stance of the government/central bank and the economic environment
○ Under rational expectations, monetary policy is effective only if the central bank implements unanticipated policy② Unanticipated policy
○ A sudden increase in inflation and nominal wage growth is mistaken for a rise in real wages, increasing labor supply
○ Effect: real wages fall, unemployment falls
○ Case 1. Unanticipated expansionary monetary policy: move along the Phillips curve
○ Case 2. If the private sector does not trust the central bank: move along the Phillips curve③ Anticipated policy
○ Nominal wages have already risen by expected inflation, so real wages are unchanged
○ Effect: no impact on unemployment; only inflation rises
○ Case 1. Anticipated expansionary monetary policy: immediate upward shift
○ Case 2. If the private sector trusts the central bank: immediate upward/downward shift
○ In countries with high average inflation, monetary policy tends to produce only small output gains
4. Monetary and Financial Policy
⑴ The central bank’s policy game (policy game)
① Social welfare function
○ If total output (Y) exceeds full-employment output (Y*), unemployment falls and social welfare rises
○ If inflation (π) rises, social welfare falls
○ α is the relative weight on the harm from inflation② The central bank’s policy objectives: price stability and employment stability
③ Case 1. Always keep inflation at 0 to anchor private inflation expectations at 0
④ Case 2. If a price-stability stance is established and expected inflation is 0
⑤ Case 3. If the private sector rationally anticipates the central bank’s revised optimal policy (π = γ/α): social welfare declines
⑵ Policy credibility and rules
① Discretion (discretion)
○ Definition: Monetary/financial policy changes frequently at the central bank’s discretion
○ It fails to be effective and only generates inflation bias
○ Inflation bias: the private sector does not fully trust promised inflation and holds a systematic bias
○ Dynamic inconsistency of optimal policy (dynamic inconsistency of optimal policy)○ Definition: The policy authority has an incentive to break implicit market trust and pursue short-run goals
○ That is, policy deviates from prior announcements over time, reducing consistency② Rule (rule)
○ If policy is kept consistent and credibility is obtained, the best outcome can be achieved
○ Example: Friedman’s k% rule
⑶ Setting goals for monetary policy
① Background
○ Because monetary policy is slow and variable in effect, intermediate targets are needed
○ Money supply and interest rates are easier to monitor than inflation and unemployment② Targeting money supply
○ Advantages
○ If the money-demand function is stably related to nominal income, growth can be adjusted easily via money supply
○ The money supply—especially the monetary base—can be controlled relatively easily
○ Disadvantages
○ The appropriate target range is unclear
○ Instability of money demand and endogeneity of money supply make target achievement difficult
○ In general, it takes considerable time to compile broad monetary aggregates③ Targeting interest rates
○ Advantages
○ Compared with money supply, the central bank can control interest rates relatively easily via open market operations
○ The real interest rate has large spillover effects on the real sector
○ The central bank’s decision on the short-term interest rate itself can act as a signal affecting investors’ expectations
○ Disadvantages
○ Investment is influenced by the long-term real interest rate, but the central bank controls only the short-term nominal rate in practice
○ If there is no stable relationship between short-term nominal and long-term real rates, it is not a valid target④ In addition to price stability and employment stability, reducing inequality is also emerging as a monetary-policy objective
⑷ Monetary policy operating frameworks
① Inflation targeting
○ Unifying the objective of monetary policy into price stability
○ Views differ as to why it succeeded: some argue prices truly stabilized; others argue China’s entry into global markets lowered costs and stabilized prices
○ Criticism 1. After the global financial crisis, employment stability became a major issue
○ Inflation targeting underestimated financial markets and fostered conditions for the global financial crisis
○ Criticism 2. Inflation targeting was originally developed in high-inflation environments and failed to create effective demand during the Great Recession② Price-level targeting
③ Taylor rule (Taylor rule)
○ Target nominal policy rate = equilibrium nominal policy rate + α × output gap + β × inflation gap
○ Equilibrium nominal policy rate = inflation rate + equilibrium real policy rate
○ α > 0: responsiveness of the target policy rate to the output gap
○ β > 0: responsiveness of the target policy rate to the inflation gap④ Gradualism strategy for reducing inflation (gradualism strategy)
○ The authority gradually lowers money growth to reduce inflation
⑤ Cold turkey strategy for reducing inflation (cold turkey strategy)
○ The authority sharply lowers money growth all at once
○ Advantage: Signals strong commitment and can build credibility
○ Disadvantage: If credibility is not secured or prices are sticky, excessive unemployment can cause large welfare losses
⑸ Applications
① Ricardian equivalence theorem (Ricardian equivalence theorem)
○ Definition: With government spending fixed, a tax cut financed by issuing government bonds has no effect on real variables
○ (Note) There is no gain without sacrifice
○ When Ricardian equivalence does not hold: if higher future taxes are expected to finance accumulated government debt, consumers may reduce consumption or increase saving, offsetting the effect of fiscal expansion② Debt deflation (deflation)
○ A chain process in which prices keep falling and national income declines at the same time
Input: 2020.11.25 11:09