Expectation Augmented Phillips curve

LRPC
 = e -  (u-u*)
If u> u*,  < e
Inflation
() If u< u*,  > e.
2
If e rises SRPC
e shift up
1
SRPC

u2 u* u1Unemployment (u)

In the long run u=u*,  = e. LRPC is vertical.

 Expansionary Monetary policy impact

 = e -  (u-u*)
LRPC

Inflation
() B
1 C

A
 e

SRPC
u*
Unemployment (u)
 Dis-inflation - Monetary policy impact

 = e -  (u-u*)
LRPC

Inflation
()
e A

C B
1 SRPC

u* u1
Unemployment (u)
RBI’s Inflation expectation
survey
 'Inflation Expectation Survey of Households'
(IESH), seeks responses from households on
price changes.
 IESH is conducted on bi-monthly basis.
 The survey was conducted during August 29 to
September 7, 2021 in 18 major cities predominantly
through field interviews. The results are based on
responses from 5,958 urban households.

https://rbi.org.in/scripts/PublicationsView.aspx?Id=20649
Relationship of Inflation and
Unemployment: U.S. 1961-2002
Relationship of Changes in Inflation and

Unemployment Rates

p= e -  (u-u*)

Simple expectation
process: e= t-1

(-t-1)= -  (u-u*)
 Inflation Expectations and the Short-Run Phillips Curve
(USA)
Stagflation = high unemployment + high inflation
Rational expectations
 Flaw in the expectations augmented
Phillips curve:
– If people know that expansionary policy
eventually leads to inflation, why don’t they
quickly revise their expectation in response
to a policy change?
RE: Expansionary Monetary policy impact

 = e -  (u-u*)
LRPC

Inflation
() B
1 C

e A
SRPC
u*
Unemployment (u)
Rational expectations
 How are expectations formed?
– Adaptive expectations – using past data
– Rational expectations
Rational expectation implies the following:
 Expectations are formed on the basis of all
available, relevant information concerning the
variable being predicted.
 Economic agents do not make systematic
forecasting errors.
Rational Expectations
The policy ineffectiveness proposition
 If expectations are rational, wages and prices
are flexible, announced policies have no
effect on the output.
 This is because economic agents revise their
expectations as soon as the polices are
announced.
Rational expectations
 If rate of money supply growth rises by 8%
people know inflation will rise by that much,
– expected and actual inflation also rise by 8%.
– = e - (u-u*). If  is always = e, u=u*
– Unemployment rate will not change
 If RE is true disinflation process will be pain-less
if govt. announces the policy.
 Why in real life when there is expansionary
monetary policy, unemployment falls? And
contractionary policy is not pain-less?
Wage price stickiness
Some explanations
 People’s expectation may be incorrect – they
expected money growth to be say 4%, when
actual growth is 8%
 Wage contracts & price contracts make change
in actual inflation rigid
 Imperfect information
 Coordination problems of raising/ lowering
wages, prices
Wage price stickiness
Some explanations (contd.)
 Efficiency wage theory – employee retention and
employee morale
 Insider-outsider model – Even though
unemployment exists, existing workers may not
allow unemployed workers to come in or agree
to lower wages.
 Okun’s Law: The Relation Between
Unemployment and GDP Growth

Cost of
unemployment –
lost production,
affects distribution
of income
Okun’s law:1%
increase in
unemployment
leads to 2% loss in
GDP (in USA)
From Phillips curve to
aggregate supply curve
  
Phillips curve: ( - e)= -  (u-u*) ……..(1)
 Okun’s law: = -μ(u-u*) ………..(2)
  and e …….(3)
 From equations (1), (2) and (3) we can derive equation
for AS curve:
Pt+1=+
Approximate version of AS (Pet+1=Pt) :
Pt+1= [1+‫(ג‬Y-Y*)], where ‫=ג‬
 FACE OFF
Bancon Conf. 2013 Nov. 16.
"The only way we can contain
food inflation is to augment
supplies. For supplies to rise
you need greater investment,
greater production, greater
distribution. You need better
logistics and you need to
reach the products to stores"
–FM, P.Chidambaram
"We can spend a long time
debating the sources of this
inflation. But ultimately,
inflation comes from
demand exceeding supply,
and it can be curtailed only
by bringing both in
balance." – RBI Gov.,
Raghuram Rajan
 LRAS AS1
P AS0

No policy response:
P2 E2 AS will return to
P1 E1 original position.
But will take time.
P0 E0
Policy response:
Expansionary
AD1
fiscal/ monetary
AD0 policy. Can
avoid recession.

Y1 Y* Y
Policy response to temporary adverse supply shock
 LRAS1 AS2
LRAS0 AS1
P AS0

P2 E2 No policy response:
P1 E1 AS will shift to AS2.
E3 LR equil: E2. Higher
P0 E0 price - P2

Policy response:
Contractionary
AD0 fiscal/ monetary
AD1 policy. Equil: E3.
Lower price -P0

Y1 Y0 Y* Y
Policy response to permanent supply shock. Potential
output falls to Y1 from Y*
Policies to bring down
hyperinflation

 Orthodox policies (monetary, fiscal

policies) alone do not work because of
high inflationary expectations.
 Heterodox policies are required –
wage/price controls, Institutional changes
 LRPC

e SRPC
Hyperinflation
1
 = e -  (u-u*)

Inflation
()

u* Unemployment (u)
High Inflation During 2009-
13: RBI’s monetary policy
response
 CPI (IW) WPI Inflation Food Inflation
25

20

15

10

-5
Date CRR Date CRR
17-Jan-09 5.00 (–0.50) 3-Nov.-2012 4.25(-0.25)
04-Mar-09 5 9-Feb.-2013 4.00 (-0.25)
21-Apr-09 5
13-Feb-10 5.50 (+0.50)
27-Feb-10 5.75 (+0.25)
19-Mar-10 5.75
20-Apr-10 5.75
24-Apr-10 6.00 (+0.25)
02-Jul-10 6
27-Jul-10 6
24-Jan-12 5.5(-0.5)
09-Mar-12 4.75 (-0.25)
17-Sep-12 4.5 (-0.25)
REPO RATE
19-Mar-10 5.00
20-Apr-10 5.25
24-Apr-10 5.25
02-Jul-10 5.50
27-Jul-10 5.75
16-Sep-10 6.00 hiked
02-Nov-10 6.25 13
25-Jan-11 6.50 times
17-Mar-11 6.75
03-May-11 7.25
16-Jun-11 7.50
26-Jul-11 8.00
16-Sep-11 8.25
26-Oct.-2011 8.50
17-Apr-12 8.00
 FM Vs. RBI Gov.
“Growth is as much a challenge as inflation. If the
government has to walk alone to face the
challenge of growth then we will walk alone.”
- Mr Chidambaram, Oct. 2012

“Both the government and the RBI share concerns

on growth. Even (the) RBI has concerns about
growth and inflation; only, our balance is shifting.
If you are asking about the nuances in the Finance
Minister’s statement, I think you should ask him,”
-the RBI governor, Subba Rao, Oct. 2012
After a short period of decline,
reduction in Inflation reversed
REPO RATE

Rate cut - premature

 REPO RATE

Repo
Date rate
29-Jan-13 7.75
19-Mar-13 7.5
03-May-13 7.25 MONETARY
20-Sept.2013 7.50 POLICY
29 - Oct.- TIGHENED
2013 7.75 AS INFLATION
18-Dec.-2013 7.75 RETURNED
28-Jan.2014 8.00

Raghurarm Rajan takes over from Subba Rao in Sept 2013

 Despite inflation reduction RBI did not Repo rate
28-Jan.2014 8.00
14
ease monetary policy till Jan. 2015. 15-Jan-2015 7.75
RBI Gov. explains why. Video (Dec 2014)
12

10

-2

-4

-6

Food WPI CPI (New) Inflation

FM, Arun Jaitely, Aug.31, 2015
 "Inflation in India is broadly under control and
you have low oil prices, you have low commodity
prices
 In a scenario where inflation is under control, the
quantum of interest rate cut is the prerogative of
the RBI,"
 "I do see RBI as a very professional institution
which will certainly take note of all these factors
when it decides its next stand,"
 REPO RATE
Repo
Date rate
29-Jan-13 7.75
19-Mar-13 7.5
Jaitley said “inflation is 03-May-13 7.25
20-Sept.2013 7.50
very much under control. 29 - Oct.-
Common sense says the 2013 7.75
rates should come down”- 18-Dec.-2013 7.75
FM on Sept. 21, 2015 28-Jan.2014 8.00
15-Jan-2015 7.75
04-Mar-15 7.50
02-Jun-15 7.25
29-Sept.2015 6.75
05-Apr-16 6.50
04-Oct-16 6.25
 Inflation targeting
 Agreement signed by RBI with govt. on
Feb 20, 2015.
 Inflation target to be set by govt. every 5
yrs. Current target : 4+/-2%
 Plus minus 2 is wide band because of
early stage in implementation of new
framework
 Inflation targeting
 6 monthly monetary policy report
-assessment of the economy. If it cannot
meet target explain to the govt. why how
and when can be achieved.
 MPC to meet at least 4 times a year.
 MPC: Governor, Dy governor, one RBI
officer, 3 eminent persons to be
nominated by govt. Governor casts
deciding vote in case of tie
 Inflation targeting
 Monetary policy committee - transparent
process. Public knows the basis.
Decision process transparent – basis and
voting pattern is disclosed
 Operating procedure: OMO to ensure that
call money rate (market rate) is close to
repo rate.
8.50

8.00

7.50

7.00

6.50

6.00

5.50

5.00

4.50

4.00

Call Repo Reverse repo