The Business Cycle: Phillips Curve and RBA Model for University Students

University of New England Week 8 Learning Objectives

une
University of
New England

Week 8
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The Business Cycle: Part III
ECON102
Week 8
Prescribed reading: Holden et. al., Chapters 19 and 20une
University of
New England

Learning Objectives

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1. Supply shocks shift the Phillips curve
2. The RBA model
3. Analysing macroeconomic shocks
4. Diagnosing the causes of macroeconomic changesune
   University of
   New England

Rising Costs Shift the Phillips Curve

Week 8
Supply shocks: Any change in production costs that leads
suppliers to change the prices they charge at any given
level of output.
.

• Supply shocks shift the Phillips curve.
  Inflation Force #3: Cost-Push Inflation
  An unexpected rise in production costs will cause higher inflation.
  1 Production costs - 1 Inflation
  Focus on unexpected changes in costs because anticipated
  rises/falls will have already been factored into inflation
  expectations.
  Three causes of supply shocks that shift the Phillips curve:

1. Input prices
2. Productivity
3. Exchange rates
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   University of
   New England

Supply Shocks and Cost-Push Inflation

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A
Rising production costs lead to rising prices at any given output gap,
shifting the Phillips curve up.
B
The result can be that inflation exceeds inflation expectations,
even when output is below potential output, as at the point shown.
Unexpected inflation
(Inflation - Inflation expectations)
New Phillips
curve
2%
A
B
1%
Old Phillips
curve
0%
-1%
-2%
-5%
0%
5%
Output gap
(GDP, relative to potential GDP)une
University of
New England

Phillips Curve Shifter 1: Input Prices

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Unexpected
inflation
Rising
input
prices
Phillips
curve
Falling
input
prices
Output gap
If the prices of your inputs rise => Your
marginal costs rise => You will raise
your prices => Pushes up inflation at
any given level of the output gap =>
Shifts up the Phillips curve.
Same forces operate in reverse if your
input prices fall.une
University of
New England

Important Input Prices That Can Spark Cost-Push Inflation

Week 8
Oil and commodity prices
Oil is a major input in many sectors of the
economy and can act as a key source of
cost-push inflation.
Rising wages
Wages can amplify a temporary inflation shock
and make it persistent (oh no!).
Wage-price spiral: a cycle where higher
prices lead to higher nominal wages, which
leads to higher prices.
Prices
rise
Workers'
spending
power falls
PRICE
Cost of
production
rises
Nominal
wages rise
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University of
New England

Phillips Curve Shifter 2: Productivity

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Unexpected
inflation
Slower
productivity
growth
Phillips
curve
Faster
productivity
growth
Output gap
Higher productivity growth lowers your
marginal costs => Greater price
restraint at any given output gap =>
Negative cost-push inflation => Shifts
down the Phillips curve.
Same forces operate in reverse if
productivity falls.une
University of
New England

Phillips Curve Shifter 3: Exchange Rates

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Unexpected
inflation
Depreciating
Australian
dollar
Phillips
curve
Appreciating
Australian dollar
Output gap
Recall: The exchange rate is the price
of an Australian dollar => When the
Australian dollar depreciates, meaning
that the Australian dollar becomes
cheaper for foreigners to buy.
Depreciating Australian dollar shifts up
the Phillips curve.
Appreciating Australian dollar shifts
down the Phillips curve.une
University of
New England

Effects of Exchange Rate Fluctuations

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Direct effect: When the Australian dollar depreciates
⇒
Foreign goods are more expensive for Australians.
It now takes more Australian dollars to pay for imported
goods => Increases the price of foreign-made goods =>
Boosts inflation
Indirect effect: More expensive foreign goods lead to
higher prices on domestic goods.
Australian business that use imported inputs face higher
marginal costs => Raise prices.
Australian businesses that compete with imported products
face less competition => Raise prices.
Australian businesses that export their products have
foreign buyers who are now willing to pay more => Raise
prices for Australian customers.une
University of
New England

Movements Along the Phillips Curve

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Recall, the Phillips curve illustrates the link between the
output gap and unexpected inflation.
Demand-pull inflation leads to movements along the
Phillips curve.
t Output gap
(1 GDP relative to potential)
Excess
demand
Rising prices
Movement along the
Phillips curve
(upward and to the right)
Unexpected
inflation
Output gap
Unexpected
inflation
Output gap
( GDP relative to potential)
Insufficient
demand
Falling prices
(or slower rates
of increase)
Movement along the
Phillips curve
(downward and to the left)
>
Output gapune
University of
New England

Shifts in the Phillips Curve

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Cost-push inflation leads to a shift in the Phillips curve.
Any factor that changes producers' pricing decisions for a
given output gap leads to a shift.
New
Old
1 Input costs (oil, wages)
Productivity growth
Rising
production costs
Rising prices
at each output gap
Phillips curve
shifts up
Output gap
Unexpected
inflation
Old
New
+ Input costs (oil, wages)
t Productivity growth
Falling
production costs
Falling prices
at each output gap
(or slower rates of increase)
Phillips curve
shifts down
î Australian dollar
Unexpected
inflation
1
Australian dollar
1
Output gapune
University of
New England

Inflation Expectations: Short-Run Versus Long-Run

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Phillips curve focuses on the short run, when realised
inflation deviates from inflation expectations.
Thus, inflation expectations neither shift nor cause a
movement along the Phillips curve.
Instead, inflation expectations are a key long-run factor in
determining overall inflation at any given level of the
output gap for any given set of input costs.
Rising
inflation expectations
Rising
expected inflation
Rising expected inflation +
No change in unexpected inflation
= Rising inflation
Falling
inflation expectations
Falling
expected inflation
Falling expected inflation +
No change in unexpected inflation
= Falling inflationthe
University of
New England

The RBA Model Combines the IS, MP, and Phillips curves

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RBA model: The framework that uses the IS curve, the
MP curve, and the Phillips curve to link interest rates,
output gap, and inflation.
Used by policymakers at the Reserve Bank (and by
economists and businesses) to analyse, forecast, and tweak
the economy.
Used to understand business cycles.
Recall:
The IS curve: Links the real interest rate to output
decisions and the output gap.
The MP curve: Illustrates the real interest rate, which is
the sum of real policy interest rate and risk premium.
Phillips curve: Links the output gap and unexpected
inflation.une
University of
New England

Curve-by-Curve Analysis

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+ Risk
premium
MP curve:
Real cash
rate
Real interest
rate
IS curve:
Real interest
rate
Output
gap
+ Expected
inflation
Output
gap
Unexpected
inflation
Inflation
Phillips curve:the
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The IS-MP-PC Analysis

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MP
curve
IS
curve
Phillips
curve
+ Expected
inflation
Real cash
rate
Real interest
rate
Output
gap
Unexpected
inflation
Inflationthe
University of
New England

The RBA Model: Output Gap and Inflation Forecast

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Use the IS-MP framework to find the output gap and the Phillips curve to forecast
unexpected inflation.
Real interest rate
6%
A
MP curve
B 4%
2%
IS curve
0%
-5%
0%
Output gap
C
(GDP, relative to potential GDP)
Start by finding the output gap
A
Find equilibrium at the point
where the IS curve intersects
the MP curve.
B Look to the left at the vertical
axis to find the real interest
rate, which is 4%.
C Then look down at the horizontal
axis to find the output gap,
which is -5%.
Unexpected inflation D
(Inflation - expected inflation)
1%
Phillips curve
0%
G
E
F -1%
Unexpected inflation
+
Expected inflation
=
Actual inflation
-2%
-5%
0%
Output gap
(GDP, relative to potential GDP)
Next, assess inflation
D Trace the output gap down to
the lower graph.
E Find the point on the Phillips
curve with the same output gap.
F
Look to the left at the vertical axis
to find unexpected inflation,
which is -1%.
G Calculate Actual inflation =
Unexpected inflation +
Expected inflation.une
University of
New England

Three Types of Macroeconomic Shocks

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There are dozens of shocks that might hit the economy:
.
Stocks crater!
Productivity surges!
Banks fail!
Confidence soars!
Exports wither!
Dollar skyrockets!
Oil prices rise!
RBA cuts rates!
Wages boom!
The RBA model categorises each possible shock into one
of three types:

1. Financial shock
2. Spending shock
3. Supply shockune
   University of
   New England

Macroeconomic Shocks Explained

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Spending shocks: (shift the IS curve)
Any change in aggregate expenditure at a given real
interest rate and level of income
e.g. Consumption, investment, government purchases, and
net exports
Financial shocks: (shift the MP curve)
Any change in borrowing conditions that affects the real
interest rate.
Monetary policy
e.g. Financial markets and the risk premium
Supply shocks: (shift the PC)
Any change in production costs that leads suppliers to
change the prices they charge at any given level of output.
e.g. Input prices, productivity, and exchange ratesthe
University of
New England

The RBA Model: Shock Analysis

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MP
curve
IS
curve
Phillips
curve
Real cash
rate
Real
interest rate
Output
gap
Unexpected
inflation
+ Expected inflation
Inflation
Shift MP curve
Shift IS curve
Shift Phillips curve
Financial shocks
Borrowing conditions
Spending shocks
Aggregate expenditure
Supply shocks
Production costs

• Monetary policy
• Consumption
• Input prices
• Financial markets
  and the risk premium
• Investment
• Productivity
  . Government purchases
• Exchange rates
  . Net exports
  =une
  University of
  New England

Three-Step Recipe For Analysing Macroeconomic Shocks

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1. Identify the shock to determine which curve to shift (and
   where)
   Financial, spending or supply shock.
2. Find the output gap
3. Assess inflation