2)Problems in the long-run

• budget deficit (if gov reduces Ms by selling more securities=>budget deficit grows because gov.(CB) should pay interest on securities=>incr in public debt)

• financial crowding out (when gov. borrowing diverts money away from the private sector; because if you buy gov. securities – you don’t buy anything from private companies)

• the target dilemma = impossibility to stabilize Ms and r at the same time

• unpredictability of the m.p. results because:

1. it is possible predict reaction of business and society on change in banks’ credit ability

2. b) m.p. may influence the velocity of money circulation: increase in Ms may decrease velocity, and vice versa Ms∙V=P∙Y

3. the link between r and investment may be weak (money transmission mechanism doesn’t work)

Adverse side effects of the credit restriction:

• decrease in banks’ competitiveness

• discouragement of small business

decrease in consumer demand, Y, AD (→risk of recession)

29. Inflation-unemployment theory: the Phillips curve and its development. Phillips curve and explanation of stagflation.

• Kinked Phillips curve =a model showing the relationship between demand-pull inflation and disequilibrium unemployment

• dependence of price level: P=(a+b)*(1/u) where a,b are constant

Un:natural rate of unemployment (no inflation)

2 Parts of curve: elastic and inelastic

1. inelastic: AD>AS, prices rise more rapidly than unemployment falls

2. AD=AS the point corresponds to natural rate of unemployment

3. elastic: AD<AS, unemployment will rise more rapidly than prices fall

Shift of Phillips curve depends on:

1. non-demand inflationary factors (↑cost-push inflation/ ↑inflationary expectations=> shift of Ph. curve upwards)

2. Changes in equilibrium unemployment (↑Ueq due to ↑unempl. benefits leads to shift of the curve to the right=> the middle point will shift to the right

Development of the inflation unemployment theory:

1)Monetarists contribution

Basic hypothesis: adaptive expectations theory = people use their expectations of inflation on the previous year infl. rates

Modification of Phillip’s curve:

• In the short-run:

  • position of Ph. curve depends on expected rate of infl. Inflation rate depends on unemployment + Pte

    • P=f(1/U)+ P_e^t

  • Where P_e^t+inflation rate in the last period

    • P_e^t= P^t-1– expected rate of inflation

• In the long-run: Phillip’s curve is vertical and intersects Un (where real AD= real AS).

In this theory Un is called NAIRU (non-accelerating-inflation rate of unemployment) (in this point inf. rate is constant)

Accelerationists theory:

If gov decreases U below Un, inflation will be accelerated each year due to accumulation of expectations. The more the gov reduces unempl, the greater the rise in inflation that year, and the more the rise in expectations the following year and each subsequent year; and hence the more rapidly will price rises accelerate. The upward shift will be more rapid if expectations adjust to the rate of increase in inflation last year (and less rapid if expectations do not fully adjust).

Policy implications:

1. if gov wants to eliminate inflation it must keep unemployment above the NAIRU.

The best way to cut U is supply-side policy, for monetarists this means policies to reduce impediments to the working of the free market encouraging private enterprises and the free play of market forces (for ex. ↓ G, tax cuts, etc). By reducing frictional and structural unemployment, such policies will shift the l-r Phillip’s curve back to the left.