Hysteresis

Hysteresis

L

- Standard analysis suggested that raising unemployment above NAIRU should reduce inflation

- But estimates of NAIRU kept rising through 70s and 80s – NAIRU= Current rate + 2 percent

- Hysteresis: once a metal is magnetized, it is easier to magnetise in the future

Explaining

- Skill atrophy

- Network Breakdown

- Scarring

- Changes in employer behavior (end of labour hoarding)

- People who have been unemployed, more likely to remain so

Implication

- Even with expectation taken into account, medium-term Phillips curve is not vertical

- Use of high unemployment to bring down inflation can have long-lasting costs

W

Hysteresis refers to systems that have memory, where the effects of the current input (or stimulus) to the system are experienced with a certain delay in time. Such a system may exhibit path dependence, or “rate-independent memory”. Hysteresis phenomena occur in magnetic materials, ferromagnetic materials and ferroelectric materials, as well as in the elastic, electric, and magnetic behavior of materials, in which a lag occurs between the application and the removal of a force or field and its subsequent effect. Electric hysteresis occurs when applying a varying electric field, and elastic hysteresis occurs in response to a varying force. The term “hysteresis” is sometimes used in other fields, such as economics or biology, where it describes a memory, or lagging effect.

In a deterministic system with no dynamics or hysteresis, it is possible to predict the system’s output at an instant in time, given only its input at that instant in time. In a system with hysteresis, this is not possible; there is no way to predict the output without knowing the system’s current state, and there is no way to know the system’s state without looking at the history of the input. This means that it is necessary to know the path that the input followed before it reached its current value.

Many physical systems naturally exhibit hysteresis. A piece of iron that is brought into a magnetic field retains some magnetization, even after the external magnetic field is removed. Once magnetized, the iron will stay magnetized indefinitely. To demagnetized the iron, it would be necessary to apply a magnetic field in the opposite direction. This is the effect that provides the element of memory in a hard disk drive.

A system may be explicitly designed to exhibit hysteresis, especially in control theory. For example, consider a thermostat that controls a furnace. The furnace is either off or on, with nothing in between. The thermostat is a system; the input is the temperature, and the output is the furnace state. If one wishes to maintain a temperature of 20 °C, then one might set the thermostat to turn the furnace on when the temperature drop below 18 °C, and turn it off when the temperature exceeds 22 °C. This thermostat has hysteresis. If the temperature is 21 °C, then it is not possible to predict whether the furnace is on or off without knowing the history of the temperature.

The word hysteresis is often used specifically to represent rate-independent state. This means that if some of input x(t) produce an output Y(t), then the inputs X(at) produce output Y(at) for any α > 0. The magnetized iron or the thermostats have this property. Not all systems with state (or, equivalently, with memory) have this property; for examples, a linear low-pass filter has state, but its state is rate-dependent.

The term is derived from ὑστέρησις, an ancient Greek word meaning deficiency or lagging behind. It was coined by Sir James Alfred Ewing.

Economics

Economics systems can exhibit hysteresis. For examples, export performance is subject to strong hysteresis effects: because of the fixed transportation costs it may take a big push to start a country’s exports, but once the transition is made, not much may be required to keep them going.

Hysteresis is a hypothesized property of unemployment rates. It is possible that there is a ratchet effect, so a short-term rise in unemployment rates tends to persist. An example is the notion that inflationary policy leads to a permanently higher natural rate of unemployment, because inflationary expectations are sticky downward due to change wage rigidities and imperfections in the labour market. Another channel through which hysteresis can occur is through learning by doing. Workers who lose their jobs due to temporary shocks may become permanently unemployed because they miss out on the job training and skill acquisition that normally takes place. This explanation has been invoked, by Olivier Blanchard among others, as explaining the differences in long run unemployment rates between Europe and the US.

Hysteresis occurs in applications of game theory to economics, in models with product quality, agent honesty or corruption of various institutions. Slightly different initial conditions can lead to opposite outcomes and resulting stable good or bad equilibria.

Another area where hysteresis phenomena are found is capitals controls. A developing country can ban a certain kind of capital flow (e.g. engagement with international private equity funds), but when the ban is removed, the system takes a long time to return to the pre-ban state.

Monetarism

Monetarism

L

Friedman’s successful critique of Keynesianism – encouraged acceptance of other views

Monetarist macroeconomics – no fine tuning

Money supply targeting

- Nominal income identity MV=PY

- Assume stable velocity + full employment

- Growth of money stock determines inflation

- Central bank can control this

- Choice of monetary aggregate – base money M1, M2, M3

Failure of monetary targeting

- Financial innovation associated with deregulation – made money supply measures hard to interpret

- More fundamental – changes in behavior associated with targeting – Goodhart’s law – the lost of its role for indicators of the target.

- Policy abandoned by early 1980s

W

Monetarism is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over the longer periods and that objective of monetary policy are best met by targeting the growth rate of the money supply.

Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of economists to accept Keynesian economics and then criticize it on its own term. Friedman and Anna Schwartz wrote an influential book, A Monetary History of US, 1867-1960, and argued that “inflation is always and everywhere a monetary phenomenon.” Friedman advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measure by growth in productivity and demand. The monetarist argument that the demand for money is a stable function gained considerable support during the late 1960s and 1970s from the work of David Laidler. The former head of US Federal Reserve, Alan Greenspan, is generally regarded as monetarist in his policy orientation. The European Central Bank officially bases its monetary policy on money supply targets.

Critics of monetarism include both neo-Keynesians who argue that demand for money is intrinsic to supply, and some conservative economists who argue that demand for money cannot be predicted. Joseph Stiglitz has argued that the relationship between inflation and money supply is weak when inflation is low.

Description

Monetarism is an economic theory which focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability.

This theory draws its roots from two almost diametrically opposed ideas: the hard money [Hard money policies are those which are opposed to fiat currency and this in support of a specie standard, usually gold or silver, typically implemented with representative money] policies that dominated monetary thinking in the late 19^th century, and the monetary theories of John Maynard Keynes, who, working in the inter-war period during the failure of the restored gold standard, proposed a demand-driven model for money which as the foundation of macroeconomics. While Keynes had focused on the value stability of currency, with the resulting panics based on an insufficient money supply leading to alternate currency and collapse, then Friedman focused on price stability, which is the equilibrium between supply and demand for money.

This result was summarized in a historical analysis of monetary policy, Monetary History of the US 1867-1960, which Friedman coauthored with Anna Schwartz. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support the money supply during a liquidity crunch.

Friedman originally proposed a fixed monetary rule, called Friedman’s K-percent rule, where the money supply would be calculated by known macroeconomic and financial factors, targeting a specific level or range of inflation. Under this rule, there would be no leeway for the central reserve bank as money supply increased could be determined “by a computer”, and business could anticipate all monetary policy decisions.

Real business cycle theory (RBC theory)

Real business cycle theory (RBC theory)

L

- A variant of New Classical macro

- Aims to show how macroeconomic fluctuations can arise in neoclassical general equilibrium

- Business cycle is an optimal response to shocks

- No role for government policy

L – Key idea

- The economy does not move rapidly back to equilibrium, as in classical economics

- Macroeconomics aggregates display autocorrelation

- This can be explained by auto-correlated shocks

o Technology

o Preferences for leisure

o Terms of trade.

W

RBC theory is a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and government should therefore concentrate on the long run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations.

According to RBC theory, business cycles are therefore “real” in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy. RBC theory differs in this way from other theories of the business cycle such as Keynesian economics and Monetarism that see recessions as the failure of some market to clear.

RBC theory is associated with freshwater economics (the Chicago school of economics in the neoclassical tradition). It is rejected and harshly criticized by other schools within mainstream economics, notably Keynesians.

Phillips curve

Phillips curve (W)

- New Classical Macro Policy

a. No Phillips curve in either short run or long run.

b. Since expectations are rational, a credible anti-inflation policy should produce an immediate reduction in inflation, with no change in unemployment.

c. Policy failed the test of practice

· Thatcher UK 1981

· NZ late 80s to 2000

(W)

In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. While it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run.

History

William Phillips, a NZ born economist, wrote a paper in 1958 title The Relationship between Unemployment and the Rate of Change of Money Wage in the UK 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow too Phillips’ work and made explicit in the link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.

In the 1920s an American economist Irving Fisher noted this kind of Phillips curve relationship. However, Phillips’ original curve descried the behavior of money wages.

In the years following Phillips’ 1958 paper, many economists in the advanced industrial countries believed that his result showed that there was a permanently stable relationship between inflation and unemployment. One implication of this for government policy was that governments could control unemployment and inflation with a Keynesian policy. They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or FP could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

During the 1960s, a leftward movement along the Philips curve described the path of the US economy. This move was not a matter of deciding to achieve low unemployment as much as an unplanned side effect of Vietnam War. In other countries, the economic boom was more the result of conscious policies.

Stagflation

In the 1970s, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under a concerted attack from a group of economics headed by Milton Friedman.

Friedman argued that the Phillips curve relationship was a short-run phenomenon. He argued that in the long run workers and employers will take inflation into account, resulting in employment contracts that increase pay at rates near anticipated inflation. Employment would then begin to fall until ‘full-employment’ was reached, but now with higher inflation rates. This result implies that over the long run there is no trade off between inflation and employment. This implication is significant for practical reasons because it implies that central banks should not set employment targets above the natural rate.

More recent research has shown that there is a moderate trade-off between low-levels of inflation and employment. Work by George Akerlof, William Dickens, and George Perry implies that if inflation is reduced from two to zero percent, employment will be permanently reduced by 1.5 percent. This is because workers generally have a higher tolerance for real wage cut to nominal ones. For example, a worker will more likely accept a wage increase of two percent when inflation is three percent, than a wage cut of one percent when the inflation is zero.

NAIRU and rational expectations

New theories, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur. The latter theory, also known as the “natural rate of unemployment”, distinguished between the short-term Phillips curve and the long term one. The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectation changes. In the long run, only a single rate of unemployment (the NAIRU or natural rate) was consistent with a stable inflation rate. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the Noble Price in Economics in 2006 for this.

In the diagram, the long-run Phillips curve is the vertical red line. The NAIRY theory says that the when unemployment is at the rate defined by this line, inflation will be stable. However, in the short-run policymakers will face an inflation-unemployment rate tradeoff marked by ‘Initial Short-Run Phillips Curve” in the graph. Policymakers can therefore reduce the unemployment rate temporarily, moving from point A to point B through expansionary policy. However, according to the NAIRU, exploiting this short-run tradeoff will raise inflation expectations, shifting the short-run curve rightward to the “New Short Run Phillips Curve” and moving the point B to C. Thus the reduction in unemployment below the “Natural Rate” will be temporary, and lead only to higher inflation in the long run.

Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The same “NAIRU” arises because with actual unemployment below it, inflation accelerates; inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve.

The rational expectations theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors. This in turn suggested that the short-run period was so short that it was non-existent: any effort to reduce unemployment below the NAIRU, for example, would immediately cause inflation expectations to rise and thus imply that the policy would fail. Unemployment would never deviate from the NAIRU expect due to random and transitory mistakes in developing expectation about future inflation rates. In this perspective, any deviation of the actual unemployment rate from the NAIRU was an illusion.

However, in the 1990s in the US, it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actual unemployment rate fell below 4% of the labor force, much lower than almost all estimates of the NAIRU. But inflation stated very moderate rather than acceleration. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.

Furthermore, the concept of rational expectation had became subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independently of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.

The Phillips curve today

Most economists no longer use the Phillips curve in this original from because it was shown to be too simplistic. This can be seen in a cursory analysis of US inflation and unemployment data 1953-92. There is no single curve that will fit the data, but there are three rough aggregations, 1955-71, 1974-84, and 1985-92 –each of which shows a general, downwards slope, but at three very different levels with the shifts occurring abruptly. The data for 1953-54 and 1972-72 do not group easily, and a more formal analysis posits up to five groups/curves over the period.

But still today, modified forms of the Phillips Curve that take inflationary expectations into account remain influential. The theory goes under several names, with some variation in its details, but all modern versions distinguish between short-run and long-run effects on unemployment. The short-run Phillips curve is also called the expectations augmented Phillips curve, since it shifts up when inflationary expectations rise, Edmund Phelps and Milton Friedman. In the long run, this implies that monetary policy cannot affect unemployment, which adjusts back to its natural rate, also called the NAIRU or long run Phillips curve. However, this long run neutrality of MP does allow for short decrease unemployment by increasing permanent inflation, and vice versa. Blanchard (2000, chapter 8) gives a textbook presentation of the expectations-augmented Phillips curve.

An equation like the expectations-augmented Phillips curve also appears in many recent New Keynesian dynamic stochastic general equilibrium models. In these macroeconomic models with sticky prices, there is a positive relation between the rate of inflation and the rate of unemployment. This relationship is often called the “New Keynesian Phillips curve.” Like the expectations-augmented Phillips curve, the New Keynesian Phillips curve implies that increased inflation can lower unemployment temporarily, but cannot lower it permanently. Two influential papers that incorporate a New Keynesian Phillips curve are Clarida, Gali,, and Gertler (1999) and Blanchard and Gali (2007).

Gordon’s triangle model

Robert J. Gordon of Northwestern University has analysed the Phillips curve to produce what he calls the triangle model, in which the actual inflation rate is determined by the sum of

1. Demand pull or short-term Phillips curve inflation,

2. Cost push or supply shocks, and

3. Built-in inflation.

The last reflects inflationary expectations and the price/wage spiral. Supply shocks and changes in built-in inflation are the main factors shifting the short-run Phillips curve and changing the trade-off. In this theory, it is not only inflationary expectations that can cause stagflation. For example, the steep climb of oil prices during the 1970s could have this result.

Changes in built-in inflation follow the partial-adjustment logic behind most theories of the NAIRU:

1. Low unemployment encourages high inflation, as with the simple Phillips curve. But if unemployment stays low and inflation stays high for a long time, as in the late 1960s in the US, both inflationary expectations and the price/wage spiral accelerate. This shifts the short-run Phillips curve upward and rightward, so that more inflation is seen at any given unemployment rate. (This is with shift B in the diagram)

2. High unemployment encourages low inflation, again as with a simple Phillips curve. But if unemployment stays high and inflation stays low for a long time, as in the early 1980s in the US inflationary expectations and the price/wage spiral low. This shifts the short-run Phillips curve downward and leftward, so that less inflation is seen at each unemployment rate.

In between these two lies the NAIRU, where the Phillips curve does not have any inherent tendency to shift, so that the inflation rate is stable. However, there seems to be a range in the middle between high and low where built-in inflation stays stable. The ends of this “non-accelerating inflation range of unemployment rates” change over time.