WS 2006/07 1 U. van SuntumKonjunktur und Beschäftigung 7. Expectations and the Phillips Curve Exogenous business cycle explanation rational expectations resulted from critique of Phillips curve extreme results in theory substantial impact on economic thought U. van Suntum KuB 6 1 U van Suntum, Lecture KuB 1

WS 2006/07 2 U. van SuntumKonjunktur und Beschäftigung Phillipscurve and Expectations Robert E. Lucas jr. born 1937 Nobelprize 1995 U. van Suntum KuB 6 2 Lucas supply function: *) U van Suntum, Lecture KuB 2

WS 2006/07 3 U. van SuntumKonjunktur und Beschäftigung Business cycle modell with Lucas supply function U. van Suntum KuB 6 3 With p = p e and u = 0 => Y real = Y real * p endogenous, dependent on p e U van Suntum, Lecture KuB 3

WS 2006/07 4 U. van SuntumKonjunktur und Beschäftigung Three versions of expectations: a) static (Keynesian version ): b) adaptive (monetaristic version): c) rational (new classical version): With it follows: U. van Suntum KuB 6 4 U van Suntum, Lecture KuB 4

WS 2006/07 5 U. van SuntumKonjunktur und Beschäftigung Nine possible combinations with monetary policy (six are relevant): Additional money supply a) static expectationsb) adaptive expectations c) rational expectations A) One off increase (prevailing) Aa B) Increase by constant rate in every period BaBb C) Increase by accelerating rate in every period CbCc => Keynesian Phillipscurve => Monetaristic Phillipscurve => New classical Phillipscurve U. van Suntum KuB 6 5 U van Suntum, Lecture KuB 5

WS 2006/07 6 U. van SuntumKonjunktur und Beschäftigung Additional money supply a) static expectationsb) adaptiv expectations c) rational expectations A) One-off increase (prevailing) B) Increase by constant rate in every period C) Increase by accelerating rate in every period => Keynesian Phillipscurve => Monetaristic Phillipscurve => New classical Phillipscurve U. van Suntum KuB 6 6 U van Suntum, Lecture KuB 6

WS 2006/07 7 U. van SuntumKonjunktur und Beschäftigung Numerical example model Ab: one-off increase of M with adaptive expectations* ) U. van Suntum KuB 6 7 Neuklassisches Konjunkturmodell.xls U van Suntum, Lecture KuB 7

WS 2006/07 8 U. van SuntumKonjunktur und Beschäftigung Phillipscurve in model Ab: U. van Suntum KuB 6 8 U van Suntum, Lecture KuB 8

WS 2006/07 9 U. van SuntumKonjunktur und Beschäftigung U. van Suntum KuB 6 9 Neuklassisches Konjunkturmodell.xls Numerical example model Ab: constant growth rate of M with adaptive expectations* U van Suntum, Lecture KuB 9

WS 2006/07 10 U. van SuntumKonjunktur und Beschäftigung Phillipscurve in model Bb: U. van Suntum KuB 6 10 U van Suntum, Lecture KuB 10

WS 2006/07 11 U. van SuntumKonjunktur und Beschäftigung U. van Suntum KuB 6 11 Phillipscurve in Germany 1973 – 2001(I) Inflation rate Unemployment rate year U van Suntum, Lecture KuB 11

WS 2006/07 12 U. van SuntumKonjunktur und Beschäftigung U. van Suntum KuB 6 12 Phillipscurve in Germany 1973 – 2001 (II) Unemployment rate inflation rate U van Suntum, Lecture KuB 12

WS 2006/07 13 U. van SuntumKonjunktur und Beschäftigung U. van Suntum KuB 6 13 Phillipscurve in Germany 1973 – 2001 (III) Unemployment rate inflation rate U van Suntum, Lecture KuB 13

WS 2006/07 14 U. van SuntumKonjunktur und Beschäftigung 1970s1980s1990s U. van Suntum KuB 6 14 Phillipscurve in Germany 1973 – 2001 (IV) Unemployment rate inflation rate U van Suntum, Lecture KuB 14

WS 2006/07 15 U. van SuntumKonjunktur und Beschäftigung Criticism of new classical theory Strengths: Role of expectations is highlighted Different versions of Phillips curve can be explained Simultanous explanation of inflation and business cycle Weaknesses: Rational expectations not a realistic assumption Money supply exongenous? One-sided U. van Suntum KuB 6 15 U van Suntum, Lecture KuB 15

WS 2006/07 16 U. van SuntumKonjunktur und Beschäftigung Learning goals/Questions What is a Lucas supply function? What kinds of expectations can be distiguished? What is the impact of different combinations of monetary policy and expectations on the Phillips curve? What are the key drivers for fluctuations in new classical theory? U. van Suntum KuB 6 16 U van Suntum, Lecture KuB 16