2 The Volcker Disinflation In October 1979, the Fed, under Paul Volcker, decided to reduce nominal money growth and decrease inflation, then close to 14% per year.Five years later, after a deep recession, inflation was down to 4% per year.
4 The Volcker Disinflation How did the Fed reduce inflation?It did it by changing the relationship between inflation and unemploymentIt caused a recession to prove it was serious about inflation. This changed expectations of inflation.
5 Output, Unemployment, and Inflation 9-1This chapter builds on three relations:Okun’s Law, which relates the change in unemployment to output growth.The Phillips curve, which relates the changes in inflation to unemployment.The aggregate demand relation, which relates output growth to both nominal money growth and inflation.
6 Output Growth, Unemployment, Inflation, and Nominal Money Growth
7 Output Growth, Unemployment, Inflation, and Nominal Money Growth We are used to thinking in terms of AS-ADAS, which shows the effect of output on prices, is split in this chapter into two parts:Output affects unemployment through Okun’s Law.A higher growth rate of output reduces unemployment.Previously, we assumed Y = N = L(1-u), but life is richer and more complicated.Unemployment affects inflation through the Phillips Curve.A lower unemployment rate causes inflation to rise.
8 Output Growth, Unemployment, Inflation, and Nominal Money Growth We are still using AD.Higher prices lower output demanded.Suppose the Central Bank increases the nominal money supply at a constant, positive rate = 5%.Inflation = 3%, so the rate of growth of real money supply is 2% = 5% – 3%.Suppose inflation rises unexpectedly to 4%.Then the real money supply will rise more slowly, at 1% per year.Higher inflation reduces the rate of growth of real money, which reduces the output growth rate.
10 Okun’s Law: From Output Growth to Unemployment If output grows, unemployment should fall, right?AssumeY = NY = L – U.Yt – Yt-1 = (Lt – Lt-1) – (Ut – Ut-1)Assume the labor force doesn’t grow (Lt – Lt-1=0). ThenYt – Yt-1 = – (Ut – Ut-1)
11 Okun’s Law: From Output Growth to Unemployment Yt – Yt-1 = – (Ut – Ut-1)This also implies that the unemployment rate (u) is negatively related to the output growth rate (g):We’ve made a lot of assumptions: no inputs besides labor, no diminishing returnsParticularly, we assumed no changes in labor productivity, constant labor force, etc.
12 Okun’s Law: From Output Growth to Unemployment The change in the unemployment rate could be equal to the negative of the growth rate of output.For example, if output growth is 4%, then the unemployment rate should decline by 4%.Now, let’s be more realistic.
13 Okun’s Law: From Output Growth to Unemployment The actual relation between output growth and the change in the unemployment rate is known as Okun’s law.This relation allows for more realistic production functions, labor market behavior, etc.Particularly, it allows for changes in labor productivity, and a growing labor force, etc, so the economy can be expected to be growing constantly.
14 Okun’s Law: From Output Growth to Unemployment Changes in the Unemployment Rate Versus Output Growth in the United States,High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate.Using thirty years of data, the line that best fits the data is given by:
15 Okun’s Law Across Countries The coefficient β in Okun’s law gives the effect on the unemployment rate of deviations of output growth from normal. A value of β of 0.4 tells us that output growth 1% above the normal growth rate for 1 year decreases the unemployment rate by 0.4%.Table 1Okun’s Law Coefficients Across Countries and TimeCountryββUnited States0.39United Kingdom0.150.54Germany0.200.32Japan0.020.12
16 Okun’s Law: From Output Growth to Unemployment According to the equation above,
17 Okun’s Law: From Output Growth to Unemployment To maintain the unemployment rate constant, output growth must be 3% per year. This growth rate of output is called the normal growth rate.Output growth 1% above normal leads only to a b%<1 reduction in unemployment.
18 Okun’s Law: From Output Growth to Unemployment Output growth 1% above normal leads only to a b%<1 reduction in unemployment, for two reasons:Labor hoarding: firms prefer to keep workers rather than lay them off when output decreases.When employment increases, not all new jobs are filled by the unemployed.Because some workers are hired away from other jobs rather from the unemployed, the number of the unemployed decreases slowly.
19 Okun’s Law: From Output Growth to Unemployment Output growth above normal leads to a decrease in the unemployment rate.If output grows below normal, the unemployment rate. Increases.This is Okun’s law:
20 Okun’s Law: From Output Growth to Unemployment Assume ut-1 = 6%gyt4%5%6%utgyt2%1%0%utgyt3%ut
21 The Phillips’s Curve: From Unemployment to Inflation
22 The Phillips Curve: From Unemployment to Inflation Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. Suppose et is well approximated by t-1. Then:The Phillips curve implies that
23 The Aggregate Demand Relation From Nominal Money Growth and Inflation To Output Growth
24 The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth If the IS curve isAnd the LM curve isThen the AD curve isAggregate Expenditure depends on all sorts of parameters (the c’s, the b’s, the d’s, t, and G), positively on M and negatively on P.
25 The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth More simply, we can say thatEven more simply, suppose that changes in output are caused only changes in the real money stock, then:
26 The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth Let’s put this in terms of growth rates:gyt = (Yt-Yt-1)/Yt-1gmt = (Mt-Mt-1)/Mt-1p = (Pt-Pt-1)/Pt-1And since g is a parameter (gt-gt-1)/gt-1=0.From this we can derive
27 The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth How do we go from to ?The easiest way is to use logarithms and calculus:Log Y = log (gM/P)Log Y = log g + log M - log PTaking a total derivative
28 The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth In terms of the growth rates of output, money, and the price level:According to the aggregate demand relation:Given inflation, expansionary monetary policy leads to high output growth.
29 The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth Assume pt = 3%gmt7%5%3%1%gytAssume gmt = 6%pt6%4%2%gyt
30 The Three RelationsOkun’s LawPhillips CurveAD Relation
31 Output Growth, Unemployment, Inflation, and Nominal Money Growth
33 The Medium RunIn chapter 6 we defined the medium run as the time when Pe=Pt-1=Pt.This meant that there was no reason for Pe to change.No changes in Pe meant that the WS would stay put, yielding a “steady-state”, medium-run level of unemployment, the natural rate of unemployment.
34 The Medium Run The medium run: Pe=Pt-1=Pt. In growth rates rather than levels, t = e.Then, by the Phillips curve, u = un.So inflation is constant.Because un is constant, so is unemployment.
35 The Medium Run Inflation is constant. Because nominal money growth is a policy variable, it changes exogenously and it is more natural to imagine that its constant.Then, by the aggregate demand curve, output growth must be constant.
36 The Medium RunIs this constant equal to which is normal output growth?It has to be. If it weren’t, u would have to be changing, which is inconsistent with u = un.
37 The Medium Run t = t-1. ut = ut-1. For any level of gm. t = e. ut = un .For any level of gm.
38 The Medium Run Alternatively, Start by assuming that This makes sense as a definition of the medium run because we want the MR to be a time of rest, stability, constancy.
39 The Medium RunSo Okun’s Law implies that output grows at its normal rate.
40 The Medium Run Assume nominal money growth is We know output growth is equal to its normal rateThen the aggregate demand relation ( )implies that inflation is constant:
41 The Medium RunAccording to the equation above, in the medium run, inflation equals the difference between nominal money growth and normal output growth.Call adjusted nominal money growth.
42 The Medium Run If inflation is constant, then t = t-1, if this is true, the Phillips curve implies thatut = un.Therefore, in the medium run, the unemployment rate must equal the natural rate of unemployment.
43 The Medium RunChanges in nominal money growth have no effect on output or unemployment in the medium run, because in the medium run ut = un and , and neither un nor normal output growth depend on the money supply.So changes in nominal money growth must be reflected one for one in changes in the rate of inflation.
44 The Medium RunInflation and Unemployment in the Medium RunIn the medium run, unemployment is equal to the natural rate of unemployment, at any level of inflation.
45 The Medium RunInflation and Unemployment in the Medium RunIn the medium run, inflation is equal to adjusted nominal money growth.
46 The Medium RunInflation and Unemployment in the Medium RunIn the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment.
47 The Medium Run Suppose In the medium run, gyt = ut = pt = Adjusted money growth =
49 From the Short Run to the Medium Run Above we defined Okun’s Law as“Unemployment falls if output grows above the normal growth rate of output.”But other authors define it as“Cyclical unemployment arises if if output grows below the normal growth rate of output.”
50 From the Short Run to the Medium Run If we use this definition of Okun’s LawAnd we remember that the Phillips curve isThen we can write an “Inflation Adjustment” curve.It will say that inflation rises when output is above normal.
51 From the Short Run to the Medium Run An “Inflation Adjustment” curve.It says that inflation rises when output is above normal.Okun’s LawPhillips’ CurveInflation-Adjustment curve
52 An “Inflation Adjustment” curve Higher output growth reduces unemployment and increases inflation.IAabIf gyt = gy,pt=pepe - abgy
53 From the Short Run to the Medium Run The Aggregate Demand curve.(For a given rate of nominal money growth),The AD curve says that if inflation rises, the real money supply grows more slowly.This raises interest rates, lowers the growth rate of spending, and lowers the growth rate of actual real output.
54 The Aggregate Demand curve gmtHigher inflation reduces the real money supply and reduces real output growth.AD
55 From the Short Run to the Medium Run IA = OL + PCADIAAt point A, output growth is below the natural rate of output growth, and inflation is below expected inflation.AAD
56 From the Short Run to the Medium Run IAADIAIn the short-run, pt<pe.IAIn the medium-run, wage-setters will lower their expectations of inflation, which shifts the IA curve down.AThis happens untilgyt = gy.AD
57 From the Short Run to the Medium Run Imagine the Central Bank shifted the AD curve up repeatedly by raising gmt in order to get short-run reductions in unemployment.IAADIn the medium-run, the IA curve will shift up over and over, keepinggyt = gy.gyt = gy means thatu=un,At any levelof gmt and pt.
58 From the Short Run to the Medium Run In the medium run, pt=peThe short-run relation between output growth and inflation disappears and the IA equationbecomesWhile AD determines inflation.AD
59 From the Short Run to the Medium Run In the short run,Aggregate demand influences output: output grows faster if inflation is below nominal money supply growth.Inflation adjusts upward if output grows above the normal rate.In the medium run,Expectations of inflation adjust so and u=un.AD only determines inflation.
60 The Medium RunInflation and Unemployment in the Medium RunIn the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment.
61 The Medium Run Suppose The CB changes In the medium run, gyt = ut = pt =Adjusted money growth =
63 The Effects of Money Growth Okun’s law relates the change in the unemployment rate to the deviation of output growth from normal:The Phillips curve relates the change in inflation to the deviation of the unemployment rate from the natural rate:The aggregate demand relation relates output growth to the difference between nominal money growth and inflation.
64 The Effects of Money Growth Output Growth, Unemployment, Inflation, and Nominal Money Growth
65 The Medium RunAssume that the central bank maintains a constant growth rate of nominal money, call it In this case, the values of output growth, unemployment, and inflation in the medium run:Output must grow at its normal rate of growth,If we define adjusted nominal money growth as equal to nominal money growth minus normal output growth, then inflation equals adjusted nominal money growth.The unemployment rate must equal to the natural rate of unemployment.
66 The Short RunNow suppose that the central bank decides to decrease nominal money growth. What will happen in the short run?Given the initial rate of inflation, lower nominal money growth leads to lower real nominal money growth , and thus to a decrease in output growth.Now, look at Okun’s law, output growth below normal leads to an increase in unemployment.Now, look at the Phillips curve relation. Unemployment above the natural rate leads to a decrease in inflation.
67 The Short RunIn words: In the short run, monetary tightening leads to a slowdown in growth and a temporary increase in unemployment. In the medium run, output growth returns to normal, and the unemployment rate returns to the natural rate.Table 9-1The Effects of Monetary TighteningYear 0Year 1Year 2Year 31 Real money growth %(gm-π)3.00.55.52 Output growth %(gy)3 Unemployment rate %(u)6.07.04 Inflation gate %(π)5.04.05 Nominal money growth %(gm)8.04.59.5
69 DisinflationTo achieve lower inflation, the rate of nominal money growth must be reduced.This implies a (possibly long) transition between one “medium-run” equilibrium and another “medium-run” equilibrium.This transition happens in the short run, so the downward sloping (Original) Phillips Curve becomes relevant again.Disinflation moves the economy (in the short run) along the short-run (Original) Phillips Curve.In the medium run, Unemployment above natural causes a shift down of the Phillips curve, until unemployment = un in the medium run.
70 The Medium RunInflation and Unemployment in the Medium RunIn the medium run, inflation is equal to adjusted nominal money growth.
71 Disinflation Inflation and Unemployment in the Medium Run In the short run, inflation is decreased by increasing unemployment.In the medium run, higher unemployment and lower inflation cause a fall in expected inflation and a shift down of the SR Phillips Curve.Decrease in expectations of inflation.
72 DisinflationTo achieve lower inflation, the rate of nominal money growth must be reduced. Here is what happens in the Short Run:In the aggregate demand relation,Then, from Okun’s law,Finally, according to the Phillips curve relation:Notice that now u > un.
73 Disinflation But over time, in the Medium Run, According to the Phillips curve relation:As p falls, it falls far enough below gm. In the aggregate demand relation,Eventually gy rises enough that gy > gy. Then, from Okun’s law,After a decrease in nominal money growth, unemployment first increases, but eventually it starts decreasing.
74 Working Out the Path of Nominal Money Growth Table Engineering Disinflation12345678Inflation (%)141210Nominal money growth (%)1713119Output growth (%)2Unemployment rate (%)The Central Bank wants to cut inflation from 14% to 4%. To do this, it cuts nominal money growth radically, which reduces output growth and increases unemployment. Inflation gradually falls.
75 How Much Unemployment? and for How Long? In the Phillips curve relation above, disinflation—a decrease in inflation—can be obtained only at the cost of higher unemployment.
76 How Much Unemployment? and for How Long? Do we have any idea of the amount of unemployment we must inflict on an economy to reduce the inflation rate?Are there measures of this sacrifice?What are the determinants?How should we design disinflation programs?
77 How Much Unemployment? and for How Long? For example, let’s assume that =1/2Then reducing inflation by 10 percentage points requires increasing unemployment above the natural rate by 20 percentage points over a number of years:Notice that while the left-hand side is a year-per-year change, the right-hand side is just the difference between two variables, one of which doesn’t change with time.
78 How Much Unemployment? and for How Long? If =1/2, reducing inflation by 10 percentage points requires 20 percentage points of excess unemployment over a number of years:Suppose we want to achieve the disinflation over 5 years: then we need 5 years of unemployment at 4 percentage points above the natural rate.Achieving the disinflation over 10 years means 10 years of unemployment at 2 percentage points above the natural rate.
79 How Much Unemployment? and for How Long? If =0.8, reducing inflation by 10 percentage points requires 12.5 percentage points of excess unemployment over a number of years:Achieving the disinflation over 2 years means 2 years of unemployment at 6.5 percentage points above the natural rate.Achieving the disinflation over 25 years means 25 years of unemployment at 0.5 percentage points above the natural rate.
80 How Much Unemployment? and for How Long? A point-year of excess unemployment is a difference between the actual and the natural unemployment rate of one percentage point for one year.So if =1/2, reducing inflation by 10 percentage points requires 20 points-years of excess unemployment.If =0.8, reducing inflation by 10 percentage points requires 12.5 points-years of excess unemployment :
81 How Much Unemployment? and for How Long? The sacrifice ratio (=1/a) is the number of point-years of excess unemployment needed to achieve a decrease in inflation of 1%.For example, if the sacrifice ratio is 1.32, then a 10% disinflation requires 13.2 point-years of excess unemployment.
82 How Much Unemployment? and for How Long? If inflation is a bad thing and the number of point-years of excess unemployment is unchangeable (because a is fixed), why not “get it over with” in one year?At the very temporary cost of high unemployment.This policy would have the great benefit of full credibility: there’s no need to wonder if the disinflation program will continue.This works if the announcement of the policy immediately changes pe.
83 How Much Unemployment? and for How Long? But if pe = pt-1, then seeing is believing, and you need at least two years.Moreover, the output loss could be huge, by Okun’s Law.Many of the effects of the recession would be permanent: discouraged workers, bankruptcies, political instability, etc.
84 How Much Unemployment? and for How Long? Suppose the Central Bank wishes to reduce inflation by 9%.If a = 1.15, what is the number of point-years of excess unemployment?Given the goal of reducing inflation by 9%, can the Central Bank affect the number of point-years of excess unemployment calculated above?a220.127.116.110.9Sacrifice ratio
85 Working Out the Path of Nominal Money Growth An important question for policy makers is what is the optimal path of money growth to achieve a disinflation.This is worked out in this way:The path of inflation shows the values of inflation before achieving a desired 4%.The path of unemployment shows the unemployment required to achieve the decrease in inflation.
86 Working Out the Path of Nominal Money Growth The path of output shows the output growth required to achieve the required path of unemployment.The path of nominal money growth shows the growth required to achieve the required path of output.
87 Working Out the Path of Nominal Money Growth Table Engineering Disinflation12345678Inflation (%)141210Nominal money growth (%)1713119Output growth (%)2Unemployment rate (%)This table shows the path of nominal money growth needed to achieve 10% disinflation over five years, which we assume requires 10 point-years of excess unemployment. That is, u > un by 2 points every year for 5 years.
88 Working Out the Path of Nominal Money Growth Table Engineering Disinflation12345678Desired path of Inflation (%)141210Unemployment rate (%)Output growth (%)Nominal money growth (%)17a=1
89 Working Out the Path of Nominal Money Growth Table Engineering Disinflation12345678Inflation (%)141210Nominal money growth (%)1713119Output growth (%)2Unemployment rate (%)If (Okun’s Law) , then gy must fall by 5 points the first year (2 / (-0.4)) = -5 below normal growth, from 3 to -2 percent.Raising unemployment by 2 points means lowering inflation by 2 points. Because ,-5 = Dgm – (– 2), then Dgm = – 7.1
90 Working Out the Path of Nominal Money Growth Table Engineering Disinflation12345678Inflation (%)141210Nominal money growth (%)1713119Output growth (%)2Unemployment rate (%)The second year, ut=ut-1. By Okun’s Law,gy must go back to normal growth, 3%. Because still u – un = 2 points, inflation falls by by 2 points, to 10%. From the AD relation , = Dgm – (-2), then Dgm = 3.2
91 Working Out the Path of Nominal Money Growth Notice that although money growth rises in year 7, inflation does not :the reason is that unemployment goes back to its natural level.
92 Working Out the Path of Nominal Money Growth A Disinflation PathFive years of unemployment above the natural rate of unemployment lead to a permanent decrease in inflation.This figure shows a path of unemployment and inflation similar to the disinflation path in Table 9-1.
93 Working Out the Path of Nominal Money Growth Credible Disinflation causes the Phillips curve to shift down. But remember what determines the position of the Phillips curve: expectations of inflation.If expectations change, this works. If they don’t it doesn’t.
94 Expectations, Credibility, and Nominal Contracts 9-4This section examines how changes in expectation formation might affect the unemployment cost of disinflation.Two separate groups of macroeconomists challenge the traditional notion that policy can change the timing, but not the number of point-years of excess unemployment.
95 Expectations and Credibility: The Lucas Critique The Lucas critique states that it is unrealistic to assume that wage setters would not consider changes in policy when forming their expectations.If wage setters could be convinced that inflation was indeed going to be lower than in the past, they would decrease their expectations of inflation, which would in turn reduce actual inflation, without the need for a change in the unemployment rate.
96 Expectations and Credibility: The Lucas Critique Thomas Sargent, who worked with Robert Lucas, argued that any in order to achieve disinflation, any increase in unemployment would have to be only small.The essential ingredient of successful disinflation, he argued, was credibility of monetary policy—the belief that the central bank was truly committed to reducing inflation. The central bank should aim for fast disinflation.
97 Expectations and Credibility: The Lucas Critique Recall that, although we assumed the Phillips curve can be approximated byit is reallyOur calculations assumed that agents didn’t form expectations based on policy, just on history.What if policy were fully credible, so that if the CB announces a future p =4%, pe becomes 4%, wage-setters set their nominal wage increase at 4%, and price-setters set price increases at 4%. Inflation becomes 4% instantaneously, and u=un.
98 Expectations and Credibility: The Lucas Critique Which program is more credible, taking into account political pressures, elections, etc.?A disinflation that happens in one year (say, the first year out of a 4-year presidential period), and then you’re done with it?Or a disinflation that is announced to start today and end in 20 years?
99 Working Out the Path of Nominal Money Growth If the Central Bank is so credible that its ultimate forecasts of inflation are believed, inflation expectations fall right away to their final level.1
100 Normal Rigidities and Contracts A contrary view was taken by Stanley Fischer and John Taylor. They emphasized the presence of nominal rigidities, or the fact that many wages and prices are not readjusted when there is a change in policy.If wages are set before the change in policy, inflation would already be built into existing wage agreements.
101 Normal Rigidities and Contracts Taylor argued that the staggering of wage decisions imposed strong limits on how fast disinflation could proceed.The way to decrease the unemployment cost of disinflation is to give wage setters time to take the change in policy into account.“Inflation won’t change much over the next year or two (to avoid costs in output). But in two years, inflation will begin to fall drastically.”If the government makes this announcement, how would you negotiate your wages?Slow but credible disinflation might have a lower cost. The central bank should go for slow disinflation.If inflation ain’t changin’, why should we believe it will?
102 Normal Rigidities and Contracts Disinflation Without Unemployment in the Taylor ModelWith staggering of wage decisions, disinflation must be phased in slowly to avoid an increase in unemployment.
103 The U.S. Disinflation,9-5What did happen in the early eighties?The U.S. disinflation of the early 1980s was associated with a substantial increase in unemployment.The Phillips curve relation proved more robust than many economists anticipated.
104 The U.S. Disinflation,Table Inflation and Unemployment,Percent1979198019811982198319841985GDP growth18.104.22.168.22.214.171.124Unemployment rate126.96.36.199.188.8.131.52CPI inflation13.3184.108.40.206Cumulative unemployment1.02.66.39.911.412.6Cumulative disinflation0.84.49.59.4Sacrifice ratio1.250.590.661.041.211.32Cumulative unemployment is the sum of point-years of excess unemployment from 1980 on, assuming a natural rate of unemployment of 6%. Cumulative disinflation is the difference between inflation in a given year and inflation in The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation.
105 The U.S. Disinflation,The Federal Funds Rate and Inflation,A sharp increase in the interest rate from September 1979 to April 1980 was followed by a sharp decline in mid 1980, and then a second and sustained increase from January 1981 on, lasting for most of 1981 and 1982.
106 The U.S. Disinflation,Laurence Ball, who examined 65 disinflation episodes concluded that:Disinflations typically lead to a period of higher unemployment.This contradicts a radical version of Lucas/Sargent.Faster disinflations are associated with smaller sacrifice ratios.This supports a moderate version of Lucas/Sargent.Sacrifice ratios are smaller in countries that have shorter wage contracts.This supports Fischer/Taylor.