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Prepared by: Fernando Quijano and Yvonn Quijano And modified by Gabriel Martinez 9 C H A P T E R Inflation, Activity, and Nominal Money Growth

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. 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. Five years later, after a deep recession, inflation was down to 4% per year.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard

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The Volcker Disinflation How did the Fed reduce inflation? How did the Fed reduce inflation? It did it by changing the relationship between inflation and unemployment It did it by changing the relationship between inflation and unemployment It caused a recession to prove it was serious about inflation. This changed expectations of inflation. It caused a recession to prove it was serious about inflation. This changed expectations of inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output, Unemployment, and Inflation This chapter builds on three relations: This chapter builds on three relations: 1.Okuns Law, which relates the change in unemployment to output growth. 2.The Phillips curve, which relates the changes in inflation to unemployment. 3.The aggregate demand relation, which relates output growth to both nominal money growth and inflation. 9-1

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output Growth, Unemployment, Inflation, and Nominal Money Growth

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output Growth, Unemployment, Inflation, and Nominal Money Growth We are used to thinking in terms of AS-AD We are used to thinking in terms of AS-AD AS, which shows the effect of output on prices, is split in this chapter into two parts: AS, which shows the effect of output on prices, is split in this chapter into two parts: Output affects unemployment through Okuns Law. Output affects unemployment through Okuns Law. A higher growth rate of output reduces unemployment. A higher growth rate of output reduces unemployment. Previously, we assumed Y = N = L(1-u), but life is richer and more complicated. Previously, we assumed Y = N = L(1-u), but life is richer and more complicated. Unemployment affects inflation through the Phillips Curve. Unemployment affects inflation through the Phillips Curve. A lower unemployment rate causes inflation to rise. A lower unemployment rate causes inflation to rise.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output Growth, Unemployment, Inflation, and Nominal Money Growth We are still using AD. We are still using AD. Higher prices lower output demanded. Higher prices lower output demanded. Suppose the Central Bank increases the nominal money supply at a constant, positive rate = 5%. 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%. Inflation = 3%, so the rate of growth of real money supply is 2% = 5% – 3%. Suppose inflation rises unexpectedly to 4%. Suppose inflation rises unexpectedly to 4%. Then the real money supply will rise more slowly, at 1% per year. 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. Higher inflation reduces the rate of growth of real money, which reduces the output growth rate.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment If output grows, unemployment should fall, right? If output grows, unemployment should fall, right? Assume Assume Y = N Y = L – U. Y = L – U. Y t – Y t-1 = (L t – L t-1 ) – (U t – U t-1 ) Assume the labor force doesnt grow (L t – L t-1 =0). Then Assume the labor force doesnt grow (L t – L t-1 =0). Then Y t – Y t-1 = – (U t – U t-1 )

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment Y t – Y t-1 = – (U t – U t-1 ) Y t – Y t-1 = – (U t – U t-1 ) This also implies that the unemployment rate (u) is negatively related to the output growth rate (g): This also implies that the unemployment rate (u) is negatively related to the output growth rate (g): Weve made a lot of assumptions: no inputs besides labor, no diminishing returns Weve made a lot of assumptions: no inputs besides labor, no diminishing returns Particularly, we assumed no changes in labor productivity, constant labor force, etc. Particularly, we assumed no changes in labor productivity, constant labor force, etc.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment The change in the unemployment rate could be equal to the negative of the growth rate of output. 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%. For example, if output growth is 4%, then the unemployment rate should decline by 4%. Now, lets be more realistic. Now, lets be more realistic.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment The actual relation between output growth and the change in the unemployment rate is known as Okuns law. The actual relation between output growth and the change in the unemployment rate is known as Okuns law. This relation allows for more realistic production functions, labor market behavior, etc. 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. Particularly, it allows for changes in labor productivity, and a growing labor force, etc, so the economy can be expected to be growing constantly.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate. Changes in the Unemployment Rate Versus Output Growth in the United States, 1970-2000 Using thirty years of data, the line that best fits the data is given by: Using thirty years of data, the line that best fits the data is given by:

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law Across Countries Table 1 Okuns Law Coefficients Across Countries and Time Country 1960-1980 β 1981-2003 β United States 0.390.39 United Kingdom 0.150.54 Germany0.200.32 Japan0.020.12 The coefficient β in Okuns 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%.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment According to the equation above, According to the equation above,

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns 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. 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 %<1 reduction in unemployment. Output growth 1% above normal leads only to a %<1 reduction in unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment Output growth 1% above normal leads only to a %<1 reduction in unemployment, for two reasons: Output growth 1% above normal leads only to a %<1 reduction in unemployment, for two reasons: 1.Labor hoarding: firms prefer to keep workers rather than lay them off when output decreases. 2.When employment increases, not all new jobs are filled by the unemployed. 1.Because some workers are hired away from other jobs rather from the unemployed, the number of the unemployed decreases slowly.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment Output growth above normal leads to a decrease in the unemployment rate. Output growth above normal leads to a decrease in the unemployment rate. If output grows below normal, the unemployment rate. Increases. If output grows below normal, the unemployment rate. Increases. This is Okuns law: This is Okuns law:

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okuns Law: From Output Growth to Unemployment Assume u t-1 = 6% g yt4%5%6% utut 2%1%0% utut 3% utut

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillipss Curve: From Unemployment to Inflation

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 e t is well approximated by t-1. Then: Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. Suppose e t is well approximated by t-1. Then: The Phillips curve implies that The Phillips curve implies that

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation From Nominal Money Growth and Inflation To Output Growth

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth If the IS curve is If the IS curve is And the LM curve is And the LM curve is Then the AD curve is Then the AD curve is Aggregate Expenditure depends on all sorts of parameters (the cs, the bs, the ds, t, and G), positively on M and negatively on P. Aggregate Expenditure depends on all sorts of parameters (the cs, the bs, the ds, t, and G), positively on M and negatively on P.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth More simply, we can say that More simply, we can say that Even more simply, suppose that changes in output are caused only changes in the real money stock, then: Even more simply, suppose that changes in output are caused only changes in the real money stock, then:

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth Lets put this in terms of growth rates: Lets put this in terms of growth rates: g yt = (Y t -Y t-1 )/Y t-1 g yt = (Y t -Y t-1 )/Y t-1 g mt = (M t -M t-1 )/M t-1 g mt = (M t -M t-1 )/M t-1 = (P t -P t-1 )/P t-1 = (P t -P t-1 )/P t-1 And since is a parameter ( t - t-1 )/ t-1 =0. And since is a parameter ( t - t-1 )/ t-1 =0. From this we can derive From this we can derive

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth How do we go from to ? How do we go from to ? The easiest way is to use logarithms and calculus: The easiest way is to use logarithms and calculus: Log Y = log ( M/P) Log Y = log + log M - log P Taking a total derivative

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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: In terms of the growth rates of output, money, and the price level: According to the aggregate demand relation: According to the aggregate demand relation: Given inflation, expansionary monetary policy leads to high output growth. Given inflation, expansionary monetary policy leads to high output growth.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth Assume t = 3% g mt7%5%3%1% g yt t6%4%2% Assume g mt = 6%

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Three Relations Okuns Law Phillips Curve AD Relation

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output Growth, Unemployment, Inflation, and Nominal Money Growth

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The Medium Run 9-2

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In chapter 6 we defined the medium run as the time when P e =P t-1 =P t. In chapter 6 we defined the medium run as the time when P e =P t-1 =P t. This meant that there was no reason for P e to change. This meant that there was no reason for P e to change. No changes in P e meant that the WS would stay put, yielding a steady-state, medium- run level of unemployment, the natural rate of unemployment. No changes in P e meant that the WS would stay put, yielding a steady-state, medium- run level of unemployment, the natural rate of unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run The medium run: P e =P t-1 =P t. The medium run: P e =P t-1 =P t. In growth rates rather than levels, t = e. In growth rates rather than levels, t = e. Then, by the Phillips curve, u = u n. Then, by the Phillips curve, u = u n. So inflation is constant. So inflation is constant. Because u n is constant, so is unemployment. Because u n is constant, so is unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Inflation is constant. Inflation is constant. Because nominal money growth is a policy variable, it changes exogenously and it is more natural to imagine that its 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. Then, by the aggregate demand curve, output growth must be constant.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Is this constant equal to which is normal output growth? Is this constant equal to which is normal output growth? It has to be. If it werent, u would have to be changing, which is inconsistent with u = u n. It has to be. If it werent, u would have to be changing, which is inconsistent with u = u n.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run t = t-1. t = t-1. t = e. t = e. u t = u t-1. u t = u t-1. u t = u n. u t = u n. For any level of g m. For any level of g m.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Alternatively, Alternatively, Start by assuming that 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. This makes sense as a definition of the medium run because we want the MR to be a time of rest, stability, constancy.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard So Okuns Law implies that output grows at its normal rate. So Okuns Law implies that output grows at its normal rate. The Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Assume nominal money growth is Assume nominal money growth is We know output growth is equal to its normal rate We know output growth is equal to its normal rate Then the aggregate demand relation ( ) Then the aggregate demand relation ( ) implies that inflation is constant: implies that inflation is constant: The Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run According to the equation above, in the medium run, inflation equals the difference between nominal money growth and normal output growth. According 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. Call adjusted nominal money growth.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run If inflation is constant, then If inflation is constant, then t = t-1, t = t-1, if this is true, the Phillips curve implies that if this is true, the Phillips curve implies that u t = u n. Therefore, in the medium run, the unemployment rate must equal the natural rate of unemployment. Therefore, in the medium run, the unemployment rate must equal the natural rate of unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Changes in nominal money growth have no effect on output or unemployment in the medium run, because in the medium run u t = u n and, and neither u n nor normal output growth depend on the money supply. Changes in nominal money growth have no effect on output or unemployment in the medium run, because in the medium run u t = u n and, and neither u n 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. So changes in nominal money growth must be reflected one for one in changes in the rate of inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In the medium run, unemployment is equal to the natural rate of unemployment, at any level of inflation. Inflation and Unemployment in the Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In the medium run, inflation is equal to adjusted nominal money growth. Inflation and Unemployment in the Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment. Inflation and Unemployment in the Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Suppose Suppose In the medium run, g yt = In the medium run, g yt = u t = u t = t = t = Adjusted money growth = Adjusted money growth =

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From the Short Run to the Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run Above we defined Okuns Law as Above we defined Okuns Law as Unemployment falls if output grows above the normal growth rate of output. Unemployment falls if output grows above the normal growth rate of output. But other authors define it as But other authors define it as Cyclical unemployment arises if if output grows below the normal growth rate of output.Cyclical unemployment arises if if output grows below the normal growth rate of output.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run If we use this definition of Okuns Law If we use this definition of Okuns Law And we remember that the Phillips curve is And we remember that the Phillips curve is Then we can write an Inflation Adjustment curve. Then we can write an Inflation Adjustment curve. It will say that inflation rises when output is above normal. It will say that inflation rises when output is above normal.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run An Inflation Adjustment curve. An Inflation Adjustment curve. It says that inflation rises when output is above normal. It says that inflation rises when output is above normal. Okuns Law Phillips Curve Inflation-Adjustment curve

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard An Inflation Adjustment curve e g y If g yt = g y, t = e IA Higher output growth reduces unemployment and increases inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run The Aggregate Demand curve. The Aggregate Demand curve. (For a given rate of nominal money growth), (For a given rate of nominal money growth), The AD curve says that if inflation rises, the real money supply grows more slowly. 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. This raises interest rates, lowers the growth rate of spending, and lowers the growth rate of actual real output.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand curve g mt AD Higher inflation reduces the real money supply and reduces real output growth.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run AD At point A, output growth is below the natural rate of output growth, and inflation is below expected inflation. IA IA = OL + PCAD A

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run AD In the short-run, t < e. IA AD In the medium-run, wage-setters will lower their expectations of inflation, which shifts the IA curve down. IA This happens until g yt = g y. A

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run AD Imagine the Central Bank shifted the AD curve up repeatedly by raising g mt in order to get short-run reductions in unemployment. IA In the medium-run, the IA curve will shift up over and over, keeping g yt = g y. g yt = g y means that u=u n, At any level of g mt and t.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run AD In the medium run, t = e The short-run relation between output growth and inflation disappears and the IA equation becomes While AD determines inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From the Short Run to the Medium Run In the short run, In the short run, Aggregate demand influences output: output grows faster if inflation is below nominal money supply growth. 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. Inflation adjusts upward if output grows above the normal rate. In the medium run, In the medium run, Expectations of inflation adjust so and u=u n. Expectations of inflation adjust so and u=u n. AD only determines inflation. AD only determines inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment. Inflation and Unemployment in the Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Suppose Suppose The CB changes The CB changes In the medium run, g yt = In the medium run, g yt = u t = u t = t = t = Adjusted money growth = Adjusted money growth =

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The Effects of Money Growth

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Effects of Money Growth Okuns law relates the change in the unemployment rate to the deviation of output growth from normal: Okuns 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 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. The aggregate demand relation relates output growth to the difference between nominal money growth and inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Effects of Money Growth Output Growth, Unemployment, Inflation, and Nominal Money Growth

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run Assume 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: Assume 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, 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. 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. The unemployment rate must equal to the natural rate of unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Short Run Now suppose that the central bank decides to decrease nominal money growth. What will happen in the short run? Now 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. 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 Okuns law, output growth below normal leads to an increase in unemployment. Now, look at Okuns 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. Now, look at the Phillips curve relation. Unemployment above the natural rate leads to a decrease in inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Short Run Table 9-1 The Effects of Monetary Tightening Year 0 Year 1 Year 2 Year 3 1 Real money growth % (g m -π) 3.00.55.53.0 2 Output growth % (g y ) 3.00.55.53.0 3 Unemployment rate % (u)6.07.06.06.0 4 Inflation gate % (π)(π)(π)(π)5.04.04.04.0 5 Nominal money growth % (g m ) 8.04.59.57.0 In 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.

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Disinflation 9-3

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier BlanchardDisinflation To achieve lower inflation, the rate of nominal money growth must be reduced. To 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 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. 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. 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 = u n in the medium run. In the medium run, Unemployment above natural causes a shift down of the Phillips curve, until unemployment = u n in the medium run.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In the medium run, inflation is equal to adjusted nominal money growth. Inflation and Unemployment in the Medium Run

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier BlanchardDisinflation 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. Inflation and Unemployment in the Medium Run Decrease in expectations of inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier BlanchardDisinflation To achieve lower inflation, the rate of nominal money growth must be reduced. Here is what happens in the Short Run: To 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, In the aggregate demand relation, Then, from Okuns law, Then, from Okuns law, Finally, according to the Phillips curve relation: Finally, according to the Phillips curve relation: Notice that now u > u n.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier BlanchardDisinflation But over time, in the Medium Run, But over time, in the Medium Run, According to the Phillips curve relation: According to the Phillips curve relation: As falls, it falls far enough below g m. In the aggregate demand relation, As falls, it falls far enough below g m. In the aggregate demand relation, Eventually g y rises enough that g y > g y. Then, from Okuns law, Eventually g y rises enough that g y > g y. Then, from Okuns law, After a decrease in nominal money growth, unemployment first increases, but eventually it starts decreasing. After a decrease in nominal money growth, unemployment first increases, but eventually it starts decreasing.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth 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. Table 9-1 Engineering Disinflation 012345678 Inflation (%) 141210864444 Nominal money growth (%)17101311971277 Output growth (%)3 2 3333833 Unemployment rate (%)688888666

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long? In the Phillips curve relation above, disinflation a decrease in inflationcan be obtained only at the cost of higher unemployment. In the Phillips curve relation above, disinflation a decrease in inflationcan be obtained only at the cost of higher unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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? 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? Are there measures of this sacrifice? What are the determinants? What are the determinants? How should we design disinflation programs? How should we design disinflation programs?

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long? For example, lets assume that =1/2 For example, lets assume that =1/2 Then reducing inflation by 10 percentage points requires increasing unemployment above the natural rate by 20 percentage points over a number of years: Then 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 doesnt change with time. 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 doesnt change with time.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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: 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. 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. Achieving the disinflation over 10 years means 10 years of unemployment at 2 percentage points above the natural rate.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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: 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 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. Achieving the disinflation over 25 years means 25 years of unemployment at 0.5 percentage points above the natural rate.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. 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. 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 : If =0.8, reducing inflation by 10 percentage points requires 12.5 points-years of excess unemployment :

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long? The sacrifice ratio (=1/ ) is the number of point- years of excess unemployment needed to achieve a decrease in inflation of 1%. The sacrifice ratio (=1/ ) 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. For example, if the sacrifice ratio is 1.32, then a 10% disinflation requires 13.2 point-years of excess unemployment.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 is fixed), why not get it over with in one year? If inflation is a bad thing and the number of point-years of excess unemployment is unchangeable (because is fixed), why not get it over with in one year? At the very temporary cost of high unemployment. At the very temporary cost of high unemployment. This policy would have the great benefit of full credibility: theres no need to wonder if the disinflation program will continue. This policy would have the great benefit of full credibility: theres no need to wonder if the disinflation program will continue. This works if the announcement of the policy immediately changes e. This works if the announcement of the policy immediately changes e.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long? But if e = t-1, then seeing is believing, and you need at least two years. But if e = t-1, then seeing is believing, and you need at least two years. Moreover, the output loss could be huge, by Okuns Law. Moreover, the output loss could be huge, by Okuns Law. Many of the effects of the recession would be permanent: discouraged workers, bankruptcies, political instability, etc. Many of the effects of the recession would be permanent: discouraged workers, bankruptcies, political instability, etc.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long? Suppose the Central Bank wishes to reduce inflation by 9%. Suppose the Central Bank wishes to reduce inflation by 9%. If = 1.15, what is the number of point-years of excess unemployment? If = 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? Given the goal of reducing inflation by 9%, can the Central Bank affect the number of point-years of excess unemployment calculated above? 1.51.31.1510.9 Sacrifice ratio

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. 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: This is worked out in this way: The path of inflation shows the values of inflation before achieving a desired 4%. 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. The path of unemployment shows the unemployment required to achieve the decrease in inflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 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. The path of nominal money growth shows the growth required to achieve the required path of output.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth 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 > u n by 2 points every year for 5 years. Table 9-1 Engineering Disinflation 012345678 Inflation (%) 141210864444 Nominal money growth (%)17101311971277 Output growth (%)3 2 3333833 Unemployment rate (%)688888666

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Table 9-1 Engineering Disinflation 012345678 Desired path of Inflation (%) 141210864444 Unemployment rate (%) 6 Output growth (%) 3 Nominal money growth (%) 17 Working Out the Path of Nominal Money Growth =1

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Table 9-1 Engineering Disinflation 012345678 Inflation (%) 141210864444 Nominal money growth (%)17101311971277 Output growth (%)3 2 3333833 Unemployment rate (%)688888666 Working Out the Path of Nominal Money Growth If (Okuns Law), then g y 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 = g m – (– 2), then g m = – 7. -5 = g m – (– 2), then g m = – 7. 1

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth The second year, u t =u t-1. By Okuns Law, g y must go back to normal growth, 3%. Because still u – u n = 2 points, inflation falls by by 2 points, to 10%. From the AD relation, 5 = g m – (-2), then g m = 3. 2 Table 9-1 Engineering Disinflation012345678 Inflation (%) 141210864444 Nominal money growth (%)17101311971277 Output growth (%)3 2 3333833 Unemployment rate (%)688888666

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth This figure shows a path of unemployment and inflation similar to the disinflation path in Table 9-1. Five years of unemployment above the natural rate of unemployment lead to a permanent decrease in inflation. A Disinflation Path

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 dont it doesnt.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expectations, Credibility, and Nominal Contracts Expectations, Credibility, and Nominal Contracts 9-4 This section examines how changes in expectation formation might affect the unemployment cost of disinflation. This 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. 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. 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. 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. 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 policythe belief that the central bank was truly committed to reducing inflation. The central bank should aim for fast disinflation. The essential ingredient of successful disinflation, he argued, was credibility of monetary policythe belief that the central bank was truly committed to reducing inflation. The central bank should aim for fast disinflation.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expectations and Credibility: The Lucas Critique Recall that, although we assumed the Phillips curve can be approximated by Recall that, although we assumed the Phillips curve can be approximated by it is really Our calculations assumed that agents didnt form expectations based on policy, just on history. What if policy were fully credible, so that if the CB announces a future =4%, e 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=u n. What if policy were fully credible, so that if the CB announces a future =4%, e 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=u n.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expectations and Credibility: The Lucas Critique Which program is more credible, taking into account political pressures, elections, etc.? 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 youre done with it? A disinflation that happens in one year (say, the first year out of a 4-year presidential period), and then youre done with it? Or a disinflation that is announced to start today and end in 20 years? Or a disinflation that is announced to start today and end in 20 years?

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 1 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. 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. If wages are set before the change in policy, inflation would already be built into existing wage agreements.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Normal Rigidities and Contracts Taylor argued that the staggering of wage decisions imposed strong limits on how fast disinflation could proceed. 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. The way to decrease the unemployment cost of disinflation is to give wage setters time to take the change in policy into account. Inflation wont change much over the next year or two (to avoid costs in output). But in two years, inflation will begin to fall drastically. Inflation wont 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? 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. Slow but credible disinflation might have a lower cost. The central bank should go for slow disinflation. If inflation aint changin, why should we believe it will? If inflation aint changin, why should we believe it will?

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Normal Rigidities and Contracts With staggering of wage decisions, disinflation must be phased in slowly to avoid an increase in unemployment. Disinflation Without Unemployment in the Taylor Model

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985 9-5 What did happen in the early eighties? What did happen in the early eighties? The U.S. disinflation of the early 1980s was associated with a substantial increase in unemployment. 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. The Phillips curve relation proved more robust than many economists anticipated.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985 Cumulative 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 1979. The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation. Table 9-2 Inflation and Unemployment, 1979-1985 Percent1979198019811982198319841985 GDP growth 2.5 0.5 1.8 2.2 3.96.23.2 Unemployment rate5.8 7.1 7.69.79.67.57.2 CPI inflation13.3 12.5 8.93.8 3.93.8 Cumulative unemployment 1.0 2.66.39.911.412.6 Cumulative disinflation 0.8 4.49.5 9.49.5 Sacrifice ratio 1.25 0.590.661.041.211.32

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985 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. The Federal Funds Rate and Inflation, 1979-1984

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985 Laurence Ball, who examined 65 disinflation episodes concluded that: Laurence Ball, who examined 65 disinflation episodes concluded that: Disinflations typically lead to a period of higher unemployment. Disinflations typically lead to a period of higher unemployment. This contradicts a radical version of Lucas/Sargent. This contradicts a radical version of Lucas/Sargent. Faster disinflations are associated with smaller sacrifice ratios. Faster disinflations are associated with smaller sacrifice ratios. This supports a moderate version of Lucas/Sargent. This supports a moderate version of Lucas/Sargent. Sacrifice ratios are smaller in countries that have shorter wage contracts. Sacrifice ratios are smaller in countries that have shorter wage contracts. This supports Fischer/Taylor. This supports Fischer/Taylor.

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