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Lecture 12 THE DYNAMICS OF INFLATION AND UNEMPLOYMENT.

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1 Lecture 12 THE DYNAMICS OF INFLATION AND UNEMPLOYMENT

2 Lecture Outline Inflation and the Price LevelInflation and the Price Level Demand-Pull InflationDemand-Pull Inflation Cost-Push InflationCost-Push Inflation Effects of InflationEffects of Inflation The Phillips CurveThe Phillips Curve Inflation and the Price LevelInflation and the Price Level Demand-Pull InflationDemand-Pull Inflation Cost-Push InflationCost-Push Inflation Effects of InflationEffects of Inflation The Phillips CurveThe Phillips Curve

3 Inflation is a process in which the price level rises and money loses value.Inflation is a process in which the price level rises and money loses value. Inflation is fundamentally a monetary phenomenon.Inflation is fundamentally a monetary phenomenon. The average level of prices is rising.The average level of prices is rising. Inflation is not high prices and inflation is not a jump in pricesInflation is not high prices and inflation is not a jump in prices Inflation is a process in which the price level rises and money loses value.Inflation is a process in which the price level rises and money loses value. Inflation is fundamentally a monetary phenomenon.Inflation is fundamentally a monetary phenomenon. The average level of prices is rising.The average level of prices is rising. Inflation is not high prices and inflation is not a jump in pricesInflation is not high prices and inflation is not a jump in prices Inflation and the Price Level

4 The figures distinguishes between a one time jump in prices and inflation.The figures distinguishes between a one time jump in prices and inflation. Part (b) shows a one time jump in the price level.Part (b) shows a one time jump in the price level. The figures distinguishes between a one time jump in prices and inflation.The figures distinguishes between a one time jump in prices and inflation. Part (b) shows a one time jump in the price level.Part (b) shows a one time jump in the price level. Inflation and the Price Level

5 Part (a) shows the process of inflation.Part (a) shows the process of inflation. The inflation rate is the percentage change in the price level during a given period.The inflation rate is the percentage change in the price level during a given period. Part (a) shows the process of inflation.Part (a) shows the process of inflation. The inflation rate is the percentage change in the price level during a given period.The inflation rate is the percentage change in the price level during a given period. Inflation and the Price Level

6 Demand-pull inflation is inflation that results from an initial increase in aggregate demand.Demand-pull inflation is inflation that results from an initial increase in aggregate demand. A demand pull inflation can result from any influence that increases aggregate demand.A demand pull inflation can result from any influence that increases aggregate demand. Demand-pull inflation is inflation that results from an initial increase in aggregate demand.Demand-pull inflation is inflation that results from an initial increase in aggregate demand. A demand pull inflation can result from any influence that increases aggregate demand.A demand pull inflation can result from any influence that increases aggregate demand. Demand-Pull Inflation

7 In a demand-pull inflation, initiallyIn a demand-pull inflation, initially –aggregate demand increases –real GDP increases above potential GDP and the price level rises –money wages rise –the price level rises further and real GDP decreases toward potential GDP. In a demand-pull inflation, initiallyIn a demand-pull inflation, initially –aggregate demand increases –real GDP increases above potential GDP and the price level rises –money wages rise –the price level rises further and real GDP decreases toward potential GDP. Demand-Pull Inflation

8 A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation.A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation. For demand pull inflation to occur, aggregate demand must persistently increase.For demand pull inflation to occur, aggregate demand must persistently increase. The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP.The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP. A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation.A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation. For demand pull inflation to occur, aggregate demand must persistently increase.For demand pull inflation to occur, aggregate demand must persistently increase. The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP.The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP. Demand-Pull Inflation

9 The figures show a demand pull inflation.The figures show a demand pull inflation. Initially, aggregate demand increases.Initially, aggregate demand increases. The figures show a demand pull inflation.The figures show a demand pull inflation. Initially, aggregate demand increases.Initially, aggregate demand increases. Demand-Pull Inflation

10 Real GDP increases and the price level rises.Real GDP increases and the price level rises. Now real GDP exceeds potential GDP.Now real GDP exceeds potential GDP. Real GDP increases and the price level rises.Real GDP increases and the price level rises. Now real GDP exceeds potential GDP.Now real GDP exceeds potential GDP. Demand-Pull Inflation

11 There is an inflationary gap.There is an inflationary gap. The money wage rate begins to rise.The money wage rate begins to rise. And the SAS curve shifts leftward.And the SAS curve shifts leftward. There is an inflationary gap.There is an inflationary gap. The money wage rate begins to rise.The money wage rate begins to rise. And the SAS curve shifts leftward.And the SAS curve shifts leftward. Demand-Pull Inflation

12 Real GDP decreases toward potential GDP.Real GDP decreases toward potential GDP. The price level rises further.The price level rises further. Real GDP decreases toward potential GDP.Real GDP decreases toward potential GDP. The price level rises further.The price level rises further. Demand-Pull Inflation

13 This process repeats in an unending price-wage spiral.This process repeats in an unending price-wage spiral. Demand-Pull Inflation

14 Cost-push inflation is an inflation that results from an initial increase in costs.Cost-push inflation is an inflation that results from an initial increase in costs. The two main sources of cost- push inflation are:The two main sources of cost- push inflation are: –an increase in the money wage rate –an increase in the money prices of raw materials Cost-push inflation is an inflation that results from an initial increase in costs.Cost-push inflation is an inflation that results from an initial increase in costs. The two main sources of cost- push inflation are:The two main sources of cost- push inflation are: –an increase in the money wage rate –an increase in the money prices of raw materials Cost-Push Inflation

15 In a cost-push inflation, initiallyIn a cost-push inflation, initially –short-run aggregate supply decreases –real GDP decreases below potential GDP and the price level rises –the economy could become stuck in this stagflation situation for some time. In a cost-push inflation, initiallyIn a cost-push inflation, initially –short-run aggregate supply decreases –real GDP decreases below potential GDP and the price level rises –the economy could become stuck in this stagflation situation for some time. Cost-Push Inflation

16 A one-time decrease in aggregate supply raises the price level but does not always start a cost-push inflation.A one-time decrease in aggregate supply raises the price level but does not always start a cost-push inflation. For cost-push inflation to occur, aggregate demand must increase in response to the cost push.For cost-push inflation to occur, aggregate demand must increase in response to the cost push. A one-time decrease in aggregate supply raises the price level but does not always start a cost-push inflation.A one-time decrease in aggregate supply raises the price level but does not always start a cost-push inflation. For cost-push inflation to occur, aggregate demand must increase in response to the cost push.For cost-push inflation to occur, aggregate demand must increase in response to the cost push. Cost-Push Inflation

17 Just like the case of demand- pull inflation, the money supply must persistently grow at a rate that exceeds the growth rate of potential GDP if an inflation is to become persistent.Just like the case of demand- pull inflation, the money supply must persistently grow at a rate that exceeds the growth rate of potential GDP if an inflation is to become persistent. Cost-Push Inflation

18 The following figures show a cost-push inflation.The following figures show a cost-push inflation. Initially, a factor price rises.Initially, a factor price rises. The following figures show a cost-push inflation.The following figures show a cost-push inflation. Initially, a factor price rises.Initially, a factor price rises. Cost-Push Inflation

19 Short-run aggregate supply decreases and the SAS curve shifts leftwardShort-run aggregate supply decreases and the SAS curve shifts leftward Cost-Push Inflation

20 Real GDP decreases and the price level rises in a stagflation.Real GDP decreases and the price level rises in a stagflation. Cost-Push Inflation

21 With no subsequet change in aggregate demand, the price level eventually falls.With no subsequet change in aggregate demand, the price level eventually falls. Cost-Push Inflation

22 There is no inflation.There is no inflation. For cost- push inflation to take hold, aggregate demand must increase.For cost- push inflation to take hold, aggregate demand must increase. There is no inflation.There is no inflation. For cost- push inflation to take hold, aggregate demand must increase.For cost- push inflation to take hold, aggregate demand must increase. Cost-Push Inflation

23 An increase in the money supply increases aggregate demand and the AD curve shifts rightward.An increase in the money supply increases aggregate demand and the AD curve shifts rightward. Cost-Push Inflation

24 Real GDP increases and the price level rises.Real GDP increases and the price level rises. Cost-Push Inflation

25 This process repeats to create an unending cost-price inflation spiral.This process repeats to create an unending cost-price inflation spiral. Cost-Push Inflation

26 HYPERINFLATIONHYPERINFLATION Very high inflation rates, over 50% per monthVery high inflation rates, over 50% per month Inflation rates observed in the US in the last 40 years are insignificant in comparison to some experiences around the world throughout historyInflation rates observed in the US in the last 40 years are insignificant in comparison to some experiences around the world throughout history Very high inflation rates, over 50% per monthVery high inflation rates, over 50% per month Inflation rates observed in the US in the last 40 years are insignificant in comparison to some experiences around the world throughout historyInflation rates observed in the US in the last 40 years are insignificant in comparison to some experiences around the world throughout history

27 HIGH INFLATIONS IN THE 1980s CountryBolivia Argentina Nicaragua Year Yearly Inflation 1,152, , , 200 Rate (%) Monthly Inflation Rate (%) Monthly Money Growth Rate (%) Source: International Financial Statistics Yearbook, 1992, (Washington DC: International Monetary Fund) CountryBolivia Argentina Nicaragua Year Yearly Inflation 1,152, , , 200 Rate (%) Monthly Inflation Rate (%) Monthly Money Growth Rate (%) Source: International Financial Statistics Yearbook, 1992, (Washington DC: International Monetary Fund)

28 DURING HYPERINFLATIONS Money no longer works very well in facilitating exchangeMoney no longer works very well in facilitating exchange Since prices are changing so fast and unpredictably, there is typically massive confusion about the true value of commoditiesSince prices are changing so fast and unpredictably, there is typically massive confusion about the true value of commodities Different stores may be raising prices at different ratesDifferent stores may be raising prices at different rates The same commodities may sell for radically different pricesThe same commodities may sell for radically different prices Everyone spends all their time hunting for bargains and finding the lowest pricesEveryone spends all their time hunting for bargains and finding the lowest prices Governments are forced to put an end to hyperinflation before it destroys their economiesGovernments are forced to put an end to hyperinflation before it destroys their economies Money no longer works very well in facilitating exchangeMoney no longer works very well in facilitating exchange Since prices are changing so fast and unpredictably, there is typically massive confusion about the true value of commoditiesSince prices are changing so fast and unpredictably, there is typically massive confusion about the true value of commodities Different stores may be raising prices at different ratesDifferent stores may be raising prices at different rates The same commodities may sell for radically different pricesThe same commodities may sell for radically different prices Everyone spends all their time hunting for bargains and finding the lowest pricesEveryone spends all their time hunting for bargains and finding the lowest prices Governments are forced to put an end to hyperinflation before it destroys their economiesGovernments are forced to put an end to hyperinflation before it destroys their economies

29 THE CAUSE OF HYPERINFLATION Excessive money growth If a government wants to spend a specified amount of money, but is collecting less in taxes, it must cover the difference in some way:If a government wants to spend a specified amount of money, but is collecting less in taxes, it must cover the difference in some way: –the government may borrow the difference from the public and issue bonds, for which it must pay back what it borrows and interest in the future –the government may print new money –governments could mix borrowing and printing money to cover the deficit government deficit = new borrowing + new money created Excessive money growth If a government wants to spend a specified amount of money, but is collecting less in taxes, it must cover the difference in some way:If a government wants to spend a specified amount of money, but is collecting less in taxes, it must cover the difference in some way: –the government may borrow the difference from the public and issue bonds, for which it must pay back what it borrows and interest in the future –the government may print new money –governments could mix borrowing and printing money to cover the deficit government deficit = new borrowing + new money created

30 HYPERINFLATIONHYPERINFLATION occurs in countries that have large deficits, but cannot borrow and are forced to print new moneyoccurs in countries that have large deficits, but cannot borrow and are forced to print new money is only stopped by eliminating the deficit, which is the basic cause:is only stopped by eliminating the deficit, which is the basic cause: –increase taxes –cut spending Once the deficit has been cut and the government stops printing money, the hyperinflation will endOnce the deficit has been cut and the government stops printing money, the hyperinflation will end occurs in countries that have large deficits, but cannot borrow and are forced to print new moneyoccurs in countries that have large deficits, but cannot borrow and are forced to print new money is only stopped by eliminating the deficit, which is the basic cause:is only stopped by eliminating the deficit, which is the basic cause: –increase taxes –cut spending Once the deficit has been cut and the government stops printing money, the hyperinflation will endOnce the deficit has been cut and the government stops printing money, the hyperinflation will end

31 INDEXEDINDEXED Describes something whose payments are adjusted for changes in prices, such as bonds or nominal contractsDescribes something whose payments are adjusted for changes in prices, such as bonds or nominal contracts In practice, countries find that indexing is not the perfect solution to problems caused by inflation:In practice, countries find that indexing is not the perfect solution to problems caused by inflation: –policymakers worry indexing lowers the resolve to fight inflation –Price indices are far from perfect and are extremely difficult to construct when prices are increasing rapidly –Some economists believe that indexing builds inflation into the economic system and makes it difficult to reduce inflation Describes something whose payments are adjusted for changes in prices, such as bonds or nominal contractsDescribes something whose payments are adjusted for changes in prices, such as bonds or nominal contracts In practice, countries find that indexing is not the perfect solution to problems caused by inflation:In practice, countries find that indexing is not the perfect solution to problems caused by inflation: –policymakers worry indexing lowers the resolve to fight inflation –Price indices are far from perfect and are extremely difficult to construct when prices are increasing rapidly –Some economists believe that indexing builds inflation into the economic system and makes it difficult to reduce inflation

32 MONETARISTSMONETARISTS Economists who traditionally emphasize the important role that the supply of money plays in determining nominal income and inflationEconomists who traditionally emphasize the important role that the supply of money plays in determining nominal income and inflation Most famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of money in economic lifeMost famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of money in economic life Philip Cagan - best known for work on hyperinflationsPhilip Cagan - best known for work on hyperinflations Monetarist economists did pioneering research on link between money, nominal income and inflationMonetarist economists did pioneering research on link between money, nominal income and inflation Economists who traditionally emphasize the important role that the supply of money plays in determining nominal income and inflationEconomists who traditionally emphasize the important role that the supply of money plays in determining nominal income and inflation Most famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of money in economic lifeMost famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of money in economic life Philip Cagan - best known for work on hyperinflationsPhilip Cagan - best known for work on hyperinflations Monetarist economists did pioneering research on link between money, nominal income and inflationMonetarist economists did pioneering research on link between money, nominal income and inflation

33 Regardless of whether its origin is demand-pull or cost-push, inflation imposes costs.Regardless of whether its origin is demand-pull or cost-push, inflation imposes costs. The costs depend on whether the inflation is anticipated or unanticipated.The costs depend on whether the inflation is anticipated or unanticipated. Regardless of whether its origin is demand-pull or cost-push, inflation imposes costs.Regardless of whether its origin is demand-pull or cost-push, inflation imposes costs. The costs depend on whether the inflation is anticipated or unanticipated.The costs depend on whether the inflation is anticipated or unanticipated. Effects of Inflation

34 ANTICIPATED INFLATION Fully Anticipated Inflation Inflation at 4% would mean workers would know that nominal wage increases of 4% were not real wage increases, andInflation at 4% would mean workers would know that nominal wage increases of 4% were not real wage increases, and Investors earning a 7% rate of interest on bonds would know that their real return would be 3% after adjusting for inflationInvestors earning a 7% rate of interest on bonds would know that their real return would be 3% after adjusting for inflation Menu costs -- the actual physical costs of changing pricesMenu costs -- the actual physical costs of changing prices Shoe leather costs -- additional wear and tear necessary to hold less cashShoe leather costs -- additional wear and tear necessary to hold less cash Our tax system and financial system do not fully adjust even to fully anticipated inflationOur tax system and financial system do not fully adjust even to fully anticipated inflation Fully Anticipated Inflation Inflation at 4% would mean workers would know that nominal wage increases of 4% were not real wage increases, andInflation at 4% would mean workers would know that nominal wage increases of 4% were not real wage increases, and Investors earning a 7% rate of interest on bonds would know that their real return would be 3% after adjusting for inflationInvestors earning a 7% rate of interest on bonds would know that their real return would be 3% after adjusting for inflation Menu costs -- the actual physical costs of changing pricesMenu costs -- the actual physical costs of changing prices Shoe leather costs -- additional wear and tear necessary to hold less cashShoe leather costs -- additional wear and tear necessary to hold less cash Our tax system and financial system do not fully adjust even to fully anticipated inflationOur tax system and financial system do not fully adjust even to fully anticipated inflation

35 This figure shows how anticipating inflation avoids the costs of deviations from potential GDP.This figure shows how anticipating inflation avoids the costs of deviations from potential GDP. Effects of Inflation

36 Anticipating inflation also avoids:Anticipating inflation also avoids: –the redistribution of income and wealth. –errors in investment and saving decisions. But anticipated inflation does have some costs.But anticipated inflation does have some costs. Anticipating inflation also avoids:Anticipating inflation also avoids: –the redistribution of income and wealth. –errors in investment and saving decisions. But anticipated inflation does have some costs.But anticipated inflation does have some costs. Effects of Inflation

37 The costs of anticipated inflation are:The costs of anticipated inflation are: –“bootleather” costs –other transactions costs –decrease in potential GDP –decrease in the long-term growth rate. These costs have been estimated to be very high, even for a modest inflation.These costs have been estimated to be very high, even for a modest inflation. The main problem is that taxes on capital income a seriously distorted by inflation.The main problem is that taxes on capital income a seriously distorted by inflation. The costs of anticipated inflation are:The costs of anticipated inflation are: –“bootleather” costs –other transactions costs –decrease in potential GDP –decrease in the long-term growth rate. These costs have been estimated to be very high, even for a modest inflation.These costs have been estimated to be very high, even for a modest inflation. The main problem is that taxes on capital income a seriously distorted by inflation.The main problem is that taxes on capital income a seriously distorted by inflation. Effects of Inflation

38 Unanticipated inflation can cause the following problems:Unanticipated inflation can cause the following problems: –redistribute income between firms and workers –move real GDP away from potential GDP –redistribute wealth between borrowers and lenders –result in too much or too little saving and investment Unanticipated inflation can cause the following problems:Unanticipated inflation can cause the following problems: –redistribute income between firms and workers –move real GDP away from potential GDP –redistribute wealth between borrowers and lenders –result in too much or too little saving and investment Effects of Inflation

39 Because unanticipated inflation is costly, people try to anticipate it.Because unanticipated inflation is costly, people try to anticipate it. To make the best possible forecast of inflation, people use all the information they can about the source of inflation and likely trends in those sources.To make the best possible forecast of inflation, people use all the information they can about the source of inflation and likely trends in those sources. Such a forecast is called a rational expectation.Such a forecast is called a rational expectation. An anticipated inflation avoids some of the costs of inflation.An anticipated inflation avoids some of the costs of inflation. Because unanticipated inflation is costly, people try to anticipate it.Because unanticipated inflation is costly, people try to anticipate it. To make the best possible forecast of inflation, people use all the information they can about the source of inflation and likely trends in those sources.To make the best possible forecast of inflation, people use all the information they can about the source of inflation and likely trends in those sources. Such a forecast is called a rational expectation.Such a forecast is called a rational expectation. An anticipated inflation avoids some of the costs of inflation.An anticipated inflation avoids some of the costs of inflation. Effects of Inflation

40 COSTS OF INFLATION AnticipatedUnanticipated InflationInflation Institutions doDistortions in theUnfair redistributions not adjusttax system, Problems in financial markets Institutions Cost of changingInstitutional adjustprices,disintegration Shoe-leather costs AnticipatedUnanticipated InflationInflation Institutions doDistortions in theUnfair redistributions not adjusttax system, Problems in financial markets Institutions Cost of changingInstitutional adjustprices,disintegration Shoe-leather costs

41 THE PHILLIPS CURVE - 1 The Phillips Curve is a graph depicting a relationship between the unemployment rate and the inflation rate. The figure below shows a typical SHORT-RUN Phillips Curve.The Phillips Curve is a graph depicting a relationship between the unemployment rate and the inflation rate. The figure below shows a typical SHORT-RUN Phillips Curve.

42 THE PHILLIPS CURVE - 2 The implication of the negative slope is that the unemployment rate and the inflation rate are inversely related - in other words, there is a trade- off between the two.The implication of the negative slope is that the unemployment rate and the inflation rate are inversely related - in other words, there is a trade- off between the two. At the beginning of the course, one things we said was that society faces a short-run trade-off between inflation and unemployment. This trade- off is embodied in the short-run Phillips Curve.At the beginning of the course, one things we said was that society faces a short-run trade-off between inflation and unemployment. This trade- off is embodied in the short-run Phillips Curve. The implication of the negative slope is that the unemployment rate and the inflation rate are inversely related - in other words, there is a trade- off between the two.The implication of the negative slope is that the unemployment rate and the inflation rate are inversely related - in other words, there is a trade- off between the two. At the beginning of the course, one things we said was that society faces a short-run trade-off between inflation and unemployment. This trade- off is embodied in the short-run Phillips Curve.At the beginning of the course, one things we said was that society faces a short-run trade-off between inflation and unemployment. This trade- off is embodied in the short-run Phillips Curve.

43 THE PHILLIPS CURVE - 3 Since inflation and unemployment are BOTH things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the Phillips Curve are important.Since inflation and unemployment are BOTH things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the Phillips Curve are important. Understanding the relationship between economic policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics.Understanding the relationship between economic policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics. Since inflation and unemployment are BOTH things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the Phillips Curve are important.Since inflation and unemployment are BOTH things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the Phillips Curve are important. Understanding the relationship between economic policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics.Understanding the relationship between economic policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics.

44 SHIFTS IN AD & THE PHILLIPS CURVE - 1 Q:What happens in the Phillips Curve diagram when there is a shift in AD? A:There is a movement along the short-run Phillips Curve and a trade-off between inflation and unemployment. Q:What happens in the Phillips Curve diagram when there is a shift in AD? A:There is a movement along the short-run Phillips Curve and a trade-off between inflation and unemployment.

45 SHIFTS IN AD & THE PHILLIPS CURVE - 2

46 SHIFTS IN AD & THE PHILLIPS CURVE - 3 In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves from point A to point B.In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves from point A to point B. There are two important things to notice about the new equilibrium (relative to the old one):There are two important things to notice about the new equilibrium (relative to the old one): –First, notice that the price level in the economy has increased (from 102 to 106) - therefore, the rate of inflation has risen. –Second, the level of output produced in the economy has risen (from Y1 to Y2). When the level of output increases, the number of people employed also rises, indicating that the unemployment rate MUST have fallen. In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves from point A to point B.In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves from point A to point B. There are two important things to notice about the new equilibrium (relative to the old one):There are two important things to notice about the new equilibrium (relative to the old one): –First, notice that the price level in the economy has increased (from 102 to 106) - therefore, the rate of inflation has risen. –Second, the level of output produced in the economy has risen (from Y1 to Y2). When the level of output increases, the number of people employed also rises, indicating that the unemployment rate MUST have fallen.

47 SHIFTS IN AD & THE PHILLIPS CURVE - 4 Relative to point A in the figure on the right, point B MUST be a point where there is higher inflation and lower unemployment - but this just represents a movement ALONG the short-run Phillips Curve. Also, if AD were to shift in the opposite direction, there would have been a movement along the Phillips Curve in the opposite direction.Relative to point A in the figure on the right, point B MUST be a point where there is higher inflation and lower unemployment - but this just represents a movement ALONG the short-run Phillips Curve. Also, if AD were to shift in the opposite direction, there would have been a movement along the Phillips Curve in the opposite direction.

48 THE LONG-RUN PHILLIPS CURVE - 1 The figure below depicts the long-run Phillips Curve:

49 THE LONG-RUN PHILLIPS CURVE - 2 Earlier in the course, we discussed the natural rate of unemployment. This was defined to be about 6% in the long-run, and it was shown that the economy tends to automatically return to this level on its own.Earlier in the course, we discussed the natural rate of unemployment. This was defined to be about 6% in the long-run, and it was shown that the economy tends to automatically return to this level on its own. If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment!If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment! Earlier in the course, we discussed the natural rate of unemployment. This was defined to be about 6% in the long-run, and it was shown that the economy tends to automatically return to this level on its own.Earlier in the course, we discussed the natural rate of unemployment. This was defined to be about 6% in the long-run, and it was shown that the economy tends to automatically return to this level on its own. If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment!If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment!

50 THE LONG-RUN PHILLIPS CURVE - 3 If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose any inflation rate they desire along this line.If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose any inflation rate they desire along this line. Q: What is the cost of reducing inflation in the long-run? A:In the long-run, there is NO cost to reducing inflation. If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose any inflation rate they desire along this line.If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose any inflation rate they desire along this line. Q: What is the cost of reducing inflation in the long-run? A:In the long-run, there is NO cost to reducing inflation.

51 THE LONG-RUN PHILLIPS CURVE - 4 This is demonstrated in the figures below:

52 THE LONG-RUN PHILLIPS CURVE - 5 On the left, if the Fed reduces the growth of the money supply in the long-run, the AD curve will shift to the left, causing the price level to fall from P0 to P1.On the left, if the Fed reduces the growth of the money supply in the long-run, the AD curve will shift to the left, causing the price level to fall from P0 to P1. However, output is NOT affected by changes in the money supply in the long-run (because of monetary neutrality). Since output remains at the natural rate of output, unemployment remains at the natural rate of unemployment.However, output is NOT affected by changes in the money supply in the long-run (because of monetary neutrality). Since output remains at the natural rate of output, unemployment remains at the natural rate of unemployment. On the left, if the Fed reduces the growth of the money supply in the long-run, the AD curve will shift to the left, causing the price level to fall from P0 to P1.On the left, if the Fed reduces the growth of the money supply in the long-run, the AD curve will shift to the left, causing the price level to fall from P0 to P1. However, output is NOT affected by changes in the money supply in the long-run (because of monetary neutrality). Since output remains at the natural rate of output, unemployment remains at the natural rate of unemployment.However, output is NOT affected by changes in the money supply in the long-run (because of monetary neutrality). Since output remains at the natural rate of output, unemployment remains at the natural rate of unemployment.

53 THE LONG-RUN PHILLIPS CURVE - 6 On the right, the reduction in the growth of the money supply has lowered the long-run rate of inflation and has NOT affected the long-run unemployment rate.On the right, the reduction in the growth of the money supply has lowered the long-run rate of inflation and has NOT affected the long-run unemployment rate.

54 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 1 While there is not a trade-off between inflation and unemployment in the long- run, there IS a short-run trade-off.While there is not a trade-off between inflation and unemployment in the long- run, there IS a short-run trade-off. From the work of Milton Friedman and Edmund Phelps, we know that expectations of future inflation plays an important role in the short-run trade-off.From the work of Milton Friedman and Edmund Phelps, we know that expectations of future inflation plays an important role in the short-run trade-off. While there is not a trade-off between inflation and unemployment in the long- run, there IS a short-run trade-off.While there is not a trade-off between inflation and unemployment in the long- run, there IS a short-run trade-off. From the work of Milton Friedman and Edmund Phelps, we know that expectations of future inflation plays an important role in the short-run trade-off.From the work of Milton Friedman and Edmund Phelps, we know that expectations of future inflation plays an important role in the short-run trade-off.

55 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 2 The figure below demonstrates the relationship between the short-run Phillips Curve and inflationary expectations:

56 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 3 Suppose the economy is initially at point ‘A’. Earlier we said that a shift in the AD curve will cause a movement along the short-run Phillips Curve.Suppose the economy is initially at point ‘A’. Earlier we said that a shift in the AD curve will cause a movement along the short-run Phillips Curve. An increase in the money supply, an increase in government spending or a tax cut could all shift the AD curve to the right - suppose one of these three occurs.An increase in the money supply, an increase in government spending or a tax cut could all shift the AD curve to the right - suppose one of these three occurs. Suppose the economy is initially at point ‘A’. Earlier we said that a shift in the AD curve will cause a movement along the short-run Phillips Curve.Suppose the economy is initially at point ‘A’. Earlier we said that a shift in the AD curve will cause a movement along the short-run Phillips Curve. An increase in the money supply, an increase in government spending or a tax cut could all shift the AD curve to the right - suppose one of these three occurs.An increase in the money supply, an increase in government spending or a tax cut could all shift the AD curve to the right - suppose one of these three occurs.

57 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 4 The rightward shift in AD is associated with rising output and a rising price level.The rightward shift in AD is associated with rising output and a rising price level. The rising price level IS an increase in the rate of inflation.The rising price level IS an increase in the rate of inflation. Rising output goes along with rising employment (and falling unemployment).Rising output goes along with rising employment (and falling unemployment). For these reasons, the rightward shift in AD will cause a movement to point ‘B’ in this figure (higher inflation and lower unemployment than point ‘A’).For these reasons, the rightward shift in AD will cause a movement to point ‘B’ in this figure (higher inflation and lower unemployment than point ‘A’). The rightward shift in AD is associated with rising output and a rising price level.The rightward shift in AD is associated with rising output and a rising price level. The rising price level IS an increase in the rate of inflation.The rising price level IS an increase in the rate of inflation. Rising output goes along with rising employment (and falling unemployment).Rising output goes along with rising employment (and falling unemployment). For these reasons, the rightward shift in AD will cause a movement to point ‘B’ in this figure (higher inflation and lower unemployment than point ‘A’).For these reasons, the rightward shift in AD will cause a movement to point ‘B’ in this figure (higher inflation and lower unemployment than point ‘A’).

58 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 5 Now, according to Friedman and Phelps, the higher ACTUAL inflation will eventually cause EXPECTED inflation to rise as well.Now, according to Friedman and Phelps, the higher ACTUAL inflation will eventually cause EXPECTED inflation to rise as well. The increase in EXPECTED inflation shifts the short-run Phillips Curve to the right (to SR-PC2), and the economy ends up at point ‘C’.The increase in EXPECTED inflation shifts the short-run Phillips Curve to the right (to SR-PC2), and the economy ends up at point ‘C’. Now, according to Friedman and Phelps, the higher ACTUAL inflation will eventually cause EXPECTED inflation to rise as well.Now, according to Friedman and Phelps, the higher ACTUAL inflation will eventually cause EXPECTED inflation to rise as well. The increase in EXPECTED inflation shifts the short-run Phillips Curve to the right (to SR-PC2), and the economy ends up at point ‘C’.The increase in EXPECTED inflation shifts the short-run Phillips Curve to the right (to SR-PC2), and the economy ends up at point ‘C’.

59 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 6 We can describe SR-PC2 as a ‘short-run Phillips Curve with high expected inflation’, while the original curve, SR-PC1 can be described as a ‘short-run Phillips Curve with low expected inflation’.We can describe SR-PC2 as a ‘short-run Phillips Curve with high expected inflation’, while the original curve, SR-PC1 can be described as a ‘short-run Phillips Curve with low expected inflation’. The result you should take from the previous figure is that government policies attempting to EXPAND aggregate demand are likely to cause permanently HIGHER rates of inflation, without affecting the long-run unemployment rate.The result you should take from the previous figure is that government policies attempting to EXPAND aggregate demand are likely to cause permanently HIGHER rates of inflation, without affecting the long-run unemployment rate. We can describe SR-PC2 as a ‘short-run Phillips Curve with high expected inflation’, while the original curve, SR-PC1 can be described as a ‘short-run Phillips Curve with low expected inflation’.We can describe SR-PC2 as a ‘short-run Phillips Curve with high expected inflation’, while the original curve, SR-PC1 can be described as a ‘short-run Phillips Curve with low expected inflation’. The result you should take from the previous figure is that government policies attempting to EXPAND aggregate demand are likely to cause permanently HIGHER rates of inflation, without affecting the long-run unemployment rate.The result you should take from the previous figure is that government policies attempting to EXPAND aggregate demand are likely to cause permanently HIGHER rates of inflation, without affecting the long-run unemployment rate.

60 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 7 The relationship between the short-run Phillips Curve and inflationary expectations described by Friedman and Phelps is stated in the following formula:The relationship between the short-run Phillips Curve and inflationary expectations described by Friedman and Phelps is stated in the following formula:

61 THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 8 In the previous example, when ACTUAL inflation exceed EXPECTED inflation (at point ‘B’), unemployment was LESS THAN the natural rate. In the long-run, actual and expected inflation will be equal, and unemployment will equal the natural rate (and the economy will be back on the long-run Phillips Curve).In the previous example, when ACTUAL inflation exceed EXPECTED inflation (at point ‘B’), unemployment was LESS THAN the natural rate. In the long-run, actual and expected inflation will be equal, and unemployment will equal the natural rate (and the economy will be back on the long-run Phillips Curve).

62 SUPPLY SHOCKS & THE PHILLIPS CURVE - 1 Q: What happens in the Phillips Curve diagram when the AS curve shifts? A: The short-run Phillips Curve shifts, changing the attractiveness of the trade- off between inflation and unemployment. Q: What happens in the Phillips Curve diagram when the AS curve shifts? A: The short-run Phillips Curve shifts, changing the attractiveness of the trade- off between inflation and unemployment.

63 SUPPLY SHOCKS & THE PHILLIPS CURVE - 2

64 SUPPLY SHOCKS & THE PHILLIPS CURVE - 3 The figure on the left in the previous slide depicts a typical supply shock in the economy (like the OPEC shocks in the 1970s).The figure on the left in the previous slide depicts a typical supply shock in the economy (like the OPEC shocks in the 1970s). As the AS curve shifts to the left, the equilibrium in the marcoeconomy moves from point A to point B.As the AS curve shifts to the left, the equilibrium in the marcoeconomy moves from point A to point B. The figure on the left in the previous slide depicts a typical supply shock in the economy (like the OPEC shocks in the 1970s).The figure on the left in the previous slide depicts a typical supply shock in the economy (like the OPEC shocks in the 1970s). As the AS curve shifts to the left, the equilibrium in the marcoeconomy moves from point A to point B.As the AS curve shifts to the left, the equilibrium in the marcoeconomy moves from point A to point B.

65 SUPPLY SHOCKS & THE PHILLIPS CURVE - 4 As with a shift in the AD curve, there are two things you should watch for when AS shifts:As with a shift in the AD curve, there are two things you should watch for when AS shifts: –First, notice that the equilibrium price level rises (from P1 to P2), indicating that the level of inflation in the economy has risen. –Second, notice that the level of output produced has FALLEN from Y1 to Y2. As output falls the number of labourers required to produce this output also falls. When these workers get laid off, the unemployment rate RISES. As with a shift in the AD curve, there are two things you should watch for when AS shifts:As with a shift in the AD curve, there are two things you should watch for when AS shifts: –First, notice that the equilibrium price level rises (from P1 to P2), indicating that the level of inflation in the economy has risen. –Second, notice that the level of output produced has FALLEN from Y1 to Y2. As output falls the number of labourers required to produce this output also falls. When these workers get laid off, the unemployment rate RISES.

66 SUPPLY SHOCKS & THE PHILLIPS CURVE - 5 In the figure on the right, point B MUST be a point with a higher inflation rate AND a higher unemployment rate.In the figure on the right, point B MUST be a point with a higher inflation rate AND a higher unemployment rate. Point B MUST be up and to the right of point A. Because of this, economists say that the short- run Phillips Curve must have shifted to the right.Point B MUST be up and to the right of point A. Because of this, economists say that the short- run Phillips Curve must have shifted to the right. This means that the trade-off between inflation and unemployment is LESS attractive, because BOTH rates have risen.This means that the trade-off between inflation and unemployment is LESS attractive, because BOTH rates have risen. In the figure on the right, point B MUST be a point with a higher inflation rate AND a higher unemployment rate.In the figure on the right, point B MUST be a point with a higher inflation rate AND a higher unemployment rate. Point B MUST be up and to the right of point A. Because of this, economists say that the short- run Phillips Curve must have shifted to the right.Point B MUST be up and to the right of point A. Because of this, economists say that the short- run Phillips Curve must have shifted to the right. This means that the trade-off between inflation and unemployment is LESS attractive, because BOTH rates have risen.This means that the trade-off between inflation and unemployment is LESS attractive, because BOTH rates have risen.

67 COSTS OF REDUCING INFLATION IN THE S/RUN - 1 The figure below illustrates the cost of reducing inflation in the short-run:The figure below illustrates the cost of reducing inflation in the short-run:

68 COSTS OF REDUCING INFLATION IN THE S/RUN - 2 To reduce inflation, the Fed will run a contractionary monetary policy.To reduce inflation, the Fed will run a contractionary monetary policy. The reduction in the money supply will shift AD to the left.The reduction in the money supply will shift AD to the left. Recall that a leftward shift in AD will cause falling output and a falling price level. The falling price level means a falling rate of inflation, while falling output means falling employment (which, in turn, means rising unemployment).Recall that a leftward shift in AD will cause falling output and a falling price level. The falling price level means a falling rate of inflation, while falling output means falling employment (which, in turn, means rising unemployment). To reduce inflation, the Fed will run a contractionary monetary policy.To reduce inflation, the Fed will run a contractionary monetary policy. The reduction in the money supply will shift AD to the left.The reduction in the money supply will shift AD to the left. Recall that a leftward shift in AD will cause falling output and a falling price level. The falling price level means a falling rate of inflation, while falling output means falling employment (which, in turn, means rising unemployment).Recall that a leftward shift in AD will cause falling output and a falling price level. The falling price level means a falling rate of inflation, while falling output means falling employment (which, in turn, means rising unemployment).

69 COSTS OF REDUCING INFLATION IN THE S/RUN - 3 The contractionary monetary policy has the effect of moving the economy from point ‘A’ to point ‘B’ in the figure. You should think of SR- PC1 as the ‘short-run Phillips Curve with HIGH inflationary expectations’.The contractionary monetary policy has the effect of moving the economy from point ‘A’ to point ‘B’ in the figure. You should think of SR- PC1 as the ‘short-run Phillips Curve with HIGH inflationary expectations’. At point ‘B’ inflation is lower and, in the long- run, inflationary expectations will adjust downwards to match the lower ACTUAL inflation. When this occurs, the short-run Phillips Curve will shift INWARD to SR-PC0 (think of SR-PC0 as the ‘short-run Phillips Curve with low inflationary expectations’.At point ‘B’ inflation is lower and, in the long- run, inflationary expectations will adjust downwards to match the lower ACTUAL inflation. When this occurs, the short-run Phillips Curve will shift INWARD to SR-PC0 (think of SR-PC0 as the ‘short-run Phillips Curve with low inflationary expectations’. The contractionary monetary policy has the effect of moving the economy from point ‘A’ to point ‘B’ in the figure. You should think of SR- PC1 as the ‘short-run Phillips Curve with HIGH inflationary expectations’.The contractionary monetary policy has the effect of moving the economy from point ‘A’ to point ‘B’ in the figure. You should think of SR- PC1 as the ‘short-run Phillips Curve with HIGH inflationary expectations’. At point ‘B’ inflation is lower and, in the long- run, inflationary expectations will adjust downwards to match the lower ACTUAL inflation. When this occurs, the short-run Phillips Curve will shift INWARD to SR-PC0 (think of SR-PC0 as the ‘short-run Phillips Curve with low inflationary expectations’.At point ‘B’ inflation is lower and, in the long- run, inflationary expectations will adjust downwards to match the lower ACTUAL inflation. When this occurs, the short-run Phillips Curve will shift INWARD to SR-PC0 (think of SR-PC0 as the ‘short-run Phillips Curve with low inflationary expectations’.

70 COSTS OF REDUCING INFLATION IN THE S/RUN - 4 Q: In this example, what WAS the short-run cost of reducing inflation? A:Temporarily higher unemployment. However, as stated before, there is NO long-run cost to reducing inflation, because the economy returned to the natural rate of unemployment as inflationary expectations adjusted. Q: In this example, what WAS the short-run cost of reducing inflation? A:Temporarily higher unemployment. However, as stated before, there is NO long-run cost to reducing inflation, because the economy returned to the natural rate of unemployment as inflationary expectations adjusted.

71 COSTS OF REDUCING INFLATION IN THE S/RUN - 5 Q: How big is the cost of reducing inflation in reality? A: There are two schools of thought: –The Sacrifice Ratio. –Rational Expectations. Q: How big is the cost of reducing inflation in reality? A: There are two schools of thought: –The Sacrifice Ratio. –Rational Expectations.

72 THE SACRIFICE RATIO The Sacrifice Ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. A typical sacrifice ratio is 5, meaning that reducing inflation by 1% will reduce the output of the economy by 5%.The Sacrifice Ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. A typical sacrifice ratio is 5, meaning that reducing inflation by 1% will reduce the output of the economy by 5%. When Paul Volcker was the Chairman of the Federal Reserve, he wanted to reduce inflation from about 10% to about 4%, meaning that the output of the economy might drop by as much as 30% (that's as large as the drop during the Great Depression from ). This school of thought indicates that the short-run cost of reducing inflation is rather large.When Paul Volcker was the Chairman of the Federal Reserve, he wanted to reduce inflation from about 10% to about 4%, meaning that the output of the economy might drop by as much as 30% (that's as large as the drop during the Great Depression from ). This school of thought indicates that the short-run cost of reducing inflation is rather large. The Sacrifice Ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. A typical sacrifice ratio is 5, meaning that reducing inflation by 1% will reduce the output of the economy by 5%.The Sacrifice Ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. A typical sacrifice ratio is 5, meaning that reducing inflation by 1% will reduce the output of the economy by 5%. When Paul Volcker was the Chairman of the Federal Reserve, he wanted to reduce inflation from about 10% to about 4%, meaning that the output of the economy might drop by as much as 30% (that's as large as the drop during the Great Depression from ). This school of thought indicates that the short-run cost of reducing inflation is rather large.When Paul Volcker was the Chairman of the Federal Reserve, he wanted to reduce inflation from about 10% to about 4%, meaning that the output of the economy might drop by as much as 30% (that's as large as the drop during the Great Depression from ). This school of thought indicates that the short-run cost of reducing inflation is rather large.

73 RATIONAL EXPECTATIONS - 1 Rational Expectations is a theory according to which people optimally use all the information they have when forecasting the future.Rational Expectations is a theory according to which people optimally use all the information they have when forecasting the future. Drawing on the analysis of Friedman and Phelps, rational expectations (which is attributed to Lucas, Sargent and Barro) claims that the short-run cost of reducing inflation will be related to the speed with which inflationary expectations adjust. Rational expectations implies that the sacrifice ratio could be much lower than 5 if the commitment to lower inflation by the Fed is seen as ‘CREDIBLE’. In other words, if people in the economy immediately believe that the Fed WILL reduce inflation, inflationary expectations could adjust downwards immediately, and the sacrifice ratio could be 0.Drawing on the analysis of Friedman and Phelps, rational expectations (which is attributed to Lucas, Sargent and Barro) claims that the short-run cost of reducing inflation will be related to the speed with which inflationary expectations adjust. Rational expectations implies that the sacrifice ratio could be much lower than 5 if the commitment to lower inflation by the Fed is seen as ‘CREDIBLE’. In other words, if people in the economy immediately believe that the Fed WILL reduce inflation, inflationary expectations could adjust downwards immediately, and the sacrifice ratio could be 0. Rational Expectations is a theory according to which people optimally use all the information they have when forecasting the future.Rational Expectations is a theory according to which people optimally use all the information they have when forecasting the future. Drawing on the analysis of Friedman and Phelps, rational expectations (which is attributed to Lucas, Sargent and Barro) claims that the short-run cost of reducing inflation will be related to the speed with which inflationary expectations adjust. Rational expectations implies that the sacrifice ratio could be much lower than 5 if the commitment to lower inflation by the Fed is seen as ‘CREDIBLE’. In other words, if people in the economy immediately believe that the Fed WILL reduce inflation, inflationary expectations could adjust downwards immediately, and the sacrifice ratio could be 0.Drawing on the analysis of Friedman and Phelps, rational expectations (which is attributed to Lucas, Sargent and Barro) claims that the short-run cost of reducing inflation will be related to the speed with which inflationary expectations adjust. Rational expectations implies that the sacrifice ratio could be much lower than 5 if the commitment to lower inflation by the Fed is seen as ‘CREDIBLE’. In other words, if people in the economy immediately believe that the Fed WILL reduce inflation, inflationary expectations could adjust downwards immediately, and the sacrifice ratio could be 0.

74 RATIONAL EXPECTATIONS - 2 When Paul Volcker implemented his disinflation policies in the early 1980s, there was neither a 30% drop in economic output, nor a 0% drop in economic output.When Paul Volcker implemented his disinflation policies in the early 1980s, there was neither a 30% drop in economic output, nor a 0% drop in economic output. The fact that the drop was greater than 0% caused many economists to refute the conclusions of rational expectations, while the much less than 30% drop in output caused proponents of rational expectations to claim success (stating that people reacted to the Fed’s policy, but NOT immediately).The fact that the drop was greater than 0% caused many economists to refute the conclusions of rational expectations, while the much less than 30% drop in output caused proponents of rational expectations to claim success (stating that people reacted to the Fed’s policy, but NOT immediately). When Paul Volcker implemented his disinflation policies in the early 1980s, there was neither a 30% drop in economic output, nor a 0% drop in economic output.When Paul Volcker implemented his disinflation policies in the early 1980s, there was neither a 30% drop in economic output, nor a 0% drop in economic output. The fact that the drop was greater than 0% caused many economists to refute the conclusions of rational expectations, while the much less than 30% drop in output caused proponents of rational expectations to claim success (stating that people reacted to the Fed’s policy, but NOT immediately).The fact that the drop was greater than 0% caused many economists to refute the conclusions of rational expectations, while the much less than 30% drop in output caused proponents of rational expectations to claim success (stating that people reacted to the Fed’s policy, but NOT immediately).

75 CONSIDERING ONGOING INFLATION Wages and prices can change for two reasons:Wages and prices can change for two reasons: –Wages and prices will tend to rise during booms and fall during recessions –Workers and firms will raise their nominal wages and prices to the extent they expect ongoing inflation to maintain the same level of real wages and real prices Wages and prices can change for two reasons:Wages and prices can change for two reasons: –Wages and prices will tend to rise during booms and fall during recessions –Workers and firms will raise their nominal wages and prices to the extent they expect ongoing inflation to maintain the same level of real wages and real prices

76 ECONOMY OPERATING AT FULL EMPLOYMENT Wages and prices will rise at the rate of inflation expected by workers and firmsWages and prices will rise at the rate of inflation expected by workers and firms If unemployment exceeds the natural rate, the high level of unemployment will put downward pressure on wages and prices, and inflation will fall relative to what is expectedIf unemployment exceeds the natural rate, the high level of unemployment will put downward pressure on wages and prices, and inflation will fall relative to what is expected If unemployment were below the natural rate, employers would bid aggressively for workers, and wages and prices would rise faster than previously expectedIf unemployment were below the natural rate, employers would bid aggressively for workers, and wages and prices would rise faster than previously expected Wages and prices will rise at the rate of inflation expected by workers and firmsWages and prices will rise at the rate of inflation expected by workers and firms If unemployment exceeds the natural rate, the high level of unemployment will put downward pressure on wages and prices, and inflation will fall relative to what is expectedIf unemployment exceeds the natural rate, the high level of unemployment will put downward pressure on wages and prices, and inflation will fall relative to what is expected If unemployment were below the natural rate, employers would bid aggressively for workers, and wages and prices would rise faster than previously expectedIf unemployment were below the natural rate, employers would bid aggressively for workers, and wages and prices would rise faster than previously expected

77 EAS 0 AD 0 Output, y yFyF Price, p CHOICES FOR THE FED

78 E AS 1 AS 0 AD 1 AD 0 Output, y yFyF Price, p CHOICES FOR THE FED If workers push up their normal wages, the aggregate supply curve will shift from AS 0 to AS 1.

79 A E AS 1 AS 0 AD 0 Output, y yFyF Price, p CHOICES FOR THE FED If workers push up their normal wages, the aggregate supply curve will shift from AS 0 to AS 1. If the Fed keeps aggregate demand constant at AD 0, a recession will occur at A and eventually the economy will return to full employment at E.

80 AF E AS 1 AS 0 AD 1 AD 0 Output, y yFyF Price, p CHOICES FOR THE FED If workers push up their normal wages, the aggregate supply curve will shift from AS 0 to AS 1. If the Fed keeps aggregate demand constant at AD 0, a recession will occur at A and eventually the economy will return to full employment at E. If the Fed increases aggregate demand, the economy remains at full employment at F, but with a higher price level.

81 EXPECTATIONS OF THE UNION The actions of a union will depend on what its leaders expect the Fed to do:The actions of a union will depend on what its leaders expect the Fed to do: –If they expect the Fed will not increase aggregate demand, their actions will trigger a recession –The union may be reluctant to negotiate a high wage, permitting the economy to remain at full employment and experience no increase in prices –If the leaders believe the Fed will increase aggregate demand, the union will increase the nominal wage –The result will be higher prices in the economy The actions of a union will depend on what its leaders expect the Fed to do:The actions of a union will depend on what its leaders expect the Fed to do: –If they expect the Fed will not increase aggregate demand, their actions will trigger a recession –The union may be reluctant to negotiate a high wage, permitting the economy to remain at full employment and experience no increase in prices –If the leaders believe the Fed will increase aggregate demand, the union will increase the nominal wage –The result will be higher prices in the economy

82 EXPECTATIONS ABOUT THE FED Expectations about the Fed’s determination to fight inflation will affect the behavior in the private sectorExpectations about the Fed’s determination to fight inflation will affect the behavior in the private sector If the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from taking aggressive actions that drive up pricesIf the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from taking aggressive actions that drive up prices Some political scientists and economists have suggested that central banks which have true independence from the rest of government, and are less subject to political influence, will be more credible in their commitment to fight inflationSome political scientists and economists have suggested that central banks which have true independence from the rest of government, and are less subject to political influence, will be more credible in their commitment to fight inflation Expectations about the Fed’s determination to fight inflation will affect the behavior in the private sectorExpectations about the Fed’s determination to fight inflation will affect the behavior in the private sector If the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from taking aggressive actions that drive up pricesIf the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from taking aggressive actions that drive up prices Some political scientists and economists have suggested that central banks which have true independence from the rest of government, and are less subject to political influence, will be more credible in their commitment to fight inflationSome political scientists and economists have suggested that central banks which have true independence from the rest of government, and are less subject to political influence, will be more credible in their commitment to fight inflation


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