1. The Dynamicsof Inflation andUnemployment F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

2. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 20 1 Do regional differences in unemployment affect the natural rate of unemployment? Regional Differences in Unemployment Increase the Natural Rate 2 Can changes in the way central banks are governed affect inflation expectations? Increased Political Independence for the Bank of England Lowered Inflation Expectations 3 Are there bonds that can protect your investments from inflation? Inflation-Indexed Bonds in the United States

3. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 20 nominal wages Wages expressed in current dollars. real wages Nominal or dollar wages adjusted for changes in purchasing power. MONEY GROWTH, INFLATION, AND INTEREST RATES 16.1 Inflation in a Steady State money illusion Confusion of real and nominal magnitudes. expectations of inflation The beliefs held by the public about the likely path of inflation in the future.

4. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 20 MONEY GROWTH, INFLATION, AND INTEREST RATES 16.1 Inflation in a Steady State INFLATION EXPECTATIONS AND INTEREST RATES INFLATION EXPECTATIONS AND MONEY DEMAND How Changes in the Growth Rate of Money Affect the Steady State

5. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 20 expectations Phillips curve The relationship between unemployment and inflation when taking into account expectations of inflation. UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 16.2

6. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 20 rational expectations The economic theory that analyzes how the public forms expectations in such a manner that, on average, they forecast the future correctly. UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 16.2 Are the Public’s Expectations About Inflation Rational? U.S. Inflation and Unemployment in the 1980s ► FIGURE 16.1 The Dynamics of Inflation and Unemployment, 1986–1993

7. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 20 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 16.2 Shifts in the Natural Rate of Unemployment in the 1990s What factors can shift the natural rate of unemployment? Demographics Institutional changes The state of the economy Changes in growth of labor productivity

8. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 20 REGIONAL DIFFERENCES IN UNEMPLOYMENT INCREASE THE NATURAL RATE APPLYING THE CONCEPTS #1: Do regional differences in unemployment affect the natural rate of unemployment? Some regions of a country may experience difficulties while others prosper. Does this matter when it comes to understanding the behavior of inflation and unemployment? When unemployment is low, firms compete for workers and bid up wages sharply. When unemployment is high, it is more difficult for firms to cut wages because workers tend to resist wage cuts. Result: Even if the total unemployment rate in the country appears to be at the natural rate of unemployment, there could still be upwards inflation pressure if wages increase faster in the low-unemployment regions than they fall in the high-unemployment regions. Economists studied how regional differences in unemployment have varied over time. Variations were relatively high during the 1980s but fell sharply in the 1990s. The U.S. labor market operated more like a national than a regional market in the 1990s. The natural rate of unemployment fell in the 1990s. Economists estimated that the effect was large and that the natural rate fell by about 2%.

9. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 20 THE MINIMUM WAGE: IT’S ALL LOCAL There will soon be 12 states with minimum wage laws that already exceed $7.00 per hour. Local governments have also gotten involved with 140 passing some form of minimum wage laws. While these laws are promoted by “living wage” advocates, they are also opposed by the National Restaurant Association. The new Democrat-controlled Congress plans to push through an increase in minimum wage as one of its first agenda items. The current federal level of $5.15 per hour is the lowest inflation-adjusted minimum wage in 50 years. Congress’s current plan is to increase that amount to $7.25 per hour. Increasing the federal minimum wage may have little or no impact in many areas where the market has already settled at equilibrium points above the expected new minimum wage. In other areas, local minimum wage laws already mandate wages higher than the proposed new federal minimum wage. Extra Application 4

10. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 20 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION 16.3 ► FIGURE 16.2 Choices of the Fed: Recession or Inflation

11. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 20 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION 16.3 ► FIGURE 16.3 How Central Bank Independence Affects Inflation

12. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 20 INCREASED POLITICAL INDEPENDENCE FOR THE BANK OF ENGLAND LOWERED INFLATION EXPECTATIONS APPLYING THE CONCEPTS #2: Can changes in the way central banks are governed affect inflation expectations? A major change in monetary policy allowed the Bank of England to be free to pursue its policy goals without direct political control. An economist studied how the British bond market reacted to the policy change by comparing the interest rates changes on two types of long-term bonds: bonds that are automatically adjusted (or indexed) for inflation and bonds that are not. The difference between the two interest rates primarily reflects expectations of inflation. If the gap narrowed following the policy announcement, this would be evidence that the new policy reduced expectations of inflation. If it did not, the announced policy would have had no effect on inflation expectations. Result: After the announcement, the gap narrowed. Conclusion: The announcement did cause expectations about inflation to fall by about half a percentage point.

13. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 20 INFLATION AND THE VELOCITY OF MONEY 16.4 velocity of money The rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

14. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 20 INFLATION-INDEXED BONDS IN THE UNITED STATES APPLYING THE CONCEPTS #3: Are there bonds that can protect your investments from inflation? In 1997, the U.S. Department of the Treasury created a new financial instrument called the Treasury Inflation-Protected Security, or TIPS. TIPS make interest payments every six months and a payment of the original principal when the bond matures. Payments are automatically adjusted for changes in inflation. Because TIPS compensate for actual inflation, the interest rate on these bonds differs from conventional bonds by the expected inflation rate. By comparing the interest rates on TIPS to other government bonds of similar maturity, economists can estimate the public’s expectations of inflation.

15. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 20 INFLATION AND THE VELOCITY OF MONEY 16.4 or quantity equation The equation that links money, velocity, prices, and real output. In symbols, we have M × V = P × y.

16. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 20 INFLATION AND THE VELOCITY OF MONEY 16.4  FIGURE 16.4 The Velocity of M2, 1959–2005

17. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 20 INFLATION AND THE VELOCITY OF MONEY 16.4 growth rate of money + growth rate of velocity = growth rate of prices + growth rate of real output growth version of the quantity equation An equation that links the growth rates of money, velocity, prices, and real output.

18. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 20 HYPERINFLATION 16.5 hyperinflation An inflation rate exceeding 50 percent per month.

19. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 20 HYPERINFLATION 16.5 seignorage Revenue raised from money creation. How Budget Deficits Lead to Hyperinflation government deficit = new borrowing from the public + new money created monetarists Economists who emphasize the role that the supply of money plays in determining nominal income and inflation.

20. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 20 expectations of inflation expectations Phillips curve growth version of the quantity equation hyperinflation monetarists money illusion nominal wages quantity equation rational expectations real wages seignorage velocity of money