1. Ch. 12: U.S. Inflation, Unemployment and Business Cycles
Demand-pull and cost-push inflation.
SR and LR tradeoff between inflation and unemployment (Phillips Curve)
Business cycle theories.

2. The Misery Index MI proposed by Arthur Okun in 1970s
MI = inflation rate plus the unemployment rate.
MI peak: 22 in 1981
MI minimum: 3 in 1953
MI in 2009: 10.0% unempl % inflation = 9.6%
We want both low inflation & low unemployment – are there trade-offs between the two?

4. Inflation and Unemployment in U.S. 1950-2009

5. Real GDP and the Price Level: 1948-2008

6. The Evolving U.S. Economy
Inflation The upward movement of the dots shows inflation. Recession Leftward movement of dots shows declining real GDP Economic Growth The rightward movement of the dots shows the growth of real GDP.

7. Inflation Cycles In the long run, according to equation of exchange:
inflation = %ch in M + % ch in V - %ch in y
inflation occurs if money grows faster than potential GDP.
In the short run,
Inflation can be initiated by
Increases in AD (demand pull inflation)
Decreases in SAS (cost push inflation)

8. Inflation Cycles Demand-Pull Inflation
starts because AD increases
can begin with any factor that increases AD.
Examples
Monetary policy & interest rates
Fiscal policy: government spending or taxes
Exports (value of $ or foreign income levels)
Investment (expected profits, technological advances)
Consumer expectations

9. Inflation Cycles: Demand Pull
Starting from full employment, an increase in AD
Increases P (spell of inflation)
Increases RGDP
Creates inflationary gap

10. Inflation Cycles: Demand Pull
Since
unempl < natural rate
money wage rate rises
SAS shifts left
P rises (another spell of inflation)
RGDP falls until GDP=potential GDP
Inflation is finished unless AD increases again.

11. Inflation Cycles: Demand Pull
Demand-Pull Inflation Process
AD must continually increase so that the process described above repeats itself
Although any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

12. Inflation Cycles: Cost Push
Cost-Push Inflation
starts with an increase in costs
Possible sources of increased costs:
An increase in the money wage rate
An increase in the money price of raw materials (e.g. oil)
Natural disasters
Regulation (e.g. carbon taxes)
Results in decrease in SAS

13. Inflation Cycles: Cost Push
Initial Effect of a Decrease in AS
A rise in the price of oil decreases SAS and shifts the curve leftward.
Real GDP decreases and the price level rises.
“stagflation” (higher prices, less output)

14. Inflation Cycles: Cost Push
Aggregate Demand Response
The initial increase in costs creates a one-time rise in the price level, not continued inflation.
To create inflation, AD must increase after AS decreases.
Although any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

15. Inflation Cycles & Inflation Expectations
Expected Inflation
If inflation is expected,
AD increases
AS decreases as workers negotiate wage increases to offset expected inflation.
Movement along LAS curve
No change in real GDP, real wages, or unemployment

16. Inflation Cycles & Inflation Expectations
When the inflation forecast is correct, the economy operates at full employment.
If AD grows faster than expected,
Inflation > expected
Real wages decrease
Real GDP increases above potential
Unemployment rate falls below natural rate
If AD grows slower than expected
Inflation < expected
Real wages rise
Unemployment rate rises above natural rate

17. AD/AS representation of impact of inflation > expected inflation

18. AD/AS representation of impact of inflation < expected inflation

19. The Phillips Curve Phillips curve SR Phillips curve LR Phillips curve
shows the relationship between the inflation rate and the unemployment rate.
SR Phillips curve
Shows tradeoff between inflation and unemployment holding constant
The expected inflation rate
The natural unemployment rate
LR Phillips curve
shows the relationship between inflation and unemployment when the actual inflation rate equals expected inflation
vertical at natural rate of unemployment

20. The Phillips Curve A short-run Phillips curve (SRPC)
As inflation increases, unemployment decreases
AD/AS explanation.
If inflation=expected, unempl= natural rate.
If inflation>expected, unempl<natural rate
If inflation < expected, unempl>natural rate

21. The Phillips Curve The long-run Phillips curve (LRPC)
vertical at the natural unemployment rate.
intersects SRPC at expected inflation rate.
Shifts only if natural unemployment rates rises or falls
Unemployment insurance
Demographics of labor force

22. The Phillips Curve
SRPC shifts up/down as inflation expectations rise/fall

23. The Phillips Curve in U.S.

25. Business Cycles Two approaches to understanding business cycles are:
Mainstream business cycle theory
Real business cycle theory
Mainstream (Demand Side) Business Cycle Theory
Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.

26. Business Cycles Real Business Cycle Theory
Argues that random fluctuations in productivity are the main source of economic fluctuations.
fluctuations in the pace of technological change.
international disturbances, climate fluctuations, or natural disasters.
rapid productivity growth generates expansion; slow productivity growth (or decreases in productivity) cause contraction.
productivity growth affects
Investment and interest rates
Labor market and wages

27. Real Business Cycles: Investment
negative productivity shock:
investment demand and loan demand falls
Interest rates fall
reverse happens for positive productivity shock

28. Real Business Cycles: Labor
Negative productivity shock
Labor demand decreases
Labor supply decreases because of lower interest rates (above) and intertemporal subst
Employment and the real wage rate decrease (assuming LD shift larger than LS).
Reverse happens when there is an expansion caused by rapid productivity increase.