The Dynamics of Inflation and Unemployment Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. In a restaurant, we use tips to evaluate and reward the performance of the servers. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU

A P P L Y I N G T H E C O N C E P T S Do regional differences in unemployment affect the natural rate of unemployment? Regional Differences in Unemployment Increase the Natural Rate Can changes in the way central banks are governed affect inflation expectations? Increased Political Independence for the Bank of England Lowered Inflation Expectations What caused a severe hyperinflation to emerge recently in Zimbabwe? Hyperinflation in Zimbabwe 1 2 3

MONEY GROWTH, INFLATION, AND INTEREST RATES 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES Inflation in a Steady State ● nominal wages Wages expressed in current dollars. ● real wages Wage rates paid to employees adjusted for changes in the price level. ● 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.

MONEY GROWTH, INFLATION, AND INTEREST RATES 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES Inflation in a Steady State INFLATION EXPECTATIONS AND INTEREST RATES When the public expects inflation, real and nominal rates of interest will differ because we need to account for inflation in calculating the real return from lending and borrowing. INFLATION EXPECTATIONS AND MONEY DEMAND

MONEY GROWTH, INFLATION, AND INTEREST RATES 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES How Changes in the Growth Rate of Money Affect the Steady State

16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION ● expectations Phillips curve The relationship between unemployment and inflation when taking into account expectations of inflation.

16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION Are the Public’s Expectations About Inflation Rational? ● rational expectations The economic theory that analyzes how the public forms expectations in such a manner that, on average, they forecast the future correctly.

16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION U.S. Inflation and Unemployment in the 1980s FIGURE 16.1 The Dynamics of Inflation and Unemployment, 1986–1993 Inflation rose and the unemployment rate fell below the natural rate. Inflation later fell as unemployment exceeded the natural rate.

16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION Shifts in the Natural Rate of Unemployment in the 1990s What factors can shift the natural rate of unemployment? Demographics Institutional changes The recent history of the economy Changes in growth of labor productivity

A P P L I C A T I O N 1 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 truly national than a regional market in the 1990s. The natural rate of unemployment fell in the 1990s. Economists estimated the effect was large and that the natural rate fell by about 2%.

HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION FIGURE 16.2 Choices of the Fed: Recession or Inflation If workers push up their nominal wages, the aggregate supply curve will shift from AS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will occur at point a, and the economy will eventually return to full employment at point c. If the Fed increases aggregate demand, the economy remains at full employment at b, but with a higher price level.

HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION FIGURE 16.3 How Central Bank Independence Affects Inflation Countries in which central banks are more independent from the rest of the government have, on average, lower inflation rates.

A P P L I C A T I O N 2 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.

INFLATION AND THE VELOCITY OF MONEY 16.4 INFLATION AND THE VELOCITY OF MONEY ● velocity of money The rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

INFLATION AND THE VELOCITY OF MONEY 16.4 INFLATION AND THE VELOCITY OF MONEY or ● quantity equation The equation that links money, velocity, prices, and real output. In symbols, we have M × V = P × y.

INFLATION AND THE VELOCITY OF MONEY 16.4 INFLATION AND THE VELOCITY OF MONEY  FIGURE 16.4 The Velocity of M2, 1959–2007

INFLATION AND THE VELOCITY OF MONEY 16.4 INFLATION AND THE VELOCITY OF MONEY 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.

16.5 HYPERINFLATION ● hyperinflation An inflation rate exceeding 50 percent per month.

16.5 HYPERINFLATION How Budget Deficits Lead to Hyperinflation ● seignorage Revenue raised from money creation. 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.

A P P L I C A T I O N 3 HYPERINFLATION IN ZIMBABWE APPLYING THE CONCEPTS #3: What caused a severe hyperinflation to emerge recently in Zimbabwe? In June 2008, the consumer price index in Zimbabwe was 8 million percent higher than it was a year before. What caused Zimbabwe to suffer from this crippling hyperinflation? The simple answer is that the political and economic system began to self-destruct. Zimbabwe has been ruled since 1980 by the dictator Robert Mugabe, whose policies to intervene militarily in African conflicts and expropriate white-owned farms had the cumulative effect of crippling the economy. As the economy deteriorated, tax revenues declined. Mugabe and his central bank simply resorted to printing new banknotes. Result: Hyperinflation and further deterioration of the economy as the financial system collapsed.

K E Y T E R M S 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