Inflation and Unemployment No 11. Chapter 12 Inflation and Unemployment

Introduction Thus far we have only tangentially discussed inflation and unemployment, despite the political attention received by these two variables This chapter examines the implications of our theory for these two variables, as well as their importance for society

Steady Inflation Revisited First recall our money neutrality proposition: In the long run, an increase in M leads to a proportionate rise in P, with real variables in our model left unchanged. We would expect that steady growth of M would result in steady growth of P, other things held equal. If P rises steadily, this is inflation. I often like to distinguish a one-time increase in P from steady increases in P For conceptual purposes, I think of inflation as a sustained increase in P, not a one-time increase

More on Steady Inflation Recall the equation for the LM Curve in our model: In the classical model (or the Keynesian long-run) both output and the interest rate are will not be affected by changes in the money supply (money neutrality again), and if inflation is steady, expected inflation will also be constant In a steady inflation, M and P are going up in proportion, and all variables on the right-hand side of the LM equation are constant.

A Change in the Steady Inflation Rate If money grows at 3% per year in our model, the inflation rate will be 3% per year; if money grows at 7% per year, the inflation rate will be 7% per year. Note: This does assume that output is not changing. However, if we have been having steady money growth of 3% and then change to steady money growth of 7%, once we reach a new steady state with 7% inflation, the real money supply must be smaller (since expected inflation is larger on the RHS below):

A One-Time Jump in P When the expected inflation rate rises (as it eventually must when the steady inflation rate changes), the LM curve shifts to the right, putting upward pressure on price. This effect is above and beyond the direct proportional effect of M on P. Illustrate with a diagram! As the economy moves to the new steady inflation path, measured inflation must temporarily exceed the new higher steady rate. This extra price rise is what produces the lower real money supply in the higher inflation steady state.

A Change in Steady Inflation Log P t* Time

Steady Inflation: IS-LM and AD-AS With steady money growth and steady inflation, IS and LM are not moving LM is subject to offsetting effects of money and price movements. AD steadily shifts up and to the right, so that P rises. So long as the inflation is expected, we are heading straight up the vertical LRAS curve.

AD-AS with Steady Inflation P LRAS P3 P2 AD3 P1 AD2 AD1 Y

Can We Have Inflation in a Keynesian Model? We have interpreted the Keynesian model as a fixed price model. In the short-run price is “stuck” so there is no price movement. However, Keynesian economists know that prices eventually change The model can be modified to even permit ongoing inflation Prices might be set at the beginning of a period, and then remain stuck until the next period starts However, prices could steadily rise from period to period, even though they are inflexible for long times within periods.

The Keynesian Model with Steady Inflation P LRAS P3 SRAS3 P2 SRAS2 AD3 P1 SRAS1 AD2 AD1 Y

The Classical Model with Monetary Misperceptions Recall the “misperceptions” extension of the classical model. In this model, SRAS curves are upward sloping, not horizontal. Some variants of Keynesian models might also have SRAS curves that slope upward, so the following analysis does not really require that we adopt all of the classical model assumptions

Lucas Misperceptions Model with Steady Inflation LRAS SRAS3 [Pe=P3] SRAS2 [Pe=P2] P3 SRAS1 [Pe=P1] P2 AD3 P1 AD2 AD1 Y

The Classical Model with Monetary Misperceptions In the misperceptions model: If aggregate demand rises faster than expected, inflation is higher than was expected, and we move up the SRAS curve If aggregate demand rises more slowly than expected, then inflation is lower than expected, and we move down the SRAS.

Expected Money Growth

Unexpected Money Growth

Output and Unemployment in the Misperceptions Model When price rises faster than expected, some workers misinterpret this as a relative price increase rather than a general price increase If a baker thinks the relative price of bread has risen, he will work harder; he also finds it worthwhile to hire more workers (perhaps offering a higher nominal wage) Job seekers begin to find acceptable wage offers more quickly and take jobs faster and the number unemployed falls. Workers initially see these job offers as attractive, because they have not yet perceived the higher price level (they incorrectly perceive the “real wage offer)

Inflation and Unemployment The preceding story suggests that as long as inflation is expected, unemployment will be at its normal rate (consistent with normal searching and turnover in the job market). But when the general price level rises faster than expected, the higher inflation is accompanied by lower unemployment. Unemployment and inflation are inversely related as aggregate demand fluctuates (holding expected inflation fixed).

An Expectational Phillips Curve: Equation Form

Phillips Curve Facts

A Menu of Possible Choices? Can we exploit this curve? Can we obtain lower unemployment if we are just willing to tolerate higher inflation? Our earlier discussion of inflation and output suggests not—output gains associated with inflation, and the employment fluctuations associated with output, only occurred when expectations were incorrect Expectations eventually change, so one can not permanently lower unemployment by going from low steady inflation to high steady inflation

Long and Short-Run Phillips Curves

Short-run Phillips Curves

Long-run Phillips Curve

More Data

Can the Natural Rate of Unemployment Change? Yes. Classical economists might note that technical change is often accompanied by job mismatches, hence changes in the natural or equilibrium level of unemployment Keynesians would rely on the efficiency wage argument A negative productivity shock can reduce labor demand--at a fixed efficiency wage, the pool of unemployed would grow and would stay higher persistently Also, changes in labor supply behavior could change the natural rate of unemployment.

Nobel Prizes Both Milton Friedman and Edmund Phelps won Nobel Prizes for work on the “expectational” Phillips curve model (and other things) The model explains why an apparent statistical relation between unemployment and inflation cannot be exploited by policymakers. If a policymaker tries to lower unemployment by way of a higher inflation rate, the attempt might be initially successful, but ultimately inflation stays higher while unemployment returns to its natural rate. Keeping unemployment low would require that inflation always be higher than expected, implying accelerating inflation (hence the term NAIRU: the non-accelerating inflation rate of unemployment)

Another Nobel Frequently policymakers assume that historical behavioral regularities observed in the past will prevail in the future (i.e. the Phillips Curve). However, changing policy rules will often change behavior. We cannot assume that empirical relationships observed under one set of policy behavior will persist under a different policy regime. This simple point, known as the Lucas Critique, was, in part, responsible for the Nobel awarded to Robert Lucas. One of its implications is that we should be wary of embedding ad hoc empirical regularities into a theory. Theory should be derived from basic assumptions about rational behavior.

Policy: What are the Costs of Unemployment? Unemployment is apparently costly People who are not working could have produced output, which has value, but that is lost. On the other hand, when I don’t work, I have more leisure, so it is not correct to infer that the loss to society is equal to the value of the forgone output. Classical economists believe that much search is voluntary, hence optimal Keynesians see a much larger cost of unemployment. In the efficiency wage model, there is true involuntary unemployment

Policy: What are the Costs of Inflation? In a world with money neutrality there are no real effects of inflation Even in the Keynesian model, money neutrality prevails in the long run. Sometimes individuals seem to believe that inflation robs them of real purchasing power. In fact, a steady inflation raises wages and prices in proportion and inflation does not reduce society’s overall real standard of living. So this is not a cost of inflation.

More on the Costs of Inflation A steady inflation does produce what are sometimes caused “shoe-leather” costs Unanticipated inflation is redistributive, and inflation volatility increases risk for borrowers and lenders In the presence of high inflation, relative prices are more difficult to observe, leading to a less effective functioning of prices in their role of allocating goods and services Inflation-Tax interactions

A Final Question So why do we sometimes see economic policy produce high inflation rates?

The End