© 2003 McGraw-Hill Ryerson Limited. Inflation and Its Relationship to Unemployment and Growth Chapter 15

© 2003 McGraw-Hill Ryerson Limited. Some Basics about Inflation u Inflation is a continuous rise in the price level. u It is measured using a price index.

© 2003 McGraw-Hill Ryerson Limited. The Distributional Effects of Inflation u There are winners and losers in an inflation.

© 2003 McGraw-Hill Ryerson Limited. The Distributional Effects of Inflation u The winners are those who can raise their prices or wages and still keep their jobs or sell their goods. u The losers in an inflation are those who cannot raise their wages or prices.

© 2003 McGraw-Hill Ryerson Limited. The Distributional Effects of Inflation u Because they often enter into fixed nominal contracts, lenders and borrowers are affected by inflation. u Unexpected inflation redistributes income from lenders to borrowers.

© 2003 McGraw-Hill Ryerson Limited. The Distributional Effects of Inflation u The composition of the winners and losers from an inflation changes over time.

© 2003 McGraw-Hill Ryerson Limited. The Distributional Effects of Inflation u People who do not expect inflation and who are tied to fixed nominal contracts are likely lose in an inflation.

© 2003 McGraw-Hill Ryerson Limited. The Distributional Effects of Inflation u If they are rational, these people will not allow it to happen again. u They will be prepared for a subsequent inflation.

© 2003 McGraw-Hill Ryerson Limited. Expectations of Inflation u Rational expectations economists argue that if expectations are rational, they will always be based on the economic model. u Rational expectations are the expectations that the economists' model predicts.

© 2003 McGraw-Hill Ryerson Limited. Expectations of Inflation u Other economists argue that rational expectations cannot be defined in terms of economists' models. These economists focus on the process by which people develop expectations.

© 2003 McGraw-Hill Ryerson Limited. Expectations of Inflation u There are two ways people form expectations. u Adaptive expectations are those based, in some way, on what has been in the past. u Extrapolative expectations are those that assume a trend will continue.

© 2003 McGraw-Hill Ryerson Limited. Productivity, Inflation, and Wages u There are two key measures that policy makers focus on to determine whether inflation may be coming: l Changes in productivity. l Changes in wages.

© 2003 McGraw-Hill Ryerson Limited. Productivity, Inflation, and Wages u The basic rule of thumb: l Wages can increase at the same rate as productivity increases without generating inflationary pressures. Inflation = Nominal wage increases - Productivity growth

© 2003 McGraw-Hill Ryerson Limited. Theories of Inflation u The quantity theory and the institutional theory are two slightly different theories of inflation. l The quantity theory emphasizes the connection between money and inflation. l The institutional theory emphasizes market structure and price-setting institutions and inflation.

© 2003 McGraw-Hill Ryerson Limited. The Quantity Theory of Money and Inflation u The quantity theory of money is summarized by the sentence: Inflation is always and everywhere a monetary phenomenon.

© 2003 McGraw-Hill Ryerson Limited. The Equation of Exchange u The logic of the quantity theory of money goes back to the equation of exchange. u According to the equation of exchange, the quantity of money times velocity of money equals price level times the quantity of real goods sold.

© 2003 McGraw-Hill Ryerson Limited. The Equation of Exchange M = quantity of money V = velocity of money (is constant and determined by institutional forces) P = price level Q = real output (is relatively constant and determined by real, not monetary forces) PQ = the economy’s nominal output (nominal GDP— the quantity of goods valued at whatever price level exists at the time u The equation of exchange: MV = PQ

© 2003 McGraw-Hill Ryerson Limited. Velocity Is Constant u The first assumption of the quantity theory is that velocity is constant. u Its rate is determined by the economy’s institutional structure.

© 2003 McGraw-Hill Ryerson Limited. Velocity Is Constant u The velocity of money is the number of times per year on average, a dollar goes around to generate a dollar's worth of income.

© 2003 McGraw-Hill Ryerson Limited. Velocity Is Constant u If velocity is constant, the quantity theory can be used to predict how much nominal GDP will grow if we know how much the money supply grows.

© 2003 McGraw-Hill Ryerson Limited. Real Output Is Independent of the Money Supply u The second assumption of the quantity theory is that real output (Q) is independent of the money supply.

© 2003 McGraw-Hill Ryerson Limited. Real Output Is Independent of the Money Supply u Q is autonomous, meaning real output is determined by forces outside the quantity theory.

© 2003 McGraw-Hill Ryerson Limited. Real Output Is Independent of the Money Supply u If Q grows, it is because of incentives in the real economy. u These incentives are on the supply side, not the demand side.

© 2003 McGraw-Hill Ryerson Limited. Real Output Is Independent of the Money Supply u The conclusion of the quantity theory is  M   P. l With both V and Q unaffected by changes in M, the only thing that can change is P.

© 2003 McGraw-Hill Ryerson Limited. Real Output Is Independent of the Money Supply u The quantity theory of money says that the price level varies in response to changes in the quantity of money.

© 2003 McGraw-Hill Ryerson Limited. Real Output Is Independent of the Money Supply u The quantity theory holds that real output is not influenced by changes in the money supply.

© 2003 McGraw-Hill Ryerson Limited. Examples of Money's Role in Inflation u The quantity theory lost its appeal in the late 1970s and early 1990s. u The formerly stable relationships between measurements of money and inflation appeared to break down.

© 2003 McGraw-Hill Ryerson Limited. Examples of Money's Role in Inflation u In the 1990s it seemed that the random elements in the relationship between money and inflation overwhelmed the connection.

© 2003 McGraw-Hill Ryerson Limited. Examples of Money's Role in Inflation u The relationships between money and inflation broke down because of technological changes and changing regulations in financial institutions. u Another reason was the increasing global interdependence of financial markets.

© 2003 McGraw-Hill Ryerson Limited. Examples of Money's Role in Inflation u The empirical evidence that supports the quantity theory of money in developing countries is most convincing in Brazil and Chile.

© 2003 McGraw-Hill Ryerson Limited. Price Level and Money in Canada, , Fig. 15-1, p 365

© 2003 McGraw-Hill Ryerson Limited. Price Level and Money in Brazil and Chile, Fig. 15-2, p 366

© 2003 McGraw-Hill Ryerson Limited. The Inflation Tax u Developing countries such as Brazil and Chile sometimes increase the money supply to keep the economy running.

© 2003 McGraw-Hill Ryerson Limited. The Inflation Tax u When their governments run a budget deficit and try to finance it domestically, their central banks often must buy the bonds to finance that deficit. u In essence, the increase in money supply is caused by the government deficit.

© 2003 McGraw-Hill Ryerson Limited. The Inflation Tax u Financing the deficit by expansionary monetary policy causes inflation.

© 2003 McGraw-Hill Ryerson Limited. The Inflation Tax u The inflation works as a kind of tax on individuals, and is often called an inflation tax. u It is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms.

© 2003 McGraw-Hill Ryerson Limited. The Inflation Tax u Central banks have to make a monetary policy choice: l Ignite inflation by bailing out their governments with an expansionary monetary policy. l Do nothing and risk recession or even a breakdown of the entire economy.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of the Quantity Theory u In terms of policy, the quantity theory says that monetary policy is powerful, but unpredictable in the short run. u Because of its unpredictability, monetary policy should not be used to control the level of output in an economy.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of the Quantity Theory u Supporters of the quantity theory oppose an activist monetary policy. u Instead, they favour a monetary policy set by rules not by discretion.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of the Quantity Theory u A monetary rule takes monetary policy out of the hands of politicians. u Many central banks use monetary regimes or feedback rules.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of the Quantity Theory u Many economists favor creating independent central banks to separate politicians from the control of money supply. l They feel that politicians will not be able to hold down the money supply because of the expansionary tendencies in politics.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of the Quantity Theory u In Canada, in 1991 the Bank of Canada announced targets for the inflation rate based on the CPI. u Canadian monetary policy is aimed at maintaining a low and stable inflation of between one and three percent.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of the Quantity Theory u The U.S. Federal Reserve Bank does not have strict rules governing money supply, but it works hard to establish credibility that it is serious about fighting inflation.

© 2003 McGraw-Hill Ryerson Limited. The Institutional Theory of Inflation u Supporters of institutional theories of inflation accept much of the quantity theory. u While they agree that money and inflation move together, they have different causes and effects.

© 2003 McGraw-Hill Ryerson Limited. The Institutional Theory of Inflation u According to the quantity theory, the direction of causation moves from left to right: MV  PQ

© 2003 McGraw-Hill Ryerson Limited. The Institutional Theory of Inflation u Institutional theories see it the other way round. u An increase in prices forces government into positions where it must increase money supply or cause unemployment. MV  PQ

© 2003 McGraw-Hill Ryerson Limited. The Institutional Theory of Inflation u According to these theorists, the source of inflation is in the price-setting process of firms. l Firms find it easier to raise prices than to lower them. l Firms do not take into account the effect of their pricing decisions on the overall price level.

© 2003 McGraw-Hill Ryerson Limited. Focus on the Price-Setting Decisions of Firms u Any increase in firms’ wages, rents, taxes, and other costs are simply passed on to consumers in the form of higher prices.

© 2003 McGraw-Hill Ryerson Limited. Focus on the Price-Setting Decisions of Firms u This works so long as the government increases the money supply so that demand is sufficient to buy the goods at the higher prices.

© 2003 McGraw-Hill Ryerson Limited. Price-Setting Strategies Depend on the Labour Market u Whether the firm selects this price- raising strategy depends on the state of the labour market.

© 2003 McGraw-Hill Ryerson Limited. Price-Setting Strategies Depend on the Labour Market u The state of the labour market plays a key role in firms’ decisions whether to give in to workers’ demands for higher wages. u That is why economists look at unemployment to measure inflationary pressures.

© 2003 McGraw-Hill Ryerson Limited. Changes in the Money Supply Follow Price-Setting by Firms u Institutional theorists see the nominal wage- and price-setting process as generating inflation.

© 2003 McGraw-Hill Ryerson Limited. Changes in the Money Supply Follow Price-Setting by Firms u One group pushes up its nominal wage and/or price, another group responds by doing the same. u More groups follow.

© 2003 McGraw-Hill Ryerson Limited. Changes in the Money Supply Follow Price-Setting by Firms u The first group finds its relative wages and/or prices have not increased, so they raise them again. u And the process begins anew.

© 2003 McGraw-Hill Ryerson Limited. Changes in the Money Supply Follow Price-Setting by Firms u At this point, government has two options: l Increase money supply, thereby accepting the inflation. l Refuse to ratify the inflation, thereby causing unemployment to rise.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u The insider-outsider model is an institutionalist story of inflation where insiders bid up wages and outsiders are unemployed.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u Insiders are business owners and workers with good jobs with excellent long-run prospects; outsiders are everyone else.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u If markets were purely competitive, wages, profits, and rents would be pushed down to equilibrium levels.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u Insiders don’t like this, so they develop sociological and institutional barriers to prevent outsiders from competing away the wages, profits and rents. l Barriers include unions, laws restricting the firing of workers, and brand recognition.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u Outsiders must take dead-end, low- paying jobs or try to undertake marginal businesses that pay little return per hour worked.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u Outsiders are the first to be fired and their businesses are the first to fail in a recession.

© 2003 McGraw-Hill Ryerson Limited. The Insider/Outsider Model and Inflation u The economy is only partially competitive – the invisible hand is thwarted by social and political forces. u Insiders push to raise their nominal wages to protect their real wages while outsiders suffer.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of Institutional Theories u The quantity theorists have a simple solution for stopping inflation – just cut the growth of the money supply.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of Institutional Theories u The institutional theorists agree with this prescription, but they argue that is not only inefficient but unfair. u It causes unemployment among those least able to handle it.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of Institutional Theories u They suggest that contractionary monetary policies be used in combination with additional policies that directly slow down inflation at its source.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of Institutional Theories u This additional policy is often called an incomes policy that places direct pressure on individuals and businesses to hold down their nominal wages and prices.

© 2003 McGraw-Hill Ryerson Limited. Policy Implications of Institutional Theories u Formal policies have been out of favour for a number of years. u Informal incomes policies exist in many European countries.

© 2003 McGraw-Hill Ryerson Limited. Inflation and Unemployment: The Phillips Curve u The AS/AD model expresses a tradeoff between inflation and unemployment. l A low unemployment rate is generally accompanied by high inflation. l A high unemployment rate is generally accompanied by low inflation.

© 2003 McGraw-Hill Ryerson Limited. Inflation and Unemployment: The Phillips Curve u The tradeoff can be represented graphically in the short-run Phillips Curve which represents the relationship between inflation and unemployment when expected inflation is constant.

© 2003 McGraw-Hill Ryerson Limited. Inflation and Unemployment: The Phillips Curve u The Phillips curve shows us what combinations of unemployment and inflation are possible. u Unemployment is measured on the horizontal axis, and inflation is measured on the vertical axis.

© 2003 McGraw-Hill Ryerson Limited. Unemployment rate Inflation A B The Hypothesized Phillips Curve, Fig. 15-3a, p 373

© 2003 McGraw-Hill Ryerson Limited. History of the Phillips Curve u In the 1950s and 1960s, whenever unemployment was high, inflation was low and vice versa. u The tradeoff between unemployment and inflation seemed relatively stable during the 1960s.

© 2003 McGraw-Hill Ryerson Limited. History of the Phillips Curve u In the 1960s, the short-run Phillips Curve began to play an important role in discussions of macroeconomic policy.

© 2003 McGraw-Hill Ryerson Limited. History of the Phillips Curve u Conservatives generally favoured contractionary monetary and fiscal policy that meant high unemployment and low inflation.

© 2003 McGraw-Hill Ryerson Limited. History of the Phillips Curve u Liberals generally favoured expansionary monetary and fiscal policy that meant low unemployment and high inflation.

© 2003 McGraw-Hill Ryerson Limited. The Breakdown of the Short- Run Phillips Curve u In the late 1970s, the relationship between inflation and unemployment began breaking down. u Unemployment was high, but so was inflation.

© 2003 McGraw-Hill Ryerson Limited. The Breakdown of the Short- Run Phillips Curve u This phenomenon was termed stagflation. u Stagflation is the combination of high and accelerating inflation and high unemployment.

© 2003 McGraw-Hill Ryerson Limited. The Phillips Curve Trade-Off, Fig. 15-3, p 373

© 2003 McGraw-Hill Ryerson Limited. The Long-Run and Short-Run Phillips Curves u The continually changing relationship between inflation and unemployment has economists somewhat perplexed.

© 2003 McGraw-Hill Ryerson Limited. The Importance of Inflation Expectations u Expectations of inflation have been incorporated into the analysis by distinguishing between short-run and long-run Phillips curves. u Expectations of inflation – the rise in the price level that the average person expects.

© 2003 McGraw-Hill Ryerson Limited. The Importance of Inflation Expectations u The short-run Phillips curve is one showing the trade-off between inflation and unemployment when expectations of inflation are fixed.

© 2003 McGraw-Hill Ryerson Limited. The Importance of Inflation Expectations u The long-run Phillips curve is thought to be a vertical curve at the unemployment rate consistent with potential output. u It shows the trade-off (or complete lack thereof) when expectations of inflation equal actual inflation.

© 2003 McGraw-Hill Ryerson Limited. The Importance of Inflation Expectations u When expectations of inflation are higher, the same level of unemployment will be associated with a higher level of inflation.

© 2003 McGraw-Hill Ryerson Limited. The Importance of Inflation Expectations u It makes sense to assume that the short-run Phillips curves moves up or down as expectations of inflation change.

© 2003 McGraw-Hill Ryerson Limited. The Importance of Inflation Expectations u The only sustainable combination of inflation and unemployment rates on the short-run Phillips curve is at points where the curve intersects the long-run Phillips curve.

© 2003 McGraw-Hill Ryerson Limited. Moving Off the Long-Run Phillips Curve u If government decides to increase aggregate demand, this pushes output above its potential. u Demand for labour goes up pushing wages higher than productivity increases.

© 2003 McGraw-Hill Ryerson Limited. Moving Off the Long-Run Phillips Curve u Workers are initially satisfied that their increased wages will raise their standard of living with the expectation of zero inflation. u But if productivity does not go up, inflation will wipe out their wage gains.

© 2003 McGraw-Hill Ryerson Limited. Moving Back onto the Long- Run Phillips Curve u When workers find their initial raise did not keep up with unexpected inflation, they ask for more money giving a boost to a wage-price spiral.

© 2003 McGraw-Hill Ryerson Limited. Moving Back onto the Long- Run Phillips Curve u If unemployment is lower than the target level of unemployment, inflation and the expectation of inflation will increase. u The short-run Phillips curve will shift up.

© 2003 McGraw-Hill Ryerson Limited. Moving Back onto the Long- Run Phillips Curve u The short-run Phillip curve will continue to shift up until output is no longer above potential.

© 2003 McGraw-Hill Ryerson Limited. Moving Back onto the Long- Run Phillips Curve u If the cause of inflation is expectations of inflation, any level of unemployment is consistent with the target level of unemployment.

© 2003 McGraw-Hill Ryerson Limited. LAS Long-run Phillips curve AD 0 AD 1 C A C PC 0 PC 1 (expected inflation = 4) Real output Price level Inflation Expectations and the Phillips Curve, Fig. 15-4, p 375 A expected inflation = 0 B B SAS 0 SAS 1 SAS Unemployment rate Inflation rate D D

© 2003 McGraw-Hill Ryerson Limited. Stagflation and the Phillips Curve u Economists theorized that the stagflation of the late 1970s and early 1980s was caused when government attempted to push down inflation through contractionary aggregate demand policy.

© 2003 McGraw-Hill Ryerson Limited. Stagflation and the Phillips Curve u The lower aggregate demand pushed the economy to the point where unemployment exceeded the target rate.

© 2003 McGraw-Hill Ryerson Limited. Stagflation and the Phillips Curve u The higher unemployment put downward pressure on wages and prices, shifting the short-run Phillips curve down.

© 2003 McGraw-Hill Ryerson Limited. The New Economy u Output expanded significantly during the late 1990s and early 2000s, and unemployment rates were lower than most economists predicted. u The cause of the good times was a combination of factors.

© 2003 McGraw-Hill Ryerson Limited. The New Economy u The economy was experiencing a temporary positive productivity shock because Internet growth and investment were shifting potential output out.

© 2003 McGraw-Hill Ryerson Limited. The New Economy u Competition increased because of globalization. u Price comparisons were made possible by e-commerce.

© 2003 McGraw-Hill Ryerson Limited. The New Economy u Workers were less concerned with real wages and more concerned with protecting their jobs, so firms did not raise wages even with extremely tight labour markets.

© 2003 McGraw-Hill Ryerson Limited. The New Economy u Some economists argued that these conditions were permanent. u Others argued that this combination of effects were temporary and that the economy would come out of its “Goldilocks period.”

© 2003 McGraw-Hill Ryerson Limited. The Relationship Between Inflation and Growth u In the AS/AD model, as the economy expands and output increases, at some point input prices begin to rise, shifting the SAS curve up. u The problem is that no one knows where the potential output is.

© 2003 McGraw-Hill Ryerson Limited. The Relationship Between Inflation and Growth u Institutional economists prefer a point where the output level is as high as possible while keeping inflation low and not accelerating.

© 2003 McGraw-Hill Ryerson Limited. The Price/Output Path, Fig. 15-5a, p 377 Keynesian range Intermediate range Classical range Low estimate of potential output Price/output path Real output Price level High estimate of potential output

© 2003 McGraw-Hill Ryerson Limited. Quantity Theory and the Inflation/Growth Trade-Off u Quantity theorists are much more likely to err on the side of preventing inflation. u For them, erring on the low side pays off by stopping any chance of inflation. u It also builds credibility for the Bank of Canada.

© 2003 McGraw-Hill Ryerson Limited. Quantity Theory and the Inflation/Growth Trade-Off u Quantity theorists justify erring on the side of preventing inflation by arguing that there is a high cost associated with igniting inflation. u Inflation undermines the economy’s long-run growth and hence its future potential income.

© 2003 McGraw-Hill Ryerson Limited. Quantity Theory and the Inflation/Growth Trade-Off u Quantity theorists argue that there is no long-run tradeoff between inflation and unemployment.

© 2003 McGraw-Hill Ryerson Limited. Quantity Theory and the Inflation/Growth Trade-Off u Quantity theorists believe low inflation leads to higher growth: l It reduces price uncertainty, making it easier for businesses to invest in future production. l It encourages businesses to enter into long- term contracts. l It makes using money much easier.

© 2003 McGraw-Hill Ryerson Limited. Quantity Theory and the Inflation/Growth Trade-Off u There is no solid empirical evidence showing who is correct, the quantity theorists or the institutionalists.

© 2003 McGraw-Hill Ryerson Limited. Growth/Inflation Tradeoff, Fig. 15-5b, p 377 Growth0 Inflation

© 2003 McGraw-Hill Ryerson Limited. Institutional Theory and the Inflation/Growth Trade-Off u Supporters of the institutional theory of inflation are less sure about a negative relationship between inflation and growth.

© 2003 McGraw-Hill Ryerson Limited. Institutional Theory and the Inflation/Growth Trade-Off u Institutional theorists agree that rises in the price level have the potential of generating inflation. u They agree that high accelerating inflation undermines growth. u They do not agree that all price level increases start an inflation.

© 2003 McGraw-Hill Ryerson Limited. Institutional Theory and the Inflation/Growth Trade-Off u If inflation does get started, the government has some medicine to give the economy that will get rid of inflation relatively easily.

© 2003 McGraw-Hill Ryerson Limited. Institutional Theory and the Inflation/Growth Trade-Off u This was highlighted in the debate about monetary policy in the early 2000.

© 2003 McGraw-Hill Ryerson Limited. Institutional Theory and the Inflation/Growth Trade-Off u Quantity theorist argued that inflation was just around the corner, and unless government instituted contractionary aggregate demand policy, the seeds of inflation would be sown.

© 2003 McGraw-Hill Ryerson Limited. Institutional Theory and the Inflation/Growth Trade-Off u Other economists argued that the institutional changes in the labour market had reduced the inflation threat and that more expansionary policy was needed. u The Bank of Canada followed a path between these two positions.

© 2003 McGraw-Hill Ryerson Limited. Inflation and Its Relationship to Unemployment and Growth End of Chapter 15