Output, Unemployment, & Inflation Tools for Disinflation Modified Phillips Curve: unemployment and the change in inflation Okun’s Law: output growth and the change in unemployment Aggregate Demand: Money, output, and prices  Money growth, Output growth, Inflation

Modified Phillips Curve

Okun’s Law: The Data

Okun’s Law: The Equation u t - u t-1 = (g yt - 3%) g yt must be at least 3% to keep unemployment from rising WHY? 1.Labor force growth 2. Increases in labor productivity g yt must be at least 3% to keep unemployment from rising WHY? 1.Labor force growth 2. Increases in labor productivity Why is the coefficient only 0.4? Firms need a minimum number of workers Firms hoard labor Changes in labor force participation When economy tanks, workers drop out of the laborforce  u doesn’t rise as much as it otherwise would Okun’s Law Coefficients Across Countries Country United States United Kingdom Germany* Japan

Okun’s Law In general, the relation between changes in unem- ployment and output growth is: : normal growth rate : how growth in excess of normal growth impacts the unemployment rate

The Aggregate Demand Relation: Money Growth (g mt ), Inflation (π t ), Output Growth (g yt ) The Aggregate Demand Relation: Money Growth (g mt ), Inflation (π t ), Output Growth (g yt ) M/P = Y L(i) Y = (1/L) M/P Disinflation 1.According to the AD relation, given inflation, output growth rate decreases when money growth decreases 2.From Okun’s Law, a decrease in output growth increases unemployment (or reduces it by less than otherwise) 3.From Modified Phillip’s Curve, higher unemployment  lower inflation

Output, Unemployment, & Inflation IN MEDIUM RUN : u t = u n  g y keeps up with productivity and labor force growth and (Assume a constant growth in the nominal money supply) Medium Run: (Okun’s Law) (Aggregate Demand)

Output, Unemployment, & Inflation: The Medium Run Unemployment Rate, u Inflation Rate,  unun Natural unemployment rate Adjusted money growth B If decreases to : u remains at u n &  falls Adjusted money growth A Adjusting to a decrease in nominal money growth

Disinflation: How much unemployment? And for how long? Scenario: Reduce inflation from 14 to 4 percent &  = 1 = Conclusion: Point years of excess unemployment equals 10 Reduce it in 1 yr: The Sacrifice Ratio: Excess point years of unemployment Decrease in Inflation If  = 1, what is the sacrifice ratio?

Working on the required path of money growth A Scenario: Reduce inflation from 14% to 4% in 5 years Inflation (%) Δ Inflation Unemployment rate (%) Output growth (%) Nominal money growth (%) Year BeforeDisinflationAfter

The disinflation path Year 1 Year 2 Year 4 B Year 5 Year 0 A C Year 6+ Year 3 Inflation Rate (percent) Unemployment Rate (percent) Transition to lower money growth and inflation is associated with a period of higher unemployment Regardless of the path, the number of point-years of excess unemployment is the same In the medium run: output and unemployment return to normal

This model indicates that policy can change the timing but not number of point-years of excess unemployment. Challenges to this model: Expectations, credibility Lucas  Rat-XNew Classical Sargent  Low sacrifice in historyEconomics Expectations & Credibility: The Lucas Critique The previous model assumed:  t e =  t-1 What if  t e is based on an expectation that Fed policy would reduce inflation from 14% to 4%. Then: 4% = 4% - 0% Inflation falls to 4% and unemployment remains at the natural rate Reduction in money growth could be neutral

A Second Challenge: Nominal rigidities and contracts Fischer – sticky wagesNew Keynesian Taylor – staggered contractsEconomics Disinflation Without Unemployment in the Taylor Model: Full credibility and staggered wage decisions Wages in new contracts set close to wages in recent contracts Commit to slow money growth dramatically in the near future Wage and price inflation begin to decline when new policy is announced…but only slowly. Disinflation Without Unemployment in the Taylor Model: Full credibility and staggered wage decisions Wages in new contracts set close to wages in recent contracts Commit to slow money growth dramatically in the near future Wage and price inflation begin to decline when new policy is announced…but only slowly.

The U.S. Disinflation, Unemployment = 5.8% GDP growth = 2.5% Inflation = 13.3% The Fed shifted from targeting interest to targeting the growth rate of nominal money 1979

The U.S. Disinflation, Did Fed credibility reduce the sacrifice ratio? GDP growth (%) Unemployment rate (%) CPI Inflation (%) Cumulative unemployment Cumulative disinflation Sacrifice ratio Cumulative unemployment is the sum of point-years of excess unemployment from 1980 on, assuming a natural rate of 6.5%. Cumulative disinflation is the difference between inflation in a given year and inflation in The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation. Disinflation was associated with high unemployment The sacrifice ratio was very close to 1: 10% disinflation with 10 point-years of excess unemployment The Modified Phillips Curve relation was very robust

Disinflation leads to higher unemployment Faster disinflations are associated with small sacrifice ratios (Lucas/Sargent) Sacrifice ratios are smaller in countries that have shorter wage contracts (Fischer & Taylor) Laurence Ball: Disinflation Experiences in 19 OECD Countries Laurence Ball: Disinflation Experiences in 19 OECD Countries

Problem 9.6 Get π t down from 12% to 2% by keeping u at 6% π t = π t e – 1 (u – 5%) a) π t e = π t-1  how long to disinflate? b) π t e =.25 * * π t-1  how long to disinflate? c) π 1 e =.25 * * π 0 & π 2 e = 2 %  how long to disinflate?

Problem 9.3 Δu = -.4 (g y – 3%) Δπ = - 1 (u – 5%) g y = g m – π a) u n = ? b) If u = u n and π = 8%. Then g y = ? and g m = ? c) Get π down from 8% to 4% in one year!  Trace values of π, u, g y and g m