Macro233 - JAFGAC Inflation and Its Relationship to Unemployment and Growth Chapter 13

Macro233 - JAFGAC Laugher Curve Economics is the only field in which two people can share a Nobel Prize for saying opposing things. Specifically, Gunnar Myrdahl and Friedrich S. Hayek shared one.

Macro233 - JAFGAC Some Basics about Inflation n Inflation is a continuous rise in the price level. n It is measured using a price index.

Macro233 - JAFGAC The Distributional Effects of Inflation n There are individual winners and losers in an inflation. n On average, winners and losers balance out.

Macro233 - JAFGAC The Distributional Effects of Inflation n The winners are those who can raise their prices or wages and still keep their jobs or sell their goods. n The losers in an inflation are those who cannot raise their wages or prices.

Macro233 - JAFGAC The Distributional Effects of Inflation n Unexpected inflation redistributes income from lenders to borrowers. n People who do not expect inflation and who are tied to fixed nominal contracts are likely lose in an inflation.

Macro233 - JAFGAC Expectations of Inflation n Expectations play a key role in the inflationary process. l Rational expectations are the expectations that the economists' model predicts. l Adaptive expectations are those based, in some way, on what has been in the past. l Extrapolative expectations are those that assume a trend will continue.

Macro233 - JAFGAC Productivity, Inflation, and Wages n Changes in productivity and changes in wages determine whether inflation may be coming. n There will be no inflationary pressures if wages and productivity increase at the same rate.

Macro233 - JAFGAC Productivity, Inflation, and Wages n The basic rule of thumb: Inflation = Nominal wage increases – Productivity growth

Macro233 - JAFGAC Deflation n Deflation is the opposite of inflation and is associated with a number of problems in the economy. n Deflation – a sustained fall in the price level.

Macro233 - JAFGAC Deflation n Deflation places a limit on how low the Fed can push the real interest rate. n Deflation is often associated with large falls in stock and real estate prices.

Macro233 - JAFGAC Theories of Inflation n The two theories of inflation are the quantity theory and the institutional theory. l The quantity theory emphasizes the connection between money and inflation. l The institutional theory emphasizes market structure and price-setting institutions and inflation.

Macro233 - JAFGAC The Quantity Theory of Money and Inflation n The quantity theory of money is summarized by the sentence: n Inflation is always and everywhere a monetary phenomenon.

Macro233 - JAFGAC The Equation of Exchange n Equation of exchange – the quantity of money times velocity of money equals price level times the quantity of real goods sold. MV = PQ l M = Quantity of money l V = velocity of money l P = price level l Q = real output l PQ = the economy’s nominal output

Macro233 - JAFGAC The Equation of Exchange n Velocity of money – the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income.

Macro233 - JAFGAC Velocity Is Constant n The first assumption of the quantity theory is that velocity is constant. n Its rate is determined by the economy’s institutional structure.

Macro233 - JAFGAC Velocity Is Constant n If velocity remains constant, the quantity theory can be used to predict how much nominal GDP will grow. n Nominal GDP will grow by the same percent as the money supply grows.

Macro233 - JAFGAC Real Output Is Independent of the Money Supply n The second assumption of the quantity theory is that real output (Q) is independent of the money supply. n Q is autonomous – real output is determined by forces outside those in the quantity theory.

Macro233 - JAFGAC Real Output Is Independent of the Money Supply n The quantity theory of money says that the price level varies in response to changes in the quantity of money. n With both V and Q unaffected by changes in M, the only thing that can change is P. %  M  %  P

Macro233 - JAFGAC Examples of Money's Role in Inflation n The quantity theory lost favor in the late 1980s and early 1990s. n The formerly stable relationships between measurements of money and inflation appeared to break down.

Macro233 - JAFGAC Examples of Money's Role in Inflation n The relationship between money and inflation broke down because: l Technological changes and changing regulations in financial institutions. l Increasing global interdependence of financial markets.

Macro233 - JAFGAC Price level and money relative to real income (1960 = 1) U.S. Price Level and Money Relative to Real Income Money Price level

Macro233 - JAFGAC Inflation and Money Growth n The empirical evidence that supports the quantity theory of money is most convincing in Brazil and Chile.

Macro233 - JAFGAC Inflation and Money Growth 1020 Annual percent change in the money supply (%) Annual percent change in inflation (%) Indonesia Chile Poland Argentina Nicaragua Zaire U.S.

Macro233 - JAFGAC The Inflation Tax n Central banks in nations such as Argentina and Chile are not a politically independent as in developed countries. n Their central banks sometimes increase the money supply to keep the economy running.

Macro233 - JAFGAC The Inflation Tax n The increase in money supply is caused by the government deficit. n The central bank must buy the government bonds or the government will default.

Macro233 - JAFGAC The Inflation Tax n Financing the deficit by expansionary monetary policy causes inflation.

Macro233 - JAFGAC The Inflation Tax n The inflation works as a kind of tax on individuals, and is often called an inflation tax. n It is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms.

Macro233 - JAFGAC The Inflation Tax n 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.

Macro233 - JAFGAC Policy Implications of the Quantity Theory n Supporters of the quantity theory oppose an activist monetary policy. l Monetary policy is powerful, but unpredictable in the short run. l Because of its unpredictability, monetary policy should not be used to control the level of output in an economy.

Macro233 - JAFGAC Policy Implications of the Quantity Theory n Quantity theorists favor a monetary policy set by rules not by discretionary monetary policy. n A monetary rule takes money supply decisions out of the hands of politicians.

Macro233 - JAFGAC Policy Implications of the Quantity Theory n Many central banks use monetary regimes or feedback rules. l New Zealand has a legally mandated monetary rule based on inflation. l The Fed does not have strict rules governing money supply, but it works hard to establish credibility that it is serious about fighting inflation.

Macro233 - JAFGAC Institutionalist Theories of Inflation n Supporters of institutional theories of inflation accept much of the quantity theory. n While they agree that money and inflation move together, they have different causes and effects.

Macro233 - JAFGAC Institutionalist Theories of Inflation n According to the quantity theory, the direction of causation moves from left to right: MV  PQ

Macro233 - JAFGAC Institutionalist Theories of Inflation n Institutional theories see it the other way round. n Increases in prices forces government into positions where it must increase money supply or cause unemployment. MV  PQ

Macro233 - JAFGAC Institutionalist Theories of Inflation n 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.

Macro233 - JAFGAC Focus on the Price-Setting Decisions of Firms n Any increase in firms’ wages, rents, taxes, and other costs are simply passed on to consumers in the form of higher prices.

Macro233 - JAFGAC Focus on the Price-Setting Decisions of Firms n This works so long as the government increases the money supply so that demand is there to buy the goods at the higher prices.

Macro233 - JAFGAC Focus on the Price-Setting Decisions of Firms n Whether the firm selects this price-raising strategy depends on the state of the labor market. l If the labor market is tight, the firm knows that it will lose workers if it doesn’t raise wages.

Macro233 - JAFGAC Changes in the Money Supply Follow Price-Setting by Firms n Institutional theorists see the nominal wage- and price-setting process as generating inflation.

Macro233 - JAFGAC Changes in the Money Supply Follow Price-Setting by Firms n One group pushes up its nominal wage and/or price, other groups responds by doing the same. n The first group finds its relative wages and/or prices have not increased, so they raise them again. n And the process begins anew.

Macro233 - JAFGAC Changes in the Money Supply Follow Price-Setting by Firms n At this point, government has two options: l Increase money supply, thereby ratifying the inflation. l Refuse to ratify the inflation, thereby causing unemployment to rise.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n The insider-outsider model is an institutionalist story of inflation where insiders bid up wages and outsiders are unemployed.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n Insiders are business owners and workers with good jobs with excellent long-run prospects; outsiders are everyone else.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n If markets were purely competitive, wages, profits, and rents would be pushed down to equilibrium levels.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n Insiders don’t like this, so they develop sociological and institutional barriers to prevent competition from outsiders. n Barriers include unions, laws restricting the firing of workers, and brand recognition.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n Outsiders must take dead-end, low-paying jobs or try to undertake marginal businesses that pay little return per hour worked.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n Outsiders are the first to be fired and their businesses are the first to fail in a recession.

Macro233 - JAFGAC The Insider/Outsider Model and Inflation n The economy is only partially competitive – the invisible hand is thwarted by social and political forces. n Insiders push to raise their nominal wages to protect their real wages while outsiders suffer.

Macro233 - JAFGAC Policy Implications of Institutionalist Theories n The quantity theorists have a simple solution for stopping inflation – just cut the growth of the money supply.

Macro233 - JAFGAC Policy Implications of Institutionalist Theories n The institutional theorists agree with this prescription, but they argue that is not only inefficient but unfair. n It causes unemployment among those least able to handle it.

Macro233 - JAFGAC Policy Implications of Institutionalist Theories n They favor contractionary monetary policies used in combination with incomes policy to directly slow down inflation. n Incomes policy – places direct pressure on individuals and businesses to hold down their nominal wages and prices.

Macro233 - JAFGAC Policy Implications of Institutionalist Theories n Formal incomes policies have been out of favor for a number of years. n Informal incomes policies exist in many European nations.

Macro233 - JAFGAC Demand-Pull and Cost-Push Inflation n Demand-pull inflation – inflation that occurs when the economy is at or above potential output. n It is generally characterized by shortages of goods and of workers.

Macro233 - JAFGAC Demand-Pull and Cost-Push Inflation n Cost-push inflation – inflation that occurs when the economy is below potential output. n Producers who raise their prices believe that they will sell their goods and workers who raise their wages believe they won’t lose their jobs.

Macro233 - JAFGAC Inflation and Unemployment: The Phillips Curve n 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.

Macro233 - JAFGAC Inflation and Unemployment: The Phillips Curve n The tradeoff can be represented graphically in the short-run Phillips Curve. n Short-run Phillips Curve – a downward- sloping curve showing the relationship between inflation and unemployment when inflation expectations are constant.

Macro233 - JAFGAC Inflation Unemployment rate A B The Hypothesized Phillips Curve

Macro233 - JAFGAC History of the Phillips Curve n In the 1950s and 1960s, whenever unemployment was high, inflation was low and vice versa. n The tradeoff between unemployment and inflation seemed relatively stable during the 1960s.

Macro233 - JAFGAC History of the Phillips Curve n In the 1960s, the short-run Phillips Curve began to play an important role in discussions of macroeconomic policy.

Macro233 - JAFGAC History of the Phillips Curve n Republicans generally favored contractionary monetary and fiscal policy that meant high unemployment and low inflation.

Macro233 - JAFGAC History of the Phillips Curve n Democrats generally favored expansionary monetary and fiscal policy that meant low unemployment and high inflation.

Unemployment rate 0456 Inflation rate The Rise of the Phillips Curve ( ) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Macro233 - JAFGAC The Breakdown of the Short- Run Phillips Curve n In the early 1970s, the relationship inflation and unemployment began breaking down. n Unemployment was high, but so was inflation.

Macro233 - JAFGAC The Breakdown of the Short- Run Phillips Curve n This phenomenon was termed stagflation. n Stagflation – the combination of high and accelerating inflation and high unemployment.

The Fall of the Phillips Curve ( ) Unemployment rate 0457 Inflation rate 6 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Macro233 - JAFGAC Questions About the Phillips Curve ( ) n Inflation fell substantially in the 1980s. n A Phillips-Curve-type relationship began to reappear beginning in n Both inflation and unemployment remained relatively low in the mid- to late-1990s.

Questions About the Phillips Curve ( ) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Unemployment rate 0457 Inflation rate

Macro233 - JAFGAC The Long-Run and Short-Run Phillips Curves n The continually changing relationship between inflation and unemployment has economists somewhat perplexed.

Macro233 - JAFGAC The Importance of Inflation Expectations n Expectations of inflation have been incorporated into the analysis by distinguishing between short-run and long- run Phillips curves.

Macro233 - JAFGAC The Importance of Inflation Expectations n Expectations of inflation – the rise in the price level that the average person expects. n Expectations of inflation do not change along a short-run Phillips curve.

Macro233 - JAFGAC The Importance of Inflation Expectations n Long-run Phillips curve – a vertical curve at the unemployment rate consistent with potential output. n It shows the trade-off between inflation and unemployment when expectations of inflation equal actual inflation.

Macro233 - JAFGAC The Importance of Inflation Expectations n When expectations of inflation are higher, the same level of unemployment will be associated with a higher level of inflation.

Macro233 - JAFGAC The Importance of Inflation Expectations n It makes sense to assume that the short- run Phillips curves moves up or down as expectations of inflation change.

Macro233 - JAFGAC The Importance of Inflation Expectations n The only sustainable combination of inflation and unemployment rates on the short-run Phillips curve is at points where it intersects the long-run Phillips curve.

Macro233 - JAFGAC Moving Off the Long-Run Phillips Curve n If government decides to increase aggregate demand, this pushes output above its potential. n Demand for labor goes up pushing wages higher than productivity increases.

Macro233 - JAFGAC Moving Off the Long-Run Phillips Curve n Workers are initially satisfied that their increased wages will raise their standard of living with the expectation of zero inflation. n But if productivity does not go up, inflation will wipe out their wage gains.

Macro233 - JAFGAC Moving Back onto the Long- Run Phillips Curve n Workers ask for more money when they find their initial raise did not keep up with unexpected inflation. n This gives a boost to a wage-price spiral.

Macro233 - JAFGAC Moving Back onto the Long- Run Phillips Curve n If unemployment is lower than the target level of unemployment, inflation and the expectation of inflation will increase. n The short-run Phillips curve will shift up.

Macro233 - JAFGAC Moving Back onto the Long- Run Phillips Curve n The short-run Phillips curve will continue to shift up until output is no longer above potential.

Macro233 - JAFGAC Moving Back onto the Long- Run Phillips Curve n If the cause of inflation is expectations of inflation, any level of unemployment is consistent with the target level of unemployment.

Macro233 - JAFGAC Stagflation and the Phillips Curve n Expectational inflation can be eliminated if aggregate demand falls. n Lower aggregate demand pushes the economy to the point where unemployment exceeds the target rate.

Macro233 - JAFGAC Stagflation and the Phillips Curve n Higher unemployment puts downward pressure on wages and prices, shifting the short-run Phillips curve down.

Macro233 - JAFGAC Stagflation and the Phillips Curve n Economists believe that the stagflation of the late 1970s and early 1980s was caused by contractionary government aggregate demand policy.

Macro233 - JAFGAC Potential output Long-run Phillips curve AD 0 AD 1 C PC 0 PC 1 (expected inflation = 4) Unemployment rate Inflation rate Real output Price level Inflation Expectations and the Phillips Curve A expected inflation = 0 B A B C SAS 0 SAS 1 SAS 2

Macro233 - JAFGAC The Rise and Fall of the New Economy n Output expanded significantly during the late 1990s and early 2000s. n The cause of the good times was a combination of factors.

Macro233 - JAFGAC The Rise and Fall of the New Economy n The economy was experiencing a temporary positive productivity shock because Internet growth and investment were shifting potential output out.

Macro233 - JAFGAC The Rise and Fall of the New Economy n Competition increased because of globalization. n Price comparisons were made possible by e-commerce.

Macro233 - JAFGAC The Rise and Fall of the New Economy n Workers were less concerned with real wages and more concerned with protecting their jobs, so firms did not raise wages even with extremely tight labor markets.

Macro233 - JAFGAC The Rise and Fall of the New Economy n Some economists argued that these conditions were permanent. n Others argued that this combination of effects were temporary and that the U.S. economy would come out of its “Goldilocks period.”

Macro233 - JAFGAC The Relationship Between Inflation and Growth n Economist generally agree that: l Below low potential output there is no inflationary, and possibly some deflationary pressures. l Above high potential output there will be significant inflationary pressures. l The degree of inflationary pressure between the extremes is ambiguous.

Macro233 - JAFGAC The Inflation/Growth Trade Off Inflationary pressures Deflationary pressures Inflationary pressures Real output High potential output Low potential output

Macro233 - JAFGAC Quantity Theory and the Inflation/Growth Trade-Off n Quantity theorists are much more likely to err on the side of preventing inflation. n For them, erring on the low side pays off by stopping any chance of inflation. n It also builds credibility for the Fed.

Macro233 - JAFGAC Quantity Theory and the Inflation/Growth Trade-Off n Quantity theorists justify erring on the side of preventing inflation by arguing that there is a high cost associated with igniting inflation. n Inflation undermines the economy’s long- run growth and hence its future potential income.

Macro233 - JAFGAC Quantity Theory and the Inflation/Growth Trade-Off n Quantity theorists argue that there is no long-run tradeoff between inflation and unemployment.

Macro233 - JAFGAC Quantity Theory and the Inflation/Growth Trade-Off n 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.

Macro233 - JAFGAC Growth/Inflation Tradeoff Growth0 Inflation 0

Macro233 - JAFGAC Institutional Theory and the Inflation/Growth Trade-Off n Supporters of the institutional theory of inflation are less sure about a negative relationship between inflation and growth.

Macro233 - JAFGAC Institutional Theory and the Inflation/Growth Trade-Off n Institutional theorists agree that rises in the price level have the potential of generating inflation. n They agree that high accelerating inflation undermines growth. n They do not agree that all price level increases start an inflation.

Macro233 - JAFGAC Institutional Theory and the Inflation/Growth Trade-Off n If inflation does get started, the government has tools that will get rid of inflation relatively easily.

Macro233 - JAFGAC Institutional Theory and the Inflation/Growth Trade-Off n This was highlighted in the debate about monetary policy in early 2000.

Macro233 - JAFGAC Institutional Theory and the Inflation/Growth Trade-Off n Quantity theorist argued that inflation was just around the corner. n The seeds of inflation would be sown unless government instituted contractionary aggregate demand policy.

Macro233 - JAFGAC Institutional Theory and the Inflation/Growth Trade-Off n Other economists argued that the institutional changes in the labor market had reduced the inflation threat and that more expansionary policy was needed. n The Fed deftly sailed between these two positions.

Macro233 - JAFGAC Inflation and Its Relationship to Unemployment and Growth End of Chapter 13