Ch. 12: U.S. Inflation, Unemployment and Business Cycles Demand-pull and cost-push inflation. SR and LR tradeoff between inflation and unemployment (Phillips Curve) Business cycle theories.

The Misery Index MI proposed by Arthur Okun in 1970s MI = inflation rate plus the unemployment rate. MI peak: 22 in 1981 MI minimum: 3 in 1953 MI in 2009: 10.0% unempl + -0.4% inflation = 9.6% We want both low inflation & low unemployment – are there trade-offs between the two?

Inflation and Unemployment in U.S. 1950-2009

Real GDP and the Price Level: 1948-2008

The Evolving U.S. Economy Inflation The upward movement of the dots shows inflation. Recession Leftward movement of dots shows declining real GDP Economic Growth The rightward movement of the dots shows the growth of real GDP.

Inflation Cycles In the long run, according to equation of exchange: inflation = %ch in M + % ch in V - %ch in y inflation occurs if money grows faster than potential GDP. In the short run, Inflation can be initiated by Increases in AD (demand pull inflation) Decreases in SAS (cost push inflation)

Inflation Cycles Demand-Pull Inflation starts because AD increases can begin with any factor that increases AD. Examples Monetary policy & interest rates Fiscal policy: government spending or taxes Exports (value of $ or foreign income levels) Investment (expected profits, technological advances) Consumer expectations

Inflation Cycles: Demand Pull Starting from full employment, an increase in AD Increases P (spell of inflation) Increases RGDP Creates inflationary gap

Inflation Cycles: Demand Pull Since unempl < natural rate money wage rate rises SAS shifts left P rises (another spell of inflation) RGDP falls until GDP=potential GDP Inflation is finished unless AD increases again.

Inflation Cycles: Demand Pull Demand-Pull Inflation Process AD must continually increase so that the process described above repeats itself Although any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

Inflation Cycles: Cost Push Cost-Push Inflation starts with an increase in costs Possible sources of increased costs: An increase in the money wage rate An increase in the money price of raw materials (e.g. oil) Natural disasters Regulation (e.g. carbon taxes) Results in decrease in SAS

Inflation Cycles: Cost Push Initial Effect of a Decrease in AS A rise in the price of oil decreases SAS and shifts the curve leftward. Real GDP decreases and the price level rises. “stagflation” (higher prices, less output)

Inflation Cycles: Cost Push Aggregate Demand Response The initial increase in costs creates a one-time rise in the price level, not continued inflation. To create inflation, AD must increase after AS decreases. Although any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

Inflation Cycles & Inflation Expectations Expected Inflation If inflation is expected, AD increases AS decreases as workers negotiate wage increases to offset expected inflation. Movement along LAS curve No change in real GDP, real wages, or unemployment

Inflation Cycles & Inflation Expectations When the inflation forecast is correct, the economy operates at full employment. If AD grows faster than expected, Inflation > expected Real wages decrease Real GDP increases above potential Unemployment rate falls below natural rate If AD grows slower than expected Inflation < expected Real wages rise Unemployment rate rises above natural rate

AD/AS representation of impact of inflation > expected inflation

AD/AS representation of impact of inflation < expected inflation

The Phillips Curve Phillips curve SR Phillips curve LR Phillips curve shows the relationship between the inflation rate and the unemployment rate. SR Phillips curve Shows tradeoff between inflation and unemployment holding constant The expected inflation rate The natural unemployment rate LR Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals expected inflation vertical at natural rate of unemployment

The Phillips Curve A short-run Phillips curve (SRPC) As inflation increases, unemployment decreases AD/AS explanation. If inflation=expected, unempl= natural rate. If inflation>expected, unempl<natural rate If inflation < expected, unempl>natural rate

The Phillips Curve The long-run Phillips curve (LRPC) vertical at the natural unemployment rate. intersects SRPC at expected inflation rate. Shifts only if natural unemployment rates rises or falls Unemployment insurance Demographics of labor force

The Phillips Curve SRPC shifts up/down as inflation expectations rise/fall

The Phillips Curve in U.S.

Business Cycles Two approaches to understanding business cycles are: Mainstream business cycle theory Real business cycle theory Mainstream (Demand Side) Business Cycle Theory Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.

Business Cycles Real Business Cycle Theory Argues that random fluctuations in productivity are the main source of economic fluctuations. fluctuations in the pace of technological change. international disturbances, climate fluctuations, or natural disasters. rapid productivity growth generates expansion; slow productivity growth (or decreases in productivity) cause contraction. productivity growth affects Investment and interest rates Labor market and wages

Real Business Cycles: Investment negative productivity shock: investment demand and loan demand falls Interest rates fall reverse happens for positive productivity shock

Real Business Cycles: Labor Negative productivity shock Labor demand decreases Labor supply decreases because of lower interest rates (above) and intertemporal subst Employment and the real wage rate decrease (assuming LD shift larger than LS). Reverse happens when there is an expansion caused by rapid productivity increase.