1. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando Quijano and Yvonn Quijano 9 C H A P T E R Inflation, Activity, and Nominal Money Growth

2. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output, Unemployment, and Inflation  This chapter builds on three relations: 1. Okun’s Law, which relates the change in unemployment to output growth. 2. The Phillips curve, which relates the changes in inflation to unemployment. 3. The aggregate demand relation, which relates output growth to both nominal money growth and inflation. 9-1

3. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Output Growth, Unemployment, Inflation, and Nominal Money Growth

4. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okun’s Law: From Output Growth to Unemployment  According to the equation above, the change in the unemployment rate should be equal to the negative of the growth rate of output.  For example, if output growth is 4%, then the unemployment rate should decline by 4%.

5. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okun’s Law: From Output Growth to Unemployment  The actual relation between output growth and the change in the unemployment rate is known as Okun’s law.  Using thirty years of data, the line that best fits the data is given by:

6. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okun’s Law: From Output Growth to Unemployment High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate. Changes in the Unemployment Rate Versus Output Growth in the United States, 1970-2000

7. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okun’s Law: From Output Growth to Unemployment  According to the equation above,  To maintain the unemployment rate constant, output growth must be 3% per year. This growth rate of output is called the normal growth rate.

8. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okun’s Law: From Output Growth to Unemployment  According to the equation above, output growth 1% above normal leads only to a 0.4% reduction in unemployment, for two reasons: 1. Labor hoarding: firms prefer to keep workers rather than lay them off when output decreases. 2. When employment increases, not all new jobs are filled by the unemployed.  A 0.6% increase in the employment rate leads to only a 0.4% decrease in the unemployment rate.

9. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Okun’s Law: From Output Growth to Unemployment  Using letters rather than numbers:  Output growth above (below) normal leads to a decrease (increase) in the unemployment rate. This is Okun’s law:

10. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Phillips Curve: From Unemployment to Inflation  Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. When  e t is well approximated by  t-1, then:  According to the Phillips curve,

11. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth  The aggregate demand relation, as stated in chapter 7, adding the time indices:  Ignoring changes in output caused by other than changes in the real money stock, then:

12. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Aggregate Demand Relation: From Nominal Money Growth and Inflation to Output Growth  In terms of the growth rates of output, money, and the price level:  According to the aggregate demand relation:  Given inflation, expansionary monetary policy leads to high output growth.

13. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run  Assume a constant growth rate of nominal money,  m.  In the medium run, the unemployment rate must be constant, so, which implies that. Output grows at its normal rate. 9-2  With nominal money growth equal to  m and output growth equal to  y, the aggregate demand relation implies that inflation is constant and satisfies  From here, an expression for inflation equals:

14. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run  According to the equation above, in the medium run, inflation equals adjusted nominal money growth.  If inflation is constant, then  t =  t-1, which in the Phillips curve implies that u t = u n. Therefore, in the medium run, the unemployment rate must equal the natural rate of unemployment.  Changes in nominal money growth have no effect on output or unemployment in the medium run, but are reflected one for one in changes in the rate of inflation.

15. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Medium Run In the medium run, unemployment is equal to the natural rate of unemployment, and inflation is equal to adjusted nominal money growth. Inflation and Unemployment in the Medium Run

16. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Disinflation  To achieve lower inflation, the rate of nominal money growth must be reduced. Here is what happens: 9-3  In the aggregate demand relation,  Then, from Okun’s law,  Finally, according to the Phillips curve relation:  But over time,  According to the Phillips curve relation:  In the aggregate demand relation,  Then, from Okun’s law,  After a decrease in nominal money growth, unemployment first increases, but eventually, it starts decreasing.

17. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long?  In the Phillips curve relation above, disinflation—a decrease in inflation—can be obtained only at the cost of higher unemployment.  A point-year of excess unemployment is a difference between the actual and the natural unemployment rate of one percentage point for one year.

18. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long?  A point-year of excess unemployment is a difference between the actual and the natural unemployment rate of one percentage point for one year.  For example, assuming that  =1, reducing inflation by 10% over 5 years requires 5 years of unemployment at 2% above the natural rate.

19. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Much Unemployment? and for How Long?  The sacrifice ratio is the number of point- years of excess unemployment needed to achieve a decrease in inflation of 1%.  For example, if  =1, a sacrifice ratio of 1.32 means that a 10% disinflation requires 13.2 point-years of excess unemployment.

20. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth This table shows the path of nominal money growth needed to achieve 10% disinflation over five years. Table 9-1 Engineering Disinflation 012345678 Inflation (%) 141210864444 Unemployment rate (%)688888666 Output growth (%)3 22 3333833 Nominal money growth (%)17101311971277

21. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth  The path of inflation shows the values of inflation before achieving a desired 6%.  The path of unemployment shows the unemployment required to achieve the decrease in inflation.  The path of output shows the output growth required to achieve the required path of unemployment.  The path of nominal money growth shows the growth required to achieve the required path of output.

22. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Working Out the Path of Nominal Money Growth This figure shows the path of unemployment and inflation implied by the disinflation path in Table 9-1. Five years of unemployment above the natural rate of unemployment lead to a permanent decrease in inflation. A Disinflation Path

23. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expectations, Credibility, and Nominal Contracts Expectations, Credibility, and Nominal Contracts 9-4  This section examines how changes in expectation formation might affect the unemployment cost of disinflation.  Two separate groups of macroeconomists challenge the traditional notion that policy can change the timing, but not the number of point- years of excess unemployment.

24. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expectations and Credibility: The Lucas Critique  The Lucas critique states that it is unrealistic to assume that wage setters would not consider changes in policy when forming their expectations.  If wage setters could be convinced that inflation was indeed going to be lower than in the past, they would decrease their expectations of inflation, which would in turn reduce actual inflation, without the need for a change in the unemployment rate.

25. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expectations and Credibility: The Lucas Critique  Thomas Sargent, who worked with Robert Lucas, argued that any in order to achieve disinflation, any increase in unemployment would have to be only small.  The essential ingredient of successful disinflation, he argued, was credibility of monetary policy—the belief that the central bank was truly committed to reducing inflation. The central bank should aim for fast disinflation.

26. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Normal Rigidities and Contracts  A contrary view was taken by Stanley Fischer and John Taylor. They emphasized the presence of nominal rigidities, or the fact that many wages and prices are not readjusted when there is a change in policy.  If wages are set before the change in policy, inflation would already be built into existing wage agreements.

27. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Normal Rigidities and Contracts  Taylor argued that the staggering of wage decisions imposed strong limits on how fast disinflation could proceed.  The way to decrease the unemployment cost of disinflation is to give wage setters time to take the change in policy into account.  Slow but credible disinflation might have a lower cost. The central bank should go for slow disinflation.

28. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Normal Rigidities and Contracts With staggering of wage decisions, disinflation must be phased in slowly to avoid an increase in unemployment. Disinflation Without Unemployment in the Taylor Model

29. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985 9-5 Cumulative unemployment is the sum of point-years of excess unemployment from 1980 on, assuming a natural rate of unemployment of 6%. Cumulative disinflation is the difference between inflation in a given year and inflation in 1979. The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation. Table 9-2 Inflation and Unemployment, 1979-1985 Percent1979198019811982198319841985 GDP growth 2.5  0.5 1.8  2.2 3.96.23.2 Unemployment rate5.8 7.1 7.69.79.67.57.2 CPI inflation13.3 12.5 8.93.8 3.93.8 Cumulative unemployment 1.0 2.66.39.911.412.6 Cumulative disinflation 0.8 4.49.5 9.49.5 Sacrifice ratio 1.25 0.590.661.041.211.32

30. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985  The U.S. disinflation of the early 1980s was associated with a substantial increase in unemployment. The Phillips curve relation proved more robust than many economists anticipated.

31. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985 A sharp increase in the interest rate from September 1979 to April 1980 was followed by a sharp decline in mid 1980, and then a second and sustained increase from January 1981 on, lasting for most of 1981 and 1982. The Federal Funds Rate and Inflation, 1979-1984

32. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The U.S. Disinflation, 1979-1985  Laurence Ball, who examined 65 disinflation episodes concluded that:  Disinflations typically lead to a period of higher unemployment.  Faster disinflations are associated with smaller sacrifice ratios.  Sacrifice ratios are smaller in countries that have shorter wage contracts.

33. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Key Terms  Okun’s law, Okun’s law, Okun’s law,  normal growth rate, normal growth rate, normal growth rate,  labor hoarding, labor hoarding, labor hoarding,  adjusted nominal money growth, adjusted nominal money growth, adjusted nominal money growth,  disinflation, disinflation,  point-year of excess unemployment, point-year of excess unemployment, point-year of excess unemployment,  sacrifice ratio, sacrifice ratio, sacrifice ratio,  Lucas critique, Lucas critique, Lucas critique,  credibility, credibility,  nominal rigidities, nominal rigidities, nominal rigidities,  staggering of wage decisions, staggering of wage decisions, staggering of wage decisions,