Presentation on theme: "Ch. 13: U.S. Inflation, Unemployment and Business Cycles"— Presentation transcript:
1 Ch. 13: 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.
2 The Misery Index MI proposed by Arthur Okun in 1970s MI = inflation rate plus the unemployment rate.MI peak: 21 in 1981MI minimum: 6 in 1964 and 1999.MI in 2007: 4.5% unempl + 4.0% inflation = 8.5%We want both low inflation & low unemployment – are there trade-offs between the two?
5 Rise; rise Rise; fall Fall; fall Fall; rise According to the U.S. experience, inflation tends to ___ during a recession and unemployment tends to ___ during a recession.Rise; riseRise; fallFall; fallFall; rise20
7 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.
8 Inflation Cycles In the long run, according to equation of exchange: inflation = %ch in M + % ch in V - %ch in yinflation occurs if money grows faster than potential GDP.In the short run,Inflation can be initiated byIncreases in AD (demand pull inflation)Decreases in SAS (cost push inflation)
9 Inflation Cycles Demand-Pull Inflation starts because AD increasescan begin with any factor that increases AD.ExamplesMonetary policy & interest ratesFiscal policy: government spending or taxesExports (value of $ or foreign income levels)Investment (expected profits, technological advances)Consumer expectations
10 Inflation Cycles: Demand Pull Starting from full employment, an increase in ADIncreases P (spell of inflation)Increases RGDPCreates inflationary gap
11 Inflation Cycles: Demand Pull Sinceunempl < natural ratemoney wage rate risesSAS shifts leftP rises (another spell of inflation)RGDP falls until GDP=potential GDPInflation is finished unless AD increases again.
12 Inflation Cycles: Demand Pull Demand-Pull Inflation ProcessAD must continually increase so that the process described above repeats itselfAlthough 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.
13 If there is a decrease in AD, the short run effect is to _____ prices, ____ real wages, and cause unemployment to _____.Decrease; decrease; increaseDecrease; increase; increaseIncrease; decrease; decreaseNone of the above20
14 Inflation Cycles: Cost Push Cost-Push Inflationstarts with an increase in costsPossible sources of increased costs:An increase in the money wage rateAn increase in the money price of raw materials (e.g. oil)Natural disastersRegulation (e.g. carbon taxes)Results in decrease in SAS
15 Inflation Cycles: Cost Push Initial Effect of a Decrease in ASA 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)
16 Inflation Cycles: Cost Push Aggregate Demand ResponseThe 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.
17 Inflation Cycles & Inflation Expectations Expected InflationIf inflation is expected,AD increasesAS decreases as workers negotiate wage increases to offset expected inflation.Movement along LAS curveNo change in real GDP, real wages, or unemployment
18 If there is exceptionally good weather in the U. S If there is exceptionally good weather in the U.S., this should cause SAS to _____. The short run effect of this is to _____ prices and _____ real GDP.Decrease; increase; increaseIncrease; decrease; increaseIncrease; increase; increaseNone of the above20
19 Inflation Cycles & Inflation Expectations When the inflation forecast is correct, the economy operates at full employment.If AD grows faster than expected,Inflation > expectedReal wages decreaseReal GDP increases above potentialUnemployment rate falls below natural rateIf AD grows slower than expectedInflation < expectedReal wages riseUnemployment rate rises above natural rate
20 AD/AS representation of impact of inflation > expected inflation
21 AD/AS representation of impact of inflation < expected inflation
22 If the Federal Reserve creates more money than people expected, in the short run, this will cause real wages to ____ and unemployment to______.Rise; riseRise; fallFall; fallFall; rise20
23 The Phillips Curve Phillips curve SR Phillips curve LR Phillips curve shows the relationship between the inflation rate and the unemployment rate.SR Phillips curveShows tradeoff between inflation and unemployment holding constantThe expected inflation rateThe natural unemployment rateLR Phillips curveshows the relationship between inflation and unemployment when the actual inflation rate equals expected inflationvertical at natural rate of unemployment
24 The Phillips Curve A short-run Phillips curve (SRPC) As inflation increases, unemployment decreasesAD/AS explanation.If inflation=expected, unempl= natural rate.If inflation>expected, unempl<natural rateIf inflation < expected, unempl>natural rate
25 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 fallsUnemployment insuranceDemographics of labor force
26 The Phillips CurveSRPC shifts up/down as inflation expectations rise/fall
27 If the Federal Reserve cuts interest rates unexpectedly, this should cause A movement downward along the Phillips curveA movement upward along the Phillips curveAn upward shift of the Phillips curveA downward shift of the Phillips curve20
28 If the general public begins to believe that the Federal Reserve stimulus is going to lead to higher inflation in the future, this should cause:A movement downward along the Phillips curveA movement upward along the Phillips curveAn upward shift of the Phillips curveA downward shift of the Phillips curve20
31 Business Cycles Two approaches to understanding business cycles are: Mainstream business cycle theoryReal business cycle theoryMainstream (Demand Side) Business Cycle TheoryBecause potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.
32 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 affectsInvestment and interest ratesLabor market and wages
33 Real Business Cycles: Investment negative productivity shock:investment demand and loan demand fallsInterest rates fallreverse happens for positive productivity shock
34 Real Business Cycles: Labor Negative productivity shockLabor demand decreasesLabor supply decreases because of lower interest rates (above) and intertemporal substEmployment and the real wage rate decrease (assuming LD shift larger than LS).Reverse happens when there is an expansion caused by rapid productivity increase.