1. Old CHAPTER 32 Labor Markets, Unemployment and Inflation PowerPoint® Slides by Can Erbil © 2005 Worth Publishers, all rights reserved READ Krugman Section 6 Module 31-36 Mankiw Ch 28,35 DO Morton Unit 5

2. 2 What you will learn in this chapter: The meaning of the natural rate of unemployment, and why it isn’t zero Why cyclical unemployment changes over the business cycle How factors such as a minimum wage and efficiency wages can lead to structural unemployment The reasons that unemployment can be higher or lower than the natural rate for extended periods The existence of a short-run trade-off between unemployment and inflation, called the short-run Phillips curve, that disappears in the long run Why the NAIRU, the nonaccelerating inflation rate of unemployment, is an important measure for policy-making

3. 3 The Nature of Unemployment Workers who spend time looking for employment are engaged in job search. Frictional unemployment is unemployment due to the time workers spend in job search. Structural unemployment is unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage.

4. 4 Distribution of the Unemployed by Duration of Unemployment, 2000

5. 5 The Effect of a Minimum Wage on the Labor Market

6. 6 Causes of Structural Unemployment  Minimum wages  Unions  Efficiency wages  Side effects of government policies

7. 7 The Natural Rate of Unemployment  The natural rate of unemployment  Cyclical unemployment

8. 8 The Changing Makeup of the U.S. Labor Force

9. 9 Changes in the Natural Rate of Unemployment  Changes in Labor Force Characteristics  Changes in Labor Market Institutions  Changes in Government Policies  Changes in Productivity OUTPUT GAP: The percentage difference between the actual level of real GDP and potential output. OKUN’s LAW: Each additional percentage point of output gap reduces the unemployment rate by less than 1 percentage point.

10. 10 The Actual Unemployment Rate Fluctuates Around the Natural Rate

11. 11 These Fluctuations Correspond to the Output Gap

12. 12 Okun’s Law Each additional percentage point of output gap reduces the unemployment rate by less than 1 percentage point. Unemployment rate = Natural rate of unemployment – (0.5 x Output gap) For example: Suppose that the natural rate of unemployment is 5.2% and that the economy is currently producing only 98% of potential output. In that case, the output gap is -2% and Okun’s Law predicts an unemployment rate of 5.2% - (0.5 x (-2%)) = 6.2%

13. 13 Unemployment and Inflation, 1961–1990

14. CHAPTER 33 Inflation, Disinflation, and Deflation PowerPoint® Slides by Can Erbil © 2005 Worth Publishers, all rights reserved

15. 15 What you will learn in this chapter: Why efforts to collect an inflation tax by printing money can lead to high rates of inflation How high inflation can spiral into hyperinflation as the public tries to avoid paying the inflation tax The economy-wide costs of inflation and disinflation, and the debate over the optimal rate of inflation Why even moderate levels of inflation can be hard to end Why deflation is a problem for economic policy

16. 16 Money and Prices According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium level.

17. 17 Money Supply Growth and Inflation in Brazil

18. 18 The Inflation Tax and Hyperinflation  The inflation tax is the reduction in the real value of money held by the public caused by inflation, equal to the inflation rate times the money supply, on those who hold money.  The real value of resources captured by the government is reflected by the real inflation tax, the inflation rate times the real money supply.  A vicious circle of a shrinking real money supply and a rising rate of inflation, leads to hyperinflation and a fiscal crisis.

19. 19 Money and Prices in Brazil, 1985–1995

20. 20 According to the FISHER EFFECT, an increase in expected inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged. (Krugman) The 1 for 1 adjustment of the nominal interest rate to the inflation rate. (Mankiw) Real Interest Rate = Nominal interest rate – inflation rate

21. 21 The Fisher Effect

22. 22 The Costs of Inflation  Shoe-leather costs of inflation  The increased costs of making transactions that arise from the public’s efforts to avoid the inflation tax. (using more money to buy the same product)  Menu costs  Small costs associated with the act of changing prices.  Unit-of-account costs  Costs arising from the way inflation makes money a less reliable unit of measurement.

23. 23 Inflation and Nominal Interest Rates in the U.S.

24. Module Money, Output, and Prices in the Long Run KRUGMAN'S MACROECONOMICS for AP* 32 Margaret Ray and David Anderson

25. What you will learn in this Module : The effects of an inappropriate monetary policy The concept of monetary neutrality and its relationship to the long-term economic effects of monetary policy

26. Short-Run and Long-Run Effects of an Increase in the Money Supply Short-Run and Long-Run Effects of an Increase in the Money Supply Increases in the money supply initially lead to an increase in output, but in the long run increased nominal wages reduce SRAS and lead only to an increased price level.

27. Money Neutrality Money Neutrality Changes in the money supply have no real effects in the economy. In the long run, the only effect of an increase in the money supply is to raise the aggregate price level. Money is neutral in the long run.

28. Changes in the Money Supply and the Interest Rate in the Long Run 1) An increase in the MS lowers the IR in the short run 2) But in the long run, higher prices lead to greater Mdem, raising the IR to original level

29. Module Types of Inflation, Disinflation, and Deflation KRUGMAN’S MACROECONOMICS for AP* 33 Margaret Ray and David Anderson

30. What you will learn in this Module : The classical model of the price level Why efforts to collect an inflation tax by printing money can lead to high rates of inflation and even hyperinflation The types of inflation: cost-push and demand-pull

31. The Classical Model of Money and Prices The Classical Model of Money and Prices Increase in MS shifts demand rightward (AD 1 to AD 2 ). Creates new SR equilibrium at E 2 and higher PL at P 2. In LR, nominal wages adjust upward and push the SRAS curve leftward to SRAS 2. The total percent change in PL from P 1 to P 2 is equal to the percent increase in MS. In the classical model of the price level, we ignore the transition period and think of the price level as rising to P 3 immediately. This is a good approximation under conditions of high inflation.

32. The Classical Model of Money and Prices The Classical Model of Money and Prices %∆ M = %∆ PL Classical Model of the Price Level (E to E’’)...Good assumption given high inflation Classical Model ignores short- run changes ( E to E’)... Poor assumption given low inflation.

33. The Inflation Tax The Inflation Tax Independent central banks issue fiat money Monetizing the debt (turning the debt (bonds) into money) Seignorage (revenue generated by the FEDs right to print money) Inflation Tax ( financial loss of value suffered by holders of cash and fixed-rate bonds, as well those on fixed income (not indexed to inflation), due to the effects of inflation)

34. The Treasury issues debt to finance the government’s purchases of goods and services. The FED monetizes the debt by creating money and buying the debt back from the public through open-market purchases of Treasury Bills. In effect, the government can and does raise revenue by printing money.

35. Seignorage = M Real Seignorage = M/P Real Seignorage = ( M/M) x (M/P) M = Money Supply = monthly change in

36. The Logic of Hyperinflation The Logic of Hyperinflation Impact of inflation tax on people’s decision to hold money Why print large sums of money? Taxi analogy (if gov taxes taxi rides, people will find substitutes, and gov will have to raise taxes on taxi rides to gain more revenue) Substituting commodities for currency In the 1920s, hyperinflation made German currency worth so little that children made kites from the banknotes.

37. Moderate Inflation and Disinflation Cost-push inflation (inflation caused by an increase in the price of inputs) Demand-pull inflation (inflation caused by an increase in aggregate demand) Politically motivated inflation (policies that produce a booming economy may also increase inflation) Disinflation? Former Federal Reserve Chairman, Alan Greenspan

38. The Output Gap and the Unemployment Rate Output Gap Actual Output = Potential Output.: Actual Unemployment = Natural Rate of Unemployment Actual Output > Potential Output.: Actual Unemployment < Natural Rate of Unemployment Actual Output Natural Rate of Unemployment

39. Module Inflation and Unemployment: The Phillips Curve KRUGMAN’S MACROECONOMICS for AP* 34 Margaret Ray and David Anderson

40. What you will learn in this Module : What the Phillips curve is and the nature of the short-run trade-off between inflation and unemployment Why there is no long-run trade-off between inflation and unemployment Why expansionary policies are limited due to the effects of expected inflation Why even moderate levels of inflation can be hard to end Why deflation is a problem for economic policy and leads policy makers to prefer a low but positive inflation rate

41. 41 Why Doesn’t the Labor Market Move Quickly to Equilibrium?  Misperceptions  Sticky Wages  Menu Costs

42. The Short-Run Phillips Curve The Short-Run Phillips Curve Phillips Curve Short-Run Phillips Curve (negative short-run relationship between inflation and unemployment) The role of supply shocks Friedman and Phelps: (1968) crucial hypothesis: expectations about future inflation directly influences the present inflation rate. Today this is the most important factor affecting inflation (other than the unemployment rate).

43. 43 Unemployment and Inflation in the 1960s

44. Inflation Expectations and the Short-Run Phillips Curve Inflation Expectations and the Short-Run Phillips Curve Expected Inflation Relationship between actual and expected inflation What determines expected inflation? Why was expected inflation not included initially?

45. 45 Unemployment and Inflation: The Phillips Curve Hypothetically…..

46. 46 Expected Inflation and the Short-Run Phillips Curve

47. Inflation and Unemployment in the Long Run The SRPC of the 1960s (click) The experience of the 1970s (if inflation is consistently high, then people will expect more of the same) The trade-off between inflation and unemployment Most economists believe there is no long-run tradeoff……

48. The short run and long run effects of expansionary policies The Long-Run Phillips Curve The Long-Run Phillips Curve The unemployment rate at which inflation does NOT change over time….. LRPC = 5% or NAIRU (non- accelerating inflation rate of unemployment) …..keeping the Infl Rate below 5% leads to ever-accelerating inflation and cannot be maintained.

49. 49 The NAIRU and the Long-Run Phillips Curve NAIRU: non- accelerating inflation rate for unemployment. ***the unemployment rate at which inflation does not change over time.

50. The Long-Run Phillips Curve The Long-Run Phillips Curve NAIRU = 5% (non- accelerating inflation rate for unemployment) LRPC = 5% Natural Rate Hypothesis– another name for the NAIRU Natural Rate = NAIRU

51. The Costs of Disinflation The Costs of Disinflation

52. 52 The Great Disinflation of the 1980s

53. 53 Stock Market Crash of 1987 (Oct 19) BLACK MONDAY. DJIA dropped by 508 points to 1738.74 (22.61%). Potential causes for the decline include program trading, overvaluation, illiquidity, and market psychology. In program trading, computers perform rapid stock executions based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage and portfolio insurance strategies. Program trading (LTCM) was also responsible for the crash in 2007.

54. Deflation Deflation: falling price level Debt Deflation: borrowers— short of cash—forced to cut spending….result is decrease in AD. Effects of Expected Deflation: Lenders gain; borrowers lose Zero Bound: IR very low—can’t go below zero Liquidity Trap: when conventional monetary policy can’t be used because nominal IR are up against zero bound

55. 55 Effects of Deflation Effects of Unexpected Deflation: - Debt deflation - **The reduction in AD arising from the increase in the real burden of outstanding debt caused by deflation. Effects of Expected Deflation: - Zero bound - **on the nominal interest rate; it cannot go below zero. - Liquidity trap - **a situation in which monetary policy can’t be used because the nominal interest rates cannot fall below zero

56. 56 Japan’s Trap