2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 1 CHAPTER Grappling with Inflation, Unemployment, and Growth CHAPTER Grappling

12002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber

CHAPTER CHAPTER Grappling with Inflation, Grappling with Inflation,

Unemployment, Unemployment, and Growth and Growth

3


Grappling with Inflation, Unemployment, and Growth

• Costs of Inflation– Redistribution of Income– Informational and Uncertainty Costs– Institutional and Constitutional Costs– Menu and Shoe Leather Costs

• Why Some Unemployment is Necessary– Flows In and Out of the Labor Market– Vacancies– Labor Market as a Matchmaker


• Natural Rate of Unemployment

• Cyclical Unemployment

• The Phillips Curve


Policy PrioritiesPolicy Priorities• Since low inflation and low

unemployment may conflict in the short run, policy makers must give one top priority

• The Federal Reserve believes that– monetary policy does not affect the natural

rate of unemployment– therefore, preventing inflation must be the

primary goal of monetary policy


Legislative Basis of PolicyLegislative Basis of Policy

• Employment Act of 1946Employment Act of 1946– Required the government to use all of its

powers to promote “maximum employment, production, and purchasing power.”

• Full Employment and Balanced Growth Full Employment and Balanced Growth Act of 1978Act of 1978– Requires the Fed chairman to present

economic forecasts and targets for money supply growth to Congress twice a year


Effects of InflationEffects of Inflation• Inflation makes buyers poorer because

they must pay higher prices

• Inflation makes sellers richer because they are paid higher prices

• Since most people are both buyers (as consumers) and sellers (as owners of factors of production), the average person’s income and wealth aren’t changed by inflation


Inflation Redistributes IncomeInflation Redistributes Income

• Inflation redistributes income from those who do not, or cannot, raise their prices to those who can, and do, raise their prices.

• People do not raise prices if inflation is unanticipated.

• People can not raise their prices if they are fixed by a contract.


Inflation Redistributes Income Inflation Redistributes Income from Lenders to Borrowersfrom Lenders to Borrowers

• Suppose that you had planned to buy a pair of shoes for $100, but instead you lend the $100 to a friend for a year at 3% interest.

• At the end of the year your friend repays you $103.

• During the year, inflation was 5%, so now the shoes cost $105.

• Your real rate of return was -2%.


Real and Nominal Interest RatesReal and Nominal Interest Rates

Nominal interest rate = Real interest rate + Anticipated inflation

If lenders anticipate inflation, they add the amount of expected inflation to the real interestrate that they require to maintain their purchasing power.


Costs of InflationCosts of Inflation

• Informational Costs– Prices are used to make comparisons

between goods, but inflation distorts that information.

• Uncertainty Costs– Inflation may distort and delay expenditures

because it makes predicting future prices more difficult.



• Institutional Costs– Inflation undermines institutions and

conventions, such as rules of thumb and contracts, which are based on relatively fixed prices.

• Constitutional Costs– Inflation undermines the convention of

money that forms the basis of exchange in the economy.



• Menu Costs– Inflation requires firms to spend time and

money posting current prices in catalogues, menus, and on ticketed merchandise.

• Shoe Leather Costs– Inflation increases the cost of managing

cash balances.


Shoe Leather Costs

• Shoe leather cost refers to the cost of time and effort (more specifically the opportunity cost of time and energy) that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank. The term comes from the fact that more walking is required (historically, although the rise of the Internet has reduced it) to go to the bank and get cash and spend it, thus wearing out shoes more quickly. The actual cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were no inflation.


Inflation: Grease or Sand?Inflation: Grease or Sand?In

flat

ion

(%

)

Growth

3

6

9

Sand

Grease

Low inflation may stimulategrowth, but inflation over 3%may reduce growth.


Why Some Unemployment is Why Some Unemployment is NecessaryNecessary

• Flows In and Out of the Labor Market– About 10 million people change their job

status every month.

• Vacancies– Vacancies arise when workers leave their

jobs and/or new jobs are created.

• Labor Market as a Matchmaker– The labor market is not an instant

matchmaker between unemployed workers and job vacancies


Flows In and Out of the Labor MarketFlows In and Out of the Labor Market

Employed127.3 Million

Unemployed 6.7 Million

Not in Labor Market 66.8 Million

2 million 1.7 million

1.7 million

1.2 million

3 million 3.5 million


Supply and Demand for LaborSupply and Demand for Labor

Employment

Rea

l Wag

e

SM

S

D

AB

N1

We

N2

DM

Point A represents labormarket equilibrium withno search costs.

Point B represents equilibriumwith search costs. N2-N1 isfrictional unemployment.


Supply and Demand for Labor Supply and Demand for Labor with Above Equilibrium Wageswith Above Equilibrium Wages

Employment

Rea

l Wag

e

SM

S

D

AB

N1

We

N2

DM

ND2ND1

W1 Above equilibrium wages cause insider-outsider unemployment NS2-ND1.


Why are Wages Above Why are Wages Above Equilibrium?Equilibrium?

• Unions may exert pressure for higher wages.

• The government may impose a minimum wage that is above the equilibrium wage.

• Efficiency wages are above equilibrium wages paid to attract and retain the best workers.


Strategies to Lower European Strategies to Lower European UnemploymentUnemployment

• Improve labor force skills with education and training

• Reform employment security laws

• Reduce regulation of work time and temporary jobs

• Reform the level and duration of unemployment benefits


The Natural Rate of The Natural Rate of UnemploymentUnemployment

• The natural rate of unemployment is the sum of frictional and insider-outsider unemployment.

• The natural rate of unemployment has decreased 0.6 to 1.1 percentage points from the mid 1980s to the late 1990s.


Causes of the Decline in the Causes of the Decline in the Natural RateNatural Rate


Cyclical UnemploymentCyclical Unemployment

• Cyclical unemployment occurs when real output is below potential output.

• Cyclical unemployment exists because of coordination failures.– Problems that develop in an economy

because decisions by individuals feed back into the economy, augmenting the effect of the initial decision.


The U.S. Unemployment Rate The U.S. Unemployment Rate and Vacancy Rateand Vacancy Rate


The Business Cycle in the Labor MarketThe Business Cycle in the Labor Market

Employment

Rea

l Wag

e

S

D

N1

We

N

Recessions cause a decreasein the demand for labor fromD to D1

The wage rate remains the same in the short-run, and employment falls to N1.

D1


Cost of Cyclical UnemploymentCost of Cyclical Unemployment

• The cost of cyclical unemployment is the difference between actual output and potential output.

• Okun’s Rule of Thumb describes the relationship between unemployment and growth in GDP.


Growth in GDP and Change in Growth in GDP and Change in UnemploymentUnemployment


Okun’s Rule of ThumbOkun’s Rule of Thumb

%Q = 3.5 - 2 U

%Q is the percent change in real GDPU is the change in the unemployment rate


Equity Costs of UnemploymentEquity Costs of Unemployment• For individuals the costs of

unemployment include lost income, a decline in skills, and loss of self-worth.

• Unemployment is not shared equally among demographic groups– Teenage unemployment is higher than the

overall unemployment rate.– The unemployment rate for blacks and

Hispanics is higher than for whites.


U.S. Unemployment by Age, Gender, U.S. Unemployment by Age, Gender, and Raceand Race


The Phillips CurveThe Phillips Curve

Unemployment Rate (%)

Infl

atio

n R

ate

(%)

A

B

7%

3%

4% 8%

The Phillips curve represents a short-run trade off between inflation and unemployment. If policy makers choose to reduce unemployment from 8% (B) to4% (A) the cost may be an increase in inflation from 3% to 7%.


Inflation and Unemployment Inflation and Unemployment 1954-20001954-2000

• The Phillips curve which shows the historical relationship between inflation and unemployment has not remained stable over time.

• Between 1958 and 1969, an inverse relationship between unemployment and inflation did exist.





• Between 1970 and 1984, the inverse relationship broke down. Both inflation and unemployment were high in those years.

• The inverse relationship between inflation and unemployment reappeared between 1985 and 1992, but disappeared again in 1992 when inflation and unemployment both decreased.


Short-Run and Long-Run Phillips CurvesShort-Run and Long-Run Phillips CurvesIn

flat

ion

Unemployment

Long-RunPhillips Curve

Short-RunPhillips Curve

Natural rateof Unemployment

There are two Phillips curves:

A long-run Phillips curve whichis vertical at the natural rate of unemployment.

A short-run Phillips curve that shifts along the long-run curve.


Short-Run and Long-Run Phillips Curves

• The long-run Phillips curve shows that policymakers cannot reduce unemployment below the natural rate by accepting more inflation.

• The short-run Phillips curve represents a tradeoff between inflation and unemployment that changes as the curve shifts.


Sacrifice RatioSacrifice Ratio

• The sacrifice ratio is the annual percentage point loss of output for every percentage point decline in the annual inflation rate.

• The sacrifice ratio during the early 1980s was 2.3.


The Sacrifice Ratio for the United The Sacrifice Ratio for the United States, 1980-1983States, 1980-1983

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2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 1 CHAPTER Grappling with Inflation, Unemployment, and Growth CHAPTER Grappling