Lecture 12 THE DYNAMICS OF INFLATION AND UNEMPLOYMENT

Lecture 12Lecture 12Lecture 12Lecture 12

THE DYNAMICS OF THE DYNAMICS OF INFLATION AND INFLATION AND

UNEMPLOYMENTUNEMPLOYMENT

THE DYNAMICS OF THE DYNAMICS OF INFLATION AND INFLATION AND

UNEMPLOYMENTUNEMPLOYMENT

Lecture OutlineLecture OutlineLecture OutlineLecture Outline

• Inflation and the Price LevelInflation and the Price Level

• Demand-Pull InflationDemand-Pull Inflation

• Cost-Push InflationCost-Push Inflation

• Effects of InflationEffects of Inflation

• The Phillips CurveThe Phillips Curve

• Inflation and the Price LevelInflation and the Price Level

• Demand-Pull InflationDemand-Pull Inflation

• Cost-Push InflationCost-Push Inflation

• Effects of InflationEffects of Inflation

• The Phillips CurveThe Phillips Curve

• InflationInflation is a is a processprocess in which the price in which the price level rises and money loses value.level rises and money loses value.

• Inflation is fundamentally a monetary Inflation is fundamentally a monetary phenomenon.phenomenon.

• The The average average level of prices is level of prices is risingrising..

• Inflation is Inflation is not high pricesnot high prices and inflation is and inflation is not a jump in pricesnot a jump in prices

• InflationInflation is a is a processprocess in which the price in which the price level rises and money loses value.level rises and money loses value.

• Inflation is fundamentally a monetary Inflation is fundamentally a monetary phenomenon.phenomenon.

• The The average average level of prices is level of prices is risingrising..

• Inflation is Inflation is not high pricesnot high prices and inflation is and inflation is not a jump in pricesnot a jump in prices

Inflation and the Price LevelInflation and the Price LevelInflation and the Price LevelInflation and the Price Level

• The figures The figures distinguishes distinguishes between a between a one time one time jump in jump in prices and prices and inflation.inflation.

• Part (b) Part (b) shows a one shows a one time jump in time jump in the price the price level. level.

• The figures The figures distinguishes distinguishes between a between a one time one time jump in jump in prices and prices and inflation.inflation.

• Part (b) Part (b) shows a one shows a one time jump in time jump in the price the price level. level.


• Part (a) Part (a) shows the shows the process of process of inflation.inflation.

• The inflation The inflation rate is the rate is the percentage percentage change in the change in the price level price level during a during a given period.given period.

• Part (a) Part (a) shows the shows the process of process of inflation.inflation.

• The inflation The inflation rate is the rate is the percentage percentage change in the change in the price level price level during a during a given period.given period.


• Demand-pull inflationDemand-pull inflation is inflation is inflation that results from an initial increase that results from an initial increase in aggregate demand.in aggregate demand.

• A demand pull inflation can result A demand pull inflation can result from any influence that increases from any influence that increases aggregate demand. aggregate demand.

• Demand-pull inflationDemand-pull inflation is inflation is inflation that results from an initial increase that results from an initial increase in aggregate demand.in aggregate demand.

• A demand pull inflation can result A demand pull inflation can result from any influence that increases from any influence that increases aggregate demand. aggregate demand.

Demand-Pull Inflation Demand-Pull Inflation Demand-Pull Inflation Demand-Pull Inflation

• In a demand-pull inflation, initiallyIn a demand-pull inflation, initially– aggregate demand increasesaggregate demand increases– real GDP increases above potential real GDP increases above potential

GDP and the price level risesGDP and the price level rises– money wages risemoney wages rise– the price level rises further and real the price level rises further and real

GDP decreases toward potential GDP decreases toward potential GDP.GDP.

• In a demand-pull inflation, initiallyIn a demand-pull inflation, initially– aggregate demand increasesaggregate demand increases– real GDP increases above potential real GDP increases above potential

GDP and the price level risesGDP and the price level rises– money wages risemoney wages rise– the price level rises further and real the price level rises further and real

GDP decreases toward potential GDP decreases toward potential GDP.GDP.


• A one-time increase in aggregate A one-time increase in aggregate demand raises the price level but demand raises the price level but does not always start a demand-pull does not always start a demand-pull inflation.inflation.

• For demand pull inflation to occur, For demand pull inflation to occur, aggregate demand must persistently aggregate demand must persistently increase.increase.

• The money supply must persistently The money supply must persistently grow at a rate that exceeds the grow at a rate that exceeds the growth rate of potential GDP.growth rate of potential GDP.

• A one-time increase in aggregate A one-time increase in aggregate demand raises the price level but demand raises the price level but does not always start a demand-pull does not always start a demand-pull inflation.inflation.

• For demand pull inflation to occur, For demand pull inflation to occur, aggregate demand must persistently aggregate demand must persistently increase.increase.

• The money supply must persistently The money supply must persistently grow at a rate that exceeds the grow at a rate that exceeds the growth rate of potential GDP.growth rate of potential GDP.


• The figures The figures show a show a demand pull demand pull inflation.inflation.

• Initially, Initially, aggregate aggregate demand demand increases.increases.

• The figures The figures show a show a demand pull demand pull inflation.inflation.

• Initially, Initially, aggregate aggregate demand demand increases.increases.


• Real GDP Real GDP increases increases and the price and the price level rises.level rises.

• Now real Now real GDP GDP exceeds exceeds potential potential GDP.GDP.

• Real GDP Real GDP increases increases and the price and the price level rises.level rises.

• Now real Now real GDP GDP exceeds exceeds potential potential GDP.GDP.


• There is an There is an inflationary inflationary gap.gap.

• The money The money wage rate wage rate begins to rise.begins to rise.

• And the And the SASSAS curve shifts curve shifts leftward.leftward.

• There is an There is an inflationary inflationary gap.gap.

• The money The money wage rate wage rate begins to rise.begins to rise.

• And the And the SASSAS curve shifts curve shifts leftward.leftward.


• Real GDP Real GDP decreases decreases toward toward potential potential GDP.GDP.

• The price The price level rises level rises further.further.

• Real GDP Real GDP decreases decreases toward toward potential potential GDP.GDP.

• The price The price level rises level rises further.further.


• This process This process repeats in an repeats in an unending unending price-wage price-wage spiral.spiral.

• This process This process repeats in an repeats in an unending unending price-wage price-wage spiral.spiral.


• Cost-push inflationCost-push inflation is an inflation is an inflation that results from an initial that results from an initial increase in costs.increase in costs.

• The two main sources of cost-The two main sources of cost-push inflation are:push inflation are:– an increase in the money wage ratean increase in the money wage rate– an increase in the money prices of an increase in the money prices of

raw materialsraw materials

• Cost-push inflationCost-push inflation is an inflation is an inflation that results from an initial that results from an initial increase in costs.increase in costs.

• The two main sources of cost-The two main sources of cost-push inflation are:push inflation are:– an increase in the money wage ratean increase in the money wage rate– an increase in the money prices of an increase in the money prices of

raw materialsraw materials

Cost-Push InflationCost-Push InflationCost-Push InflationCost-Push Inflation

• In a cost-push inflation, initiallyIn a cost-push inflation, initially– short-run aggregate supply short-run aggregate supply

decreasesdecreases– real GDP decreases below real GDP decreases below

potential GDP and the price level potential GDP and the price level risesrises

– the economy could become stuck the economy could become stuck in this in this stagflationstagflation situation for situation for some time.some time.

• In a cost-push inflation, initiallyIn a cost-push inflation, initially– short-run aggregate supply short-run aggregate supply

decreasesdecreases– real GDP decreases below real GDP decreases below

potential GDP and the price level potential GDP and the price level risesrises

– the economy could become stuck the economy could become stuck in this in this stagflationstagflation situation for situation for some time.some time.


• A one-time decrease in aggregate A one-time decrease in aggregate supply raises the price level but does supply raises the price level but does not always start a cost-push inflation.not always start a cost-push inflation.

• For cost-push inflation to occur, For cost-push inflation to occur, aggregate demand must increase in aggregate demand must increase in response to the cost push.response to the cost push.

• A one-time decrease in aggregate A one-time decrease in aggregate supply raises the price level but does supply raises the price level but does not always start a cost-push inflation.not always start a cost-push inflation.

• For cost-push inflation to occur, For cost-push inflation to occur, aggregate demand must increase in aggregate demand must increase in response to the cost push.response to the cost push.


• Just like the case of demand-Just like the case of demand-pull inflation, the money supply pull inflation, the money supply must persistently grow at a rate must persistently grow at a rate that exceeds the growth rate of that exceeds the growth rate of potential GDP if an inflation is to potential GDP if an inflation is to become persistent.become persistent.

• Just like the case of demand-Just like the case of demand-pull inflation, the money supply pull inflation, the money supply must persistently grow at a rate must persistently grow at a rate that exceeds the growth rate of that exceeds the growth rate of potential GDP if an inflation is to potential GDP if an inflation is to become persistent.become persistent.


• The The following following figures figures show a show a cost-push cost-push inflation.inflation.

• Initially, a Initially, a factor price factor price rises.rises.

• The The following following figures figures show a show a cost-push cost-push inflation.inflation.

• Initially, a Initially, a factor price factor price rises.rises.


• Short-run Short-run aggregate aggregate supply supply decreases decreases and the and the SASSAS curve curve shifts shifts leftwardleftward

• Short-run Short-run aggregate aggregate supply supply decreases decreases and the and the SASSAS curve curve shifts shifts leftwardleftward


• Real GDP Real GDP decreases decreases and the and the price level price level rises in a rises in a stagflationstagflation..

• Real GDP Real GDP decreases decreases and the and the price level price level rises in a rises in a stagflationstagflation..


• With no With no subsequet subsequet change in change in aggregate aggregate demand, demand, the price the price level level eventually eventually falls.falls.

• With no With no subsequet subsequet change in change in aggregate aggregate demand, demand, the price the price level level eventually eventually falls.falls.


• There is no There is no inflation.inflation.

• For cost-For cost-push push inflation to inflation to take hold, take hold, aggregate aggregate demand demand must must increase.increase.

• There is no There is no inflation.inflation.

• For cost-For cost-push push inflation to inflation to take hold, take hold, aggregate aggregate demand demand must must increase.increase.


• An increase An increase in the money in the money supply supply increases increases aggregate aggregate demand and demand and the the ADAD curve curve shifts shifts rightward.rightward.

• An increase An increase in the money in the money supply supply increases increases aggregate aggregate demand and demand and the the ADAD curve curve shifts shifts rightward.rightward.


• Real GDP Real GDP increases increases and the and the price level price level rises.rises.

• Real GDP Real GDP increases increases and the and the price level price level rises.rises.


• This This process process repeats to repeats to create an create an unending unending cost-price cost-price inflation inflation spiral.spiral.

• This This process process repeats to repeats to create an create an unending unending cost-price cost-price inflation inflation spiral.spiral.


HYPERINFLATIONHYPERINFLATIONHYPERINFLATIONHYPERINFLATION

• Very high inflation rates, over 50% per Very high inflation rates, over 50% per monthmonth

• Inflation rates observed in the US in Inflation rates observed in the US in the last 40 years are insignificant in the last 40 years are insignificant in comparison to some experiences comparison to some experiences around the world throughout history around the world throughout history

• Very high inflation rates, over 50% per Very high inflation rates, over 50% per monthmonth

• Inflation rates observed in the US in Inflation rates observed in the US in the last 40 years are insignificant in the last 40 years are insignificant in comparison to some experiences comparison to some experiences around the world throughout history around the world throughout history

HIGH INFLATIONS IN THE 1980sHIGH INFLATIONS IN THE 1980sHIGH INFLATIONS IN THE 1980sHIGH INFLATIONS IN THE 1980s

Country Bolivia Argentina Nicaragua Year 1985 1989 1988

Yearly Inflation 1,152, 200 975, 000 302, 200Rate (%)

Monthly Inflation 118 95 115Rate (%)

Monthly Money 91 93 66Growth Rate (%)

Source: Source: International Financial Statistics YearbookInternational Financial Statistics Yearbook, 1992,, 1992,

(Washington DC: International Monetary Fund)(Washington DC: International Monetary Fund)

DURING HYPERINFLATIONSDURING HYPERINFLATIONSDURING HYPERINFLATIONSDURING HYPERINFLATIONS• Money no longer works very well in facilitating Money no longer works very well in facilitating

exchangeexchange• Since prices are changing so fast and unpredictably, Since prices are changing so fast and unpredictably,

there is typically massive confusion about the true there is typically massive confusion about the true value of commoditiesvalue of commodities

• Different stores may be raising prices at different ratesDifferent stores may be raising prices at different rates• The same commodities may sell for radically different The same commodities may sell for radically different

pricesprices• Everyone spends all their time hunting for bargains and Everyone spends all their time hunting for bargains and

finding the lowest pricesfinding the lowest prices• Governments are forced to put an end to hyperinflation Governments are forced to put an end to hyperinflation

before it destroys their economiesbefore it destroys their economies

• Money no longer works very well in facilitating Money no longer works very well in facilitating exchangeexchange

• Since prices are changing so fast and unpredictably, Since prices are changing so fast and unpredictably, there is typically massive confusion about the true there is typically massive confusion about the true value of commoditiesvalue of commodities

• Different stores may be raising prices at different ratesDifferent stores may be raising prices at different rates• The same commodities may sell for radically different The same commodities may sell for radically different

pricesprices• Everyone spends all their time hunting for bargains and Everyone spends all their time hunting for bargains and

finding the lowest pricesfinding the lowest prices• Governments are forced to put an end to hyperinflation Governments are forced to put an end to hyperinflation

before it destroys their economiesbefore it destroys their economies

THE CAUSE OF HYPERINFLATIONTHE CAUSE OF HYPERINFLATIONTHE CAUSE OF HYPERINFLATIONTHE CAUSE OF HYPERINFLATIONExcessive money growthExcessive money growth

• If a government wants to spend a specified If a government wants to spend a specified amount of money, but is collecting less in amount of money, but is collecting less in taxes, it must cover the difference in some way:taxes, it must cover the difference in some way:– the government may borrow the difference from the public the government may borrow the difference from the public

and issue bonds, for which it must pay back what it borrows and issue bonds, for which it must pay back what it borrows and interest in the futureand interest in the future

– the government may print new moneythe government may print new money– governments could mix borrowing and printing money to governments could mix borrowing and printing money to

cover the deficitcover the deficit

government deficit = new borrowing + new money createdgovernment deficit = new borrowing + new money created

Excessive money growthExcessive money growth• If a government wants to spend a specified If a government wants to spend a specified

amount of money, but is collecting less in amount of money, but is collecting less in taxes, it must cover the difference in some way:taxes, it must cover the difference in some way:– the government may borrow the difference from the public the government may borrow the difference from the public

and issue bonds, for which it must pay back what it borrows and issue bonds, for which it must pay back what it borrows and interest in the futureand interest in the future

– the government may print new moneythe government may print new money– governments could mix borrowing and printing money to governments could mix borrowing and printing money to

cover the deficitcover the deficit

government deficit = new borrowing + new money createdgovernment deficit = new borrowing + new money created

HYPERINFLATIONHYPERINFLATIONHYPERINFLATIONHYPERINFLATION• occurs in countries that have large deficits, occurs in countries that have large deficits,

but cannot borrow and are forced to print but cannot borrow and are forced to print new moneynew money

• is only stopped by eliminating the deficit, is only stopped by eliminating the deficit, which is the basic cause:which is the basic cause:– increase taxesincrease taxes– cut spendingcut spending

• Once the deficit has been cut and the Once the deficit has been cut and the government stops printing money, the government stops printing money, the hyperinflation will end hyperinflation will end

• occurs in countries that have large deficits, occurs in countries that have large deficits, but cannot borrow and are forced to print but cannot borrow and are forced to print new moneynew money

• is only stopped by eliminating the deficit, is only stopped by eliminating the deficit, which is the basic cause:which is the basic cause:– increase taxesincrease taxes– cut spendingcut spending

• Once the deficit has been cut and the Once the deficit has been cut and the government stops printing money, the government stops printing money, the hyperinflation will end hyperinflation will end

INDEXEDINDEXEDINDEXEDINDEXED• Describes something whose payments are adjusted Describes something whose payments are adjusted

for changes in prices, such as bonds or nominal for changes in prices, such as bonds or nominal contractscontracts

• In practice, countries find that indexing is not the In practice, countries find that indexing is not the perfect solution to problems caused by inflation:perfect solution to problems caused by inflation:– policymakers worry indexing lowers the resolve to fight policymakers worry indexing lowers the resolve to fight

inflationinflation– Price indices are far from perfect and are Price indices are far from perfect and are extremely extremely

difficult to construct when prices are difficult to construct when prices are increasing rapidlyincreasing rapidly– Some economists believe that indexing builds Some economists believe that indexing builds inflation inflation

into the economic system and makes it difficult to reduce into the economic system and makes it difficult to reduce inflationinflation

• Describes something whose payments are adjusted Describes something whose payments are adjusted for changes in prices, such as bonds or nominal for changes in prices, such as bonds or nominal contractscontracts

• In practice, countries find that indexing is not the In practice, countries find that indexing is not the perfect solution to problems caused by inflation:perfect solution to problems caused by inflation:– policymakers worry indexing lowers the resolve to fight policymakers worry indexing lowers the resolve to fight

inflationinflation– Price indices are far from perfect and are Price indices are far from perfect and are extremely extremely

difficult to construct when prices are difficult to construct when prices are increasing rapidlyincreasing rapidly– Some economists believe that indexing builds Some economists believe that indexing builds inflation inflation

into the economic system and makes it difficult to reduce into the economic system and makes it difficult to reduce inflationinflation

MONETARISTSMONETARISTSMONETARISTSMONETARISTS• Economists who traditionally emphasize the Economists who traditionally emphasize the

important role that the supply of money plays in important role that the supply of money plays in determining nominal income and inflationdetermining nominal income and inflation

• Most famous - Milton Friedman, Nobel laureate - Most famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of studied versions of quantity equation and role of money in economic lifemoney in economic life

• Philip Cagan - best known for work on Philip Cagan - best known for work on hyperinflationshyperinflations

• Monetarist economists did pioneering research on Monetarist economists did pioneering research on link between money, nominal income and inflationlink between money, nominal income and inflation

• Economists who traditionally emphasize the Economists who traditionally emphasize the important role that the supply of money plays in important role that the supply of money plays in determining nominal income and inflationdetermining nominal income and inflation

• Most famous - Milton Friedman, Nobel laureate - Most famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of studied versions of quantity equation and role of money in economic lifemoney in economic life

• Philip Cagan - best known for work on Philip Cagan - best known for work on hyperinflationshyperinflations

• Monetarist economists did pioneering research on Monetarist economists did pioneering research on link between money, nominal income and inflationlink between money, nominal income and inflation

• Regardless of whether its origin is Regardless of whether its origin is demand-pull or cost-push, inflation demand-pull or cost-push, inflation imposes costs.imposes costs.

• The costs depend on whether the The costs depend on whether the inflation is anticipated or unanticipated.inflation is anticipated or unanticipated.

• Regardless of whether its origin is Regardless of whether its origin is demand-pull or cost-push, inflation demand-pull or cost-push, inflation imposes costs.imposes costs.

• The costs depend on whether the The costs depend on whether the inflation is anticipated or unanticipated.inflation is anticipated or unanticipated.

Effects of InflationEffects of InflationEffects of InflationEffects of Inflation

ANTICIPATED INFLATIONANTICIPATED INFLATIONANTICIPATED INFLATIONANTICIPATED INFLATION

Fully Anticipated InflationFully Anticipated Inflation• Inflation at 4% would mean workers would know that Inflation at 4% would mean workers would know that

nominal wage increases of 4% were not real wage nominal wage increases of 4% were not real wage increases, andincreases, and

• Investors earning a 7% rate of interest on bonds Investors earning a 7% rate of interest on bonds would know that their real return would be 3% after would know that their real return would be 3% after adjusting for inflationadjusting for inflation

• Menu costsMenu costs -- the actual physical costs of changing -- the actual physical costs of changing pricesprices

• Shoe leather costsShoe leather costs -- additional wear and tear -- additional wear and tear necessary to hold less cashnecessary to hold less cash

• Our tax system and financial system do not fully Our tax system and financial system do not fully adjust even to fully anticipated inflationadjust even to fully anticipated inflation

Fully Anticipated InflationFully Anticipated Inflation• Inflation at 4% would mean workers would know that Inflation at 4% would mean workers would know that

nominal wage increases of 4% were not real wage nominal wage increases of 4% were not real wage increases, andincreases, and

• Investors earning a 7% rate of interest on bonds Investors earning a 7% rate of interest on bonds would know that their real return would be 3% after would know that their real return would be 3% after adjusting for inflationadjusting for inflation

• Menu costsMenu costs -- the actual physical costs of changing -- the actual physical costs of changing pricesprices

• Shoe leather costsShoe leather costs -- additional wear and tear -- additional wear and tear necessary to hold less cashnecessary to hold less cash

• Our tax system and financial system do not fully Our tax system and financial system do not fully adjust even to fully anticipated inflationadjust even to fully anticipated inflation

• This figure This figure shows how shows how anticipating anticipating inflation inflation avoids the avoids the costs of costs of deviations deviations from from potential potential GDP.GDP.

• This figure This figure shows how shows how anticipating anticipating inflation inflation avoids the avoids the costs of costs of deviations deviations from from potential potential GDP.GDP.


• Anticipating inflation also avoids:Anticipating inflation also avoids:– the redistribution of income and wealth.the redistribution of income and wealth.– errors in investment and saving errors in investment and saving

decisions.decisions.

• But anticipated inflation does have But anticipated inflation does have some costs.some costs.

• Anticipating inflation also avoids:Anticipating inflation also avoids:– the redistribution of income and wealth.the redistribution of income and wealth.– errors in investment and saving errors in investment and saving

decisions.decisions.

• But anticipated inflation does have But anticipated inflation does have some costs.some costs.


• The costs of anticipated inflation are:The costs of anticipated inflation are:– ““bootleather” costsbootleather” costs– other transactions costsother transactions costs– decrease in potential GDPdecrease in potential GDP– decrease in the long-term growth rate.decrease in the long-term growth rate.

• These costs have been estimated to be These costs have been estimated to be very high, even for a modest inflation.very high, even for a modest inflation.

• The main problem is that taxes on capital The main problem is that taxes on capital income a seriously distorted by inflation.income a seriously distorted by inflation.

• The costs of anticipated inflation are:The costs of anticipated inflation are:– ““bootleather” costsbootleather” costs– other transactions costsother transactions costs– decrease in potential GDPdecrease in potential GDP– decrease in the long-term growth rate.decrease in the long-term growth rate.

• These costs have been estimated to be These costs have been estimated to be very high, even for a modest inflation.very high, even for a modest inflation.

• The main problem is that taxes on capital The main problem is that taxes on capital income a seriously distorted by inflation.income a seriously distorted by inflation.


• Unanticipated inflationUnanticipated inflation can cause the can cause the following problems:following problems:– redistribute income between firms and redistribute income between firms and

workersworkers– move real GDP away from potential GDPmove real GDP away from potential GDP– redistribute wealth between borrowers redistribute wealth between borrowers

and lendersand lenders– result in too much or too little saving and result in too much or too little saving and

investmentinvestment

• Unanticipated inflationUnanticipated inflation can cause the can cause the following problems:following problems:– redistribute income between firms and redistribute income between firms and

workersworkers– move real GDP away from potential GDPmove real GDP away from potential GDP– redistribute wealth between borrowers redistribute wealth between borrowers

and lendersand lenders– result in too much or too little saving and result in too much or too little saving and

investmentinvestment


• Because unanticipated inflation is costly, Because unanticipated inflation is costly, people try to anticipate it.people try to anticipate it.

• To make the best possible forecast of To make the best possible forecast of inflation, people use all the information inflation, people use all the information they can about the source of inflation and they can about the source of inflation and likely trends in those sources.likely trends in those sources.

• Such a forecast is called a Such a forecast is called a rational rational expectation.expectation.

• An anticipated inflation avoids some of the An anticipated inflation avoids some of the costs of inflation.costs of inflation.

• Because unanticipated inflation is costly, Because unanticipated inflation is costly, people try to anticipate it.people try to anticipate it.

• To make the best possible forecast of To make the best possible forecast of inflation, people use all the information inflation, people use all the information they can about the source of inflation and they can about the source of inflation and likely trends in those sources.likely trends in those sources.

• Such a forecast is called a Such a forecast is called a rational rational expectation.expectation.

• An anticipated inflation avoids some of the An anticipated inflation avoids some of the costs of inflation.costs of inflation.


COSTS OF INFLATIONCOSTS OF INFLATIONCOSTS OF INFLATIONCOSTS OF INFLATION

Anticipated UnanticipatedInflation Inflation

Institutions do Distortions in the Unfair redistributionsnot adjust tax system,

Problems in financial markets

Institutions Cost of changing Institutionaladjust prices, disintegration

Shoe-leather costs

THE PHILLIPS CURVE - 1THE PHILLIPS CURVE - 1THE PHILLIPS CURVE - 1THE PHILLIPS CURVE - 1• The Phillips Curve is a graph depicting a The Phillips Curve is a graph depicting a

relationship between the unemployment relationship between the unemployment rate and the inflation rate. The figure below rate and the inflation rate. The figure below shows a typical SHORT-RUN Phillips Curve.shows a typical SHORT-RUN Phillips Curve.

• The Phillips Curve is a graph depicting a The Phillips Curve is a graph depicting a relationship between the unemployment relationship between the unemployment rate and the inflation rate. The figure below rate and the inflation rate. The figure below shows a typical SHORT-RUN Phillips Curve.shows a typical SHORT-RUN Phillips Curve.

THE PHILLIPS CURVE - 2THE PHILLIPS CURVE - 2THE PHILLIPS CURVE - 2THE PHILLIPS CURVE - 2

• The implication of the negative slope is that the The implication of the negative slope is that the unemployment rate and the inflation rate are unemployment rate and the inflation rate are inversely related - in other words, there is a trade-inversely related - in other words, there is a trade-off between the two.off between the two.

• At the beginning of the course, one things we said At the beginning of the course, one things we said was that society faces a short-run trade-off was that society faces a short-run trade-off between inflation and unemployment. This trade-between inflation and unemployment. This trade-off is embodied in the short-run Phillips Curve.off is embodied in the short-run Phillips Curve.

• The implication of the negative slope is that the The implication of the negative slope is that the unemployment rate and the inflation rate are unemployment rate and the inflation rate are inversely related - in other words, there is a trade-inversely related - in other words, there is a trade-off between the two.off between the two.

• At the beginning of the course, one things we said At the beginning of the course, one things we said was that society faces a short-run trade-off was that society faces a short-run trade-off between inflation and unemployment. This trade-between inflation and unemployment. This trade-off is embodied in the short-run Phillips Curve.off is embodied in the short-run Phillips Curve.

THE PHILLIPS CURVE - 3THE PHILLIPS CURVE - 3THE PHILLIPS CURVE - 3THE PHILLIPS CURVE - 3• Since inflation and unemployment are BOTH Since inflation and unemployment are BOTH

things we don't like, the relationship between the things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the AD-AS (short-run) macroeconomic model and the Phillips Curve are important.Phillips Curve are important.

• Understanding the relationship between economic Understanding the relationship between economic policy and the inflation-unemployment trade-off is policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics.key to your understanding of macroeconomics.

• Since inflation and unemployment are BOTH Since inflation and unemployment are BOTH things we don't like, the relationship between the things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the AD-AS (short-run) macroeconomic model and the Phillips Curve are important.Phillips Curve are important.

• Understanding the relationship between economic Understanding the relationship between economic policy and the inflation-unemployment trade-off is policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics.key to your understanding of macroeconomics.

SHIFTS IN AD & THE PHILLIPS SHIFTS IN AD & THE PHILLIPS CURVE - 1CURVE - 1


Q:Q: What happens in the Phillips Curve What happens in the Phillips Curve diagram when there is a shift in AD?diagram when there is a shift in AD?

A:A: There is a movement along the short-run There is a movement along the short-run Phillips Curve and a trade-off between Phillips Curve and a trade-off between inflation and unemployment. inflation and unemployment.

Q:Q: What happens in the Phillips Curve What happens in the Phillips Curve diagram when there is a shift in AD?diagram when there is a shift in AD?

A:A: There is a movement along the short-run There is a movement along the short-run Phillips Curve and a trade-off between Phillips Curve and a trade-off between inflation and unemployment. inflation and unemployment.





• In the previous slide, AD increases from AD1 to AD2. In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves As a result, the equilibrium in the economy moves from point A to point B. from point A to point B.

• There are two important things to notice about the There are two important things to notice about the new equilibrium (relative to the old one):new equilibrium (relative to the old one):

– First, notice that the price level in the economy has First, notice that the price level in the economy has increased (from 102 to 106) - therefore, the rate of inflation increased (from 102 to 106) - therefore, the rate of inflation has risen. has risen.

– Second, the level of output produced in the economy has Second, the level of output produced in the economy has risen (from Y1 to Y2). When the level of output increases, risen (from Y1 to Y2). When the level of output increases, the number of people employed also rises, indicating that the number of people employed also rises, indicating that the unemployment rate MUST have fallen.the unemployment rate MUST have fallen.

• In the previous slide, AD increases from AD1 to AD2. In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves As a result, the equilibrium in the economy moves from point A to point B. from point A to point B.

• There are two important things to notice about the There are two important things to notice about the new equilibrium (relative to the old one):new equilibrium (relative to the old one):

– First, notice that the price level in the economy has First, notice that the price level in the economy has increased (from 102 to 106) - therefore, the rate of inflation increased (from 102 to 106) - therefore, the rate of inflation has risen. has risen.

– Second, the level of output produced in the economy has Second, the level of output produced in the economy has risen (from Y1 to Y2). When the level of output increases, risen (from Y1 to Y2). When the level of output increases, the number of people employed also rises, indicating that the number of people employed also rises, indicating that the unemployment rate MUST have fallen.the unemployment rate MUST have fallen.



• Relative to point A in the figure on the right, Relative to point A in the figure on the right, point B MUST be a point where there is higher point B MUST be a point where there is higher inflation and lower unemployment - but this just inflation and lower unemployment - but this just represents a movement ALONG the short-run represents a movement ALONG the short-run Phillips Curve. Also, if AD were to shift in the Phillips Curve. Also, if AD were to shift in the opposite direction, there would have been a opposite direction, there would have been a movement along the Phillips Curve in the movement along the Phillips Curve in the opposite direction. opposite direction.

• Relative to point A in the figure on the right, Relative to point A in the figure on the right, point B MUST be a point where there is higher point B MUST be a point where there is higher inflation and lower unemployment - but this just inflation and lower unemployment - but this just represents a movement ALONG the short-run represents a movement ALONG the short-run Phillips Curve. Also, if AD were to shift in the Phillips Curve. Also, if AD were to shift in the opposite direction, there would have been a opposite direction, there would have been a movement along the Phillips Curve in the movement along the Phillips Curve in the opposite direction. opposite direction.

THE LONG-RUN PHILLIPS THE LONG-RUN PHILLIPS CURVE - 1CURVE - 1


The figure below depicts the long-run Phillips The figure below depicts the long-run Phillips Curve:Curve:The figure below depicts the long-run Phillips The figure below depicts the long-run Phillips Curve:Curve:



• Earlier in the course, we discussed the Earlier in the course, we discussed the natural rate of unemployment. This was natural rate of unemployment. This was defined to be about 6% in the long-run, defined to be about 6% in the long-run, and it was shown that the economy tends and it was shown that the economy tends to automatically return to this level on its to automatically return to this level on its own. own.

• If this is true, then the long-run Phillips If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment!vertical line at 6% unemployment!

• Earlier in the course, we discussed the Earlier in the course, we discussed the natural rate of unemployment. This was natural rate of unemployment. This was defined to be about 6% in the long-run, defined to be about 6% in the long-run, and it was shown that the economy tends and it was shown that the economy tends to automatically return to this level on its to automatically return to this level on its own. own.

• If this is true, then the long-run Phillips If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment!vertical line at 6% unemployment!



• If the long-run Phillips Curve is vertical at 6%, If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose then policymakers must be able to choose any inflation rate they desire along this line.any inflation rate they desire along this line.

Q: What is the cost of reducing inflation in the Q: What is the cost of reducing inflation in the long-run?long-run?

A:A: In the long-run, there is NO cost to reducing In the long-run, there is NO cost to reducing inflation. inflation.

• If the long-run Phillips Curve is vertical at 6%, If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose then policymakers must be able to choose any inflation rate they desire along this line.any inflation rate they desire along this line.

Q: What is the cost of reducing inflation in the Q: What is the cost of reducing inflation in the long-run?long-run?

A:A: In the long-run, there is NO cost to reducing In the long-run, there is NO cost to reducing inflation. inflation.



This is demonstrated in the figures below:This is demonstrated in the figures below:This is demonstrated in the figures below:This is demonstrated in the figures below:



• On the left, if the Fed reduces the growth of the On the left, if the Fed reduces the growth of the money supply in the long-run, the AD curve will money supply in the long-run, the AD curve will shift to the left, causing the price level to fall shift to the left, causing the price level to fall from P0 to P1.from P0 to P1.

• However, output is NOT affected by changes in However, output is NOT affected by changes in the money supply in the long-run (because of the money supply in the long-run (because of monetary neutrality). Since output remains at the monetary neutrality). Since output remains at the natural rate of output, unemployment remains at natural rate of output, unemployment remains at the natural rate of unemployment.the natural rate of unemployment.

• On the left, if the Fed reduces the growth of the On the left, if the Fed reduces the growth of the money supply in the long-run, the AD curve will money supply in the long-run, the AD curve will shift to the left, causing the price level to fall shift to the left, causing the price level to fall from P0 to P1.from P0 to P1.

• However, output is NOT affected by changes in However, output is NOT affected by changes in the money supply in the long-run (because of the money supply in the long-run (because of monetary neutrality). Since output remains at the monetary neutrality). Since output remains at the natural rate of output, unemployment remains at natural rate of output, unemployment remains at the natural rate of unemployment.the natural rate of unemployment.



• On the right, the reduction in the growth of the On the right, the reduction in the growth of the money supply has lowered the long-run rate of money supply has lowered the long-run rate of inflation and has NOT affected the long-run inflation and has NOT affected the long-run unemployment rate.unemployment rate.

• On the right, the reduction in the growth of the On the right, the reduction in the growth of the money supply has lowered the long-run rate of money supply has lowered the long-run rate of inflation and has NOT affected the long-run inflation and has NOT affected the long-run unemployment rate.unemployment rate.

THE SHORT-RUN PHILLIPS THE SHORT-RUN PHILLIPS CURVE & EXPECTATIONS - 1CURVE & EXPECTATIONS - 1THE SHORT-RUN PHILLIPS THE SHORT-RUN PHILLIPS

CURVE & EXPECTATIONS - 1CURVE & EXPECTATIONS - 1

• While there is not a trade-off between While there is not a trade-off between inflation and unemployment in the long-inflation and unemployment in the long-run, there IS a short-run trade-off. run, there IS a short-run trade-off.

• From the work of Milton Friedman and From the work of Milton Friedman and Edmund Phelps, we know that Edmund Phelps, we know that expectations of future inflation plays an expectations of future inflation plays an important role in the short-run trade-off.important role in the short-run trade-off.

• While there is not a trade-off between While there is not a trade-off between inflation and unemployment in the long-inflation and unemployment in the long-run, there IS a short-run trade-off. run, there IS a short-run trade-off.

• From the work of Milton Friedman and From the work of Milton Friedman and Edmund Phelps, we know that Edmund Phelps, we know that expectations of future inflation plays an expectations of future inflation plays an important role in the short-run trade-off.important role in the short-run trade-off.



The figure below demonstrates the relationship The figure below demonstrates the relationship between the short-run Phillips Curve and between the short-run Phillips Curve and inflationary expectations:inflationary expectations:

The figure below demonstrates the relationship The figure below demonstrates the relationship between the short-run Phillips Curve and between the short-run Phillips Curve and inflationary expectations:inflationary expectations:



• Suppose the economy is initially at point Suppose the economy is initially at point ‘A’. Earlier we said that a shift in the AD ‘A’. Earlier we said that a shift in the AD curve will cause a movement along the curve will cause a movement along the short-run Phillips Curve. short-run Phillips Curve.

• An increase in the money supply, an An increase in the money supply, an increase in government spending or a tax increase in government spending or a tax cut could all shift the AD curve to the right cut could all shift the AD curve to the right - suppose one of these three occurs.- suppose one of these three occurs.

• Suppose the economy is initially at point Suppose the economy is initially at point ‘A’. Earlier we said that a shift in the AD ‘A’. Earlier we said that a shift in the AD curve will cause a movement along the curve will cause a movement along the short-run Phillips Curve. short-run Phillips Curve.

• An increase in the money supply, an An increase in the money supply, an increase in government spending or a tax increase in government spending or a tax cut could all shift the AD curve to the right cut could all shift the AD curve to the right - suppose one of these three occurs.- suppose one of these three occurs.



• The rightward shift in AD is associated with rising The rightward shift in AD is associated with rising output and a rising price level. output and a rising price level.

• The rising price level IS an increase in the rate of The rising price level IS an increase in the rate of inflation. inflation.

• Rising output goes along with rising employment Rising output goes along with rising employment (and falling unemployment). (and falling unemployment).

• For these reasons, the rightward shift in AD will For these reasons, the rightward shift in AD will cause a movement to point ‘B’ in this figure cause a movement to point ‘B’ in this figure (higher inflation and lower unemployment than (higher inflation and lower unemployment than point ‘A’).point ‘A’).

• The rightward shift in AD is associated with rising The rightward shift in AD is associated with rising output and a rising price level. output and a rising price level.

• The rising price level IS an increase in the rate of The rising price level IS an increase in the rate of inflation. inflation.

• Rising output goes along with rising employment Rising output goes along with rising employment (and falling unemployment). (and falling unemployment).

• For these reasons, the rightward shift in AD will For these reasons, the rightward shift in AD will cause a movement to point ‘B’ in this figure cause a movement to point ‘B’ in this figure (higher inflation and lower unemployment than (higher inflation and lower unemployment than point ‘A’).point ‘A’).



• Now, according to Friedman and Phelps, Now, according to Friedman and Phelps, the higher ACTUAL inflation will eventually the higher ACTUAL inflation will eventually cause EXPECTED inflation to rise as well.cause EXPECTED inflation to rise as well.

• The increase in EXPECTED inflation shifts The increase in EXPECTED inflation shifts the short-run Phillips Curve to the right (to the short-run Phillips Curve to the right (to SR-PC2), and the economy ends up at SR-PC2), and the economy ends up at point ‘C’.point ‘C’.

• Now, according to Friedman and Phelps, Now, according to Friedman and Phelps, the higher ACTUAL inflation will eventually the higher ACTUAL inflation will eventually cause EXPECTED inflation to rise as well.cause EXPECTED inflation to rise as well.

• The increase in EXPECTED inflation shifts The increase in EXPECTED inflation shifts the short-run Phillips Curve to the right (to the short-run Phillips Curve to the right (to SR-PC2), and the economy ends up at SR-PC2), and the economy ends up at point ‘C’.point ‘C’.


CURVE & EXPECTATIONS - 6CURVE & EXPECTATIONS - 6• We can describe SR-PC2 as a ‘short-run Phillips We can describe SR-PC2 as a ‘short-run Phillips

Curve with high expected inflation’, while the Curve with high expected inflation’, while the original curve, SR-PC1 can be described as a ‘short-original curve, SR-PC1 can be described as a ‘short-run Phillips Curve with low expected inflation’.run Phillips Curve with low expected inflation’.

• The result you should take from the previous figure The result you should take from the previous figure is that government policies attempting to EXPAND is that government policies attempting to EXPAND aggregate demand are likely to cause permanently aggregate demand are likely to cause permanently HIGHER rates of inflation, without affecting the HIGHER rates of inflation, without affecting the long-run unemployment rate. long-run unemployment rate.

• We can describe SR-PC2 as a ‘short-run Phillips We can describe SR-PC2 as a ‘short-run Phillips Curve with high expected inflation’, while the Curve with high expected inflation’, while the original curve, SR-PC1 can be described as a ‘short-original curve, SR-PC1 can be described as a ‘short-run Phillips Curve with low expected inflation’.run Phillips Curve with low expected inflation’.

• The result you should take from the previous figure The result you should take from the previous figure is that government policies attempting to EXPAND is that government policies attempting to EXPAND aggregate demand are likely to cause permanently aggregate demand are likely to cause permanently HIGHER rates of inflation, without affecting the HIGHER rates of inflation, without affecting the long-run unemployment rate. long-run unemployment rate.


CURVE & EXPECTATIONS - 7CURVE & EXPECTATIONS - 7• The relationship between the short-run Phillips The relationship between the short-run Phillips

Curve and inflationary expectations described Curve and inflationary expectations described by Friedman and Phelps is stated in the by Friedman and Phelps is stated in the following formula:following formula:

• The relationship between the short-run Phillips The relationship between the short-run Phillips Curve and inflationary expectations described Curve and inflationary expectations described by Friedman and Phelps is stated in the by Friedman and Phelps is stated in the following formula:following formula:



• In the previous example, when ACTUAL inflation In the previous example, when ACTUAL inflation exceed EXPECTED inflation (at point ‘B’), exceed EXPECTED inflation (at point ‘B’), unemployment was LESS THAN the natural rate. unemployment was LESS THAN the natural rate. In the long-run, actual and expected inflation will In the long-run, actual and expected inflation will be equal, and unemployment will equal the be equal, and unemployment will equal the natural rate (and the economy will be back on natural rate (and the economy will be back on the long-run Phillips Curve). the long-run Phillips Curve).

• In the previous example, when ACTUAL inflation In the previous example, when ACTUAL inflation exceed EXPECTED inflation (at point ‘B’), exceed EXPECTED inflation (at point ‘B’), unemployment was LESS THAN the natural rate. unemployment was LESS THAN the natural rate. In the long-run, actual and expected inflation will In the long-run, actual and expected inflation will be equal, and unemployment will equal the be equal, and unemployment will equal the natural rate (and the economy will be back on natural rate (and the economy will be back on the long-run Phillips Curve). the long-run Phillips Curve).

SUPPLY SHOCKS & THE SUPPLY SHOCKS & THE PHILLIPS CURVE - 1PHILLIPS CURVE - 1


Q: What happens in the Phillips Curve Q: What happens in the Phillips Curve diagram when the AS curve shifts?diagram when the AS curve shifts?

A: The short-run Phillips Curve shifts, A: The short-run Phillips Curve shifts, changing the attractiveness of the trade-changing the attractiveness of the trade-off between inflation and unemployment. off between inflation and unemployment.

Q: What happens in the Phillips Curve Q: What happens in the Phillips Curve diagram when the AS curve shifts?diagram when the AS curve shifts?

A: The short-run Phillips Curve shifts, A: The short-run Phillips Curve shifts, changing the attractiveness of the trade-changing the attractiveness of the trade-off between inflation and unemployment. off between inflation and unemployment.





• The figure on the left in the previous slide The figure on the left in the previous slide depicts a typical supply shock in the depicts a typical supply shock in the economy (like the OPEC shocks in the economy (like the OPEC shocks in the 1970s). 1970s).

• As the AS curve shifts to the left, the As the AS curve shifts to the left, the equilibrium in the marcoeconomy moves equilibrium in the marcoeconomy moves from point A to point B. from point A to point B.

• The figure on the left in the previous slide The figure on the left in the previous slide depicts a typical supply shock in the depicts a typical supply shock in the economy (like the OPEC shocks in the economy (like the OPEC shocks in the 1970s). 1970s).

• As the AS curve shifts to the left, the As the AS curve shifts to the left, the equilibrium in the marcoeconomy moves equilibrium in the marcoeconomy moves from point A to point B. from point A to point B.



• As with a shift in the AD curve, there are two things As with a shift in the AD curve, there are two things you should watch for when AS shifts:you should watch for when AS shifts:

– First, notice that the equilibrium price level rises (from P1 First, notice that the equilibrium price level rises (from P1 to P2), indicating that the level of inflation in the economy to P2), indicating that the level of inflation in the economy has risen.has risen.

– Second, notice that the level of output produced has Second, notice that the level of output produced has FALLEN from Y1 to Y2. As output falls the number of FALLEN from Y1 to Y2. As output falls the number of labourers required to produce this output also falls. When labourers required to produce this output also falls. When these workers get laid off, the unemployment rate RISES.these workers get laid off, the unemployment rate RISES.

• As with a shift in the AD curve, there are two things As with a shift in the AD curve, there are two things you should watch for when AS shifts:you should watch for when AS shifts:

– First, notice that the equilibrium price level rises (from P1 First, notice that the equilibrium price level rises (from P1 to P2), indicating that the level of inflation in the economy to P2), indicating that the level of inflation in the economy has risen.has risen.

– Second, notice that the level of output produced has Second, notice that the level of output produced has FALLEN from Y1 to Y2. As output falls the number of FALLEN from Y1 to Y2. As output falls the number of labourers required to produce this output also falls. When labourers required to produce this output also falls. When these workers get laid off, the unemployment rate RISES.these workers get laid off, the unemployment rate RISES.



• In the figure on the right, point B MUST be a In the figure on the right, point B MUST be a point with a higher inflation rate AND a higher point with a higher inflation rate AND a higher unemployment rate. unemployment rate.

• Point B MUST be up and to the right of point A. Point B MUST be up and to the right of point A. Because of this, economists say that the short-Because of this, economists say that the short-run Phillips Curve must have shifted to the right. run Phillips Curve must have shifted to the right.

• This means that the trade-off between inflation This means that the trade-off between inflation and unemployment is LESS attractive, because and unemployment is LESS attractive, because BOTH rates have risen.BOTH rates have risen.

• In the figure on the right, point B MUST be a In the figure on the right, point B MUST be a point with a higher inflation rate AND a higher point with a higher inflation rate AND a higher unemployment rate. unemployment rate.

• Point B MUST be up and to the right of point A. Point B MUST be up and to the right of point A. Because of this, economists say that the short-Because of this, economists say that the short-run Phillips Curve must have shifted to the right. run Phillips Curve must have shifted to the right.

• This means that the trade-off between inflation This means that the trade-off between inflation and unemployment is LESS attractive, because and unemployment is LESS attractive, because BOTH rates have risen.BOTH rates have risen.

COSTS OF REDUCING COSTS OF REDUCING INFLATION IN THE S/RUN - 1INFLATION IN THE S/RUN - 1


• The figure below illustrates the cost of reducing The figure below illustrates the cost of reducing inflation in the short-run:inflation in the short-run:

• The figure below illustrates the cost of reducing The figure below illustrates the cost of reducing inflation in the short-run:inflation in the short-run:



• To reduce inflation, the Fed will run a To reduce inflation, the Fed will run a contractionary monetary policy. contractionary monetary policy.

• The reduction in the money supply will shift AD The reduction in the money supply will shift AD to the left. to the left.

• Recall that a leftward shift in AD will cause Recall that a leftward shift in AD will cause falling output and a falling price level. The falling falling output and a falling price level. The falling price level means a falling rate of inflation, while price level means a falling rate of inflation, while falling output means falling employment (which, falling output means falling employment (which, in turn, means rising unemployment).in turn, means rising unemployment).

• To reduce inflation, the Fed will run a To reduce inflation, the Fed will run a contractionary monetary policy. contractionary monetary policy.

• The reduction in the money supply will shift AD The reduction in the money supply will shift AD to the left. to the left.

• Recall that a leftward shift in AD will cause Recall that a leftward shift in AD will cause falling output and a falling price level. The falling falling output and a falling price level. The falling price level means a falling rate of inflation, while price level means a falling rate of inflation, while falling output means falling employment (which, falling output means falling employment (which, in turn, means rising unemployment).in turn, means rising unemployment).



• The contractionary monetary policy has the effect of The contractionary monetary policy has the effect of moving the economy from point ‘A’ to point ‘B’ in the moving the economy from point ‘A’ to point ‘B’ in the figure. You should think of SR-PC1 as the ‘short-run figure. You should think of SR-PC1 as the ‘short-run Phillips Curve with HIGH inflationary expectations’. Phillips Curve with HIGH inflationary expectations’.

• At point ‘B’ inflation is lower and, in the long-run, At point ‘B’ inflation is lower and, in the long-run, inflationary expectations will adjust downwards to inflationary expectations will adjust downwards to match the lower ACTUAL inflation. When this occurs, match the lower ACTUAL inflation. When this occurs, the short-run Phillips Curve will shift INWARD to SR-the short-run Phillips Curve will shift INWARD to SR-PC0 (think of SR-PC0 as the ‘short-run Phillips Curve PC0 (think of SR-PC0 as the ‘short-run Phillips Curve with low inflationary expectations’.with low inflationary expectations’.

• The contractionary monetary policy has the effect of The contractionary monetary policy has the effect of moving the economy from point ‘A’ to point ‘B’ in the moving the economy from point ‘A’ to point ‘B’ in the figure. You should think of SR-PC1 as the ‘short-run figure. You should think of SR-PC1 as the ‘short-run Phillips Curve with HIGH inflationary expectations’. Phillips Curve with HIGH inflationary expectations’.

• At point ‘B’ inflation is lower and, in the long-run, At point ‘B’ inflation is lower and, in the long-run, inflationary expectations will adjust downwards to inflationary expectations will adjust downwards to match the lower ACTUAL inflation. When this occurs, match the lower ACTUAL inflation. When this occurs, the short-run Phillips Curve will shift INWARD to SR-the short-run Phillips Curve will shift INWARD to SR-PC0 (think of SR-PC0 as the ‘short-run Phillips Curve PC0 (think of SR-PC0 as the ‘short-run Phillips Curve with low inflationary expectations’.with low inflationary expectations’.



Q: In this example, what WAS the short-run Q: In this example, what WAS the short-run cost of reducing inflation?cost of reducing inflation?

A:A: Temporarily higher unemployment. Temporarily higher unemployment. However, as stated before, there is NO However, as stated before, there is NO long-run cost to reducing inflation, because long-run cost to reducing inflation, because the economy returned to the natural rate of the economy returned to the natural rate of unemployment as inflationary expectations unemployment as inflationary expectations adjusted.adjusted.

Q: In this example, what WAS the short-run Q: In this example, what WAS the short-run cost of reducing inflation?cost of reducing inflation?

A:A: Temporarily higher unemployment. Temporarily higher unemployment. However, as stated before, there is NO However, as stated before, there is NO long-run cost to reducing inflation, because long-run cost to reducing inflation, because the economy returned to the natural rate of the economy returned to the natural rate of unemployment as inflationary expectations unemployment as inflationary expectations adjusted.adjusted.



Q: Q: How big is the cost of reducing inflation in How big is the cost of reducing inflation in reality?reality?

A: A: There are two schools of thought:There are two schools of thought:– The Sacrifice Ratio.The Sacrifice Ratio.– Rational Expectations.Rational Expectations.

Q: Q: How big is the cost of reducing inflation in How big is the cost of reducing inflation in reality?reality?

A: A: There are two schools of thought:There are two schools of thought:– The Sacrifice Ratio.The Sacrifice Ratio.– Rational Expectations.Rational Expectations.

THE SACRIFICE RATIOTHE SACRIFICE RATIOTHE SACRIFICE RATIOTHE SACRIFICE RATIO• The Sacrifice Ratio is the number of percentage points of The Sacrifice Ratio is the number of percentage points of

annual output lost in the process of reducing inflation by 1 annual output lost in the process of reducing inflation by 1 percentage point. A typical sacrifice ratio is 5, meaning that percentage point. A typical sacrifice ratio is 5, meaning that reducing inflation by 1% will reduce the output of the reducing inflation by 1% will reduce the output of the economy by 5%. economy by 5%.

• When Paul Volcker was the Chairman of the Federal Reserve, When Paul Volcker was the Chairman of the Federal Reserve, he wanted to reduce inflation from about 10% to about 4%, he wanted to reduce inflation from about 10% to about 4%, meaning that the output of the economy might drop by as meaning that the output of the economy might drop by as much as 30% (that's as large as the drop during the Great much as 30% (that's as large as the drop during the Great Depression from 1929-1933). This school of thought indicates Depression from 1929-1933). This school of thought indicates that the short-run cost of reducing inflation is rather large. that the short-run cost of reducing inflation is rather large.

• The Sacrifice Ratio is the number of percentage points of The Sacrifice Ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 annual output lost in the process of reducing inflation by 1 percentage point. A typical sacrifice ratio is 5, meaning that percentage point. A typical sacrifice ratio is 5, meaning that reducing inflation by 1% will reduce the output of the reducing inflation by 1% will reduce the output of the economy by 5%. economy by 5%.

• When Paul Volcker was the Chairman of the Federal Reserve, When Paul Volcker was the Chairman of the Federal Reserve, he wanted to reduce inflation from about 10% to about 4%, he wanted to reduce inflation from about 10% to about 4%, meaning that the output of the economy might drop by as meaning that the output of the economy might drop by as much as 30% (that's as large as the drop during the Great much as 30% (that's as large as the drop during the Great Depression from 1929-1933). This school of thought indicates Depression from 1929-1933). This school of thought indicates that the short-run cost of reducing inflation is rather large. that the short-run cost of reducing inflation is rather large.

RATIONAL EXPECTATIONS - 1RATIONAL EXPECTATIONS - 1RATIONAL EXPECTATIONS - 1RATIONAL EXPECTATIONS - 1• Rational Expectations is a theory according to which people Rational Expectations is a theory according to which people

optimally use all the information they have when forecasting the optimally use all the information they have when forecasting the future.future.

• Drawing on the analysis of Friedman and Phelps, rational Drawing on the analysis of Friedman and Phelps, rational

expectations (which is attributed to Lucas, Sargent and Barro) expectations (which is attributed to Lucas, Sargent and Barro) claims that the short-run cost of reducing inflation will be related claims that the short-run cost of reducing inflation will be related to the speed with which inflationary expectations adjust. Rational to the speed with which inflationary expectations adjust. Rational expectations implies that the sacrifice ratio could be much lower expectations implies that the sacrifice ratio could be much lower than 5 if the commitment to lower inflation by the Fed is seen as than 5 if the commitment to lower inflation by the Fed is seen as ‘CREDIBLE’. In other words, if people in the economy immediately ‘CREDIBLE’. In other words, if people in the economy immediately believe that the Fed WILL reduce inflation, inflationary believe that the Fed WILL reduce inflation, inflationary expectations could adjust downwards immediately, and the expectations could adjust downwards immediately, and the sacrifice ratio could be 0. sacrifice ratio could be 0.

• Rational Expectations is a theory according to which people Rational Expectations is a theory according to which people optimally use all the information they have when forecasting the optimally use all the information they have when forecasting the future.future.

• Drawing on the analysis of Friedman and Phelps, rational Drawing on the analysis of Friedman and Phelps, rational

expectations (which is attributed to Lucas, Sargent and Barro) expectations (which is attributed to Lucas, Sargent and Barro) claims that the short-run cost of reducing inflation will be related claims that the short-run cost of reducing inflation will be related to the speed with which inflationary expectations adjust. Rational to the speed with which inflationary expectations adjust. Rational expectations implies that the sacrifice ratio could be much lower expectations implies that the sacrifice ratio could be much lower than 5 if the commitment to lower inflation by the Fed is seen as than 5 if the commitment to lower inflation by the Fed is seen as ‘CREDIBLE’. In other words, if people in the economy immediately ‘CREDIBLE’. In other words, if people in the economy immediately believe that the Fed WILL reduce inflation, inflationary believe that the Fed WILL reduce inflation, inflationary expectations could adjust downwards immediately, and the expectations could adjust downwards immediately, and the sacrifice ratio could be 0. sacrifice ratio could be 0.

RATIONAL EXPECTATIONS - 2RATIONAL EXPECTATIONS - 2RATIONAL EXPECTATIONS - 2RATIONAL EXPECTATIONS - 2• When Paul Volcker implemented his disinflation When Paul Volcker implemented his disinflation

policies in the early 1980s, there was neither a 30% policies in the early 1980s, there was neither a 30% drop in economic output, nor a 0% drop in economic drop in economic output, nor a 0% drop in economic output.output.

• The fact that the drop was greater than 0% caused The fact that the drop was greater than 0% caused many economists to refute the conclusions of rational many economists to refute the conclusions of rational expectations, while the much less than 30% drop in expectations, while the much less than 30% drop in output caused proponents of rational expectations to output caused proponents of rational expectations to claim success (stating that people reacted to the Fed’s claim success (stating that people reacted to the Fed’s policy, but NOT immediately). policy, but NOT immediately).

• When Paul Volcker implemented his disinflation When Paul Volcker implemented his disinflation policies in the early 1980s, there was neither a 30% policies in the early 1980s, there was neither a 30% drop in economic output, nor a 0% drop in economic drop in economic output, nor a 0% drop in economic output.output.

• The fact that the drop was greater than 0% caused The fact that the drop was greater than 0% caused many economists to refute the conclusions of rational many economists to refute the conclusions of rational expectations, while the much less than 30% drop in expectations, while the much less than 30% drop in output caused proponents of rational expectations to output caused proponents of rational expectations to claim success (stating that people reacted to the Fed’s claim success (stating that people reacted to the Fed’s policy, but NOT immediately). policy, but NOT immediately).

CONSIDERING ONGOING CONSIDERING ONGOING INFLATIONINFLATION

CONSIDERING ONGOING CONSIDERING ONGOING INFLATIONINFLATION

• Wages and prices can change for two Wages and prices can change for two reasons:reasons:

– Wages and prices will tend to rise Wages and prices will tend to rise during booms and fall during during booms and fall during recessionsrecessions

– Workers and firms will raise their Workers and firms will raise their nominal wages and prices to the extent nominal wages and prices to the extent they expect ongoing inflation to they expect ongoing inflation to maintain the same level of real wages maintain the same level of real wages and real pricesand real prices

• Wages and prices can change for two Wages and prices can change for two reasons:reasons:

– Wages and prices will tend to rise Wages and prices will tend to rise during booms and fall during during booms and fall during recessionsrecessions

– Workers and firms will raise their Workers and firms will raise their nominal wages and prices to the extent nominal wages and prices to the extent they expect ongoing inflation to they expect ongoing inflation to maintain the same level of real wages maintain the same level of real wages and real pricesand real prices

ECONOMY OPERATING AT ECONOMY OPERATING AT FULL EMPLOYMENTFULL EMPLOYMENT

ECONOMY OPERATING AT ECONOMY OPERATING AT FULL EMPLOYMENTFULL EMPLOYMENT

• Wages and prices will rise at the rate of inflation Wages and prices will rise at the rate of inflation expected by workers and firmsexpected by workers and firms

• If unemployment If unemployment exceedsexceeds the natural rate, the the natural rate, the high level of unemployment will put downward high level of unemployment will put downward pressure on wages and prices, and inflation will pressure on wages and prices, and inflation will falfall relative to what is expectedl relative to what is expected

• If unemployment were If unemployment were belowbelow the natural rate, the natural rate, employers would bid aggressively for workers, employers would bid aggressively for workers, and wages and prices would and wages and prices would riserise faster than faster than previously expectedpreviously expected

• Wages and prices will rise at the rate of inflation Wages and prices will rise at the rate of inflation expected by workers and firmsexpected by workers and firms

• If unemployment If unemployment exceedsexceeds the natural rate, the the natural rate, the high level of unemployment will put downward high level of unemployment will put downward pressure on wages and prices, and inflation will pressure on wages and prices, and inflation will falfall relative to what is expectedl relative to what is expected

• If unemployment were If unemployment were belowbelow the natural rate, the natural rate, employers would bid aggressively for workers, employers would bid aggressively for workers, and wages and prices would and wages and prices would riserise faster than faster than previously expectedpreviously expected

E AS0

AD0

Output, yyF

Price, p

CHOICES FOR THE FED

E

AS1

AS0

AD1AD0

Output, yyF

Price, p

CHOICES FOR THE FED

If workers push up their normal wages, the aggregate supply curve will shift fromAS0 to AS1.

A

E

AS1

AS0

AD0

Output, yyF

Price, p

CHOICES FOR THE FED

If workers push up their normal wages, the aggregate supply curve will shift fromAS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will occur at A and eventually the economy will return to full employment at E.

A F

E

AS1

AS0

AD1AD0

Output, yyF

Price, p

CHOICES FOR THE FED

If workers push up their normal wages, the aggregate supply curve will shift fromAS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will occur at A and eventually the economy will return to full employment at E. If the Fed increases aggregate demand , the economy remains at full employment at F, but with a higher price level.

EXPECTATIONS OF THE UNIONEXPECTATIONS OF THE UNIONEXPECTATIONS OF THE UNIONEXPECTATIONS OF THE UNION• The actions of a union will depend on what its The actions of a union will depend on what its

leaders expect the Fed to do:leaders expect the Fed to do:

– If they expect the Fed will not increase aggregate If they expect the Fed will not increase aggregate demand, their actions will trigger a recessiondemand, their actions will trigger a recession

– The union may be reluctant to negotiate a high wage, The union may be reluctant to negotiate a high wage, permitting the economy to remain at full employment permitting the economy to remain at full employment and experience no increase in pricesand experience no increase in prices

– If the leaders believe the Fed will increase aggregate If the leaders believe the Fed will increase aggregate demand, the union will increase the nominal wagedemand, the union will increase the nominal wage

– The result will be higher prices in the economyThe result will be higher prices in the economy

• The actions of a union will depend on what its The actions of a union will depend on what its leaders expect the Fed to do:leaders expect the Fed to do:

– If they expect the Fed will not increase aggregate If they expect the Fed will not increase aggregate demand, their actions will trigger a recessiondemand, their actions will trigger a recession

– The union may be reluctant to negotiate a high wage, The union may be reluctant to negotiate a high wage, permitting the economy to remain at full employment permitting the economy to remain at full employment and experience no increase in pricesand experience no increase in prices

– If the leaders believe the Fed will increase aggregate If the leaders believe the Fed will increase aggregate demand, the union will increase the nominal wagedemand, the union will increase the nominal wage

– The result will be higher prices in the economyThe result will be higher prices in the economy

EXPECTATIONS ABOUT THE EXPECTATIONS ABOUT THE FEDFED

EXPECTATIONS ABOUT THE EXPECTATIONS ABOUT THE FEDFED

• Expectations about the Fed’s determination to Expectations about the Fed’s determination to fight inflation will affect the behavior in the private fight inflation will affect the behavior in the private sectorsector

• If the Fed is credible or believable in its desire to If the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from fight inflation, it can deter the private sector from taking aggressive actions that drive up pricestaking aggressive actions that drive up prices

• Some political scientists and economists have Some political scientists and economists have suggested that central banks which have true suggested that central banks which have true independence from the rest of government, and independence from the rest of government, and are less subject to political influence, will be more are less subject to political influence, will be more credible in their commitment to fight inflationcredible in their commitment to fight inflation

• Expectations about the Fed’s determination to Expectations about the Fed’s determination to fight inflation will affect the behavior in the private fight inflation will affect the behavior in the private sectorsector

• If the Fed is credible or believable in its desire to If the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from fight inflation, it can deter the private sector from taking aggressive actions that drive up pricestaking aggressive actions that drive up prices

• Some political scientists and economists have Some political scientists and economists have suggested that central banks which have true suggested that central banks which have true independence from the rest of government, and independence from the rest of government, and are less subject to political influence, will be more are less subject to political influence, will be more credible in their commitment to fight inflationcredible in their commitment to fight inflation

Documents

Lecture 12 THE DYNAMICS OF INFLATION AND UNEMPLOYMENT