Prepared by: Fernando Quijano and Yvonn Quijano And modified by Gabriel Martinez 9 C H A P T E R Inflation, Activity, and Nominal Money Growth

Prepared by:

Fernando Quijano and Yvonn Quijano

And modified by Gabriel Martinez

99C H A P T E RC H A P T E R

Inflation, Activity,Inflation, Activity,and Nominal Moneyand Nominal MoneyGrowthGrowth

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Volcker Disinflation The Volcker Disinflation

In October 1979, the Fed, under Paul In October 1979, the Fed, under Paul Volcker, decided to reduce nominal money Volcker, decided to reduce nominal money growth and decrease inflation, then close to growth and decrease inflation, then close to 14% per year.14% per year.

Five years later, after a deep recession, Five years later, after a deep recession, inflation was down to 4% per year.inflation was down to 4% per year.



The Volcker Disinflation The Volcker Disinflation

How did the Fed reduce inflation?How did the Fed reduce inflation? It did it It did it by changing the relationship between by changing the relationship between

inflation and unemploymentinflation and unemployment It caused a recession to prove it was serious It caused a recession to prove it was serious

about inflation. This changed expectations of about inflation. This changed expectations of inflation.inflation.


Output, Unemployment,Output, Unemployment,and Inflationand Inflation

This chapter builds on three relations:This chapter builds on three relations:1.1. Okun’s Law, which relates the change in Okun’s Law, which relates the change in

unemployment to output growth.unemployment to output growth.

2.2. The Phillips curve, which relates the changes The Phillips curve, which relates the changes in inflation to unemployment.in inflation to unemployment.

3.3. The aggregate demand relation, which relates The aggregate demand relation, which relates output growth to both nominal money growth output growth to both nominal money growth and inflation.and inflation.

9-1


Output Growth, Unemployment, Inflation, Output Growth, Unemployment, Inflation, and Nominal Money Growthand Nominal Money Growth



We are used to thinking in terms of AS-ADWe are used to thinking in terms of AS-AD AS, which shows the effect of output on prices, AS, which shows the effect of output on prices,

is split in this chapter into two parts:is split in this chapter into two parts: Output affects unemployment through Okun’s Law.Output affects unemployment through Okun’s Law.

A higher growth rate of output reduces unemployment.A higher growth rate of output reduces unemployment. Previously, we assumed Y = N = L(1-u), but life is richer Previously, we assumed Y = N = L(1-u), but life is richer

and more complicated.and more complicated.

Unemployment affects inflation through the Phillips Unemployment affects inflation through the Phillips Curve.Curve. A lower unemployment rate causes inflation to rise.A lower unemployment rate causes inflation to rise.



We are still using AD.We are still using AD. Higher prices lower output demanded.Higher prices lower output demanded.

Suppose the Central Bank increases the Suppose the Central Bank increases the nominal money supply at a constant, positive nominal money supply at a constant, positive rate = 5%.rate = 5%.

Inflation = 3%, so the rate of growth of Inflation = 3%, so the rate of growth of realreal money supply is 2% = 5% money supply is 2% = 5% –– 3%. 3%.

Suppose inflation rises unexpectedly to 4%.Suppose inflation rises unexpectedly to 4%. Then the Then the realreal money supply will rise more money supply will rise more

slowly, at 1% per year.slowly, at 1% per year.

Higher inflation reduces the rate of growth of real Higher inflation reduces the rate of growth of real money, money, which reduces the output growth ratewhich reduces the output growth rate..


Okun’s Law:Okun’s Law:

FromFromOutput Growth to Output Growth to UnemploymentUnemployment


Okun’s Law: FromOkun’s Law: FromOutput Growth to UnemploymentOutput Growth to Unemployment If output grows, unemployment should If output grows, unemployment should

fall, right?fall, right? AssumeAssume

Y = N Y = N Y = L – U. Y = L – U.

YYtt – Y – Yt-1t-1 = (L = (Ltt – L – Lt-1t-1) – (U) – (Utt – U – Ut-1t-1)) Assume the labor force doesn’t grow (LAssume the labor force doesn’t grow (Ltt – –

LLt-1t-1=0). Then=0). Then

YYtt – Y – Yt-1t-1 = – (U = – (Utt – U – Ut-1t-1))


Okun’s Law: FromOkun’s Law: FromOutput Growth to UnemploymentOutput Growth to Unemployment YYtt – Y – Yt-1t-1 = – (U = – (Utt – U – Ut-1t-1)) This also implies that the unemployment This also implies that the unemployment raterate

(u) is negatively related to the output (u) is negatively related to the output growth growth raterate (g): (g):

We’ve made a lot of assumptions: no inputs We’ve made a lot of assumptions: no inputs besides labor, no diminishing returnsbesides labor, no diminishing returns

Particularly, we assumed no changes in labor Particularly, we assumed no changes in labor productivity, constant labor force, etc.productivity, constant labor force, etc.

u u gt t y t 1

ytt

tt gY

YY

1

1

tt

t uL

U


Okun’s Law: FromOkun’s Law: FromOutput Growth to UnemploymentOutput Growth to Unemployment

The change in the unemployment rate could The change in the unemployment rate could be equal to the negative of the growth rate of be equal to the negative of the growth rate of output.output.

For example, if output growth is 4%, then the For example, if output growth is 4%, then the unemployment rate should decline by 4%.unemployment rate should decline by 4%.

Now, let’s be more realistic.Now, let’s be more realistic.

u u gt t y t 1



The The actualactual relation between output relation between output growth and the change in the growth and the change in the unemployment rate is known as unemployment rate is known as Okun’s Okun’s law.law. This relation allows for more realistic This relation allows for more realistic

production functions, labor market behavior, production functions, labor market behavior, etc.etc.

Particularly, it allows for changes in labor Particularly, it allows for changes in labor productivity, and a growing labor force, etc, productivity, and a growing labor force, etc, so the economy can be expected to be so the economy can be expected to be growing constantly.growing constantly.



High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate.

Changes in the Changes in the Unemployment Rate Unemployment Rate Versus Output Versus Output Growth in the United Growth in the United States, 1970-2000States, 1970-2000

Using thirty years of data, the line that best fits Using thirty years of data, the line that best fits the data is given by:the data is given by: u u gt t y t 1 0 4 3 % ). (


Okun’s Law Across CountriesOkun’s Law Across Countries

Table 1Table 1 Okun’s Law Coefficients Across Countries and TimeOkun’s Law Coefficients Across Countries and Time

CountryCountry 1960-1980 1960-1980 ββ 1981-2003 1981-2003 ββ

United StatesUnited States 0.390.39 0.390.39

United KingdomUnited Kingdom 0.150.15 0.540.54

GermanyGermany 0.200.20 0.320.32

JapanJapan 0.020.02 0.120.12

The coefficient β in Okun’s law gives the effect on the unemployment rate of deviations of output growth from normal. A value of β of 0.4 tells us that output growth 1% above the normal growth rate for 1 year decreases the unemployment rate by 0.4%.



According to the equation above,According to the equation above,

u u gt t y t 1 0 4 3 % ). (

If g , then uyt t tu 3 % 0 4 01 . ( )

If g , then uyt t tu 3 % 0 4 01 . ( )

If g , then uyt t tu 3 % 0 4 0 01 . ( )



yg

To maintain the unemployment rate To maintain the unemployment rate constant, output growth must be 3% per constant, output growth must be 3% per year. This growth rate of output is called the year. This growth rate of output is called the normal growth rate.normal growth rate.

Output growth 1% Output growth 1% above normalabove normal leads only leads only to a to a %<1 reduction in unemployment.%<1 reduction in unemployment.



1β

t t yt yu u ( g g )

-- =- -

Output growth above normal leads to a Output growth above normal leads to a decrease in the unemployment rate. decrease in the unemployment rate.

If output grows below normal, the If output grows below normal, the unemployment rate. Increases.unemployment rate. Increases.

This is Okun’s law:This is Okun’s law: g g u uyt y t t 1

g g u uyt y t t 1



%)3(4.01 yttt guu Assume ut-1 = 6%

gyt 4%4% 5%5% 6%6%

ut

gyt 2%2% 1%1% 0%0%

ut

gyt 3%3%

ut


The Phillips’s Curve:The Phillips’s Curve:

FromFromUnemployment to InflationUnemployment to Inflation


The Phillips Curve: From The Phillips Curve: From Unemployment to InflationUnemployment to Inflation

Inflation depends on expected inflation and on Inflation depends on expected inflation and on the deviation of unemployment from the natural the deviation of unemployment from the natural rate of unemployment. Suppose rate of unemployment. Suppose ee

tt is well is well

approximated by approximated by t-1t-1. Then:. Then:

1π π α

t t t n( u u )

-- =- -

π π αe

t t t n( u u )= - -

The Phillips curve implies thatThe Phillips curve implies that

u ut n t t 1

u ut n t t 1


The Aggregate Demand RelationThe Aggregate Demand Relation

FromFromNominal Money Growth and Nominal Money Growth and

InflationInflationToTo

Output GrowthOutput Growth


The Aggregate Demand Relation:The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output GrowthFrom Nominal Money Growth and Inflation to Output Growth

If the IS curve isIf the IS curve is

And the LM curve isAnd the LM curve is

Then the AD curve isThen the AD curve is

Aggregate Expenditure depends on all sorts of Aggregate Expenditure depends on all sorts of parameters (the c’s, the b’s, the d’s, t, and G), parameters (the c’s, the b’s, the d’s, t, and G), positively on positively on M M and negatively on and negatively on PP..

0

2200

21211 /)1(1

1G

Pd

Mbbc

ddbbtcY

020011 )1(1

1Gibbc

btcY

Pd

MY

d

di

22

1



More simply, we can say thatMore simply, we can say that

A D R ela tio YM

PG Tt

t

tt tn Y

, ,

Even more simply, suppose that changes in Even more simply, suppose that changes in output are caused only changes in the real output are caused only changes in the real money stock, then:money stock, then:

γ tt

t

MY

P=



γ tt

t

MY

P=

Let’s put this in terms of growth rates:Let’s put this in terms of growth rates: ggytyt = (Y = (Ytt-Y-Yt-1t-1)/Y)/Yt-1t-1

ggmtmt = (M = (Mtt-M-Mt-1t-1)/M)/Mt-1t-1

= (P= (Ptt-P-Pt-1t-1)/P)/Pt-1t-1

And since And since is a parameter ( is a parameter (tt--t-1t-1)/)/t-1t-1=0.=0.

From this we can deriveFrom this we can deriveg gyt m t t



How do we go from to ?How do we go from to ?

The easiest way is to use logarithms and calculus:The easiest way is to use logarithms and calculus:Log Y = log (Log Y = log (M/P)M/P)

Log Y = log Log Y = log + log M - log P + log M - log PTaking a Taking a total derivativetotal derivative

g gyt m t t γ tt

t

MY

P=

tmtyt

tttttttt

gg

P

PP

M

MM

Y

YY

P

dP

M

dMd

Y

dY

dP

Pd

dM

Md

d

d

dY

Yd

1111

loglogloglog



In terms of the In terms of the growth rates growth rates of output, of output, money, and the price level:money, and the price level:

According to the aggregate demand relation:According to the aggregate demand relation:

g gyt m t t

g gm t t y t 0

g gm t t y t 0

Given inflation, expansionary monetary policy Given inflation, expansionary monetary policy leads to high output growth.leads to high output growth.



tmtyt gg Assume t = 3%

gmt 7%7% 5%5% 3%3% 1%1%

gyt

t 6%6% 4%4% 2%2%

gyt

Assume gmt = 6%


The Three Relations The Three Relations

g gyt m t t 1

π π αt t t n

( u u )-

- =- -1

βt t yt y

u u ( g g )-

- =- -• Okun’s Law

• Phillips Curve

• AD Relation



g gyt m t t

1π π α

t t t n( u u )

-- =- -

1β

t t yt yu u ( g g )

-- =- -

The Medium RunThe Medium Run

9-2



In chapter 6 we defined the medium run In chapter 6 we defined the medium run as the time when as the time when PPee=P=Pt-1t-1=P=Ptt.. This meant that there was no reason for This meant that there was no reason for PPee to to

change.change. No changes in No changes in PPee meant that the WS would meant that the WS would

stay put, yielding a “stay put, yielding a “steady-statesteady-state”, medium-”, medium-run level of unemployment, the natural rate run level of unemployment, the natural rate of unemployment.of unemployment.



The medium run: The medium run: PPee=P=Pt-1t-1=P=Ptt..

In growth rates rather than levels, In growth rates rather than levels, t t = = ee..

Then, by the Phillips curve, Then, by the Phillips curve, u = uu = unn..

So inflation is constant.So inflation is constant.

Because Because uunn is constant, so is is constant, so is

unemployment.unemployment.



Inflation is constant.Inflation is constant. Because nominal money growth is a policy Because nominal money growth is a policy

variable, it changes exogenously and it is more variable, it changes exogenously and it is more natural to imagine that its constant.natural to imagine that its constant.

Then, by the aggregate demand curve,Then, by the aggregate demand curve,

output growth must be constant.output growth must be constant.ytg

mm gg

g gyt m t t



Is this constant equal toIs this constant equal to

which is normal output growth?which is normal output growth?

It has to be. If it weren’t, It has to be. If it weren’t, uu would have to would have to be changing, which is inconsistent withbe changing, which is inconsistent withu = uu = unn..

ygytg

1β

t t yt yu u ( g g )

-- =- -



t t = = t-1t-1..

t t = = ee..

uutt = u = ut-1t-1..

uutt = u = un n ..

For any level of For any level of ggmm..

)1( tyyt gg

yyt gg



Alternatively,Alternatively,

Start by assuming thatStart by assuming that

This makes sense as a definition of the This makes sense as a definition of the medium run because we want the MR to be a medium run because we want the MR to be a time of rest, stability, constancy. time of rest, stability, constancy.

u ut t 1


So Okun’s Law implies that output grows So Okun’s Law implies that output grows at its normal rateat its normal rate..

u ut t 1

yyt gg



u ut t 1

Assume nominal money growth is Assume nominal money growth is

We know output growth is equal to its normal rateWe know output growth is equal to its normal rate

Then the aggregate demand relation ( )Then the aggregate demand relation ( )

implies that inflation is constant:implies that inflation is constant:

g gm y

yyt gg

yg

g gyt m t t


mm gg



According to the equation above, in the medium According to the equation above, in the medium run, inflation equals the difference between run, inflation equals the difference between nominal money growth and nominal money growth and normalnormal output output growth.growth.

Call Call adjusted nominal money adjusted nominal money growth.growth.

g gm y

ym gg



If inflation is constant, thenIf inflation is constant, then

t t = = t-1t-1,,

if this is true, the Phillips curve implies if this is true, the Phillips curve implies thatthat

uutt = u = unn..

Therefore, in the medium run, the Therefore, in the medium run, the unemployment rate must equal the unemployment rate must equal the natural rate of unemployment.natural rate of unemployment.



Changes in nominal money growth have no Changes in nominal money growth have no effect on output or unemployment effect on output or unemployment in the in the medium runmedium run, because in the medium run, because in the medium runuutt = u = unn and , and neither and , and neither uunn nor normal nor normal

output growth depend on the money supply.output growth depend on the money supply.

So changes in nominal money growth must be So changes in nominal money growth must be reflected one for one in changes in the rate of reflected one for one in changes in the rate of inflation.inflation.

yyt gg



In the medium run, unemployment is equal to the natural rate of unemployment, at any level of inflation.

Inflation and Inflation and UnemploymentUnemploymentin the Medium Runin the Medium Run



In the medium run, inflation is equal to adjusted nominal money growth.




In the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment.




SupposeSuppose

In the medium run, gIn the medium run, gytyt = =

uutt = =

tt = =

Adjusted money growth =Adjusted money growth =

%2%,6%,7 ynm gandug

From the Short Run to the From the Short Run to the Medium RunMedium Run


From the Short Run to the Medium From the Short Run to the Medium RunRun

Above we defined Okun’s Law asAbove we defined Okun’s Law as

““Unemployment falls if output grows above the normal Unemployment falls if output grows above the normal growth rate of output.”growth rate of output.”

But other authors define it asBut other authors define it as

““Cyclical unemploymentCyclical unemployment arises if if output grows below arises if if output grows below the normal growth rate of output.”the normal growth rate of output.”

1β

t t yt yu u ( g g )

-- =- -

)( yytnt gguu



If we use this definition of Okun’s LawIf we use this definition of Okun’s Law

And we remember that the Phillips curve isAnd we remember that the Phillips curve is

Then we can write an “Inflation Adjustment” Then we can write an “Inflation Adjustment” curve.curve. It will say that inflation rises when output is It will say that inflation rises when output is

above normal.above normal.

)( yytnt gguu

π π αe

t t t n( u u )= - -



An “Inflation Adjustment” curve.An “Inflation Adjustment” curve. It says that inflation rises when output is above It says that inflation rises when output is above

normal.normal.

)( yyte

t gg

)( yytnt gguu

π π αe

t t t n( u u )= - -

Okun’s Law

Phillips’ Curve

Inflation-Adjustment curve


An “Inflation Adjustment” curveAn “Inflation Adjustment” curve

ytye

t gg

t

ytg

e gy

yg

e

)( yyte

t gg

If gyt = gy,

t=e

IA

Higher output growth reduces

unemployment and increases inflation.



The Aggregate Demand curve.The Aggregate Demand curve. (For a given rate of nominal money growth),(For a given rate of nominal money growth), The AD curve says that if inflation rises, the real The AD curve says that if inflation rises, the real

money supply grows more slowly.money supply grows more slowly. This raises interest rates, lowers the growth rate This raises interest rates, lowers the growth rate

of spending, and lowers the growth rate of of spending, and lowers the growth rate of actual real output.actual real output.

g gyt m t t


The Aggregate Demand curveThe Aggregate Demand curve

t

ytg

gmt

AD

g gyt m t t

Higher inflation reduces the real

money supply and reduces real output

growth.



t

ytg

AD

g gyt m t t

At point A, output growth is below the

natural rate of output growth, and inflation is below

expected inflation.

yg

e

IA

)( yyte

t gg IA = OL + PC AD

A



t

ytg

AD

g gyt m t t

In the short-run, t<e.

yg

e

IA

)( yyte

t gg IA AD

In the medium-run, wage-setters will lower

their expectations of inflation, which shifts the IA curve down.

IA

This happens until

gyt = gy.

A



t

ytg

AD

Imagine the Central Bank shifted the AD

curve up repeatedly by raising gmt in order to

get short-run reductions in unemployment.

yg

IA

In the medium-run, the IA curve will shift up

over and over, keeping

gyt = gy.

gyt = gy means that

u=un,

At any level

of gmt and t.



t

ytg

AD

In the medium run, t=e

The short-run relation between output growth and inflation disappears and the IA equation

becomes

While AD determines inflation.

yg

yyt gg

)( yyte

t gg



In the short run,In the short run, Aggregate demand influences output: output Aggregate demand influences output: output

grows faster if inflation is below nominal money grows faster if inflation is below nominal money supply growth.supply growth.

Inflation adjusts upward if output grows above Inflation adjusts upward if output grows above the normal rate.the normal rate.

In the medium run,In the medium run, Expectations of inflation adjust so and Expectations of inflation adjust so and

u=uu=unn..

AD only determines inflation.AD only determines inflation.

yyt gg



In the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment.




SupposeSuppose

The CB changes The CB changes

In the medium run, gIn the medium run, gytyt = =

uutt = =

tt = =

Adjusted money growth =Adjusted money growth =

%2%,6%,7 ynm gandug

%3tomg

The Effects of Money GrowthThe Effects of Money Growth



Okun’s law relates the change in the Okun’s law relates the change in the unemployment rate to the deviation of output unemployment rate to the deviation of output growth from normal:growth from normal:

The Phillips curve relates the change in The Phillips curve relates the change in inflation to the deviation of the unemployment inflation to the deviation of the unemployment rate from the natural rate:rate from the natural rate:

The aggregate demand relation relates output The aggregate demand relation relates output growth to the difference between nominal growth to the difference between nominal money growth and inflation.money growth and inflation.

u u g gt t y t y 1 ( )

t t t nu u 1 ( )

g gyt m t t



Output Growth, Unemployment, Inflation, and Nominal Money Growth



Assume that the central bank maintains a constant Assume that the central bank maintains a constant growth rate of nominal money, call it . In this case, growth rate of nominal money, call it . In this case, the values of output growth, unemployment, and the values of output growth, unemployment, and inflation in the inflation in the medium run:medium run: Output must grow at its normal rate of growth, Output must grow at its normal rate of growth, If we define If we define adjusted nominal money growthadjusted nominal money growth as equal to as equal to

nominal money growth minus normal output growth, then nominal money growth minus normal output growth, then inflation equals adjusted nominal money growth.inflation equals adjusted nominal money growth.

The unemployment rate must equal to the natural rate of The unemployment rate must equal to the natural rate of unemployment. unemployment.

g y

gm

ytmtt gg


The Short RunThe Short Run

Now suppose that the central bank decides Now suppose that the central bank decides to decrease nominal money growth. What will to decrease nominal money growth. What will happen in the short run?happen in the short run? Given the initial rate of inflation, lower nominal Given the initial rate of inflation, lower nominal

money growth leads to lower real nominal money money growth leads to lower real nominal money growth , and thus to a decrease in output growth.growth , and thus to a decrease in output growth.

Now, look at Okun’s law, output growth below Now, look at Okun’s law, output growth below normal leads to an increase in unemployment.normal leads to an increase in unemployment.

Now, look at the Phillips curve relation. Now, look at the Phillips curve relation. Unemployment above the natural rate leads to a Unemployment above the natural rate leads to a decrease in inflation.decrease in inflation.


The Short RunThe Short Run

Table 9-1Table 9-1 The Effects of Monetary TighteningThe Effects of Monetary Tightening

Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3

1 Real money growth %1 Real money growth % (g(gmm--ππ)) 3.03.0 0.50.5 5.55.5 3.03.0

2 Output growth %2 Output growth % (g(gyy)) 3.03.0 0.50.5 5.55.5 3.03.0

3 Unemployment rate %3 Unemployment rate % (u)(u) 6.06.0 7.07.0 6.06.0 6.06.0

4 Inflation gate %4 Inflation gate % ((ππ)) 5.05.0 4.04.0 4.04.0 4.04.0

5 Nominal money growth %5 Nominal money growth % (g(gmm)) 8.08.0 4.54.5 9.59.5 7.07.0

In words: In the short run, monetary tightening leads to a slowdown in growth and a temporary increase in unemployment. In the medium run, output growth returns to normal, and the unemployment rate returns to the natural rate.

DisinflationDisinflation9-3


DisinflationDisinflation

To achieve lower inflation, the rate of nominal money To achieve lower inflation, the rate of nominal money growth must be reduced.growth must be reduced.

This implies a (possibly long) transition between one This implies a (possibly long) transition between one “medium-run” equilibrium and another “medium-run” “medium-run” equilibrium and another “medium-run” equilibrium.equilibrium.

This This transitiontransition happens in the short run, so the happens in the short run, so the downward sloping (Original) Phillips Curve becomes downward sloping (Original) Phillips Curve becomes relevant again.relevant again.

Disinflation moves the economy (in the short run) Disinflation moves the economy (in the short run) alongalong the short-run (Original) Phillips Curve. the short-run (Original) Phillips Curve.

In the medium run, Unemployment above natural In the medium run, Unemployment above natural causes a shift causes a shift downdown of the Phillips curve, until of the Phillips curve, until unemployment = uunemployment = unn in the medium run. in the medium run.



In the medium run, inflation is equal to adjusted nominal money growth.




In the short run, inflation is decreased by increasing unemployment.In the medium run, higher unemployment and lower inflation cause a fall in expected inflation and a shift down of the SR Phillips Curve.


Decrease in expectations of inflation.


DisinflationDisinflation To achieve lower inflation, the rate of nominal money To achieve lower inflation, the rate of nominal money

growth must be reduced. Here is what happens in the growth must be reduced. Here is what happens in the Short Run:Short Run:

In the aggregate demand relation,In the aggregate demand relation,

Then, from Okun’s law,Then, from Okun’s law,

Finally, according to the Phillips curve relation:Finally, according to the Phillips curve relation:

g g gm m y( )

g uy

u

• Notice that now u > un.

g gyt m t t

1π π α

t t t n( u u )

-- =- -

1β

t t yt yu u ( g g )

-- =- -



But over time, in the Medium Run,But over time, in the Medium Run, According to the Phillips curve relation:According to the Phillips curve relation:

As As falls, it falls far enough below falls, it falls far enough below ggmm..

In the aggregate demand relation,In the aggregate demand relation,

Eventually Eventually ggyy rises enough that rises enough that ggy y > > ggyy..

Then, from Okun’s law,Then, from Okun’s law,

After a decrease in nominal money growth, unemployment After a decrease in nominal money growth, unemployment first increases, but eventually it starts decreasing.first increases, but eventually it starts decreasing.

u u n

g g uy y

g gyt m t t

1π π α

t t t n( u u )

-- =- -

1β

t t yt yu u ( g g )

-- =- -

0 ym gg


Working Out the PathWorking Out the Pathof Nominal Money Growthof Nominal Money Growth

The Central Bank wants to cut inflation from 14% to The Central Bank wants to cut inflation from 14% to 4%. To do this, it cuts nominal money growth 4%. To do this, it cuts nominal money growth radically, which reduces output growth and radically, which reduces output growth and increases unemployment. Inflation gradually falls.increases unemployment. Inflation gradually falls.

Table 9-1 Engineering Disinflation00 11 22 33 44 55 66 77 88

Inflation (%) 14 12 10 8 6 4 4 4 4

Nominal money growth (%) 17 10 13 11 9 7 12 7 7

Output growth (%) 3 2 3 3 3 3 8 3 3

Unemploymentrate (%) 6 8 8 8 8 8 6 6 6


How Much Unemployment?How Much Unemployment?and for How Long?and for How Long?

In the Phillips curve relation above, In the Phillips curve relation above, disinflationdisinflation——a decrease in inflation—can be obtained only at a decrease in inflation—can be obtained only at the cost of higher unemployment.the cost of higher unemployment.

1π π α

t t t n( u u )

-- =- -

1π π 0 0

t t t n t n( ) ( u u ) u u

-- < Þ - > Þ >



Do we have any idea of the amount of Do we have any idea of the amount of unemployment we must inflict on an unemployment we must inflict on an economy to reduce the inflation rate?economy to reduce the inflation rate?

Are there measures of this sacrifice?Are there measures of this sacrifice? What are the determinants?What are the determinants? How should we design disinflation How should we design disinflation

programs?programs?



For example, let’s assume that For example, let’s assume that =1/2 =1/2 Then reducing inflation by 10 percentage points Then reducing inflation by 10 percentage points

requires increasing unemployment above the requires increasing unemployment above the natural rate by 20 percentage points over a natural rate by 20 percentage points over a number of years:number of years: Notice that while the left-hand side is a year-per-year Notice that while the left-hand side is a year-per-year

change, the right-hand side is just the difference change, the right-hand side is just the difference between two variables, one of which doesn’t change between two variables, one of which doesn’t change with time.with time.

1π π α

t t t n( u u )

-- =- -



If If =1/2, reducing inflation by 10 percentage =1/2, reducing inflation by 10 percentage points requires 20 percentage points of excess points requires 20 percentage points of excess unemployment over a number of years:unemployment over a number of years: Suppose we want to achieve the disinflation Suppose we want to achieve the disinflation

over 5 years: then we need 5 years of over 5 years: then we need 5 years of unemployment at 4 percentage points above unemployment at 4 percentage points above the natural rate.the natural rate.

Achieving the disinflation over 10 years means Achieving the disinflation over 10 years means 10 years of unemployment at 2 percentage 10 years of unemployment at 2 percentage points above the natural rate.points above the natural rate.

1π π α

t t t n( u u )

-- =- -



If If =0.8, reducing inflation by 10 percentage =0.8, reducing inflation by 10 percentage points requires 12.5 percentage points of excess points requires 12.5 percentage points of excess unemployment over a number of years:unemployment over a number of years: Achieving the disinflation over 2 years means Achieving the disinflation over 2 years means

2 years of unemployment at 6.5 percentage 2 years of unemployment at 6.5 percentage points above the natural rate.points above the natural rate.

Achieving the disinflation over 25 years means Achieving the disinflation over 25 years means 25 years of unemployment at 0.5 percentage 25 years of unemployment at 0.5 percentage points above the natural rate.points above the natural rate.

1π π α

t t t n( u u )

-- =- -



A A point-year of excess unemploymentpoint-year of excess unemployment is is a difference between the actual and the a difference between the actual and the natural unemployment rate of one natural unemployment rate of one percentage point for one year.percentage point for one year. So if So if =1/2, reducing inflation by 10 percentage =1/2, reducing inflation by 10 percentage

points requires 20 points-years of excess points requires 20 points-years of excess unemployment.unemployment.

If If =0.8, reducing inflation by 10 percentage =0.8, reducing inflation by 10 percentage points requires 12.5 points-years of excess points requires 12.5 points-years of excess unemployment :unemployment :



The The sacrifice ratiosacrifice ratio (=1/ (=1/) is the number of point-) is the number of point-years of excess unemployment needed to achieve years of excess unemployment needed to achieve a decrease in inflation of 1%.a decrease in inflation of 1%.

For example, if the sacrifice ratio is 1.32, then For example, if the sacrifice ratio is 1.32, then a 10% disinflation requires 13.2 point-years of a 10% disinflation requires 13.2 point-years of excess unemployment.excess unemployment.

1π π α

t t t n( u u )

-- =- -

inflationin decreasepoint perc. 1

ntunemployme excess of years-Point Ratio Sacrifice



If inflation is a bad thing and the number If inflation is a bad thing and the number of point-years of excess unemployment of point-years of excess unemployment is unchangeable (because is unchangeable (because is fixed), is fixed), why not “get it over with” in one year?why not “get it over with” in one year? At the very temporary cost of high At the very temporary cost of high

unemployment.unemployment. This policy would have the great benefit of This policy would have the great benefit of

full credibility: there’s no need to wonder if full credibility: there’s no need to wonder if the disinflation program will continue.the disinflation program will continue.

This works if the announcement of the This works if the announcement of the policy immediately changes policy immediately changes ee..



But if But if ee = = t-1t-1, then seeing is believing, , then seeing is believing,

and you need at least two years.and you need at least two years. Moreover, the output loss could be huge, Moreover, the output loss could be huge,

by Okun’s Law.by Okun’s Law. Many of the effects of the recession would Many of the effects of the recession would

be permanent: discouraged workers, be permanent: discouraged workers, bankruptcies, political instability, etc.bankruptcies, political instability, etc.



Suppose the Central Bank wishes to reduce Suppose the Central Bank wishes to reduce inflation by 9%.inflation by 9%. If If = 1.15, what is the number of point-years of excess = 1.15, what is the number of point-years of excess

unemployment?unemployment? Given the goal of reducing inflation by 9%, can the Given the goal of reducing inflation by 9%, can the

Central Bank affect the number of point-years of excess Central Bank affect the number of point-years of excess unemployment calculated above?unemployment calculated above?

1.51.5 1.31.3 1.151.15 11 0.90.9

Sacrifice ratioSacrifice ratio



An important question for policy makers An important question for policy makers is what is the optimal path of money is what is the optimal path of money growth to achieve a disinflation.growth to achieve a disinflation.

This is worked out in this way:This is worked out in this way: The path of inflation shows the values of The path of inflation shows the values of

inflation before achieving a desired 4%.inflation before achieving a desired 4%. The path of unemployment shows the The path of unemployment shows the

unemployment required to achieve the unemployment required to achieve the decrease in inflation.decrease in inflation.



The path of output shows the output The path of output shows the output growth required to achieve the required growth required to achieve the required path of unemployment.path of unemployment.

The path of nominal money growth The path of nominal money growth shows the growth required to achieve the shows the growth required to achieve the required path of output.required path of output.

11 ttttym uugg



This table shows the path of nominal money growth This table shows the path of nominal money growth needed to achieve 10% disinflation over five years, needed to achieve 10% disinflation over five years, which we assume requires 10 point-years of excess which we assume requires 10 point-years of excess unemployment. That is, u > uunemployment. That is, u > unn by 2 points every by 2 points every year for 5 years.year for 5 years.


Inflation (%) 14 12 10 8 6 4 4 4 4


Output growth (%) 3 2 3 3 3 3 8 3 3




Desired path of Inflation (%)

14 12 10 8 6 4 4 4 4

Unemploymentrate (%)

6

Output growth (%)

3

Nominal money growth (%)

17


u u gt t y t 1 0 4 3 % ). (

my gg

tn uu =1



Inflation (%) 14 12 10 8 6 4 4 4 4


Output growth (%) 3 2 3 3 3 3 8 3 3



If (Okun’s Law) , then If (Okun’s Law) , then ggyy must fall by 5 points the must fall by 5 points the first year (2 / (-0.4)) = -5 below normal growth, from 3 to -2 percent.first year (2 / (-0.4)) = -5 below normal growth, from 3 to -2 percent.Raising unemployment by 2 points means lowering inflation by 2 points. Raising unemployment by 2 points means lowering inflation by 2 points. Because ,Because , -5 = -5 = ggmm – (– 2), then – (– 2), then ggmm = – 7. = – 7.

u u gt t y t 1 0 4 3 % ). (

my gg1



The second year, uThe second year, utt=u=ut-1t-1. By Okun’s Law,. By Okun’s Law,

ggyy must go back to normal growth, 3%. Because still u – u must go back to normal growth, 3%. Because still u – unn = =

2 points, inflation falls by by 2 points, to 10%. From the AD 2 points, inflation falls by by 2 points, to 10%. From the AD relation , 5 = relation , 5 = ggmm – (-2), then – (-2), then ggmm = 3. = 3.

u u gt t y t 1 0 4 3 % ). (

my gg

2


Inflation (%) 14 12 10 8 6 4 4 4 4


Output growth (%) 3 2 3 3 3 3 8 3 3




-5

0

5

10

15

20

1 2 3 4 5 6 7 8 9

Inflation (%) Nominal money growth (%)

Output growth (%) Unemployment rate(%)

Notice that although money growth rises in year 7, inflation does not :

the reason is that unemployment goes back to its natural level.



This figure shows a path of unemployment and This figure shows a path of unemployment and inflation similar to the disinflation path in Table 9-1.inflation similar to the disinflation path in Table 9-1.

Five years of unemployment above the natural rate of unemployment lead to a permanent decrease in inflation.

A Disinflation PathA Disinflation Path



Credible Disinflation causes the Phillips curve to shift down. But remember what determines the position of the Phillips curve: expectations of inflation.

If expectations change, this works. If they don’t it doesn’t.


Expectations, Credibility,Expectations, Credibility,and Nominal Contractsand Nominal Contracts

9-4

This section examines how changes in This section examines how changes in expectation formation might affect the expectation formation might affect the unemployment cost of disinflation.unemployment cost of disinflation.

Two separate groups of macroeconomists Two separate groups of macroeconomists challenge the traditional notion that policy challenge the traditional notion that policy can change the timing, but not the number can change the timing, but not the number of point-years of excess unemployment.of point-years of excess unemployment.


Expectations and Credibility:Expectations and Credibility:The Lucas CritiqueThe Lucas Critique

The The Lucas critiqueLucas critique states that it is states that it is unrealistic to assume that wage setters unrealistic to assume that wage setters would not consider changes in policy when would not consider changes in policy when forming their expectations.forming their expectations. If wage setters could be convinced that inflation If wage setters could be convinced that inflation

was indeed going to be lower than in the past, was indeed going to be lower than in the past, they would decrease their expectations of they would decrease their expectations of inflation, which would in turn reduce actual inflation, which would in turn reduce actual inflation, without the need for a change in the inflation, without the need for a change in the unemployment rate.unemployment rate.



Thomas Sargent, who worked with Robert Thomas Sargent, who worked with Robert Lucas, argued that any in order to achieve Lucas, argued that any in order to achieve disinflation, any increase in unemployment disinflation, any increase in unemployment would have to be only small.would have to be only small.

The essential ingredient of successful The essential ingredient of successful disinflation, he argued, was disinflation, he argued, was credibilitycredibility of of monetary policy—the belief that the central monetary policy—the belief that the central bank was truly committed to reducing bank was truly committed to reducing inflation. The central bank should aim for fast inflation. The central bank should aim for fast disinflation.disinflation.



Recall that, although we assumed the Phillips curve Recall that, although we assumed the Phillips curve can be approximated by can be approximated by

it is reallyit is really

Our calculations assumed that agents didn’t form Our calculations assumed that agents didn’t form expectations based on policy, just on history.expectations based on policy, just on history.

What if policy were fully credible, so that if the CB What if policy were fully credible, so that if the CB announces a future announces a future =4%, =4%, ee becomes 4%, wage- becomes 4%, wage-setters set their nominal wage increase at 4%, and setters set their nominal wage increase at 4%, and price-setters set price increases at 4%. Inflation price-setters set price increases at 4%. Inflation becomes 4% instantaneously, and u=ubecomes 4% instantaneously, and u=unn..

1π π α

t t t n( u u )

-- =- -

π π αe

t t t n( u u )= - -



Which program is more credible, taking Which program is more credible, taking into account political pressures, into account political pressures, elections, etc.?elections, etc.? A disinflation that happens in one year A disinflation that happens in one year

(say, the first year out of a 4-year (say, the first year out of a 4-year presidential period), and then you’re presidential period), and then you’re done with it?done with it?

Or a disinflation that is announced to Or a disinflation that is announced to start today and end in 20 years?start today and end in 20 years?


1


If the Central Bank is so credible that its ultimate forecasts of inflation are believed, inflation expectations fall right away to their final level.


Normal Rigidities and ContractsNormal Rigidities and Contracts

A contrary view was taken by Stanley A contrary view was taken by Stanley Fischer and John Taylor. They emphasized Fischer and John Taylor. They emphasized the presence of the presence of nominal rigiditiesnominal rigidities, or the , or the fact that many wages and prices are not fact that many wages and prices are not readjusted when there is a change in policy.readjusted when there is a change in policy.

If wages are set before the change in policy, If wages are set before the change in policy, inflation would already be built into existing inflation would already be built into existing wage agreements.wage agreements.


Normal Rigidities and ContractsNormal Rigidities and Contracts Taylor argued that the Taylor argued that the staggering of wage decisionsstaggering of wage decisions

imposed strong limits on how fast disinflation could imposed strong limits on how fast disinflation could proceed.proceed.

The way to decrease the unemployment cost of The way to decrease the unemployment cost of disinflation is to give wage setters time to take the disinflation is to give wage setters time to take the change in policy into account.change in policy into account. ““Inflation won’t change much over the next year or two (to Inflation won’t change much over the next year or two (to

avoid costs in output). But in two years, inflation will begin to avoid costs in output). But in two years, inflation will begin to fall drastically.”fall drastically.”

If the government makes this announcement, how would you If the government makes this announcement, how would you negotiate your wages?negotiate your wages?

Slow but Slow but crediblecredible disinflation might have a lower cost. disinflation might have a lower cost. The central bank should go for slow disinflation. The central bank should go for slow disinflation. If inflation ain’t changin’, why should we believe it will?If inflation ain’t changin’, why should we believe it will?


Normal Rigidities and ContractsNormal Rigidities and Contracts

With staggering of wage decisions, disinflation must be phased in slowly to avoid an increase in unemployment.

Disinflation Without Disinflation Without UnemploymentUnemploymentin the Taylor Modelin the Taylor Model


The U.S. Disinflation,The U.S. Disinflation,1979-19851979-1985

9-5

What did happen in the early eighties?What did happen in the early eighties? The U.S. disinflation of the early 1980s was The U.S. disinflation of the early 1980s was

associated with a substantial increase in associated with a substantial increase in unemployment.unemployment.

The Phillips curve relation proved more The Phillips curve relation proved more robust than many economists anticipated.robust than many economists anticipated.



Cumulative unemployment is the sum of point-years of excess unemployment from Cumulative unemployment is the sum of point-years of excess unemployment from 1980 on, assuming a natural rate of unemployment of 6%. Cumulative disinflation 1980 on, assuming a natural rate of unemployment of 6%. Cumulative disinflation is the difference between inflation in a given year and inflation in 1979. The is the difference between inflation in a given year and inflation in 1979. The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation.sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation.

Table 9-2 Inflation and Unemployment, 1979-1985PercentPercent 19791979 19801980 19811981 19821982 19831983 19841984 19851985

GDP growth 2.5 0.5 1.8 2.2 3.9 6.2 3.2

Unemployment rate 5.8 7.1 7.6 9.7 9.6 7.5 7.2

CPI inflation 13.3 12.5 8.9 3.8 3.8 3.9 3.8

Cumulative unemployment 1.0 2.6 6.3 9.9 11.4 12.6

Cumulative disinflation 0.8 4.4 9.5 9.5 9.4 9.5

Sacrifice ratio 1.25 0.59 0.66 1.04 1.21 1.32


The U.S. Disinflation, 1979-1985The U.S. Disinflation, 1979-1985

A sharp increase in the interest rate from September 1979 to April 1980 was followed by a sharp decline in mid 1980, and then a second and sustained increase from January 1981 on, lasting for most of 1981 and 1982.

The Federal Funds RateThe Federal Funds Rateand Inflation, 1979-1984and Inflation, 1979-1984



Laurence Ball, who examined 65 disinflation Laurence Ball, who examined 65 disinflation episodes concluded that:episodes concluded that: Disinflations typically lead to a period of higher Disinflations typically lead to a period of higher

unemployment.unemployment. This contradicts a radical version of Lucas/Sargent.This contradicts a radical version of Lucas/Sargent.

Faster disinflations are associated with smaller Faster disinflations are associated with smaller sacrifice ratios.sacrifice ratios. This supports a moderate version of Lucas/Sargent.This supports a moderate version of Lucas/Sargent.

Sacrifice ratios are smaller in countries that have Sacrifice ratios are smaller in countries that have shorter wage contracts.shorter wage contracts. This supports Fischer/Taylor.This supports Fischer/Taylor.

Documents

Prepared by: Fernando Quijano and Yvonn Quijano And modified by Gabriel Martinez 9 C H A P T E R Inflation, Activity, and Nominal Money Growth