Inflation revisited

1
Recall that inflation is a sustained increase in
the ave. prices of goods and services
Inflation revisited

• ? We want to examine the following issues
• What are the costs of inflation?
• Is there a tradeoff between inflation and
  unemployment?
• Assuming there is a tradeoff between inflation
  and unemployment, can unemployment be too low?
• Why is it that once inflation starts, it tends to
  persist?
• Is monetary expansion to blame for inflation?

2
The Phillips Curve
The Phillips curve is namedfor A.W. Phillips,
who identified an inverse correlation
between inflation and unemployment in the
U.K.Note the shape of the curve impliesa policy
trade-off.
10
8
Inflation rate ()
6
4
2
0
1
2
3
4
5
Unemployment rate ()
3
Phillips curves for the U.S.
Critics such as Professors Friedman and
Lucasargue there is nostable
trade-offbetween inflationand
unemployment.Data for the U.S. appears to
support their view
12
1980-83
1986-95
6
Inflation rate ()
1960-69
0
5
10
Unemployment rate ()
4
The NAIRU
NAIRU is an acronymfor non-acceleratinginflatio
n rate of unemployment.
?Below U(alsocalled the natural rate,the
inflation ratewill accelerate--thats the theory
Inflation rate ()
U
Unemployment rate ()
5
No Long Run Trade-Off
Some advocates of the NAIRUassert that any
trade-off between inflation and unemployment
will blow up as household and firms catch up
to a change in prices of goods and services
6
The expectations-augmented Phillips curve

• Let
• ? denote the inflation rate.
• ?et is the expected inflation rate in month t.
• ? at is the actual inflation rate in month t .?
  For the sake of simplicity, we assume ?et ?
  at -1

People are assumedto extrapolate basedon the
inflation in the mostrecent month
7
A failure to perceive that the value of money has
changed
Money illusion
Money wage (w)
Mistakenly thinking the realwage
increased, Bobby worked 5 more hours per week
Ns (Pe 1.20)
Ns (Pe 1.00)
12
10
40
45
Hours per week
Bobby's supply of labor
8
The vertical long-run Phillips curve
? A,B, and C are short-run curvescorresponding
to inflationary expectations
Long-runPhillips curve
?
C
B
7
?e 7
A
3
?e 3
0
U0
unemployment
U
?e 0
9
Moral of the Story
The effort by policy makers to drive
unemploymentbelow the NAIRU worksin the
short-term but is doomedto fail in the long-run.
Moreover, the attempt to exploit the
short-runrelation has damaging effectsin terms
of inflationary expectations
10
Once inflationary expectations take hold,then
it is possibleto overestimate inflation.The
result is stagflation
Explaining Stagflation
?
Long-run Phillips curve
13.5
1981
10.3
?e 13.5
0
unemployment
7.6
U
11
What is the NAIRU?
Just a few years ago, estimatesof the NAIRU
ranged from5.5 to 6.5. Those estimatesappear
off base in light of recent experience