Inflation, Activity, and Money Growth The Medium Run

1
Chapter 9

• Inflation, Activity, and Money GrowthThe Medium
  Run

2
Inflation, Activity, Money Growth The Medium
Run
Chapter Tour

• The links between output, unemployment, and
  inflation
• The short and medium-run effects of money growth
  on inflation and activity
• U.S. disinflation of the late 1970s

3
Output, Unemployment, Inflation
Three Relations

• Okuns Law
• Phillips Curve
• Aggregate Demand

4
Output, Unemployment, Inflation
Okuns Law Output Growth Changes in
Unemployment
Assuming

• The labor force is constant
• Changes in output lead to equal changes in
  employment

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Output, Unemployment, Inflation
Okuns Law The Data
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Output, Unemployment, Inflation
Okuns Law The Equation
ut-ut-1 -0.4(gyt-3)
gyt must be at least 3 to keep unemployment from
rising
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Output, Unemployment, Inflation
Okuns Law
Why must output grow 3 to keep unemployment from
rising?

• Two factors
• Growth in the labor force
• Increases in the productivity of labor

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Output, Unemployment, Inflation
Okuns Law An Example
Assume

• The labor force grows 1.7 per year, employment
  must grow 1.7 to keep the unemployment rate
  constant
• Labor productivity is growing 1.3 per year

If YAN (Aoutput/worker Nemployment) Then
The growth rate of Y productivity growth rate
employment growth rate Therefore Output must
grow 3 (1.31.7) to keep unemployment
constant
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Output, Unemployment, Inflation
Okuns Law An Example
Normal growth rate Rate of output growth needed
to maintain constant unemployment For the U.S.
since 19603 ut-ut-1 - 0.4(gYT-3)
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Output, Unemployment, Inflation
Okuns Law An Example
ut-ut-1 - 0.4(gYT-3)
Explaining the -0.4 coefficient

• If output growth is 1 greater than normal
  growth
• Then in the previous model, unemployment fell
  1
• However, actual U.S. data shows unemployment
  falls by 0.4

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Output, Unemployment, Inflation
Okuns Law An Example
ut-ut-1 - 0.4(gYT-3)

• Why is the coefficient only 0.4?
• Firms hoard labor and there is a
  minimum number of workers required regardless of
  output
• Changes in labor force participation

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Okuns Law Across Countries
Okuns Law CoefficientsAcross Countries and Time
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Output, Unemployment, Inflation
Okuns Law
In general, the relation between changes in
unem-ployment and output growth is
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Output, Unemployment, Inflation
Okuns Law
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Output, Unemployment, Inflation
The Phillips Curve Unemployment and the Change
in Inflation
Inflation depends on expected inflation and
thedeviation of unemployment from the natural
rate
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Output, Unemployment, Inflation
The Phillips Curve Unemployment and the Change
in Inflation
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Output, Unemployment, Inflation
The Phillips Curve Unemployment and the Change
in Inflation
According to
Unemployment gtun ? decrease in inflation Unemploy
ment ltun ? increase in inflation or
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Output, Unemployment, Inflation
The Aggregate Demand Relation Money Growth,
Inflation, and Output Growth
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Output, Unemployment, Inflation
The Aggregate Demand Relation Money Growth,
Inflation, and Output Growth
Moving from output level (Y) to the growth rate
(gyt)
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Output, Unemployment, Inflation
The Aggregate Demand Relation Money Growth,
Inflation, and Output Growth
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Output, Unemployment, Inflation
How does money growth effect output, inflation,
and unemployment in the medium run?
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Output, Unemployment, Inflation
A Review

• Okuns Law Change in unemployment Deviation
  of output from normal growth

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Output, Unemployment, Inflation
A Review
2. Phillips Curve Change in the
Deviation of unemployment inflation rate
from the natural rate
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Output, Unemployment, Inflation
A Review
3. The AD RelationRate of growth Rate of
growth of nominal of output money
minus inflation
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Output, Unemployment, Inflation
A Scenario The money growth rate falls
(short-run)
According to

• The AD relation, given inflation, output will
  fall
• From Okuns Law, a decrease in growth will
  increase unemployment
• From the Phillips Curve, higher unemployment
  implies lower inflation

Will the impact end herewhat about the medium
run?
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Output, Unemployment, Inflation
The Medium Run
27
Output, Unemployment, Inflation
The Medium Run
Inflation Adjusted nominal money growth
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Output, Unemployment, Inflation
The Medium Run
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Output, Unemployment, Inflation
The Medium Run A Review

• Inflation equals adjusted nominal money growth
• Unemployment is equal to the natural rate

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Output, Unemployment, Inflation
The Medium Run
An Observation
Changes in the nominal money growth have no
effect on output or unemployment in the medium
run.
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Output, Unemployment, Inflation
Adjusting to a decrease in nominal money growth
Inflation Rate, ?
Unemployment Rate, u
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Output, Unemployment, Inflation
Disinflation A First Pass
A Scenario

• The economy is in medium run equilibrium

• Inflation is high and there is a consensus to
  reduce it

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Output, Unemployment, Inflation
Disinflation A First Pass
What do you think

• How can policy makers achieve disinflation?

Answer Reducing money growth

• How will reducing money growth impact growth and
  unemployment?

Answer Reduce growth and increase
unemployment
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Output, Unemployment, Inflation
Disinflation How much unemployment? And for how
long?
Consider the Phillips Curve

• The total amount of unemployment does not vary
  with how quickly disinflation is achieved

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Output, Unemployment, Inflation
Disinflation How much unemployment? And for how
long?
Choosing between rapid or slow disinflation

• Point-year of excess unemployment Difference
  between the actual and the natural unemployment
  of one percent point for one year
• Example un 6.5 u 9 for 4 years 4 x
  (9-6.5) 10 point-years of excess
  unemployment

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Output, Unemployment, Inflation
Disinflation How much unemployment? And for how
long?
Scenario Reduce inflation from 14 to 4 percent
? 1
Conclusion Point years of excess unemployment
equals 10
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Output, Unemployment, Inflation
Disinflation How much unemployment? And for how
long?
If ? 1, what is the sacrifice ratio?
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Output, Unemployment, Inflation
Disinflation How much unemployment? And for how
long?
If the sacrifice ratio is constant, is the speed
of disinflation irrelevant?
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Output, Unemployment, Inflation
The Speed of DisinflationAn Example
Time Frame 1 year
ut 10 gt un un 6.5 ut 16.5
16.5 - 6.5 - 0.4(gyt-3)
-15 in 1931the greatest negative growth rate
this century.
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Output, Unemployment, Inflation
Working on the required path of money growth
A Scenario Reduce inflation from 14 to 4 in 5
years
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Output, Unemployment, Inflation
The disinflation path
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Output, Unemployment, Inflation
The Disinflation Path
Conclusions

• The transition to lower money growth and
  inflation is associated with a period of higher
  unemployment
• Regardless of the path, the number of point-years
  of excess unemployment is the same
• In the medium run output and unemployment
  return to normal

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Output, Unemployment, Inflation
This model indicates that policy can change the
timing but not number of point-years of excess
unemployment.

• Two challenges to this model
• Expectations, credibility
• Nominal rigidities and contracts

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Output, Unemployment, Inflation
Expectations Credibility The Lucas Critique

• The previous model assumed ? te ? t-1
• What if ? te is based on an expectation that Fed
  policy would reduce inflation from 14 to 4.
  Then

4 4 - 0

• Inflation falls to 4 and unemployment remains at
  the natural rate
• Reduction in money growth could be neutral

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Output, Unemployment, Inflation
Expectations Credibility The Lucas Critique
Observations

• To have a low sacrifice ratio, monetary policy
  must be credible
• Clear and quick disinflation is more credible

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Output, Unemployment, Inflation
Nominal Rigidities and Contracts

• Nominal rigidities keep prices from adjusting
• Consequently, disinflation policy would be very
  costly
• Disinflation policy should be announced before
  implementation

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Output, Unemployment, Inflation
Nominal Rigidities and Contracts
The impact of staggering wage decisions The
Taylor Model

• Wage contracts reflect other contracts
• Creates wage rigidities
• The rigidities prevent rapid response to
  disinflation policy and imply a high rate of
  unemployment
• Fed should phase in disinflationary policy

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Output, Unemployment, Inflation
Disinflation Without Unemployment in the Taylor
Model
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Output, Unemployment, Inflation
Comparison of Lucas-Sargent Model and the Taylor
Model

• Both models emphasize the role of expectation
• Slow end credible disinflation might have lower
  cost than the traditional model

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Output, Unemployment, Inflation
The U.S. Disinflation, 1979-1985
1979

• Unemployment 5.8
• GDP growth 2.5
• Inflation 13.3
• The Fed shifted from targeting interest to
  targeting the growth rate of nominal money

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Output, Unemployment, Inflation
The U.S. Disinflation, 1979-1984
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Output, Unemployment, Inflation
The U.S. Disinflation, 1979-1984
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Output, Unemployment, Inflation
The U.S. Disinflation, 1979-1984
Observations

• Disinflation was associated with high
  unemployment
• The sacrifice ratio was very close to 10
  disinflation with 10 point-years of excess
  unemployment
• Phillips Curve relation was very robust

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Output, Unemployment, Inflation
Disinflation Experiences in 19 OECD Countries

• Disinflation leads to higher unemployment
• Faster disinflations are associated with small
  sacrifice ratios (Lucas/Sargent)
• Sacrifice ratios are smaller in countries that
  have shorter wage contracts (Fischer Taylor)

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End of Chapter

• Inflation, Activity, and Money GrowthThe Medium
  Run