CHAPTER Grappling with Inflation, Unemployment, and Growth

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CHAPTER Grappling with Inflation,
Unemployment, and Growth
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Grappling with Inflation, Unemployment, and Growth

• Costs of Inflation
• Redistribution of Income
• Informational and Uncertainty Costs
• Institutional and Constitutional Costs
• Menu and Shoe Leather Costs
• Why Some Unemployment is Necessary
• Flows In and Out of the Labor Market
• Vacancies
• Labor Market as a Matchmaker

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• Natural Rate of Unemployment
• Cyclical Unemployment
• The Phillips Curve

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Policy Priorities

• Since low inflation and low unemployment may
  conflict in the short run, policy makers must
  give one top priority
• The Federal Reserve believes that
• monetary policy does not affect the natural rate
  of unemployment
• therefore, preventing inflation must be the
  primary goal of monetary policy

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Legislative Basis of Policy

• Employment Act of 1946
• Required the government to use all of its powers
  to promote maximum employment, production, and
  purchasing power.
• Full Employment and Balanced Growth Act of 1978
• Requires the Fed chairman to present economic
  forecasts and targets for money supply growth to
  Congress twice a year

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Effects of Inflation

• Inflation makes buyers poorer because they must
  pay higher prices
• Inflation makes sellers richer because they are
  paid higher prices
• Since most people are both buyers (as consumers)
  and sellers (as owners of factors of production),
  the average persons income and wealth arent
  changed by inflation

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Inflation Redistributes Income

• Inflation redistributes income from those who do
  not, or cannot, raise their prices to those who
  can, and do, raise their prices.
• People do not raise prices if inflation is
  unanticipated.
• People can not raise their prices if they are
  fixed by a contract.

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Inflation Redistributes Income from Lenders to
Borrowers

• Suppose that you had planned to buy a pair of
  shoes for 100, but instead you lend the 100 to
  a friend for a year at 3 interest.
• At the end of the year your friend repays you
  103.
• During the year, inflation was 5, so now the
  shoes cost 105.
• Your real rate of return was -2.

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Real and Nominal Interest Rates
Nominal interest rate Real interest rate
Anticipated inflation
If lenders anticipate inflation, they add the
amount of expected inflation to the real
interest rate that they require to maintain their
purchasing power.
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Costs of Inflation

• Informational Costs
• Prices are used to make comparisons between
  goods, but inflation distorts that information.
• Uncertainty Costs
• Inflation may distort and delay expenditures
  because it makes predicting future prices more
  difficult.

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Costs of Inflation

• Institutional Costs
• Inflation undermines institutions and
  conventions, such as rules of thumb and
  contracts, which are based on relatively fixed
  prices.
• Constitutional Costs
• Inflation undermines the convention of money that
  forms the basis of exchange in the economy.

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Costs of Inflation

• Menu Costs
• Inflation requires firms to spend time and money
  posting current prices in catalogues, menus, and
  on ticketed merchandise.
• Shoe Leather Costs
• Inflation increases the cost of managing cash
  balances.

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Inflation Grease or Sand?
Sand
Inflation ()
Low inflation may stimulate growth, but inflation
over 3 may reduce growth.
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3
Grease
Growth
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Why Some Unemployment is Necessary

• Flows In and Out of the Labor Market
• About 10 million people change their job status
  every month.
• Vacancies
• Vacancies arise when workers leave their jobs
  and/or new jobs are created.
• Labor Market as a Matchmaker
• The labor market is not an instant matchmaker
  between unemployed workers and job vacancies

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Flows In and Out of the Labor Market
Employed 127.3 Million
2 million
1.7 million
3 million
3.5 million
1.2 million
Not in Labor Market 66.8 Million
Unemployed 6.7 Million
1.7 million
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Supply and Demand for Labor
Point A represents labor market equilibrium
with no search costs.
SM
Real Wage
S
B
Point B represents equilibrium with search costs.
N2-N1 is frictional unemployment.
A
?
?
We
D
DM
Employment
N1
N2
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Supply and Demand for Labor with Above
Equilibrium Wages
SM
Real Wage
S
W1
Above equilibrium wages cause insider-outsider
unemployment NS2-ND1.
B
A
?
?
We
D
DM
Employment
N1
N2
ND2
ND1
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Why are Wages Above Equilibrium?

• Unions may exert pressure for higher wages.
• The government may impose a minimum wage that is
  above the equilibrium wage.
• Efficiency wages are above equilibrium wages paid
  to attract and retain the best workers.

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Strategies to Lower European Unemployment

• Improve labor force skills with education and
  training
• Reform employment security laws
• Reduce regulation of work time and temporary jobs
• Reform the level and duration of unemployment
  benefits

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The Natural Rate of Unemployment

• The natural rate of unemployment is the sum of
  frictional and insider-outsider unemployment.
• The natural rate of unemployment has decreased
  0.6 to 1.1 percentage points from the mid 1980s
  to the late 1990s.

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Causes of the Decline in the Natural Rate
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Cyclical Unemployment

• Cyclical unemployment occurs when real output is
  below potential output.
• Cyclical unemployment exists because of
  coordination failures.
• Problems that develop in an economy because
  decisions by individuals feed back into the
  economy, augmenting the effect of the initial
  decision.

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The U.S. Unemployment Rate and Vacancy Rate
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The Business Cycle in the Labor Market
Recessions cause a decrease in the demand for
labor from D to D1
Real Wage
S
The wage rate remains the same in the short-run,
and employment falls to N1.
We
D
D1
N1
Employment
N
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Cost of Cyclical Unemployment

• The cost of cyclical unemployment is the
  difference between actual output and potential
  output.
• Okuns Rule of Thumb describes the relationship
  between unemployment and growth in GDP.

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Growth in GDP and Change in Unemployment
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Okuns Rule of Thumb
?Q 3.5 - 2? ?U
?Q is the percent change in real GDP ?U is the
change in the unemployment rate
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Equity Costs of Unemployment

• For individuals the costs of unemployment include
  lost income, a decline in skills, and loss of
  self-worth.
• Unemployment is not shared equally among
  demographic groups
• Teenage unemployment is higher than the overall
  unemployment rate.
• The unemployment rate for blacks and Hispanics is
  higher than for whites.

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U.S. Unemployment by Age, Gender, and Race
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The Phillips Curve
The Phillips curve represents a short-run trade
off between inflation and unemployment. If
policy makers choose to reduce unemployment from
8 (B) to 4 (A) the cost may be an increase in
inflation from 3 to 7.
Inflation Rate ()
A
7
B
3
Unemployment Rate ()
4
8
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Inflation and Unemployment 1954-2000

• The Phillips curve which shows the historical
  relationship between inflation and unemployment
  has not remained stable over time.
• Between 1958 and 1969, an inverse relationship
  between unemployment and inflation did exist.

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Inflation and Unemployment 1954-2000
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Inflation and Unemployment 1954-2000

• Between 1970 and 1984, the inverse relationship
  broke down. Both inflation and unemployment were
  high in those years.
• The inverse relationship between inflation and
  unemployment reappeared between 1985 and 1992,
  but disappeared again in 1992 when inflation and
  unemployment both decreased.

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Short-Run and Long-Run Phillips Curves
There are two Phillips curves
A long-run Phillips curve which is vertical at
the natural rate of unemployment.
Long-Run Phillips Curve
Inflation
A short-run Phillips curve that shifts along the
long-run curve.
Short-Run Phillips Curve
Natural rate of Unemployment
Unemployment
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Short-Run and Long-Run Phillips Curves

• The long-run Phillips curve shows that
  policymakers cannot reduce unemployment below the
  natural rate by accepting more inflation.
• The short-run Phillips curve represents a
  tradeoff between inflation and unemployment that
  changes as the curve shifts.

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Sacrifice Ratio

• The sacrifice ratio is the annual percentage
  point loss of output for every percentage point
  decline in the annual inflation rate.
• The sacrifice ratio during the early 1980s was
  2.3.

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The Sacrifice Ratio for the United States,
1980-1983