Grappling with Inflation, Unemployment, and Growth

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Grappling with Inflation, Unemployment, and
Growth
CHAPTER
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Thread

• We have explored the goals and data of
  macroeconomic policy in some detail
• Largely descriptive
• Now, we begin to put these in an interpretative
  framework
• Starting with a trade-off between inflation and
  unemployment
• Phillips Curve

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Objectives you should be able to

• State of the costs/benefits of inflation and
  unemployment
• Interpret policy choices in light of the
  trade-off debate over inflation vs.
  unemployment
• Critically evaluate the natural rate of
  unemployment
• Describe and use the Phillips Curve (short run
  and long run)

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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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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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Inflation who benefits?

• Losers
• Lenders
• The bond market
• Banks
• Fixed incomes
• Retirees
• Employers paying higher wages in competitive
  labor markets.

• Gainers
• Borrowers
• Home owners
• Mfg. corp.
• Flexible incomes
• Union members
• Workers in danger of losing jobs if UR goes up.

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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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The Natural Rate of Unemployment

• Here add Pollin
• 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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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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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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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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U.S. Unemployment by Age, Gender, and Race
1991 1992 1993 1994 1995 1996 1997
1998 1999 2000 All workers 6.8 7.5
6.9 6.1 5.6 5.4 4.9 4.5
4.2 4.0 All 16- to 18.7 20.1
19.0 17.6 17.3 16.7 16.0 14.6
13.9 13.1 19-year-olds Males 7.2 7.9
7.2 6.2 5.6 5.4 4.9
4.4 4.1 3.9 Females 6.4 7.0
6.6 6.0 5.6 5.4 5.0 4.6
4.3 4.1 Blacks 12.5 14.2 13.0
11.5 10.4 10.5 10.0 8.9 8.0
7.6 Blacks 36.1 39.7 38.8 35.2 35.7
33.6 32.4 27.6 27.9 24.7 (age
1619) Whites 6.1 6.6 6.1 5.3
4.9 4.7 4.2 3.9 3.7
3.5 Hispanics 10.0 11.6 10.8 9.9
9.3 8.9 7.7 7.2 6.4 5.7
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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
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Group exercise

• Page 96 . problems 8, 9, 10
• AND . FM exercise . What does it predict about
  the future trade-off between UR and PCGDPD