Output, Unemployment,

1
Output, Unemployment, Inflation
Three Relations

1. Phillips Curve unemployment and the change in
   inflation
2. Okuns Law growth and the change in unemployment
3. Aggregate Demand Money, output, and prices

2
Output, Unemployment, Inflation
The Phillips Curve Unemployment and the Change
in Inflation
3
Output, Unemployment, Inflation
Okuns Law The Data
4
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
• WHY?
• Two factors
• Growth in the labor force
• Increases in the productivity of labor

5
Output, Unemployment, Inflation
?u 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
• Changes in labor force participation
• Okuns Law Coefficients Across Countries
• Country 1960-1980 1981-1998
• United States 0.39 0.42United Kingdom 0.15
  0.51Germany 0.20 0.32Japan 0.10
  0.20

6
Output, Unemployment, Inflation
Okuns Law
In general, the relation between changes in
unem-ployment and output growth is
7
Output, Unemployment, Inflation
The Aggregate Demand Relation Money Growth,
Inflation, and Output Growth
8

• Or going straight to the equation of exchange
• MV PY
• VdM MdV YdP PdY
• dM/M dV/V dP/P dY/Y
• gmt dV/V pt gyt

9
Output, Unemployment, Inflation
The Aggregate Demand Relation Money Growth,
Inflation, and Output Growth
When velocity is constant, dV/V 0
10
Our Three Relations

• Phillips Curve (AS)
• ??t - a (ut ut)
• Okuns Law
• ? ut - ß (gyt - gn)
• Equation of exchange (AD)
• gyt gmt - pt

11
Output, Unemployment, Inflation
A Scenario The money growth rate falls
(short-run)
According to

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

Will the impact end herewhat about the medium
run?
12
Output, Unemployment, Inflation
13
Output, Unemployment, InflationThe Medium Run
Adjusting to a decrease in nominal money growth
Inflation Rate, ?
Unemployment Rate, u
14
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
15
Output, Unemployment, Inflation
Disinflation How much unemployment? And for how
long?
If ? 1, what is the sacrifice ratio?
16
Output, Unemployment, Inflation
Working on the required path of money growth
A Scenario Reduce inflation from 14 to 4 in 5
years
17
Output, Unemployment, Inflation
The disinflation path
18
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

19
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
• Lucas Rat-X
• Sargent Low sacrifice in history
• Nominal rigidities and contracts
• Fischer sticky wages
• Taylor staggered contracts

20
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

21
Output, Unemployment, Inflation
Disinflation Without Unemployment in the Taylor
Model
22
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

23
Output, Unemployment, Inflation
The U.S. Disinflation, 1979-1984
24
Output, Unemployment, Inflation
The U.S. Disinflation, 1979-1984
25
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

26
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)