Inflation and Its Relationship to Unemployment and Growth

1
Inflation and Its Relationship to Unemployment
and Growth

• Chapter 15

2
Laugher Curve

• Economics is the only field in which two people
  can share a Nobel Prize for saying opposing
  things.
• Specifically, Gunnar Myrdahl and Friedrich S.
  Hayek shared one.

3
Some Basics about Inflation

• Inflation is a continuous rise in the price
  level.
• It is measured using a price index.

4
The Distributional Effects of Inflation

• There are winners and losers in an inflation.

5
The Distributional Effects of Inflation

• The winners are those who can raise their prices
  or wages and still keep their jobs or sell their
  goods.

6
The Distributional Effects of Inflation

• Because they often enter into fixed nominal
  contracts, lenders and borrowers are affected by
  inflation.

7
The Distributional Effects of Inflation

• The composition of the winners and losers from an
  inflation changes over time.

8
The Distributional Effects of Inflation

• People who do not expect inflation and who are
  tied to fixed nominal contracts are likely lose
  in an inflation.

9
The Distributional Effects of Inflation

• If they are rational, these people will not allow
  it to happen again.

10
Expectations of Inflation

• Rational expectations economists argue that if
  expectations are rational, they will always be
  based on the economist's model.
• Rational expectations are the expectations that
  the economists' model predicts.

11
Expectations of Inflation

• Other economists argue that rational expectations
  cannot be defined in terms of economists' models.
  These economists focus on the process by which
  people develop expectations.

12
Expectations of Inflation

• There are two ways people form expectations.

13
Productivity, Inflation, and Wages

• There are two key measures that policy makers
  focus on to determine whether inflation may be
  coming
• Changes in productivity.
• Changes in wages.

14
Productivity, Inflation, and Wages

• The basic rule of thumb

15
Theories of Inflation

• The quantity theory and the institutional theory
  are two slightly different theories of inflation.
• The quantity theory emphasizes the connection
  between money and inflation.
• The institutional theory emphasizes market
  structure and price-setting institutions and
  inflation.

16
The Quantity Theory of Money and Inflation
17
The Quantity Theory of Money and Inflation

• The quantity theory of money is summarized by the
  sentence Inflation is always and everywhere a
  monetary phenomenon.

18
The Equation of Exchange

• The logic of the quantity theory of money goes
  back to the equation of exchange.
• According to the equation of exchange, the
  quantity of money times velocity of money equals
  price level times the quantity of real goods sold.

19
The Equation of Exchange

• M money supply
• V velocity of money (is constant and determined
  by institutional forces)
• P price level
• Q real output (is relatively constant and
  determined by real, not monetary forces)
• PQ the economys nominal output (nominal
  GDPthe quantity of goods valued at whatever
  price level exists at the time

20
Velocity Is Constant

• The first assumption of the quantity theory is
  that velocity is constant.
• Its rate is determined by the economys
  institutional structure.

21
Velocity Is Constant

• The velocity of money is the number of times per
  year on average, a dollar goes around to generate
  a dollar's worth of income.

22
Velocity Is Constant

• If velocity is constant, the quantity theory can
  be used to predict how much nominal GDP will grow
  if we know how much the money supply grows.

23
Real Output Is Independent of the Money Supply

• The second assumption of the quantity theory is
  that real output (Q) is independent of the money
  supply.

24
Real Output Is Independent of the Money Supply

• Q is autonomous, meaning real output is
  determined by forces outside the quantity theory.

25
Real Output Is Independent of the Money Supply

• If Q grows, it is because of incentives in the
  real economy.

26
Real Output Is Independent of the Money Supply

• The conclusion of the quantity theory is ?M ? ?P.

27
Real Output Is Independent of the Money Supply

• The quantity theory of money says that the price
  level varies in response to changes in the
  quantity of money.

28
Real Output Is Independent of the Money Supply

• The quantity theory holds that real output is not
  influenced by changes in the money supply.

29
Examples of Money's Role in Inflation

• The quantity theory lost favor in the late 1980s
  and early 1990s.
• The formerly stable relationships between
  measurements of money and inflation appeared to
  break down.

30
Examples of Money's Role in Inflation

• In the 1990s it seemed that the random elements
  in the relationship between money and inflation
  overwhelmed the connection.

31
Examples of Money's Role in Inflation

• The relationships between money and inflation
  broke down because of technological changes and
  changing regulations in financial institutions.

32
Examples of Money's Role in Inflation

• The empirical evidence that supports the quantity
  theory of money is most convincing in Brazil and
  Chile.

33
Price Level and Money Relative to Real Income in
the United States, 1953-1997
34
The Inflation Tax

• Developing nations such as Brazil and Chile
  sometimes increase the money supply to keep the
  economy running.

35
The Inflation Tax

• When their governments run a budget deficit and
  try to finance it domestically, their central
  banks often must buy the bonds to finance that
  deficit.

36
The Inflation Tax

• Financing the deficit by expansionary monetary
  policy causes inflation.

37
The Inflation Tax

• The inflation works as a kind of tax on
  individuals, and is often called an inflation tax.

38
The Inflation Tax

• Central banks have to make a monetary policy
  choice

39
Price Level and Money Relative to Real Income in
Brazil and Chile
40
Policy Implications of the Quantity Theory

• In terms of policy, the quantity theory says that
  monetary policy is powerful, but unpredictable in
  the short run.
• Because of its unpredictability, monetary policy
  should not be used to control the level of output
  in an economy.

41
Policy Implications of the Quantity Theory

• Supporters of the quantity theory oppose an
  activist monetary policy.

42
Policy Implications of the Quantity Theory

• A monetary rule takes monetary policy out of the
  hands of politicians.

43
Policy Implications of the Quantity Theory

• Many economists favor creating central banks to
  separate politicians from the control of money
  supply.

44
Policy Implications of the Quantity Theory

• The Fed does not have strict rules governing
  money supply, but it works hard to establish
  credibility that it is serious about fighting
  inflation.

45
Institutionalist Theories of Inflation

• Supporters of institutional theories of inflation
  accept much of the quantity theory.
• While they agree that money and inflation move
  together, they have different causes and effects.

46
Institutionalist Theories of Inflation

• According to the quantity theory, the direction
  of causation moves from left to right

47
Institutionalist Theories of Inflation

• Institutional theories see it the other way round.

48
Institutionalist Theories of Inflation

• According to these theorists, the source of
  inflation is in the price-setting process of
  firms.

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Focus on the Price-Setting Decisions of Firms

• Any increase in firms wages, rents, taxes, and
  other costs are simply passed on to consumers in
  the form of higher prices.

50
Focus on the Price-Setting Decisions of Firms

• This works so long as the government increases
  the money supply so that demand is there to buy
  the goods at the higher prices.

51
Price-Setting Strategies Depend on the Labor
Market

• Whether the firm selects this price-raising
  strategy depends on the state of the labor market.

52
Price-Setting Strategies Depend on the Labor
Market

• The state of the labor market plays a key role in
  firms decisions whether to give in to workers
  demands for higher wages.

53
Changes in the Money Supply Follow Price-Setting
by Firms

• Institutional theorists see the nominal age- and
  price-setting process as generating inflation.

54
Changes in the Money Supply Follow Price-Setting
by Firms

• One group pushes up its nominal wage and/or
  price, another group responds by doing the same.

55
Changes in the Money Supply Follow Price-Setting
by Firms

• The first group finds its relative wages and/or
  prices have not increased, so they raise them
  again.

56
Changes in the Money Supply Follow Price-Setting
by Firms

• At this point, government has two options

57
The Insider/Outsider Model and Inflation

• The insider-outsider model is an institutionalist
  story of inflation where insiders bid up wages
  and outsiders are unemployed.

58
The Insider/Outsider Model and Inflation

• Insiders are business owners and workers with
  good jobs with excellent long-run prospects
  outsiders are everyone else.

59
The Insider/Outsider Model and Inflation

• If markets were purely competitive, wages,
  profits, and rents would be pushed down to
  equilibrium levels.

60
The Insider/Outsider Model and Inflation

• Insiders dont like this, so they develop
  sociological and institutional barriers to
  prevent competition from outsiders.

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The Insider/Outsider Model and Inflation

• Outsiders must take dead-end, low-paying jobs or
  try to undertake marginal businesses that pay
  little return per hour worked.

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The Insider/Outsider Model and Inflation

• Outsiders are the first to be fired and their
  businesses are the first to fail in a recession.

63
The Insider/Outsider Model and Inflation

• The economy is only partially competitive the
  invisible hand is thwarted by social and
  political forces.

64
Policy Implications of Institutionalist Theories

• The quantity theorists have a simple solution for
  stopping inflation just cut the growth of the
  money supply.

65
Policy Implications of Institutionalist Theories

• The institutional theorists agree with this
  prescription, but they argue that is not only
  inefficient but unfair.
• It causes unemployment among those least able to
  handle it.

66
Policy Implications of Institutionalist Theories

• They suggest that contractionary monetary
  policies be used in combination with additional
  policies that directly slow down inflation at its
  source.

67
Policy Implications of Institutionalist Theories

• This additional policy is often called an incomes
  policy that places direct pressure on individuals
  and businesses to hold down their nominal wages
  and prices.

68
Policy Implications of Institutionalist Theories

• Formal policies have been out of favor for a
  number of years.

69
Inflation and Unemployment The Phillips Curve

• The AS/AD model expresses a tradeoff between
  inflation and unemployment.
• A low unemployment rate is generally accompanied
  by high inflation.
• A high unemployment rate is generally accompanied
  by low inflation.

70
Inflation and Unemployment The Phillips Curve

• The tradeoff can be represented graphically in
  the short-run Phillips Curve which represents the
  relation between inflation and unemployment.

71
Inflation and Unemployment The Phillips Curve

• The Phillips curve shows us what combinations of
  those two phenomena are possible.

72
The Hypothesized Phillips Curve
73
History of the Phillips Curve

• In the 1950s and 1960s, whenever unemployment was
  high, inflation was low and vice versa.
• The tradeoff between unemployment and inflation
  seemed relatively stable during the 1960s.

74
History of the Phillips Curve

• In the 1960s, the short-run Phillips Curve began
  to play an important role in discussions of
  macroeconomic policy.

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History of the Phillips Curve

• Republicans generally favored contractionary
  monetary and fiscal policy that meant high
  unemployment and low inflation.

76
History of the Phillips Curve

• Democrats generally favored expansionary monetary
  and fiscal policy that meant low unemployment and
  high inflation.

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The Breakdown of the Short-Run Phillips Curve

• In the early 1970s, the relationship inflation
  and unemployment began breaking down.
• Unemployment was high, but so was inflation.

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The Breakdown of the Short-Run Phillips Curve

• This phenomenon was termed stagflation.

79
The Rise of the Phillips Curve (1954-1968)
80
The Fall of the Phillips Curve (1969-1981)
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Questions About the Phillips Curve (1981-1996)
82
The Long-Run Phillips and Short-Run Phillips
Curves

• The continually changing relationship between
  inflation and unemployment has economists
  somewhat perplexed.

83
The Importance of Inflation Expectations

• Expectations of inflation have been incorporated
  into the analysis by distinguishing between
  short-run and long-run Phillips curves.
• Expectations of inflation the rise in the price
  level that the average person expects.

84
The Importance of Inflation Expectations

• The short-run Phillips curve is one showing the
  trade-off between inflation and unemployment when
  expectations of inflation are fixed.

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The Importance of Inflation Expectations

• The long-run Phillips curve is thought to be a
  vertical curve at the unemployment rate
  consistent with potential output.

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The Importance of Inflation Expectations

• When expectations of inflation are higher, the
  same level of unemployment will be associated
  with a higher level of inflation.

87
The Importance of Inflation Expectations

• It makes sense to assume that the short-run
  Phillips curves moves up or down as expectations
  of inflation change.

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The Importance of Inflation Expectations

• The only sustainable combination of inflation and
  unemployment rates on the short-run Phillips
  curve is at points where the curve intersects the
  long-run Phillips curve.

89
Moving Off the Long-Run Phillips Curve

• If government decides to increase aggregate
  demand, this pushes output above its potential.
• Demand for labor goes up pushing wages higher
  than productivity increases.

90
Moving Off the Long-Run Phillips Curve

• Workers are initially satisfied that their
  increased wages will raise their standard of
  living with the expectation of zero inflation.

91
Moving Back onto the Long-Run Phillips Curve

• When workers find their initial raise did not
  keep up with unexpected inflation, they ask for
  more money giving a boost to a wage-price spiral.

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Moving Back onto the Long-Run Phillips Curve

• If unemployment is lower than the target level of
  unemployment, inflation and the expectation of
  inflation will increase.

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Moving Back onto the Long-Run Phillips Curve

• The short-run Phillip curve will continue to
  shift up until output is no longer above
  potential.

94
Moving Back onto the Long-Run Phillips Curve

• If the cause of inflation is expectations of
  inflation, any level of unemployment is
  consistent with the target level of unemployment.

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Stagflation and the Phillips Curve

• Economists theorized that the stagflation of the
  late 1970s and early 1980s was caused when
  government attempted to push down inflation
  through contractionary aggregate demand policy.

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Stagflation and the Phillips Curve

• The lower aggregate demand pushed the economy to
  the point where unemployment exceeded the target
  rate.

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Stagflation and the Phillips Curve

• The higher unemployment put downward pressure on
  wages and prices, shifting the short-run Phillips
  curve down.

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Inflation Expectations and the Phillips Curve
99
The New Economy

• Output expanded significantly during the late
  1990s and early 2000s.
• The cause of the good times was a combination of
  factors.

100
The New Economy

• The economy was experiencing a temporary positive
  productivity shock because Internet growth and
  investment were shifting potential output out.

101
The New Economy

• Competition increased because of globalization.

102
The New Economy

• Workers were less concerned with real wages and
  more concerned with protecting their jobs, so
  firms did not raise wages even with extremely
  tight labor markets.

103
The New Economy

• Some economists argued that these conditions were
  permanent.

104
The Relationship Between Inflation and Growth

• In the AS/AD model, as the economy expands and
  output increases, at some point input prices
  begin to rise, shifting the AS curve up.
• The problem is that no knows where that point is.

105
The Relationship Between Inflation and Growth

• Institutionalist economists prefers a point where
  the output level is high as possible while
  keeping inflation low and not accelerating.

106
The Price/Output Path
107
Quantity Theory and the Inflation/Growth Trade-Off

• Quantity theorists are much more likely to err on
  the side of preventing inflation.
• For them, erring on the low side pays off by
  stopping any chance of inflation.
• It also builds credibility for the Fed.

108
Quantity Theory and the Inflation/Growth Trade-Off

• Quantity theorists justify erring on the side of
  preventing inflation by arguing that there is a
  high cost associated with igniting inflation.

109
Quantity Theory and the Inflation/Growth Trade-Off

• Quantity theorists argue that there is no
  long-run tradeoff between inflation and
  unemployment.

110
Quantity Theory and the Inflation/Growth Trade-Off

• Quantity theorists believe low inflation leads to
  higher growth

111
Quantity Theory and the Inflation/Growth Trade-Off

• There is no solid empirical evidence showing who
  is correct, the quantity theorists or the
  institutionalists.

112
Growth/Inflation Tradeoff
113
Institutional Theory and the Inflation/Growth
Trade-Off

• Supporters of the institutional theory of
  inflation are less sure about a negative
  relationship between inflation and growth.

114
Institutional Theory and the Inflation/Growth
Trade-Off

• Institutional theorists agree that rises in the
  price level have the potential of generating
  inflation.

115
Institutional Theory and the Inflation/Growth
Trade-Off

• If inflation does get started, the government has
  some medicine to give the economy that will get
  rid of inflation relatively easily.

116
Institutional Theory and the Inflation/Growth
Trade-Off

• This was highlighted in the debate about monetary
  policy in early 2000.

117
Institutional Theory and the Inflation/Growth
Trade-Off

• Quantity theorist argued that inflation was just
  around the corner, and unless government
  instituted contractionary aggregate demand
  policy, the seeds of inflation would be sown.

118
Institutional Theory and the Inflation/Growth
Trade-Off

• Other economists argued that the institutional
  changes in the labor market had reduced the
  inflation threat and that more expansionary
  policy was needed.

119
Inflation and Its Relationship to Unemployment
and Growth

• End of Chapter 15

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