© 2003 McGraw-Hill Ryerson Limited. Inflation and Its Relationship to Unemployment and Growth Chapter 15

© 2003 McGraw-Hill Ryerson Limited.

Inflation and Its Inflation and Its Relationship to Relationship to

Unemployment and Unemployment and Growth Growth

Chapter 15Chapter 15

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Some Basics about Some Basics about InflationInflation Inflation is a continuous rise in the

price level. It is measured using a price index.

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The Distributional The Distributional Effects of InflationEffects of Inflation There are winners and losers in an

inflation.

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The Distributional The Distributional Effects of InflationEffects of Inflation The winners are those who can raise

their prices or wages and still keep their jobs or sell their goods.

The losers in an inflation are those who cannot raise their wages or prices.

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The Distributional The Distributional Effects of InflationEffects of Inflation Because they often enter into fixed

nominal contracts, lenders and borrowers are affected by inflation.

Unexpected inflation redistributes income from lenders to borrowers.

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The Distributional The Distributional Effects of InflationEffects of Inflation The composition of the winners and

losers from an inflation changes over time.

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The Distributional The Distributional Effects of InflationEffects of Inflation People who do not expect inflation and

who are tied to fixed nominal contracts are likely lose in an inflation.

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The Distributional The Distributional Effects of InflationEffects of Inflation If they are rational, these people will not

allow it to happen again. They will be prepared for a subsequent

inflation.

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Expectations of InflationExpectations of Inflation

Rational expectations economists argue that if expectations are rational, they will always be based on the economic model.

Rational expectations are the expectations that the economists' model predicts.

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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.

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There are two ways people form expectations.

Adaptive expectations are those based, in some way, on what has been in the past.

Extrapolative expectations are those that assume a trend will continue.

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Productivity, Inflation, Productivity, Inflation, and Wagesand Wages There are two key measures that policy

makers focus on to determine whether inflation may be coming: Changes in productivity. Changes in wages.

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Productivity, Inflation, Productivity, Inflation, and Wagesand Wages The basic rule of thumb:

Wages can increase at the same rate as productivity increases without generating inflationary pressures.

Inflation = Nominal wage increases - Productivity growth

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Theories of InflationTheories 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.

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The Quantity Theory of The Quantity Theory of Money and InflationMoney and Inflation The quantity theory of money is

summarized by the sentence: Inflation is always and everywhere a monetary phenomenon.

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The Equation of The Equation of ExchangeExchange 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.

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The Equation of The Equation of ExchangeExchange

M = quantity of moneyV = velocity of money (is

constant and determined by institutional forces)

P = price levelQ = real output (is relatively

constant and determined by real, not monetary forces)

PQ = the economy’s nominal output (nominal GDP—the quantity of goods valued at whatever price level exists at the time

The equation of exchange:

MV = PQ

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Velocity Is ConstantVelocity Is Constant

The first assumption of the quantity theory is that velocity is constant.

Its rate is determined by the economy’s institutional structure.

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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.

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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.

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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply The second assumption of the quantity

theory is that real output (Q) is independent of the money supply.

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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply Q is autonomous, meaning real output

is determined by forces outside the quantity theory.

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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply If Q grows, it is because of incentives in

the real economy. These incentives are on the supply side,

not the demand side.

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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply The conclusion of the quantity theory

is M P. With both V and Q unaffected by changes in M, the only thing that can change is P.

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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply The quantity theory of money says

that the price level varies in response to changes in the quantity of money.

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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply The quantity theory holds that real

output is not influenced by changes in the money supply.

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Examples of Money's Examples of Money's Role in InflationRole in Inflation The quantity theory lost its appeal in the

late 1970s and early 1990s. The formerly stable relationships

between measurements of money and inflation appeared to break down.

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Examples of Money's Examples of Money's Role in InflationRole in Inflation In the 1990s it seemed that the random

elements in the relationship between money and inflation overwhelmed the connection.

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Examples of Money's Examples of Money's Role in InflationRole in Inflation The relationships between money and

inflation broke down because of technological changes and changing regulations in financial institutions.

Another reason was the increasing global interdependence of financial markets.

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Examples of Money's Examples of Money's Role in InflationRole in Inflation The empirical evidence that supports

the quantity theory of money in developing countries is most convincing in Brazil and Chile.

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Price Level and Money in Price Level and Money in Canada, 1953-2001, Canada, 1953-2001, Fig. 15-1, Fig. 15-1,

p 365p 365

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Price Level and Money in Price Level and Money in Brazil and Chile, Brazil and Chile, Fig. 15-2, p 366Fig. 15-2, p 366

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The Inflation TaxThe Inflation Tax

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

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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.

In essence, the increase in money supply is caused by the government deficit.

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Financing the deficit by expansionary monetary policy causes inflation.

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

It is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms.

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Central banks have to make a monetary policy choice: Ignite inflation by bailing out their

governments with an expansionary monetary policy.

Do nothing and risk recession or even a breakdown of the entire economy.

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Policy Implications of Policy Implications of the Quantity Theorythe 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.

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Policy Implications of Policy Implications of the Quantity Theorythe Quantity Theory Supporters of the quantity theory

oppose an activist monetary policy. Instead, they favour a monetary policy

set by rules not by discretion.

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Policy Implications of Policy Implications of the Quantity Theorythe Quantity Theory A monetary rule takes monetary policy

out of the hands of politicians. Many central banks use monetary

regimes or feedback rules.

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Policy Implications of Policy Implications of the Quantity Theorythe Quantity Theory Many economists favor creating

independent central banks to separate politicians from the control of money supply. They feel that politicians will not be

able to hold down the money supply because of the expansionary tendencies in politics.

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Policy Implications of Policy Implications of the Quantity Theorythe Quantity Theory In Canada, in 1991 the Bank of Canada

announced targets for the inflation rate based on the CPI.

Canadian monetary policy is aimed at maintaining a low and stable inflation of between one and three percent.

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Policy Implications of Policy Implications of the Quantity Theorythe Quantity Theory The U.S. Federal Reserve Bank does

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

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The Institutional Theory The Institutional Theory of Inflation 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.

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The Institutional Theory The Institutional Theory of Inflationof Inflation According to the quantity theory, the

direction of causation moves from left to right:

MV PQ

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The Institutional Theory The Institutional Theory of Inflationof Inflation Institutional theories see it the other way

round. An increase in prices forces government

into positions where it must increase money supply or cause unemployment.

MV PQ

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The Institutional Theory The Institutional Theory of Inflationof Inflation According to these theorists, the source

of inflation is in the price-setting process of firms. Firms find it easier to raise prices

than to lower them. Firms do not take into account the

effect of their pricing decisions on the overall price level.

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Focus on the Price-Focus on the Price-Setting Decisions of Setting Decisions of FirmsFirms Any increase in firms’ wages, rents,

taxes, and other costs are simply passed on to consumers in the form of higher prices.

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Focus on the Price-Focus on the Price-Setting Decisions of Setting Decisions of FirmsFirms This works so long as the government

increases the money supply so that demand is sufficient to buy the goods at the higher prices.

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Price-Setting Strategies Price-Setting Strategies Depend on the Labour Depend on the Labour MarketMarket Whether the firm selects this price-

raising strategy depends on the state of the labour market.

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Price-Setting Strategies Price-Setting Strategies Depend on the Labour Depend on the Labour MarketMarket The state of the labour market plays a

key role in firms’ decisions whether to give in to workers’ demands for higher wages.

That is why economists look at unemployment to measure inflationary pressures.

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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms Institutional theorists see the nominal

wage- and price-setting process as generating inflation.

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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms One group pushes up its nominal wage

and/or price, another group responds by doing the same.

More groups follow.

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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms The first group finds its relative wages

and/or prices have not increased, so they raise them again.

And the process begins anew.

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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms At this point, government has two

options: Increase money supply, thereby

accepting the inflation. Refuse to ratify the inflation, thereby

causing unemployment to rise.

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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation The insider-outsider model is an

institutionalist story of inflation where insiders bid up wages and outsiders are unemployed.

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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation Insiders are business owners and

workers with good jobs with excellent long-run prospects; outsiders are everyone else.

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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation If markets were purely competitive,

wages, profits, and rents would be pushed down to equilibrium levels.

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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation Insiders don’t like this, so they develop

sociological and institutional barriers to prevent outsiders from competing away the wages, profits and rents.

Barriers include unions, laws restricting the firing of workers, and brand recognition.

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The Insider/Outsider The Insider/Outsider Model and InflationModel 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 The Insider/Outsider Model and InflationModel and Inflation Outsiders are the first to be fired and

their businesses are the first to fail in a recession.

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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation The economy is only partially

competitive – the invisible hand is thwarted by social and political forces.

Insiders push to raise their nominal wages to protect their real wages while outsiders suffer.

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Policy Implications of Policy Implications of Institutional TheoriesInstitutional Theories The quantity theorists have a simple

solution for stopping inflation – just cut the growth of the money supply.

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Policy Implications of Policy Implications of Institutional TheoriesInstitutional 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.

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Policy Implications of Policy Implications of Institutional TheoriesInstitutional Theories They suggest that contractionary

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

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Policy Implications of Policy Implications of Institutional TheoriesInstitutional 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.

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Policy Implications of Policy Implications of Institutional TheoriesInstitutional Theories Formal policies have been out of favour

for a number of years. Informal incomes policies exist in many

European countries.

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Inflation and Inflation and Unemployment: The Unemployment: The Phillips CurvePhillips 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.

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Inflation and Inflation and Unemployment: The Unemployment: The Phillips CurvePhillips Curve The tradeoff can be represented

graphically in the short-run Phillips Curve which represents the relationship between inflation and unemployment when expected inflation is constant.

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Inflation and Inflation and Unemployment: The Unemployment: The Phillips CurvePhillips Curve The Phillips curve shows us what

combinations of unemployment and inflation are possible.

Unemployment is measured on the horizontal axis, and inflation is measured on the vertical axis.

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Unemployment rate

5

4

3

2

1

0 4 5 6 7

Infla

tion

A

B

The Hypothesized The Hypothesized Phillips Curve, Phillips Curve, Fig. 15-3a, p 373Fig. 15-3a, p 373

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History of the Phillips History of the Phillips CurveCurve 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.

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History of the Phillips History of the Phillips CurveCurve 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 History of the Phillips CurveCurve Conservatives generally favoured

contractionary monetary and fiscal policy that meant high unemployment and low inflation.

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History of the Phillips History of the Phillips CurveCurve Liberals generally favoured

expansionary monetary and fiscal policy that meant low unemployment and high inflation.

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The Breakdown of the The Breakdown of the Short-Run Phillips CurveShort-Run Phillips Curve In the late 1970s, the relationship

between inflation and unemployment began breaking down.

Unemployment was high, but so was inflation.

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The Breakdown of the The Breakdown of the Short-Run Phillips CurveShort-Run Phillips Curve This phenomenon was termed

stagflation. Stagflation is the combination of high

and accelerating inflation and high unemployment.

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The Phillips Curve The Phillips Curve Trade-Off, Trade-Off, Fig. 15-3, p 373Fig. 15-3, p 373

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The Long-Run and Short-The Long-Run and Short-Run Phillips CurvesRun Phillips Curves The continually changing relationship

between inflation and unemployment has economists somewhat perplexed.

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The Importance of The Importance of Inflation ExpectationsInflation 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.

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The Importance of The Importance of Inflation ExpectationsInflation 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 The Importance of Inflation ExpectationsInflation Expectations The long-run Phillips curve is thought to

be a vertical curve at the unemployment rate consistent with potential output.

It shows the trade-off (or complete lack thereof) when expectations of inflation equal actual inflation.

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The Importance of The Importance of Inflation ExpectationsInflation Expectations When expectations of inflation are

higher, the same level of unemployment will be associated with a higher level of inflation.

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The Importance of The Importance of Inflation ExpectationsInflation 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 The Importance of Inflation ExpectationsInflation 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.

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Moving Off the Long-Run Moving Off the Long-Run Phillips CurvePhillips Curve If government decides to increase

aggregate demand, this pushes output above its potential.

Demand for labour goes up pushing wages higher than productivity increases.

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Moving Off the Long-Run Moving Off the Long-Run Phillips CurvePhillips Curve Workers are initially satisfied that their

increased wages will raise their standard of living with the expectation of zero inflation.

But if productivity does not go up, inflation will wipe out their wage gains.

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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-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 Moving Back onto the Long-Run Phillips CurveLong-Run Phillips Curve If unemployment is lower than the target

level of unemployment, inflation and the expectation of inflation will increase.

The short-run Phillips curve will shift up.

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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-Run Phillips Curve The short-run Phillip curve will continue

to shift up until output is no longer above potential.

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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-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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LASLong-run Phillips curve

AD0

AD1

C

AC

PC0PC1 (expected inflation = 4)

Real output

Price level

Inflation Expectations Inflation Expectations and the Phillips Curve, and the Phillips Curve, Fig. Fig.

15-4, p 37515-4, p 375

A

expected inflation = 0

B

B SAS0

SAS1

SAS28

6

4

2

Unemployment rate

4.5 5.5 6.5

Inflation rate

D

D

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Stagflation and the Stagflation and the Phillips CurvePhillips 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 Stagflation and the Phillips CurvePhillips Curve The lower aggregate demand pushed

the economy to the point where unemployment exceeded the target rate.

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Stagflation and the Stagflation and the Phillips CurvePhillips Curve The higher unemployment put

downward pressure on wages and prices, shifting the short-run Phillips curve down.

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The New EconomyThe New Economy

Output expanded significantly during the late 1990s and early 2000s, and unemployment rates were lower than most economists predicted.

The cause of the good times was a combination of factors.

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

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Competition increased because of globalization.

Price comparisons were made possible by e-commerce.

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

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Some economists argued that these conditions were permanent.

Others argued that this combination of effects were temporary and that the economy would come out of its “Goldilocks period.”

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The Relationship The Relationship Between Inflation and Between Inflation and GrowthGrowth In the AS/AD model, as the economy

expands and output increases, at some point input prices begin to rise, shifting the SAS curve up.

The problem is that no one knows where the potential output is.

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The Relationship The Relationship Between Inflation and Between Inflation and GrowthGrowth Institutional economists prefer a point

where the output level is as high as possible while keeping inflation low and not accelerating.

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The Price/Output Path, The Price/Output Path, Fig. 15-5a, p 377Fig. 15-5a, p 377

Keynesian range

Intermediate range

Classical range

Low estimate of potential

output

Price/output path

Real output

Price level

High estimate of potential

output

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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff 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 Bank of

Canada.

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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists justify erring on the

side of preventing inflation by arguing that there is a high cost associated with igniting inflation.

Inflation undermines the economy’s long-run growth and hence its future potential income.

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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists argue that there is no

long-run tradeoff between inflation and unemployment.

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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists believe low inflation

leads to higher growth: It reduces price uncertainty, making it

easier for businesses to invest in future production.

It encourages businesses to enter into long-term contracts.

It makes using money much easier.

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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff There is no solid empirical evidence

showing who is correct, the quantity theorists or the institutionalists.

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Growth/Inflation Growth/Inflation Tradeoff, Tradeoff, Fig. 15-5b, p 377Fig. 15-5b, p 377

Growth0

Inflation

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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Supporters of the institutional theory of

inflation are less sure about a negative relationship between inflation and growth.

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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Institutional theorists agree that rises in

the price level have the potential of generating inflation.

They agree that high accelerating inflation undermines growth.

They do not agree that all price level increases start an inflation.

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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off If inflation does get started, the

government has some medicine to give the economy that will get rid of inflation relatively easily.

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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off This was highlighted in the debate

about monetary policy in the early 2000.

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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-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.

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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Other economists argued that the

institutional changes in the labour market had reduced the inflation threat and that more expansionary policy was needed.

The Bank of Canada followed a path between these two positions.


Inflation and Its Inflation and Its Relationship to Relationship to

Unemployment and Unemployment and Growth Growth

End of Chapter 15End of Chapter 15

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© 2003 McGraw-Hill Ryerson Limited. Inflation and Its Relationship to Unemployment and Growth Chapter 15