12. Infl. & Unemployment

8/8/2019 12. Infl. & Unemployment

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Lecture 12Lecture 12Lecture 12Lecture 12THE DYNAMICS OFTHE DYNAMICS OF

INFLATION ANDINFLATION ANDUNEMPLOYMENTUNEMPLOYMENT

THE DYNAMICS OFTHE DYNAMICS OFINFLATION ANDINFLATION AND

UNEMPLOYMENTUNEMPLOYMENT


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InflationInflation is ais a process process in which the pricein which the pricelevel rises and money loses value.level rises and money loses value.Inflation is fundamentally a monetaryInflation is fundamentally a monetaryphenomenon.phenomenon.

TheThe averageaverage level of prices islevel of prices is risingrising ..Inflation isInflation is not high pricesnot high prices and inflation isand inflation isnot a jump in pricesnot a jump in prices

InflationInflation is ais a process process in which the pricein which the pricelevel rises and money loses value.level rises and money loses value.Inflation is fundamentally a monetaryInflation is fundamentally a monetaryphenomenon.phenomenon.

TheThe averageaverage level of prices islevel of prices is risingrising ..Inflation isInflation is not high pricesnot high prices and inflation isand inflation isnot a jump in pricesnot a jump in prices

Inflation and the Price LevelInflation and the Price LevelInflation and the Price LevelInflation and the Price Level


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The figuresThe figuresdistinguishesdistinguishesbetween abetween aone timeone time

jump in jump inprices andprices andinflation.inflation.Part (b)Part (b)shows a oneshows a onetime jump intime jump inthe pricethe pricelevel.level.

The figuresThe figuresdistinguishesdistinguishesbetween abetween aone timeone time

jump in jump inprices andprices andinflation.inflation.Part (b)Part (b)shows a oneshows a onetime jump intime jump inthe pricethe pricelevel.level.



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Part (a)Part (a)shows theshows theprocess of process of

inflation.inflation.The inflationThe inflationrate is therate is thepercentagepercentagechange in thechange in theprice levelprice levelduring aduring agiven period.given period.

Part (a)Part (a)shows theshows theprocess of process of

inflation.inflation.The inflationThe inflationrate is therate is thepercentagepercentagechange in thechange in theprice levelprice levelduring aduring agiven period.given period.



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DemandDemand- -pull inflationpull inflation is inflation thatis inflation that

results from an initial increase inresults from an initial increase inaggregate demand.aggregate demand.A demand pull inflation can resultA demand pull inflation can resultfrom any influence that increasesfrom any influence that increasesaggregate demand.aggregate demand.

DemandDemand- -pull inflationpull inflation is inflation thatis inflation that

results from an initial increase inresults from an initial increase inaggregate demand.aggregate demand.A demand pull inflation can resultA demand pull inflation can resultfrom any influence that increasesfrom any influence that increasesaggregate demand.aggregate demand.

DemandDemand- -Pull InflationPull InflationDemandDemand- -Pull InflationPull Inflation


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In a demandIn a demand- -pull inflation, initiallypull inflation, initially aggregate demand increasesaggregate demand increases real GDP increases above potentialreal GDP increases above potential

GDP and the price level risesGDP and the price level rises money wages risemoney wages rise

the price level rises further and realthe price level rises further and realGDP decreases toward potentialGDP decreases toward potentialGDP.GDP.

In a demandIn a demand- -pull inflation, initiallypull inflation, initially aggregate demand increasesaggregate demand increases real GDP increases above potentialreal GDP increases above potential

GDP and the price level risesGDP and the price level rises money wages risemoney wages rise

the price level rises further and realthe price level rises further and realGDP decreases toward potentialGDP decreases toward potentialGDP.GDP.



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A oneA one- -time increase in aggregatetime increase in aggregatedemand raises the price level butdemand raises the price level but

does not always start a demanddoes not always start a demand- -pullpullinflation.inflation.For demand pull inflation to occur,For demand pull inflation to occur,aggregate demand must persistentlyaggregate demand must persistentlyincrease.increase.The money supply must persistentlyThe money supply must persistentlygrow at a rate that exceeds thegrow at a rate that exceeds thegrowth rate of potential GDP.growth rate of potential GDP.

A oneA one- -time increase in aggregatetime increase in aggregatedemand raises the price level butdemand raises the price level but

does not always start a demanddoes not always start a demand- -pullpullinflation.inflation.For demand pull inflation to occur,For demand pull inflation to occur,aggregate demand must persistentlyaggregate demand must persistentlyincrease.increase.The money supply must persistentlyThe money supply must persistentlygrow at a rate that exceeds thegrow at a rate that exceeds thegrowth rate of potential GDP.growth rate of potential GDP.



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The figuresThe figuresshow ashow a

demand pulldemand pullinflation.inflation.Initially,Initially,

aggregateaggregatedemanddemandincreases.increases.

The figuresThe figuresshow ashow a

demand pulldemand pullinflation.inflation.Initially,Initially,

aggregateaggregatedemanddemandincreases.increases.



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R eal GDPR eal GDPincreasesincreases

and the priceand the pricelevel rises.level rises.Now realNow real

GDPGDPexceedsexceedspotentialpotentialGDP.GDP.


and the priceand the pricelevel rises.level rises.Now realNow real

GDPGDPexceedsexceedspotentialpotentialGDP.GDP.



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There is anThere is aninflationaryinflationarygap.gap.The moneyThe moneywage ratewage ratebegins to rise.begins to rise.

And theAnd the SAS SAS curve shiftscurve shiftsleftward.leftward.

There is anThere is aninflationaryinflationarygap.gap.The moneyThe moneywage ratewage ratebegins to rise.begins to rise.

And theAnd the SAS SAS curve shiftscurve shiftsleftward.leftward.



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R eal GDPR eal GDPdecreasesdecreases

towardtowardpotentialpotentialGDP.GDP.

The priceThe pricelevel riseslevel risesfurther.further.


towardtowardpotentialpotentialGDP.GDP.

The priceThe pricelevel riseslevel risesfurther.further.



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This processThis processrepeats in anrepeats in an

unendingunendingpriceprice- -wagewagespiral.spiral.

This processThis processrepeats in anrepeats in an

unendingunendingpriceprice- -wagewagespiral.spiral.



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CostCost--push inflationpush inflation is an inflationis an inflationthat results from an initialthat results from an initialincrease in costs.increase in costs.The two main sources of costThe two main sources of cost- -push inflation are:push inflation are: an increase in the money wage ratean increase in the money wage rate an increase in the money prices of an increase in the money prices of

raw materialsraw materials

CostCost--push inflationpush inflation is an inflationis an inflationthat results from an initialthat results from an initialincrease in costs.increase in costs.The two main sources of costThe two main sources of cost- -push inflation are:push inflation are: an increase in the money wage ratean increase in the money wage rate an increase in the money prices of an increase in the money prices of

raw materialsraw materials

CostCost- -Push InflationPush InflationCostCost- -Push InflationPush Inflation


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In a costIn a cost- -push inflation, initiallypush inflation, initially shortshort- -run aggregate supplyrun aggregate supply

decreasesdecreases real GDP decreases belowreal GDP decreases belowpotential GDP and the price levelpotential GDP and the price levelrisesrises

the economy could become stuckthe economy could become stuckin thisin this stagflationstagflation situation for situation for some time.some time.

In a costIn a cost- -push inflation, initiallypush inflation, initially shortshort- -run aggregate supplyrun aggregate supply

decreasesdecreases real GDP decreases belowreal GDP decreases belowpotential GDP and the price levelpotential GDP and the price levelrisesrises

the economy could become stuckthe economy could become stuckin thisin this stagflationstagflation situation for situation for some time.some time.



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A oneA one- -time decrease in aggregatetime decrease in aggregatesupply raises the price level but doessupply raises the price level but does

not always start a costnot always start a cost- -pushpushinflation.inflation.For costFor cost- -push inflation to occur,push inflation to occur,aggregate demand must increase inaggregate demand must increase in

response to the cost push.response to the cost push.

A oneA one- -time decrease in aggregatetime decrease in aggregatesupply raises the price level but doessupply raises the price level but does

not always start a costnot always start a cost- -pushpushinflation.inflation.For costFor cost- -push inflation to occur,push inflation to occur,aggregate demand must increase inaggregate demand must increase in

response to the cost push.response to the cost push.



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J ust like the case of demandJ ust like the case of demand- -pull inflation, the money supplypull inflation, the money supplymust persistently grow at a ratemust persistently grow at a ratethat exceeds the growth rate of that exceeds the growth rate of potential GDP if an inflation is topotential GDP if an inflation is to

become persistent.become persistent.

J ust like the case of demandJ ust like the case of demand- -pull inflation, the money supplypull inflation, the money supplymust persistently grow at a ratemust persistently grow at a ratethat exceeds the growth rate of that exceeds the growth rate of potential GDP if an inflation is topotential GDP if an inflation is to

become persistent.become persistent.



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TheThefollowingfollowing

figuresfiguresshow ashow acostcost- -pushpushinflation.inflation.Initially, aInitially, afactor pricefactor pricerises.rises.

TheThefollowingfollowing

figuresfiguresshow ashow acostcost- -pushpushinflation.inflation.Initially, aInitially, afactor pricefactor pricerises.rises.



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ShortShort- -runrunaggregateaggregate

supplysupplydecreasesdecreasesand theand theSAS SAS curvecurveshiftsshiftsleftwardleftward

ShortShort- -runrunaggregateaggregate

supplysupplydecreasesdecreasesand theand theSAS SAS curvecurveshiftsshiftsleftwardleftward



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and theand theprice levelprice levelrises in arises in astagflationstagflation ..


and theand theprice levelprice levelrises in arises in astagflationstagflation ..



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W ith noW ith nosubsequetsubsequet

change inchange inaggregateaggregatedemand,demand,the pricethe pricelevelleveleventuallyeventuallyfalls.falls.

W ith noW ith nosubsequetsubsequet

change inchange inaggregateaggregatedemand,demand,the pricethe pricelevelleveleventuallyeventuallyfalls.falls.



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There is noThere is noinflation.inflation.For costFor cost- -pushpushinflation toinflation totake hold,take hold,

aggregateaggregatedemanddemandmustmustincrease.increase.

There is noThere is noinflation.inflation.For costFor cost- -pushpushinflation toinflation totake hold,take hold,

aggregateaggregatedemanddemandmustmustincrease.increase.



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An increaseAn increasein the moneyin the moneysupplysupplyincreasesincreasesaggregateaggregatedemand anddemand andthethe AD AD curvecurveshiftsshiftsrightward.rightward.

An increaseAn increasein the moneyin the moneysupplysupplyincreasesincreasesaggregateaggregatedemand anddemand andthethe AD AD curvecurveshiftsshiftsrightward.rightward.



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and theand theprice levelprice levelrises.rises.


and theand theprice levelprice levelrises.rises.



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ThisThisprocessprocess

repeats torepeats tocreate ancreate anunendingunendingcostcost- -pricepriceinflationinflationspiral.spiral.

ThisThisprocessprocess

repeats torepeats tocreate ancreate anunendingunendingcostcost- -pricepriceinflationinflationspiral.spiral.



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HYPER

INFLATIONHYPER

INFLATIONHYPER

INFLATIONHYPER

INFLATIONVery high inflation rates, over 50% per Very high inflation rates, over 50% per monthmonthInflation rates observed in the US inInflation rates observed in the US inthe last 40 years are insignificant inthe last 40 years are insignificant incomparison to some experiencescomparison to some experiencesaround the world throughout historyaround the world throughout history

Very high inflation rates, over 50% per Very high inflation rates, over 50% per monthmonthInflation rates observed in the US inInflation rates observed in the US inthe last 40 years are insignificant inthe last 40 years are insignificant incomparison to some experiencescomparison to some experiencesaround the world throughout historyaround the world throughout history


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HIGH INFLATIONS IN THE 1980sHIGH INFLATIONS IN THE 1980sHIGH INFLATIONS IN THE 1980sHIGH INFLATIONS IN THE 1980s

Country Bolivia Argentina Nicaragua Year 1985 1989 198 Yearly Inflation 1,152, 200 975, 000 302, 200

R ate (%)Monthly Inflation 118 95 115

R ate (%)Monthly Money 91 93 66

Growth

R ate (%)Source:Source: International Financial Statistics YearbookInternational Financial Statistics Yearbook, 1992, , 1992,(W ashington DC: International Monetary Fund)(W ashington DC: International Monetary Fund)


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DUR ING HYPE R INFLATIONSDUR ING HYPE R INFLATIONSDUR ING HYPE R INFLATIONSDUR ING HYPE R INFLATIONSMoney no longer works very well in facilitatingMoney no longer works very well in facilitatingexchangeexchangeSince prices are changing so fast and unpredictably,Since prices are changing so fast and unpredictably,there is typically massive confusion about the truethere is typically massive confusion about the truevalue of commoditiesvalue of commodities

Different stores may be raising prices at different ratesDifferent stores may be raising prices at different ratesThe same commodities may sell for radically differentThe same commodities may sell for radically differentpricespricesEveryone spends all their time hunting for bargains andEveryone spends all their time hunting for bargains and

finding the lowest pricesfinding the lowest pricesGovernments are forced to put an end to hyperinflationGovernments are forced to put an end to hyperinflationbefore it destroys their economiesbefore it destroys their economies

Money no longer works very well in facilitatingMoney no longer works very well in facilitatingexchangeexchangeSince prices are changing so fast and unpredictably,Since prices are changing so fast and unpredictably,there is typically massive confusion about the truethere is typically massive confusion about the truevalue of commoditiesvalue of commodities

Different stores may be raising prices at different ratesDifferent stores may be raising prices at different ratesThe same commodities may sell for radically differentThe same commodities may sell for radically differentpricespricesEveryone spends all their time hunting for bargains andEveryone spends all their time hunting for bargains and

finding the lowest pricesfinding the lowest pricesGovernments are forced to put an end to hyperinflationGovernments are forced to put an end to hyperinflationbefore it destroys their economiesbefore it destroys their economies


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THE CAUSE OF HYPE R INFLATIONTHE CAUSE OF HYPE R INFLATIONTHE CAUSE OF HYPE R INFLATIONTHE CAUSE OF HYPE R INFLATIONExcessive money growthExcessive money growth

If a government wants to spend a specifiedIf a government wants to spend a specifiedamount of money, but is collecting less inamount of money, but is collecting less intaxes, it must cover the difference in sometaxes, it must cover the difference in someway:way: the government may borrow the difference from thethe government may borrow the difference from the

public and issue bonds, for which it must pay backpublic and issue bonds, for which it must pay backwhat it borrows and interest in the futurewhat it borrows and interest in the future

the government may print new moneythe government may print new money

governments could mix borrowing and printing moneygovernments could mix borrowing and printing moneyto cover the deficitto cover the deficit

government deficit = new borrowing + new money createdgovernment deficit = new borrowing + new money created

Excessive money growthExcessive money growth

If a government wants to spend a specifiedIf a government wants to spend a specifiedamount of money, but is collecting less inamount of money, but is collecting less intaxes, it must cover the difference in sometaxes, it must cover the difference in someway:way: the government may borrow the difference from thethe government may borrow the difference from the

public and issue bonds, for which it must pay backpublic and issue bonds, for which it must pay backwhat it borrows and interest in the futurewhat it borrows and interest in the future

the government may print new moneythe government may print new money

governments could mix borrowing and printing moneygovernments could mix borrowing and printing moneyto cover the deficitto cover the deficit

government deficit = new borrowing + new money createdgovernment deficit = new borrowing + new money created


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HYPE R INFLATIONHYPE R INFLATIONHYPE R INFLATIONHYPE R INFLATION

occurs in countries that have large deficits,occurs in countries that have large deficits,but cannot borrow and are forced to printbut cannot borrow and are forced to printnew moneynew moneyis only stopped by eliminating the deficit,is only stopped by eliminating the deficit,which is the basic cause:which is the basic cause: increase taxesincrease taxes cut spendingcut spending

Once the deficit has been cut and theOnce the deficit has been cut and thegovernment stops printing money, thegovernment stops printing money, thehyperinflation will endhyperinflation will end

occurs in countries that have large deficits,occurs in countries that have large deficits,but cannot borrow and are forced to printbut cannot borrow and are forced to printnew moneynew moneyis only stopped by eliminating the deficit,is only stopped by eliminating the deficit,which is the basic cause:which is the basic cause: increase taxesincrease taxes cut spendingcut spending

Once the deficit has been cut and theOnce the deficit has been cut and thegovernment stops printing money, thegovernment stops printing money, thehyperinflation will endhyperinflation will end


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INDEXEDINDEXEDINDEXEDINDEXEDDescribesDescribes somethingsomething whosewhose paymentspayments areareadjustedadjusted for for changeschanges in in prices,prices, suchsuch asasbondsbonds or or nominalnominal contractscontractsInIn practice,practice, countriescountries findfind thatthat indexingindexing is is

notnot thethe perfectperfect solutionsolution to to problemsproblems causedcausedbyby inflationinflation: : policymakerspolicymakers worryworry indexingindexing lowerslowers thethe resolveresolve toto

fightfight inflationinflation

PricePrice indicesindices areare far far fromfrom perfectperfect andand areareextremelyextremely difficultdifficult toto constructconstruct whenwhen pricesprices areareincreasingincreasing rapidlyrapidly

SomeSome economistseconomists believebelieve thatthat indexingindexing buildsbuildsinflationinflation intointo thethe economiceconomic systemsystem andand makesmakes it it

difficultdifficult toto reducereduce inflationinflation

DescribesDescribes somethingsomething whosewhose paymentspayments areareadjustedadjusted for for changeschanges in in prices,prices, suchsuch asasbondsbonds or or nominalnominal contractscontractsInIn practice,practice, countriescountries findfind thatthat indexingindexing is is

notnot thethe perfectperfect solutionsolution to to problemsproblems causedcausedbyby inflationinflation: : policymakerspolicymakers worryworry indexingindexing lowerslowers thethe resolveresolve toto

fightfight inflationinflation

PricePrice indicesindices areare far far fromfrom perfectperfect andand areareextremelyextremely difficultdifficult toto constructconstruct whenwhen pricesprices areareincreasingincreasing rapidlyrapidly

SomeSome economistseconomists believebelieve thatthat indexingindexing buildsbuildsinflationinflation intointo thethe economiceconomic systemsystem andand makesmakes it it

difficultdifficult toto reducereduce inflationinflation


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MONETA R ISTSMONETA R ISTSMONETA R ISTSMONETA R ISTS

Economists who traditionally emphasize theEconomists who traditionally emphasize theimportant role that the supply of money plays inimportant role that the supply of money plays indetermining nominal income and inflationdetermining nominal income and inflationMost famousMost famous - - Milton Friedman, Nobel laureateMilton Friedman, Nobel laureate - -

studied versions of quantity equation and role of studied versions of quantity equation and role of money in economic lifemoney in economic lifePhilip CaganPhilip Cagan - - best known for work onbest known for work onhyperinflationshyperinflationsMonetarist economists did pioneering researchMonetarist economists did pioneering researchon link between money, nominal income andon link between money, nominal income andinflationinflation

Economists who traditionally emphasize theEconomists who traditionally emphasize theimportant role that the supply of money plays inimportant role that the supply of money plays indetermining nominal income and inflationdetermining nominal income and inflationMost famousMost famous - - Milton Friedman, Nobel laureateMilton Friedman, Nobel laureate - -

studied versions of quantity equation and role of studied versions of quantity equation and role of money in economic lifemoney in economic lifePhilip CaganPhilip Cagan - - best known for work onbest known for work onhyperinflationshyperinflationsMonetarist economists did pioneering researchMonetarist economists did pioneering researchon link between money, nominal income andon link between money, nominal income andinflationinflation


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R egardlessR egardless of of whether whether itsits originorigin isisdemanddemand- -pullpull or or costcost- -push,push, inflationinflationimposesimposes costscosts. .TheThe costscosts dependdepend onon whether whether thetheinflationinflation isis anticipatedanticipated or or unanticipatedunanticipated. .

R egardlessR egardless of of whether whether itsits originorigin isisdemanddemand- -pullpull or or costcost- -push,push, inflationinflationimposesimposes costscosts. .TheThe costscosts dependdepend onon whether whether thetheinflationinflation isis anticipatedanticipated or or unanticipatedunanticipated. .

Effects of InflationEffects of InflationEffects of InflationEffects of Inflation


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ANTICIPATED INFLATIONANTICIPATED INFLATIONANTICIPATED INFLATIONANTICIPATED INFLATION

Fully Anticipated InflationFully Anticipated InflationInflation at 4% would mean workers would know thatInflation at 4% would mean workers would know thatnominal wage increases of 4% were not real wagenominal wage increases of 4% were not real wageincreases, andincreases, andInvestors earning a 7% rate of interest on bondsInvestors earning a 7% rate of interest on bondswould know that their real return would be 3% after would know that their real return would be 3% after adjusting for inflationadjusting for inflationMenu costsMenu costs -- -- the actual physical costs of changingthe actual physical costs of changingpricesprices

Shoe leather costsShoe leather costs -- -- additional wear and tear additional wear and tear necessary to hold less cashnecessary to hold less cashOur tax system and financial system do not fullyOur tax system and financial system do not fullyadjust even to fully anticipated inflationadjust even to fully anticipated inflation

Fully Anticipated InflationFully Anticipated InflationInflation at 4% would mean workers would know thatInflation at 4% would mean workers would know thatnominal wage increases of 4% were not real wagenominal wage increases of 4% were not real wageincreases, andincreases, andInvestors earning a 7% rate of interest on bondsInvestors earning a 7% rate of interest on bondswould know that their real return would be 3% after would know that their real return would be 3% after adjusting for inflationadjusting for inflationMenu costsMenu costs -- -- the actual physical costs of changingthe actual physical costs of changingpricesprices

Shoe leather costsShoe leather costs -- -- additional wear and tear additional wear and tear necessary to hold less cashnecessary to hold less cashOur tax system and financial system do not fullyOur tax system and financial system do not fullyadjust even to fully anticipated inflationadjust even to fully anticipated inflation


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This figureThis figureshows howshows howanticipatinganticipatinginflationinflationavoids theavoids thecosts of costs of deviationsdeviationsfromfrompotentialpotentialGDP.GDP.

This figureThis figureshows howshows howanticipatinganticipatinginflationinflationavoids theavoids thecosts of costs of deviationsdeviationsfromfrompotentialpotentialGDP.GDP.



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Anticipating inflation also avoids:Anticipating inflation also avoids: the redistribution of income andthe redistribution of income and

wealth.wealth. errors in investment and savingerrors in investment and saving

decisions.decisions.

But anticipated inflation does haveBut anticipated inflation does havesome costs.some costs.

Anticipating inflation also avoids:Anticipating inflation also avoids: the redistribution of income andthe redistribution of income and

wealth.wealth. errors in investment and savingerrors in investment and saving

decisions.decisions.

But anticipated inflation does haveBut anticipated inflation does havesome costs.some costs.



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The costs of anticipated inflation are:The costs of anticipated inflation are: bootleather costsbootleather costs other transactions costsother transactions costs

decrease in potential GDPdecrease in potential GDP decrease in the longdecrease in the long- -term growth rate.term growth rate.

These costs have been estimated to beThese costs have been estimated to bevery high, even for a modest inflation.very high, even for a modest inflation.

The main problem is that taxes on capitalThe main problem is that taxes on capitalincome a seriously distorted by inflation.income a seriously distorted by inflation.

The costs of anticipated inflation are:The costs of anticipated inflation are: bootleather costsbootleather costs other transactions costsother transactions costs

decrease in potential GDPdecrease in potential GDP decrease in the longdecrease in the long- -term growth rate.term growth rate.

These costs have been estimated to beThese costs have been estimated to bevery high, even for a modest inflation.very high, even for a modest inflation.

The main problem is that taxes on capitalThe main problem is that taxes on capitalincome a seriously distorted by inflation.income a seriously distorted by inflation.



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Unanticipated inflationUnanticipated inflation can cause thecan cause thefollowing problems:following problems: redistribute income between firms andredistribute income between firms and

workersworkers move real GDP away from potential GDPmove real GDP away from potential GDP redistribute wealth between borrowersredistribute wealth between borrowers

and lendersand lenders result in too much or too little saving andresult in too much or too little saving andinvestmentinvestment

Unanticipated inflationUnanticipated inflation can cause thecan cause thefollowing problems:following problems: redistribute income between firms andredistribute income between firms and

workersworkers move real GDP away from potential GDPmove real GDP away from potential GDP redistribute wealth between borrowersredistribute wealth between borrowers

and lendersand lenders result in too much or too little saving andresult in too much or too little saving andinvestmentinvestment



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BecauseBecause unanticipatedunanticipated inflationinflation isis costly,costly,peoplepeople trytry toto anticipateanticipate it it..ToTo makemake thethe bestbest possiblepossible forecastforecast of of

inflation,inflation, peoplepeople useuse allall thethe informationinformationtheythey cancan aboutabout thethe sourcesource of of inflationinflation andandlikelylikely trendstrends inin thosethose sourcessources. .SuchSuch a a forecastforecast is is calledcalled a a rationalrational

expectationexpectation. .AnAn anticipatedanticipated inflationinflation avoidsavoids somesome of of thethecostscosts of of inflationinflation. .

BecauseBecause unanticipatedunanticipated inflationinflation isis costly,costly,peoplepeople trytry toto anticipateanticipate it it..ToTo makemake thethe bestbest possiblepossible forecastforecast of of

inflation,inflation, peoplepeople useuse allall thethe informationinformationtheythey cancan aboutabout thethe sourcesource of of inflationinflation andandlikelylikely trendstrends inin thosethose sourcessources. .SuchSuch a a forecastforecast is is calledcalled a a rationalrational

expectationexpectation. .AnAn anticipatedanticipated inflationinflation avoidsavoids somesome of of thethecostscosts of of inflationinflation. .



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COSTS OF INFLATIONCOSTS OF INFLATIONCOSTS OF INFLATIONCOSTS OF INFLATIONAnticipated UnanticipatedInflation Inflation

Institutions do Distortions in the Unfair redistributionsnot adjust tax system,

Problems infinancial markets

Institutions Cost of changing Institutionaladjust prices, disintegrationShoe-leather costs


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THE PHILLIPS CU R VETHE PHILLIPS CU R VE -- 11THE PHILLIPS CU R VETHE PHILLIPS CU R VE -- 11

The Phillips Curve is a graph depicting aThe Phillips Curve is a graph depicting arelationship between the unemploymentrelationship between the unemploymentrate and the inflation rate. The figure belowrate and the inflation rate. The figure below

shows a typical SHOR

Tshows a typical SHOR

T--R

UN Phillips Curve.R

UN Phillips Curve.

The Phillips Curve is a graph depicting aThe Phillips Curve is a graph depicting arelationship between the unemploymentrelationship between the unemploymentrate and the inflation rate. The figure belowrate and the inflation rate. The figure below

shows a typical SHOR

Tshows a typical SHOR

T--R

UN Phillips Curve.R

UN Phillips Curve.


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TheThe implicationimplication of of thethe negativenegative slopeslope isis thatthat thetheunemploymentunemployment raterate andand thethe inflationinflation raterate areareinverselyinversely relatedrelated - - inin other other words,words, therethere isis aa tradetrade- -

off off betweenbetween thethe twotwo..

AtAt thethe beginningbeginning of of thethe course,course, oneone thingsthings wewe saidsaidwaswas thatthat societysociety facesfaces a a shortshort- -runrun tradetrade- -off off betweenbetween inflationinflation andand unemploymentunemployment. . ThisThis tradetrade- -off off isis embodiedembodied in in thethe shortshort- -runrun PhillipsPhillips CurveCurve. .

TheThe implicationimplication of of thethe negativenegative slopeslope isis thatthat thetheunemploymentunemployment raterate andand thethe inflationinflation raterate areareinverselyinversely relatedrelated - - inin other other words,words, therethere isis aa tradetrade- -

off off betweenbetween thethe twotwo..

AtAt thethe beginningbeginning of of thethe course,course, oneone thingsthings wewe saidsaidwaswas thatthat societysociety facesfaces a a shortshort- -runrun tradetrade- -off off betweenbetween inflationinflation andand unemploymentunemployment. . ThisThis tradetrade- -off off isis embodiedembodied in in thethe shortshort- -runrun PhillipsPhillips CurveCurve. .


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SinceSince inflationinflation andand unemploymentunemployment are are BOTHBOTHthingsthings wewe don'tdon't like,like, thethe relationshiprelationship betweenbetween thetheADAD--ASAS (short(short- -run)run) macroeconomicmacroeconomic modelmodel andand thethePhillipsPhillips CurveCurve areare importantimportant. .

UnderstandingUnderstanding the the relationshiprelationship betweenbetweeneconomiceconomic policypolicy andand thethe inflationinflation- -unemploymentunemployment

tradetrade- -off off isis keykey toto your your understandingunderstanding of of macroeconomicsmacroeconomics. .

SinceSince inflationinflation andand unemploymentunemployment are are BOTHBOTHthingsthings wewe don'tdon't like,like, thethe relationshiprelationship betweenbetween thetheADAD--ASAS (short(short- -run)run) macroeconomicmacroeconomic modelmodel andand thethePhillipsPhillips CurveCurve areare importantimportant. .

UnderstandingUnderstanding the the relationshiprelationship betweenbetweeneconomiceconomic policypolicy andand thethe inflationinflation- -unemploymentunemployment

tradetrade- -off off isis keykey toto your your understandingunderstanding of of macroeconomicsmacroeconomics. .


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SHIFTS IN AD & THE PHILLIPSSHIFTS IN AD & THE PHILLIPSCU R VECU R VE -- 11


Q:Q: W hat happens in the Phillips CurveW hat happens in the Phillips Curvediagram when there is a shift in AD?diagram when there is a shift in AD?

A:A: There is a movement along the shortThere is a movement along the short- -runrunPhillips Curve and a tradePhillips Curve and a trade- -off betweenoff between

inflation and unemployment.inflation and unemployment.

Q:Q: W hat happens in the Phillips CurveW hat happens in the Phillips Curvediagram when there is a shift in AD?diagram when there is a shift in AD?

A:A: There is a movement along the shortThere is a movement along the short- -runrunPhillips Curve and a tradePhillips Curve and a trade- -off betweenoff between

inflation and unemployment.inflation and unemployment.


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In the previous slide, AD increases from AD1 toIn the previous slide, AD increases from AD1 toAD2. As a result, the equilibrium in the economyAD2. As a result, the equilibrium in the economymoves from point A to point B.moves from point A to point B.

There are two important things to notice aboutThere are two important things to notice aboutthe new equilibrium (relative to the old one):the new equilibrium (relative to the old one): First, notice that the price level in the economy hasFirst, notice that the price level in the economy has

increased (from 102 to 106)increased (from 102 to 106) - - therefore, the rate of therefore, the rate of

inflation has risen.inflation has risen. Second, the level of output produced in the economySecond, the level of output produced in the economy

has risen (from Y1 to Y2). W hen the level of outputhas risen (from Y1 to Y2). W hen the level of outputincreases, the number of people employed also rises,increases, the number of people employed also rises,

indicating that the unemployment rate MUST haveindicating that the unemployment rate MUST havefallen.fallen.

In the previous slide, AD increases from AD1 toIn the previous slide, AD increases from AD1 toAD2. As a result, the equilibrium in the economyAD2. As a result, the equilibrium in the economymoves from point A to point B.moves from point A to point B.

There are two important things to notice aboutThere are two important things to notice aboutthe new equilibrium (relative to the old one):the new equilibrium (relative to the old one): First, notice that the price level in the economy hasFirst, notice that the price level in the economy has

increased (from 102 to 106)increased (from 102 to 106) - - therefore, the rate of therefore, the rate of

inflation has risen.inflation has risen. Second, the level of output produced in the economySecond, the level of output produced in the economy

has risen (from Y1 to Y2). W hen the level of outputhas risen (from Y1 to Y2). W hen the level of outputincreases, the number of people employed also rises,increases, the number of people employed also rises,

indicating that the unemployment rate MUST haveindicating that the unemployment rate MUST havefallen.fallen.


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R elativeR elative toto pointpoint AA inin thethe figurefigure onon thethe right,right,pointpoint BB MUSTMUST bebe aa pointpoint wherewhere therethere isis higher higher inflationinflation andand lower lower unemploymentunemployment - - butbut thisthis just just

representsrepresents a a movementmovement ALONGALONG thethe shortshort- -runrunPhillipsPhillips CurveCurve. . Also,Also, if if ADAD werewere toto shiftshift inin thetheoppositeopposite direction,direction, therethere wouldwould havehave beenbeen a amovementmovement alongalong thethe PhillipsPhillips CurveCurve inin thethe

oppositeopposite directiondirection. .

R elativeR elative toto pointpoint AA inin thethe figurefigure onon thethe right,right,pointpoint BB MUSTMUST bebe aa pointpoint wherewhere therethere isis higher higher inflationinflation andand lower lower unemploymentunemployment - - butbut thisthis just just

representsrepresents a a movementmovement ALONGALONG thethe shortshort- -runrunPhillipsPhillips CurveCurve. . Also,Also, if if ADAD werewere toto shiftshift inin thetheoppositeopposite direction,direction, therethere wouldwould havehave beenbeen a amovementmovement alongalong thethe PhillipsPhillips CurveCurve inin thethe

oppositeopposite directiondirection. .


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THE LONGTHE LONG- -R UN PHILLIPSR UN PHILLIPSCU R VECU R VE -- 11


The figure below depicts the longThe figure below depicts the long- -run Phillipsrun PhillipsCurve:Curve:The figure below depicts the longThe figure below depicts the long- -run Phillipsrun PhillipsCurve:Curve:


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Earlier in the course, we discussed theEarlier in the course, we discussed thenatural rate of unemployment. This wasnatural rate of unemployment. This wasdefined to be about 6% in the longdefined to be about 6% in the long- -run,run,and it was shown that the economy tendsand it was shown that the economy tendsto automatically return to this level on itsto automatically return to this level on itsown.own.

If this is true, then the longIf this is true, then the long- -run Phillipsrun PhillipsCurve is quite easy to drawCurve is quite easy to draw - - it MUST be ait MUST be avertical line at 6% unemployment!vertical line at 6% unemployment!

Earlier in the course, we discussed theEarlier in the course, we discussed thenatural rate of unemployment. This wasnatural rate of unemployment. This wasdefined to be about 6% in the longdefined to be about 6% in the long- -run,run,and it was shown that the economy tendsand it was shown that the economy tendsto automatically return to this level on itsto automatically return to this level on itsown.own.

If this is true, then the longIf this is true, then the long- -run Phillipsrun PhillipsCurve is quite easy to drawCurve is quite easy to draw - - it MUST be ait MUST be avertical line at 6% unemployment!vertical line at 6% unemployment!


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If If thethe longlong- -runrun PhillipsPhillips CurveCurve isis verticalvertical atat66%%,, thenthen policymakerspolicymakers mustmust bebe ableable totochoosechoose anyany inflationinflation raterate theythey desiredesire alongalongthisthis lineline. .

QQ:: W hatW hat isis thethe costcost of of reducingreducing inflationinflation inin thethe

longlong- -run?run?

AA:: InIn thethe longlong- -run,run, therethere isis NONO costcost toto

reducingreducing inflationinflation. .

If If thethe longlong- -runrun PhillipsPhillips CurveCurve isis verticalvertical atat66%%,, thenthen policymakerspolicymakers mustmust bebe ableable totochoosechoose anyany inflationinflation raterate theythey desiredesire alongalongthisthis lineline. .

QQ:: W hatW hat isis thethe costcost of of reducingreducing inflationinflation inin thethe

longlong- -run?run?

AA:: InIn thethe longlong- -run,run, therethere isis NONO costcost toto

reducingreducing inflationinflation. .


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This is demonstrated in the figures below:This is demonstrated in the figures below:This is demonstrated in the figures below:This is demonstrated in the figures below:


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OnOn thethe left,left, if if thethe FedFed reducesreduces thethe growthgrowth of of thethemoneymoney supplysupply inin thethe longlong- -run,run, thethe ADAD curvecurve willwillshiftshift toto thethe left,left, causingcausing thethe priceprice levellevel toto fallfall

fromfrom PP00 toto PP11..

However,However, outputoutput isis NOTNOT affectedaffected byby changeschanges in inthethe moneymoney supplysupply inin thethe longlong- -runrun (because(because of of monetarymonetary neutrality)neutrality). . SinceSince outputoutput remainsremains at at thethenaturalnatural raterate of of output,output, unemploymentunemployment remainsremains at atthethe naturalnatural raterate of of unemploymentunemployment. .

OnOn thethe left,left, if if thethe FedFed reducesreduces thethe growthgrowth of of thethemoneymoney supplysupply inin thethe longlong- -run,run, thethe ADAD curvecurve willwillshiftshift toto thethe left,left, causingcausing thethe priceprice levellevel toto fallfall

fromfrom PP00 toto PP11..

However,However, outputoutput isis NOTNOT affectedaffected byby changeschanges in inthethe moneymoney supplysupply inin thethe longlong- -runrun (because(because of of monetarymonetary neutrality)neutrality). . SinceSince outputoutput remainsremains at at thethenaturalnatural raterate of of output,output, unemploymentunemployment remainsremains at atthethe naturalnatural raterate of of unemploymentunemployment. .


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OnOn thethe right,right, thethe reductionreduction in in thethe growthgrowth of of thethemoneymoney supplysupply hashas loweredlowered thethe longlong- -runrun raterate of of inflationinflation andand hashas NOTNOT affectedaffected thethe longlong- -runrun

unemploymentunemployment raterate. .

OnOn thethe right,right, thethe reductionreduction in in thethe growthgrowth of of thethemoneymoney supplysupply hashas loweredlowered thethe longlong- -runrun raterate of of inflationinflation andand hashas NOTNOT affectedaffected thethe longlong- -runrun

unemploymentunemployment raterate. .


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THE SHO R TTHE SHO R T--R UN PHILLIPSR UN PHILLIPSCU R VE & EXPECTATIONSCU R VE & EXPECTATIONS - - 11THE SHO R TTHE SHO R T--R UN PHILLIPSR UN PHILLIPS

CU R VE & EXPECTATIONSCU R VE & EXPECTATIONS - - 11

W hileW hile therethere isis notnot aa tradetrade- -off off betweenbetweeninflationinflation andand unemploymentunemployment in in thethe longlong- -run,run, therethere ISIS aa shortshort- -runrun tradetrade- -off off..FromFrom thethe workwork of of MiltonMilton FriedmanFriedman andandEdmundEdmund Phelps,Phelps, wewe knowknow thatthat

expectationsexpectations of of futurefuture inflationinflation playsplays ananimportantimportant rolerole inin thethe shortshort- -runrun tradetrade- -off off..

W hileW hile therethere isis notnot aa tradetrade- -off off betweenbetweeninflationinflation andand unemploymentunemployment in in thethe longlong- -run,run, therethere ISIS aa shortshort- -runrun tradetrade- -off off..FromFrom thethe workwork of of MiltonMilton FriedmanFriedman andandEdmundEdmund Phelps,Phelps, wewe knowknow thatthat

expectationsexpectations of of futurefuture inflationinflation playsplays ananimportantimportant rolerole inin thethe shortshort- -runrun tradetrade- -off off..


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CU R VE & EXPECTATIONSCU R VE & EXPECTATIONS - - 22TheThe figurefigure belowbelow demonstratesdemonstrates the the relationshiprelationshipbetweenbetween thethe shortshort- -runrun PhillipsPhillips CurveCurve andandinflationaryinflationary expectationsexpectations: :

TheThe figurefigure belowbelow demonstratesdemonstrates the the relationshiprelationshipbetweenbetween thethe shortshort- -runrun PhillipsPhillips CurveCurve andandinflationaryinflationary expectationsexpectations: :


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SupposeSuppose thethe economyeconomy is is initiallyinitially atat pointpointAA.. Earlier Earlier wewe saidsaid thatthat aa shiftshift inin thethe ADAD

curvecurve willwill causecause a a movementmovement alongalong thetheshortshort- -runrun PhillipsPhillips CurveCurve. .

AnAn increaseincrease in in thethe moneymoney supply,supply, ananincreaseincrease in in governmentgovernment spendingspending or or aa taxtaxcutcut couldcould allall shiftshift thethe ADAD curvecurve toto thethe rightright-- supposesuppose oneone of of thesethese threethree occursoccurs. .

SupposeSuppose thethe economyeconomy is is initiallyinitially atat pointpointAA.. Earlier Earlier wewe saidsaid thatthat aa shiftshift inin thethe ADAD

curvecurve willwill causecause a a movementmovement alongalong thetheshortshort- -runrun PhillipsPhillips CurveCurve. .

AnAn increaseincrease in in thethe moneymoney supply,supply, ananincreaseincrease in in governmentgovernment spendingspending or or aa taxtaxcutcut couldcould allall shiftshift thethe ADAD curvecurve toto thethe rightright-- supposesuppose oneone of of thesethese threethree occursoccurs. .


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TheThe rightwardrightward shiftshift inin ADAD isis associatedassociated withwithrisingrising outputoutput andand aa risingrising priceprice levellevel. .

TheThe risingrising priceprice levellevel ISIS anan increaseincrease in in thethe raterate of of inflationinflation. .R isingR ising outputoutput goesgoes alongalong withwith risingrisingemploymentemployment (and(and fallingfalling unemployment)unemployment). .

For For thesethese reasons,reasons, thethe rightwardrightward shiftshift inin ADAD willwillcausecause a a movementmovement to to pointpoint BB inin thisthis figurefigure(higher (higher inflationinflation andand lower lower unemploymentunemployment thanthanpointpoint A)A)..

TheThe rightwardrightward shiftshift inin ADAD isis associatedassociated withwithrisingrising outputoutput andand aa risingrising priceprice levellevel. .

TheThe risingrising priceprice levellevel ISIS anan increaseincrease in in thethe raterate of of inflationinflation. .R isingR ising outputoutput goesgoes alongalong withwith risingrisingemploymentemployment (and(and fallingfalling unemployment)unemployment). .

For For thesethese reasons,reasons, thethe rightwardrightward shiftshift inin ADAD willwillcausecause a a movementmovement to to pointpoint BB inin thisthis figurefigure(higher (higher inflationinflation andand lower lower unemploymentunemployment thanthanpointpoint A)A)..


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Now, according to Friedman and Phelps,Now, according to Friedman and Phelps,the higher ACTUAL inflation will eventuallythe higher ACTUAL inflation will eventuallycause EXPECTED inflation to rise as well.cause EXPECTED inflation to rise as well.

The increase in EXPECTED inflation shiftsThe increase in EXPECTED inflation shiftsthe shortthe short- -run Phillips Curve to the right (torun Phillips Curve to the right (toS RS R --PC2), and the economy ends up atPC2), and the economy ends up atpoint C.point C.

Now, according to Friedman and Phelps,Now, according to Friedman and Phelps,the higher ACTUAL inflation will eventuallythe higher ACTUAL inflation will eventuallycause EXPECTED inflation to rise as well.cause EXPECTED inflation to rise as well.

The increase in EXPECTED inflation shiftsThe increase in EXPECTED inflation shiftsthe shortthe short- -run Phillips Curve to the right (torun Phillips Curve to the right (toS RS R --PC2), and the economy ends up atPC2), and the economy ends up atpoint C.point C.


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CU R VE & EXPECTATIONSCU R VE & EXPECTATIONS - - 66W eW e cancan describedescribe S RS R --PCPC22 asas aa shortshort--runrun PhillipsPhillipsCurveCurve withwith highhigh expectedexpected inflation,inflation, whilewhile thetheoriginaloriginal curve,curve, S RS R --PCPC11 cancan bebe describeddescribed as as aa

shortshort--runrun PhillipsPhillips CurveCurve withwith lowlow expectedexpectedinflationinflation..

TheThe resultresult youyou shouldshould taketake fromfrom thethe previouspreviousfigurefigure isis thatthat governmentgovernment policiespolicies attemptingattempting to toEXPANDEXPAND aggregateaggregate demanddemand areare likelylikely toto causecausepermanentlypermanently HIGHE RHIGHE R ratesrates of of inflation,inflation, withoutwithout

affectingaffecting thethe longlong- -runrun unemploymentunemployment raterate. .

W eW e cancan describedescribe S RS R --PCPC22 asas aa shortshort--runrun PhillipsPhillipsCurveCurve withwith highhigh expectedexpected inflation,inflation, whilewhile thetheoriginaloriginal curve,curve, S RS R --PCPC11 cancan bebe describeddescribed as as aa

shortshort--runrun PhillipsPhillips CurveCurve withwith lowlow expectedexpectedinflationinflation..

TheThe resultresult youyou shouldshould taketake fromfrom thethe previouspreviousfigurefigure isis thatthat governmentgovernment policiespolicies attemptingattempting to toEXPANDEXPAND aggregateaggregate demanddemand areare likelylikely toto causecausepermanentlypermanently HIGHE RHIGHE R ratesrates of of inflation,inflation, withoutwithout

affectingaffecting thethe longlong- -runrun unemploymentunemployment raterate. .


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CU R VE & EXPECTATIONSCU R VE & EXPECTATIONS - - 77TheThe relationshiprelationship betweenbetween thethe shortshort- -runrun PhillipsPhillipsCurveCurve andand inflationaryinflationary expectationsexpectations describeddescribedbyby FriedmanFriedman andand PhelpsPhelps is is statedstated inin thethe

followingfollowing formulaformula: :

TheThe relationshiprelationship betweenbetween thethe shortshort- -runrun PhillipsPhillipsCurveCurve andand inflationaryinflationary expectationsexpectations describeddescribedbyby FriedmanFriedman andand PhelpsPhelps is is statedstated inin thethe

followingfollowing formulaformula: :


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InIn thethe previousprevious example,example, whenwhen ACTUALACTUAL inflationinflationexceedexceed EXPECTEDEXPECTED inflationinflation (at(at pointpoint B),B),unemploymentunemployment waswas LESSLESS THANTHAN thethe naturalnatural raterate. .InIn thethe longlong- -run,run, actualactual andand expectedexpected inflationinflation willwillbebe equal,equal, andand unemploymentunemployment willwill equalequal thethenaturalnatural raterate (and(and thethe economyeconomy willwill bebe backback ononthethe longlong- -runrun PhillipsPhillips Curve)Curve). .

InIn thethe previousprevious example,example, whenwhen ACTUALACTUAL inflationinflationexceedexceed EXPECTEDEXPECTED inflationinflation (at(at pointpoint B),B),unemploymentunemployment waswas LESSLESS THANTHAN thethe naturalnatural raterate. .InIn thethe longlong- -run,run, actualactual andand expectedexpected inflationinflation willwillbebe equal,equal, andand unemploymentunemployment willwill equalequal thethenaturalnatural raterate (and(and thethe economyeconomy willwill bebe backback ononthethe longlong- -runrun PhillipsPhillips Curve)Curve). .


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SUPPLY SHOCKS & THESUPPLY SHOCKS & THEPHILLIPS CU R VEPHILLIPS CU R VE -- 11


QQ:: W hatW hat happenshappens in in thethe PhillipsPhillips CurveCurvediagramdiagram whenwhen thethe ASAS curvecurve shifts?shifts?

A: The shortA: The short- -run Phillips Curve shifts,run Phillips Curve shifts,changing the attractiveness of the tradechanging the attractiveness of the trade- -

off between inflation and unemployment.off between inflation and unemployment.

QQ:: W hatW hat happenshappens in in thethe PhillipsPhillips CurveCurvediagramdiagram whenwhen thethe ASAS curvecurve shifts?shifts?

A: The shortA: The short- -run Phillips Curve shifts,run Phillips Curve shifts,changing the attractiveness of the tradechanging the attractiveness of the trade- -

off between inflation and unemployment.off between inflation and unemployment.


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TheThe figurefigure onon thethe leftleft inin thethe previousprevious slideslidedepictsdepicts a a typicaltypical supplysupply shockshock inin thethe

economyeconomy (like(like thethe OPECOPEC shocksshocks in in thethe19701970s)s)..

AsAs thethe ASAS curvecurve shiftsshifts toto thethe left,left, thetheequilibriumequilibrium in in thethe marcoeconomymarcoeconomy movesmovesfromfrom pointpoint AA toto pointpoint BB..

TheThe figurefigure onon thethe leftleft inin thethe previousprevious slideslidedepictsdepicts a a typicaltypical supplysupply shockshock inin thethe

economyeconomy (like(like thethe OPECOPEC shocksshocks in in thethe19701970s)s)..

AsAs thethe ASAS curvecurve shiftsshifts toto thethe left,left, thetheequilibriumequilibrium in in thethe marcoeconomymarcoeconomy movesmovesfromfrom pointpoint AA toto pointpoint BB..


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S S OC S &S S OC S &S S OC S &S S OC S &


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InIn thethe figurefigure onon thethe right,right, pointpoint BB MUSTMUST bebe aapointpoint withwith aa higher higher inflationinflation raterate ANDAND aa higher higher unemploymentunemployment raterate. .

PointPoint BB MUSTMUST bebe upup andand toto thethe rightright of of pointpoint AA..BecauseBecause of of this,this, economistseconomists saysay thatthat thethe shortshort- -runrun PhillipsPhillips CurveCurve mustmust havehave shiftedshifted toto thethe rightright. .ThisThis meansmeans thatthat thethe tradetrade- -off off betweenbetween inflationinflationandand unemploymentunemployment is is LESSLESS attractive,attractive, becausebecauseBOTHBOTH ratesrates havehave risenrisen. .

InIn thethe figurefigure onon thethe right,right, pointpoint BB MUSTMUST bebe aapointpoint withwith aa higher higher inflationinflation raterate ANDAND aa higher higher unemploymentunemployment raterate. .

PointPoint BB MUSTMUST bebe upup andand toto thethe rightright of of pointpoint AA..BecauseBecause of of this,this, economistseconomists saysay thatthat thethe shortshort- -runrun PhillipsPhillips CurveCurve mustmust havehave shiftedshifted toto thethe rightright. .ThisThis meansmeans thatthat thethe tradetrade- -off off betweenbetween inflationinflationandand unemploymentunemployment is is LESSLESS attractive,attractive, becausebecauseBOTHBOTH ratesrates havehave risenrisen. .


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COSTS OF R EDUCINGCOSTS OF R EDUCING

INFLATION IN THE S/R

UNINFLATION IN THE S/R

UN -- 11

COSTS OF R EDUCINGCOSTS OF R EDUCING

INFLATION IN THE S/R

UNINFLATION IN THE S/R

UN -- 11TheThe figurefigure belowbelow illustratesillustrates thethe costcost of of reducingreducinginflationinflation inin thethe shortshort- -runrun: :TheThe figurefigure belowbelow illustratesillustrates thethe costcost of of reducingreducinginflationinflation inin thethe shortshort- -runrun: :

COSTS OF R EDUCINGCOSTS OF R EDUCINGCOSTS OF R EDUCINGCOSTS OF R EDUCING


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COSTS OF R EDUCINGCOSTS OF R EDUCINGINFLATION IN THE S/ R UNINFLATION IN THE S/ R UN -- 22

COSTS OF R EDUCINGCOSTS OF R EDUCINGINFLATION IN THE S/ R UNINFLATION IN THE S/ R UN -- 22ToTo reducereduce inflation,inflation, thethe FedFed willwill runrun aacontractionarycontractionary monetarymonetary policypolicy. .TheThe reductionreduction in in thethe moneymoney supplysupply willwill shiftshift ADADtoto thethe leftleft..R ecallR ecall thatthat aa leftwardleftward shiftshift inin ADAD willwill causecausefallingfalling outputoutput andand aa fallingfalling priceprice levellevel. . TheThe fallingfallingpriceprice levellevel meansmeans a a fallingfalling raterate of of inflation,inflation, whilewhilefallingfalling outputoutput meansmeans fallingfalling employmentemployment (which,(which,inin turn,turn, meansmeans risingrising unemployment)unemployment). .

ToTo reducereduce inflation,inflation, thethe FedFed willwill runrun aacontractionarycontractionary monetarymonetary policypolicy. .TheThe reductionreduction in in thethe moneymoney supplysupply willwill shiftshift ADADtoto thethe leftleft..R ecallR ecall thatthat aa leftwardleftward shiftshift inin ADAD willwill causecausefallingfalling outputoutput andand aa fallingfalling priceprice levellevel. . TheThe fallingfallingpriceprice levellevel meansmeans a a fallingfalling raterate of of inflation,inflation, whilewhilefallingfalling outputoutput meansmeans fallingfalling employmentemployment (which,(which,inin turn,turn, meansmeans risingrising unemployment)unemployment). .



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COSTS OF R EDUCINGCOSTS OF R EDUCINGINFLATION IN THE S/ R UNINFLATION IN THE S/ R UN -- 33TheThe contractionarycontractionary monetarymonetary policypolicy hashas thetheeffecteffect of of movingmoving thethe economyeconomy fromfrom pointpoint AA totopointpoint BB inin thethe figurefigure. . You You shouldshould thinkthink of of S RS R --

PCPC11 asas thethe shortshort--runrun PhillipsPhillips CurveCurve withwith HIGHHIGHinflationaryinflationary expectationsexpectations. .AtAt pointpoint BB inflationinflation is is lower lower and,and, inin thethe longlong- -run,run, inflationaryinflationary expectationsexpectations willwill adjustadjustdownwardsdownwards to to matchmatch thethe lower lower ACTUALACTUALinflationinflation. . W henW hen thisthis occurs,occurs, thethe shortshort- -runrunPhillipsPhillips CurveCurve willwill shiftshift IN W AR DINW AR D toto S RS R --PCPC00(think(think of of S RS R --PCPC00 asas thethe shortshort--runrun PhillipsPhillips CurveCurvewithwith lowlow inflationaryinflationary expectationsexpectations. .

TheThe contractionarycontractionary monetarymonetary policypolicy hashas thetheeffecteffect of of movingmoving thethe economyeconomy fromfrom pointpoint AA totopointpoint BB inin thethe figurefigure. . You You shouldshould thinkthink of of S RS R --

PCPC11 asas thethe shortshort--runrun PhillipsPhillips CurveCurve withwith HIGHHIGHinflationaryinflationary expectationsexpectations. .AtAt pointpoint BB inflationinflation is is lower lower and,and, inin thethe longlong- -run,run, inflationaryinflationary expectationsexpectations willwill adjustadjustdownwardsdownwards to to matchmatch thethe lower lower ACTUALACTUALinflationinflation. . W henW hen thisthis occurs,occurs, thethe shortshort- -runrunPhillipsPhillips CurveCurve willwill shiftshift IN W AR DINW AR D toto S RS R --PCPC00(think(think of of S RS R --PCPC00 asas thethe shortshort--runrun PhillipsPhillips CurveCurvewithwith lowlow inflationaryinflationary expectationsexpectations. .



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QQ:: InIn thisthis example,example, whatwhat W ASW AS thethe shortshort- -runruncostcost of of reducingreducing inflation?inflation?

AA:: TemporarilyTemporarily higher higher unemploymentunemployment..However,However, asas statedstated before,before, therethere isis NONOlonglong- -runrun costcost toto reducingreducing inflation,inflation,becausebecause thethe economyeconomy returnedreturned to to thethenaturalnatural raterate of of unemploymentunemployment as asinflationaryinflationary expectationsexpectations adjustedadjusted. .

QQ:: InIn thisthis example,example, whatwhat W ASW AS thethe shortshort- -runruncostcost of of reducingreducing inflation?inflation?

AA:: TemporarilyTemporarily higher higher unemploymentunemployment..However,However, asas statedstated before,before, therethere isis NONOlonglong- -runrun costcost toto reducingreducing inflation,inflation,becausebecause thethe economyeconomy returnedreturned to to thethenaturalnatural raterate of of unemploymentunemployment as asinflationaryinflationary expectationsexpectations adjustedadjusted. .



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Q:Q: How big is the cost of reducing inflation inHow big is the cost of reducing inflation inreality?reality?

A:A: There are two schools of thought:There are two schools of thought: The Sacrifice R atio.The Sacrifice R atio. R ational Expectations.R ational Expectations.

Q:Q: How big is the cost of reducing inflation inHow big is the cost of reducing inflation inreality?reality?

A:A: There are two schools of thought:There are two schools of thought: The Sacrifice R atio.The Sacrifice R atio. R ational Expectations.R ational Expectations.


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THE SAC R IFICE R ATIOTHE SAC R IFICE R ATIOTHE SAC R IFICE R ATIOTHE SAC R IFICE R ATIO

TheThe SacrificeSacrifice R atioR atio isis thethe number number of of percentagepercentage pointspoints of of annualannual outputoutput lostlost inin thethe processprocess of of reducingreducing inflationinflation byby11 percentagepercentage pointpoint. . AA typicaltypical sacrificesacrifice ratioratio isis 55,, meaningmeaningthatthat reducingreducing inflationinflation byby 11%% willwill reducereduce thethe outputoutput of of thetheeconomyeconomy byby 55%%..

W henW hen PaulPaul Volcker Volcker waswas thethe ChairmanChairman of of thethe FederalFederalR eserve,R eserve, hehe wantedwanted toto reducereduce inflationinflation fromfrom aboutabout 1010%% totoaboutabout 4 4%%,, meaningmeaning thatthat thethe outputoutput of of thethe economyeconomy mightmight

dropdrop byby asas muchmuch asas 3030%% (that's(that's asas largelarge asas thethe dropdropduringduring thethe GreatGreat DepressionDepression fromfrom 19291929--19331933)).. ThisThisschoolschool of of thoughtthought indicatesindicates thatthat thethe shortshort- -runrun costcost of of reducingreducing inflationinflation isis rather rather largelarge. .

TheThe SacrificeSacrifice R atioR atio isis thethe number number of of percentagepercentage pointspoints of of annualannual outputoutput lostlost inin thethe processprocess of of reducingreducing inflationinflation byby11 percentagepercentage pointpoint. . AA typicaltypical sacrificesacrifice ratioratio isis 55,, meaningmeaningthatthat reducingreducing inflationinflation byby 11%% willwill reducereduce thethe outputoutput of of thetheeconomyeconomy byby 55%%..

W henW hen PaulPaul Volcker Volcker waswas thethe ChairmanChairman of of thethe FederalFederalR eserve,R eserve, hehe wantedwanted toto reducereduce inflationinflation fromfrom aboutabout 1010%% totoaboutabout 4 4%%,, meaningmeaning thatthat thethe outputoutput of of thethe economyeconomy mightmight

dropdrop byby asas muchmuch asas 3030%% (that's(that's asas largelarge asas thethe dropdropduringduring thethe GreatGreat DepressionDepression fromfrom 19291929--19331933)).. ThisThisschoolschool of of thoughtthought indicatesindicates thatthat thethe shortshort- -runrun costcost of of reducingreducing inflationinflation isis rather rather largelarge. .


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R ATIONAL EXPECTATIONSR ATIONAL EXPECTATIONS - - 22R ATIONAL EXPECTATIONSR ATIONAL EXPECTATIONS - - 22

W henW hen PaulPaul Volcker Volcker implementedimplemented his his disinflationdisinflationpoliciespolicies inin thethe earlyearly 19801980s,s, therethere waswas neither neither a a3030%% dropdrop inin economiceconomic output,output, nor nor aa 00%% dropdrop inineconomiceconomic outputoutput. .

TheThe factfact thatthat thethe dropdrop waswas greater greater thanthan 00%%causedcaused manymany economistseconomists to to refuterefute thetheconclusionsconclusions of of rationalrational expectations,expectations, whilewhile thethemuchmuch lessless thanthan 3030%% dropdrop inin outputoutput causedcausedproponentsproponents of of rationalrational expectationsexpectations to to claimclaimsuccesssuccess (stating(stating thatthat peoplepeople reactedreacted to to thethe FedsFedspolicy,policy, butbut NOTNOT immediately)immediately). .

W henW hen PaulPaul Volcker Volcker implementedimplemented his his disinflationdisinflationpoliciespolicies inin thethe earlyearly 19801980s,s, therethere waswas neither neither a a3030%% dropdrop inin economiceconomic output,output, nor nor aa 00%% dropdrop inineconomiceconomic outputoutput. .

TheThe factfact thatthat thethe dropdrop waswas greater greater thanthan 00%%causedcaused manymany economistseconomists to to refuterefute thetheconclusionsconclusions of of rationalrational expectations,expectations, whilewhile thethemuchmuch lessless thanthan 3030%% dropdrop inin outputoutput causedcausedproponentsproponents of of rationalrational expectationsexpectations to to claimclaimsuccesssuccess (stating(stating thatthat peoplepeople reactedreacted to to thethe FedsFedspolicy,policy, butbut NOTNOT immediately)immediately). .

CONSIDE R ING ONGOINGCONSIDE R ING ONGOINGCONSIDE R ING ONGOINGCONSIDE R ING ONGOING


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CONSIDE R ING ONGOINGCONSIDE R ING ONGOINGINFLATIONINFLATION

CONSIDE R ING ONGOINGCONSIDE R ING ONGOINGINFLATIONINFLATION

W agesW ages andand pricesprices cancan changechange for for twotworeasonsreasons: : W agesW ages andand pricesprices willwill tendtend toto riserise

duringduring boomsbooms andand fallfall duringduringrecessionsrecessions

W orkersW orkers andand firmsfirms willwill raiseraise their their

nominalnominal wageswages andand pricesprices toto thethe extentextenttheythey expectexpect ongoingongoing inflationinflation totomaintainmaintain thethe samesame levellevel of of realreal wageswagesandand realreal pricesprices

W agesW ages andand pricesprices cancan changechange for for twotworeasonsreasons: : W agesW ages andand pricesprices willwill tendtend toto riserise

duringduring boomsbooms andand fallfall duringduringrecessionsrecessions

W orkersW orkers andand firmsfirms willwill raiseraise their their

nominalnominal wageswages andand pricesprices toto thethe extentextenttheythey expectexpect ongoingongoing inflationinflation totomaintainmaintain thethe samesame levellevel of of realreal wageswagesandand realreal pricesprices

ECONOMY OPE R ATING ATECONOMY OPE R ATING ATECONOMY OPE R ATING ATECONOMY OPE R ATING AT


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ECONOMY OPE R ATING ATECONOMY OPE R ATING ATFULL EMPLOYMENTFULL EMPLOYMENT

ECONOMY OPE R ATING ATECONOMY OPE R ATING ATFULL EMPLOYMENTFULL EMPLOYMENT

W ages and prices will rise at the rate of inflationW ages and prices will rise at the rate of inflationexpected by workers and firmsexpected by workers and firmsIf unemploymentIf unemployment exceedsexceeds the natural rate, thethe natural rate, the

high level of unemployment will put downwardhigh level of unemployment will put downwardpressure on wages and prices, and inflation willpressure on wages and prices, and inflation willfalfall relative to what is expectedl relative to what is expectedIf unemployment wereIf unemployment were belowbelow the natural rate,the natural rate,

employers would bid aggressively for workers,employers would bid aggressively for workers,and wages and prices wouldand wages and prices would rise rise faster thanfaster thanpreviously expectedpreviously expected

W ages and prices will rise at the rate of inflationW ages and prices will rise at the rate of inflationexpected by workers and firmsexpected by workers and firmsIf unemploymentIf unemployment exceedsexceeds the natural rate, thethe natural rate, the

high level of unemployment will put downwardhigh level of unemployment will put downwardpressure on wages and prices, and inflation willpressure on wages and prices, and inflation willfalfall relative to what is expectedl relative to what is expectedIf unemployment wereIf unemployment were belowbelow the natural rate,the natural rate,

employers would bid aggressively for workers,employers would bid aggressively for workers,and wages and prices wouldand wages and prices would rise rise faster thanfaster thanpreviously expectedpreviously expected

CHOICES FO R THE FED


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E AS 0

AD0

Output, yyF

Price, p

CHOICES FO THE FED



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E

AS 1

AS 0

AD1AD0

Output, yyF

Price, p

C O C S O

If workers push up their normal wages, the aggregate supply curve will shift fromAS 0 to AS 1.



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A

E

AS 1

AS 0

AD0

Output, yyF

Price, p

If workers push up their normal wages, the aggregate supply curve will shift fromAS 0 to AS 1. If the Fed keeps aggregate demand constant at AD 0, a recession willoccur at A and eventually the economy will return to full employment at E.



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A F

E

AS 1

AS 0

AD1AD0

Output, yyF

Price, p

CHOICES FO THE FED

If workers push up their normal wages, the aggregate supply curve will shift fromAS 0 to AS 1. If the Fed keeps aggregate demand constant at AD 0, a recession willoccur at A and eventually the economy will return to full employment at E.

If the Fed increases aggregate demand , the economy remains at fullemployment at F, but with a higher price level.


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EXPECTATIONS OF THE UNIONEXPECTATIONS OF THE UNIONEXPECTATIONS OF THE UNIONEXPECTATIONS OF THE UNIONThe actions of a union will depend on what itsThe actions of a union will depend on what itsleaders expect the Fed to do:leaders expect the Fed to do:

If they expect the Fed will not increase aggregateIf they expect the Fed will not increase aggregatedemand, their actions will trigger a recessiondemand, their actions will trigger a recession

The union may be reluctant to negotiate a high wage,The union may be reluctant to negotiate a high wage,permitting the economy to remain at full employmentpermitting the economy to remain at full employmentand experience no increase in pricesand experience no increase in prices

If the leaders believe the Fed will increase aggregateIf the leaders believe the Fed will increase aggregatedemand, the union will increase the nominal wagedemand, the union will increase the nominal wage

The result will be higher prices in the economyThe result will be higher prices in the economy

The actions of a union will depend on what itsThe actions of a union will depend on what itsleaders expect the Fed to do:leaders expect the Fed to do:

If they expect the Fed will not increase aggregateIf they expect the Fed will not increase aggregatedemand, their actions will trigger a recessiondemand, their actions will trigger a recession

The union may be reluctant to negotiate a high wage,The union may be reluctant to negotiate a high wage,permitting the economy to remain at full employmentpermitting the economy to remain at full employmentand experience no increase in pricesand experience no increase in prices

If the leaders believe the Fed will increase aggregateIf the leaders believe the Fed will increase aggregatedemand, the union will increase the nominal wagedemand, the union will increase the nominal wage

The result will be higher prices in the economyThe result will be higher prices in the economy


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Documents

12. Infl. & Unemployment