Chapter 13

Unemployment and Inflation

Economics 282

University of Alberta

Unemployment and Inflation

• The Phillips curve is a negative empirical relationship between unemployment and inflation.

• In 1970-2003 there seemed to be no reliable relationship between unemployment and inflation.

The Expectations Augmented Phillips Curve

• A negative relationship should exist between unanticipated inflation and cyclical unemployment.

The Phillips Curve (continued)

• If increase in M is anticipated, there is no misperception, the economy remains at , unemployment remains at , cyclical unemployment is zero.

Yu

The Phillips Curve (continued)

• If increase in M is unanticipated, unanticipated inflation is created, Y is above , u is below .Y u

)uh(uππ e

The Phillips Curve (continued)

• h measures the strength of the relationship between unanticipated inflation and cyclical unemployment.

The Phillips Curve (continued)

• The expectation-augmented Phillips curve states that π exceeds πe if u is less than .

h is related to the slope of the SRAS curve.

u

)uh(uππ e

Shifting of the Philips Curve• The Phillips curve depends on the

expected rate of inflation and the natural rate of unemployment. If either factor changes the Phillips curve will shift.

huuhππ e

Changes in the Expected Rate of Inflation

• If households anticipate a change in the price level they respond by their expectations of the price level (the rate of inflation) one-for-one.

• The Phillips curve shifts up by the amount of the increase in the expected rate of inflation.

Changes in the Natural Rate of Unemployment

• An increase in the natural unemployment rate causes the Phillips curve to shift up and to the right.

Supply Shocks and the Phillips Curve

• An adverse supply shock causes a burst of inflation and raises the natural rate of unemployment:– by increasing the degree of mismatch

between workers and jobs (classical economists);

– by reducing MPN and labour demanded at full employment (Keynesian economists).

Supply Shocks and the Phillips Curve

• An adverse supply shock should shift the Phillips curve up and to the right.

• The Phillips curve should be particular unstable during periods of supply shocks.

The Shifting Phillips Curve in Practice

• The Friedman-Phelps analysis shows that a negative relationship between the levels of inflation and unemployment holds as long as expected inflation and the natural unemployment rate are approximately constant.

The Shifting Phillips Curve in Practice (continued)

• During 1970-2003 there was a number of productivity shocks as well as changes in government and macroeconomic policies.

• A negative relationship between unanticipated inflation and cyclical unemployment does appear in the data.

Macroeconomic Policy and the Phillips Curve

• Keynesians believe that in a recession expansionary AD policy can increase inflation back to anticipated levels used as a basis for nominal wage contracts and pricing.

The Lucas Critique• Because new policies change the

economic “rules” and, thus, affect economic behaviour, no one can safely assume that historical relationships between variables will hold when policies change.

The Long-Run Phillips Curve• Economists agree that in the long run

economy will adjust to the general equilibrium in which π=πe and u= .

• The long-run Phillips curve is vertical line at u= . It is related to the long-run neutrality of money.

u

u

The Cost of Unemployment• The output is lost because fewer people

are productively employed.

• Unemployed workers and their families face psychological cost.

• The offsetting factors are acquiring new skills and more leisure time.

The Long-Term Behaviour of the Unemployment Rate

• The overall unemployment rate may have risen due to:– changes in the composition of the labour force

by age and sex;– structural changes in the economy;– changes in employment insurance.

Hysteresis in Unemployment

• Hysteresis in unemployment means that the natural unemployment rate changes in response to the actual unemployment rate.

• If workers are idle for long periods of time their skills deteriorate and the mismatch increases.

Hysteresis in Unemployment (continued)

• Due to regulations firms are more cautious to hire workers because it is difficult to fire them.

• The insider-outsider theory suggests that unionized labour increases wages for insiders and leaves outsiders unemployed.

How to Reduce the Natural Rate of Unemployment

• Increase government support for job training and reallocation.

• Increase labour market flexibility.

• Reform Employment Insurance program.

• Use aggressive policy to keep actual unemployment rate low.

Perfectly Anticipated Inflation

• Because nominal wages are rising together with prices, the purchasing power is not hurt by the perfectly anticipated inflation.

• Perfectly anticipated inflation would not hurt the value of savings accounts.

The Cost of Perfectly Anticipated Inflation

• Shoe leather costs of inflation is time and effort incurred by people and firms who are trying to minimize their holdings of cash.

• Menu costs of inflation.

• Welfare costs of inflation-induced tax distortions.

The Cost of Unanticipated Inflation

• Creditors and those with incomes set in nominal terms are hurt, whereas debtors and those who make fixed nominal payments are helped by unanticipated inflation.

The Cost of Unanticipated Inflation (continued)

• People are made worse off by increasing risk of gaining or losing wealth as a result of unanticipated inflation.

• People must spend time and effort learning about different prices.

The Cost of Hyperinflation• Hyperinflation occurs when the inflation

rate is extremely high for a sustained period of time.– The shoe leather costs are enormous.– The government’s ability to collect taxes is

undermined.– The market efficiency is disrupted.

Fighting Inflation: The Role of Inflationary Expectations

• The only factor that can create sustained rises in aggregate demand and ongoing inflation is a high rate of money growth.

• Governments may print money to finance their spending or use unbalanced monetary policy to fight recession.

Fighting Inflation (continued)

• The process of disinflation – the reduction of money growth – leads to a serious recession.

• If inflation falls below the expected rate, unemployment will rise above the natural rate.

• A recession can be avoided if expected inflation rate can fall.

Rapid versus Gradual Disinflation

• A cold turkey strategy is a rapid and decisive reduction in the growth rate of the money supply.

• It may lead to a significant increase in cyclical unemployment.

Rapid versus Gradual Disinflation (continued)

• Inflation expectations may not lower if the government is expected to abandon the policy under political pressure.

Rapid versus Gradual Disinflation (continued)

• A policy of gradualism is a policy of reducing the rate of money growth gradually over a period of time.

Rapid versus Gradual Disinflation (continued)

• This policy will raise unemployment by less than the cold-turkey strategy, but the period of higher unemployment will be longer.

Wage and Price Controls• Wage and price controls (income policies)

are legal limits on the ability of firms to raise wages or prices.

• Price controls are likely to make shortages.

• Wage-price controls have a major effect on the public’s expectations.

Credibility and Reputation• The expected inflation adjusts quickly if

government’s announced disinflationary policy is credible.

• Policymakers increase their credibility by developing reputation for carrying through on their promises.

Credibility and Reputation (continued)

• A strong and independent central bank creates credibility of monetary policy with the public.

End of Chapter