Output, Inflation, and Unemployment

The Monetarist Counterrevolution

Muhammad Irwan Ariffin

December 16, 2015

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 1 / 11
Outline

1 Introduction

2 The Natural Rate Theory

3 Phillips Curve
Monetary Policy in the Short Run
Monetary Policy in the Long Run

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 2 / 11
 Introduction

Monetarist Propositions
The Monetarist Counterrevolution

Recall: The Monetarist Propositions:

1 M s is the dominant influence on P Y

M s P Y
2 In S-R: M s influence real variables
M s Y
3 In L-R: M s affects P and nominal variables only
M s P
Real variables are determined by real factors only
4 Private sector is stable

Conclusion: A stable M s growth leads to a stable economy

Need to adopt a rule for monetary policy

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 3 / 11
 Introduction

Monetarist Propositions
The Monetarist Counterrevolution

In the previous class, we have achieved the followings:

Goal 1: Examine Monetarist position
Goal 2: Describe why M is so dominant according to Monetarist
(Proposition 1)
Goal 3: Describe why in S-R: M s Y , change in real variables
(Proposition 2)
Today, we want to achieve the followings:
Goal 3: Describe why in L-R: M s P , change in nominal
variables (Proposition 3)
We shall look at the impact of MP on these variables:
Output (Y )
Inflation (P = P )
Unemployment (U )

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 4 / 11
 The Natural Rate Theory

The Natural Rate Theory

The Natural Rate Theory concept: there exists an equilibrium Y and

U that determined naturally by the real supply-side factors: K, N ,
and technology
The natural rate of unemployment, U (which corresponds to the
natural rate of employment, N )
The natural rate of output, Y
AD shocks temporary movements of the economy away from the
natural rate (in the S-R)
Expansionary M s move Y above Y and move U below U
temporarily
M s AD P , but P cannot fully adjust in the S-R

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 5 / 11
 The Natural Rate Theory

The Natural Rate Theory

How U (= N ) and Y are determined?
Real suppy-side factors
N is determined by the L-R equilibrium between N d and N s in the
labor market
N d = M P N , inversely related to real wage W/P
N s = N s ( P eW=P ), inversely related to expected price
Recall: Asymmetric information between firms and labor in the S-R:
In the S-R, due to imperfect info, labors are unable to make the correct
prediction, so P e 6= P in S-R (maybe), and labors may make an
incorrect N s decision
In the L-R, labors obtain enough info to make better prediction such
that P e = P , and labors are able to make the correct N s decision
we use N obtained in the
Now, assuming that K is given (as K),
N ) to
labor market and plug it in the production function Y = F (K,
obtain Y

Refer to Figure 10-1 in textbook

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 Phillips Curve

Phillips Curve
Unemployment and Inflation Relationship

In S-R: Y and N diverge from Y and N temporarily

In L-R: Y and N converge to Y and N
We shall analyze these two statements by looking at the impact of an
expansionary MP ( M s ) on N , Y , and P in S-R and L-R
We shall use the Phillips Curve: a schedule showing the relationship
between U and P
U on the x-axis, P on the y-axis

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 7 / 11
 Phillips Curve Monetary Policy in the Short Run

Monetary Policy in the Short Run

Phillips Curve

Initial situation:
The economy is at the natural rates U (= 6%) and Y ), with Y
growing at 3%
Following Monetarist sugggestion, Central Bank adopts a rule for MP
where M s is stable and equals to Y (growth in M s equals growth
of real output), say at 3%
Hence, P has been stable for quit some time (recall Monetarist QTM
M = kP Y ) P = 0

Muhammad Irwan Ariffin Output, Inflation, and Unemployment December 16, 2015 8 / 11
 Phillips Curve Monetary Policy in the Short Run

Monetary Policy in the Short Run

Phillips Curve

Suppose Central Bank increased growth rate of M s from 3% to 5%

AD P Y , rise in nominal income
As AD , firms increase Y by hiring more labor, N d
Existing workers willing to work longer hours or attract unemployed to
work, N s
Hence, N goes up above N (correspondingly, U goes down below U )
AD is faster than N P , so P is no longer zero, say now
P = 2%
In S-R: trade-off between U and P
P CSR is downward sloping
Refer to Figure 10-2 in textbook

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 Phillips Curve Monetary Policy in the Long Run

Monetary Policy in the Long Run

Phillips Curve

As we move from S-R to L-R...

P W/P firms demand more labor and willing to offer higher W
But labor didnt know P , they still thought that P unchanged, hence
they didnt change their P e and attracted to higher W offered by firms
by increasing N s (this is why Y in S-R)
Workers observe the higher P , correct their expectation on price level
P e = P and demand higher W until reaches the initial equilibrium in
the labor market at real wage (W/P )
P CSR shifts to the right from P C(P = 0) to P C(P = 2%)
In L-R, if Central Bank continues the 5% growth in M s :
Workers will be able to anticipate inflation rate, P e = P
N goes back to N (U goes back to U = 6%)
Y goes back to Y , but P is now higher!
P CLR is vertical at P C(P e = P )
Refer to Figure 10-3 in textbook
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 Phillips Curve Monetary Policy in the Long Run

Monetary Policy in the Long Run

Phillips Curve

What happens if the government is not satisfied with U = U = 6%?

They may instruct the Central Bank to raise growth of M s from 5% to
7% to fight unemployment (this is an example of an unstable M s
growth policy)
If Central Bank further raises the growth in M s to 7%...
U , Y temporarily
Once workers have corrected their P e = P P CSR shifts to the right
to P C(P e = 4%) Vertical P CLR
If government attemt to peg U by increasing growth of M s
permanently the cycle continues where U and Y always go back to
U and Y but P is higher and higher
An attempt to lower inflation at this stage will make the economy to
suffer from high inflation and high unemployment
Refer to Figure 10-4 in textbook
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