Inflation and Money Growth1

Intermediate Economics B

Davide Romelli

1
Chapter 10 of Macroeconomics: A European Perspective
 Output, Unemployment and Inflation

This chapter characterises the economy by two relations:

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 Output, Unemployment and Inflation

This chapter characterises the economy by two relations:

Okun’s Law, which relates the change in unemployment to output
growth

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 Output, Unemployment and Inflation

This chapter characterises the economy by two relations:

Okun’s Law, which relates the change in unemployment to output
growth
The aggregate demand relation, which relates output growth to both
nominal money growth and inflation

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 Unemployment and Output Growth
Constant labour force, constant labour productivity and linear relation
between output and employment implies

ut − ut−1 = −gyt

where gyt is growth rate of output.

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 Unemployment and Output Growth
Constant labour force, constant labour productivity and linear relation
between output and employment implies

ut − ut−1 = −gyt

where gyt is growth rate of output.

Empirically, Arthur Okun estimated

ut − ut−1 = −0.4(gyt − 3%)

To maintain constant unemployment rate, output growth must be 3%

per year. This growth rate of output is called the normal growth rate

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 Unemployment and Output Growth
Constant labour force, constant labour productivity and linear relation
between output and employment implies

ut − ut−1 = −gyt

where gyt is growth rate of output.

Empirically, Arthur Okun estimated

ut − ut−1 = −0.4(gyt − 3%)

To maintain constant unemployment rate, output growth must be 3%

per year. This growth rate of output is called the normal growth rate
According to the above equation, output growth 1% above normal
leads only to a 0.4% reduction in unemployment, for two reasons:
I Labour hoarding: firms prefer to keep workers rather than lay them off
when output decreases

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 Unemployment and Output Growth
Constant labour force, constant labour productivity and linear relation
between output and employment implies

ut − ut−1 = −gyt

where gyt is growth rate of output.

Empirically, Arthur Okun estimated

ut − ut−1 = −0.4(gyt − 3%)

To maintain constant unemployment rate, output growth must be 3%

per year. This growth rate of output is called the normal growth rate
According to the above equation, output growth 1% above normal
leads only to a 0.4% reduction in unemployment, for two reasons:
I Labour hoarding: firms prefer to keep workers rather than lay them off
when output decreases
In general
ut − ut−1 = −β(gyt − ḡy )
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 Output, Unemployment and Inflation
Okun’s Law

Changes in the unemployment rate versus output growth in the

USA since 1970
High output growth is associated with a reduction in the unemployment
rate; low output growth is associated with an increase in the
unemployment rate
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 Okun’s Law across countries
The coefficient β in Okun’s law gives the effect on the unemployment rate
of deviations of output growth from normal. A value of β of 0.4 tells us
that output growth 1% above the normal growth rate for one year
decreases the unemployment rate by 0.4%

Okun’s law coefficients across countries and time

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 AD Relation, Money Growth and Inflation

From AS-AD model,

 
Mt
Yt = Y , Gt , Tt , .
Pt
 
Mt
Yt = Y ,.
Pt

Simple form
Mt
Yt = γ
Pt
(Recall Mt /Pt affects AD via shift in LM curve)
In growth rates
gyt = gMt − πt

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 The Effects of Money Growth

The Phillips curve relates the change in inflation to the deviation of

the unemployment rate from the natural rate:

πt − πt−1 = −α(ut − un )

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 The Effects of Money Growth

The Phillips curve relates the change in inflation to the deviation of

the unemployment rate from the natural rate:

πt − πt−1 = −α(ut − un )

Okun’s law relates the change in the unemployment rate to the

deviation of output growth from normal:

ut − ut−1 = −β(gyt − ḡy )

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 The Effects of Money Growth

The Phillips curve relates the change in inflation to the deviation of

the unemployment rate from the natural rate:

πt − πt−1 = −α(ut − un )

Okun’s law relates the change in the unemployment rate to the

deviation of output growth from normal:

ut − ut−1 = −β(gyt − ḡy )

The aggregate demand relation relates output growth to the
difference between nominal money growth and inflation

gyt = gMt − πt

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 Output growth, unemployment, inflation and
nominal money growth

Output growth, unemployment, inflation and nominal money growth

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 The Effects of Money Growth – The Short Run

Now suppose that the central bank decides to decrease nominal money
growth (gMt ). What will happen in the short run?

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 The Effects of Money Growth – The Short Run

Now suppose that the central bank decides to decrease nominal money
growth (gMt ). What will happen in the short run?
Given the initial rate of inflation, lower nominal money growth leads
to lower real nominal money growth and thus to a decrease in output
growth
I Negative shift in AD - lower output growth

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 The Effects of Money Growth – The Short Run

Now suppose that the central bank decides to decrease nominal money
growth (gMt ). What will happen in the short run?
Given the initial rate of inflation, lower nominal money growth leads
to lower real nominal money growth and thus to a decrease in output
growth
I Negative shift in AD - lower output growth
Now, look at Okun’s law, output growth below normal leads to an
increase in unemployment
I Okun’s Law - higher unemployment

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 The Effects of Money Growth – The Short Run

Now suppose that the central bank decides to decrease nominal money
growth (gMt ). What will happen in the short run?
Given the initial rate of inflation, lower nominal money growth leads
to lower real nominal money growth and thus to a decrease in output
growth
I Negative shift in AD - lower output growth
Now, look at Okun’s law, output growth below normal leads to an
increase in unemployment
I Okun’s Law - higher unemployment
Now, look at the Phillips curve relation. Unemployment above the
natural rate leads to a decrease in inflation
I Phillips Curve - lower inflation
Over time, all variables return to the medium run equilibrium

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 The Effects of Money Growth – The Short Run
(Continued)

In words: In the short run, monetary tightening leads to a slowdown in

growth and a temporary increase in unemployment. In the medium run,
output growth returns to normal and the unemployment rate returns to
the natural rate

The effects of a monetary tightening

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