Lecture 12

THE DYNAMICS OF
INFLATION AND
UNEMPLOYMENT
UNEMPLOYMENT
 Lecture Outline

• Inflation and the Price Level

• Demand-Pull Inflation
Demand-Pull Inflation
• Cost-Push Inflation
• Effects of Inflation
• The Phillips
The Phillips Curve
Curve
 Inflation and the Price Level

• Inflation is a process in which the price

level rises and money loses value.
• Inflation is fundamentally a monetary
phenomenon.
phenomenon.
• The average level of prices is rising.
• Inflation is not high prices and inflation is
not aa jump
not jump in
in prices
prices
 Inflation and the Price Level
•• The
The figures
figures
distinguishes
distinguishes
between aa
between
one time
one time
jump in
jump in
prices and
prices and
inflation.
inflation.
•• Part
Part (b)
(b)
shows aa one
shows one
time jump
time jump in
in
the price
the price
level.
level.
 Inflation and the Price Level
• Part
Part (a)
(a)
shows the
process of
inflation.
inflation.
• The inflation
rate is the
percentage
percentage
change in the
price level
during a
given period.
 Demand-Pull Inflation

• Demand-pull inflation is inflation

that results
that results from
from an
an initial
initial increase
increase
in aggregate demand.
• A demand pull inflation can result
from any influence that increases
aggregate demand.
 Demand-Pull Inflation

• In a demand-pull inflation, initially

–– aggregate
aggregate demand
demand increases
increases
–– real
real GDP
GDP increases
increases above
above potential
potential
GDP and
GDP and the
the price
price level
level rises
rises
–– money
money wages
wages rise
rise
–– the
the price
price level
level rises
rises further
further and
and real
real
GDP decreases
GDP decreases toward
toward potential
potential
GDP.
GDP.
 Demand-Pull Inflation
• A one-time increase in aggregate
demand raises the price level but
does not
does not always
always start
start aa demand-pull
demand-pull
inflation.
• For
For demand
demand pull
pull inflation
inflation to
to occur,
occur,
aggregate demand must persistently
increase.
increase.
• The money supply must persistently
grow at a rate that exceeds the
growth rate of potential GDP.
 Demand-Pull Inflation
• The figures
show a
demand pull
inflation.
inflation.
• Initially,
aggregate
demand
demand
increases.
 Demand-Pull Inflation
• Real GDP
increases
and the price
level rises.
level rises.
• Now real
GDP
exceeds
exceeds
potential
GDP.
 Demand-Pull Inflation
•• There
There isis an
an
inflationary
inflationary
gap.
gap.
•• The
The money
money
wage rate
wage rate
begins to
begins to rise.
rise.
•• And
And the
the SAS
SAS
curve shifts
curve shifts
leftward.
leftward.
 Demand-Pull Inflation
• Real GDP
decreases
toward
potential
potential
GDP.
• The price
level rises
level rises
further.
 Demand-Pull Inflation
• This process
repeats in an
unending
price-wage
price-wage
spiral.
 Cost-Push Inflation
• Cost-push
Cost-push inflation
inflation is
is an
an inflation
inflation
that results from an initial
increase in costs.
• The two main sources of cost-
push inflation are:
–– an
an increase
increase in
in the
the money
money wage
wage rate
rate
–– an
an increase
increase in
in the
the money
money prices
prices of
of
raw materials
raw materials
 Cost-Push Inflation
• In a cost-push inflation, initially
–– short-run
short-run aggregate
aggregate supply
supply
decreases
decreases
–– real
real GDP
GDP decreases
decreases below
below
potential GDP
potential GDP and
and the
the price
price level
level
rises
rises
–– the
the economy
economy could
could become
become stuck
stuck
in this
in this stagflation
stagflation situation
situation for
for
some time.
some time.
 Cost-Push Inflation

•• A
A one-time
one-time decrease
decrease in in aggregate
aggregate
supply raises
supply raises the
the price
price level
level but
but does
does
not always
not always start
start aa cost-push
cost-push inflation.
inflation.
•• For
For cost-push
cost-push inflation
inflation to
to occur,
occur,
aggregate demand
aggregate demand mustmust increase
increase in
in
response to
response to the
the cost
cost push.
push.
 Cost-Push Inflation

• Just
Just like
like the
the case
case of
of demand-
demand-
pull inflation, the money supply
must persistently grow at a rate
that exceeds
that exceeds thethe growth
growth rate
rate of
of
potential GDP if an inflation is to
become persistent.
 Cost-Push Inflation
• The
The
following
figures
show a
cost-push
inflation.
inflation.
• Initially, a
factor price
rises.
 Cost-Push Inflation
• Short-run
Short-run
aggregate
supply
decreases
and the
SAS curve
SAS curve
shifts
leftward
 Cost-Push Inflation
• Real
Real GDP
GDP
decreases
and the
price level
rises in a
stagflation..
stagflation
 Cost-Push Inflation
• With
With nono
subsequet
change in
aggregate
demand,
the price
the price
level
eventually
falls.
 Cost-Push Inflation
• There
There isis no
no
inflation.
• For cost-
push
inflation to
take hold,
aggregate
demand
must
must
increase.
 Cost-Push Inflation
•• An
An increase
increase
in the
in the money
money
supply
supply
increases
increases
aggregate
aggregate
demand and
demand and
the AD
the AD curve
curve
shifts
shifts
rightward.
rightward.
 Cost-Push Inflation
• Real
Real GDP
GDP
increases
and the
price level
rises.
 Cost-Push Inflation
• This
This
process
repeats to
create an
unending
cost-price
cost-price
inflation
spiral.
 HYPERINFLATION
• Very high inflation rates, over 50% per
month
• Inflation rates observed in the US in
the last 40 years are insignificant in
comparison to
comparison to some
some experiences
experiences
around the world throughout history
 HIGH INFLATIONS IN THE 1980s

Country Bolivia Argentina Nicaragua

Year 1985 1989 1988
Yearly Inflation 1,152, 200 975, 000 302, 200
Rate (%)
Monthly Inflation 118 95 115
Rate (%)
Monthly Money 91 93 66
Growth
Rate (%)
Source: International Financial Statistics Yearbook, 1992,
(Washington DC: International Monetary Fund)
 DURING HYPERINFLATIONS
•• Money
Money no no longer
longer works
works very
very well
well in
in facilitating
facilitating
exchange
exchange
•• Since
Since prices
prices areare changing
changing so so fast
fast and
and unpredictably,
unpredictably,
there is
there is typically
typically massive
massive confusion
confusion about
about the
the true
true
value of
value of commodities
commodities
•• Different
Different stores
stores may
may be be raising
raising prices
prices atat different
different rates
rates
•• The
The same
same commodities
commodities may may sell
sell for
for radically
radically different
different
prices
prices
•• Everyone
Everyone spends
spends all
all their
their time
time hunting
hunting forfor bargains
bargains and
and
finding the
finding the lowest
lowest prices
prices
•• Governments
Governments are are forced
forced to to put
put an
an end
end toto hyperinflation
hyperinflation
before itit destroys
before destroys their
their economies
economies
 THE CAUSE OF HYPERINFLATION
Excessive money
Excessive money growth
growth
•• If
If aa government
government wants
wants to
to spend
spend aa specified
specified
amount of
amount of money,
money, but
but is
is collecting
collecting less
less in
in
taxes, it
taxes, it must
must cover
cover the
the difference
difference in
in some
some way:
way:
–– the
the government
government may may borrow
borrow thethe difference
difference from
from the
the public
public
and issue
and issue bonds,
bonds, for
for which
which itit must
must pay
pay back
back what
what itit borrows
borrows
and interest
and interest in
in the
the future
future
–– the
the government
government may may print
print new
new money
money
–– governments
governments could
could mix
mix borrowing
borrowing and and printing
printing money
money to to
cover the
cover the deficit
deficit

government deficit
government deficit == new
new borrowing
borrowing ++ new
new money
money created
created
 HYPERINFLATION
• occurs
occurs in
in countries
countries that
that have
have large
large deficits,
deficits,
but cannot borrow and are forced to print
new money
• is only stopped by eliminating the deficit,
which is the basic cause:
–– increase
increase taxes
taxes
–– cut
cut spending
spending
• Once the deficit has been cut and the
government stops printing money, the
hyperinflation will
hyperinflation will end
end
 INDEXED
•• Describes
Describes something
something whose
whose payments
payments are are
adjusted for
adjusted for changes
changes in
in prices,
prices, such
such as
as bonds
bonds oror
nominal contracts
nominal contracts
•• In
In practice,
practice, countries
countries find
find that
that indexing
indexing is
is not
not the
the
perfect solution
perfect solution to
to problems
problems caused
caused by
by inflation:
inflation:
–– policymakers
policymakers worry
worry indexing
indexing lowers
lowers the
the resolve
resolve toto fight
fight
inflation
inflation
–– Price
Price indices
indices are
are far
far from
from perfect
perfect and
and are
are extremely
extremely difficult
difficult
to construct
to construct when
when prices
prices are
are increasing
increasing rapidly
rapidly
–– Some
Some economists
economists believe
believe that
that indexing
indexing builds
builds inflation
inflation into
into
the economic
the economic system
system andand makes
makes itit difficult
difficult to
to reduce
reduce
inflation
inflation
 MONETARISTS
•• Economists
Economists who who traditionally
traditionally emphasize
emphasize thethe
important role
important role that
that the
the supply
supply ofof money
money plays
plays in
in
determining nominal
determining nominal income
income and
and inflation
inflation
•• Most
Most famous
famous -- Milton
Milton Friedman,
Friedman, Nobel
Nobel laureate
laureate --
studied versions
studied versions ofof quantity
quantity equation
equation and
and role
role of
of
money in
money in economic
economic lifelife
•• Philip
Philip Cagan
Cagan -- best
best known
known forfor work
work on
on
hyperinflations
hyperinflations
•• Monetarist
Monetarist economists
economists did did pioneering
pioneering research
research onon
link between
link between money,
money, nominal
nominal income
income and
and inflation
inflation
 Effects of Inflation
• Regardless of whether its origin is
demand-pull or
demand-pull or cost-push,
cost-push, inflation
inflation
imposes costs.
• The costs depend on whether the
inflation is
inflation is anticipated
anticipated or
or unanticipated.
unanticipated.
 ANTICIPATED INFLATION
Fully Anticipated
Fully Anticipated Inflation
Inflation
•• Inflation
Inflation at
at 4%
4% would
would mean
mean workers
workers would
would know
know that
that
nominal wage
nominal wage increases
increases of of 4%
4% were
were not
not real
real wage
wage
increases, and
increases, and
•• Investors
Investors earning
earning aa 7% 7% rate
rate of
of interest
interest on
on bonds
bonds
would know
would know that
that their
their real
real return
return would
would bebe 3%
3% after
after
adjusting for
adjusting for inflation
inflation
•• Menu
Menu costs
costs --
-- the
the actual
actual physical
physical costs
costs of
of changing
changing
prices
prices
•• Shoe
Shoe leather
leather costs
costs ---- additional
additional wear
wear and
and tear
tear
necessary to
necessary to hold
hold less
less cash
cash
•• Our
Our tax
tax system
system and and financial
financial system
system do do not
not fully
fully
adjust even
adjust even to
to fully
fully anticipated
anticipated inflation
inflation
 Effects of Inflation
• This figure
shows how
anticipating
anticipating
inflation
avoids the
costs of
deviations
from
potential
GDP.
 Effects of Inflation

• Anticipating
Anticipating inflation
inflation also
also avoids:
avoids:
–– the
the redistribution
redistribution of
of income
income and
and wealth.
wealth.
–– errors
errors in
in investment
investment and
and saving
saving
decisions.
decisions.
• But anticipated inflation does have
some costs.
some costs.
 Effects of Inflation
•• The
The costs
costs of
of anticipated
anticipated inflation
inflation are:
are:
–– ““bootleather”
bootleather” costs
costs
–– other
other transactions
transactions costs
costs
–– decrease
decrease in
in potential
potential GDP
GDP
–– decrease
decrease in
in the
the long-term
long-term growth
growth rate.
rate.
•• These
These costs
costs have
have been
been estimated
estimated toto be
be
very high,
very high, even
even for
for aa modest
modest inflation.
inflation.
•• The
The main
main problem
problem isis that
that taxes
taxes on
on capital
capital
income aa seriously
income seriously distorted
distorted by
by inflation.
inflation.
 Effects of Inflation
• Unanticipated inflation can cause the
following problems:
following problems:
–– redistribute
redistribute income
income between
between firms
firms and
and
workers
workers
–– move
move real
real GDP
GDP away
away from
from potential
potential GDP
GDP
–– redistribute
redistribute wealth
wealth between
between borrowers
borrowers
and lenders
and lenders
–– result
result in
in too
too much
much or
or too
too little
little saving
saving and
and
investment
investment
 Effects of Inflation
•• Because
Because unanticipated
unanticipated inflation
inflation is
is costly,
costly,
people try
people try to
to anticipate
anticipate it.
it.
•• To
To make
make the the best
best possible
possible forecast
forecast of of
inflation, people
inflation, people useuse all
all the
the information
information
they can
they can about
about the
the source
source of of inflation
inflation and
and
likely trends
likely trends inin those
those sources.
sources.
•• Such
Such aa forecast
forecast is is called
called aa rational
rational
expectation.
expectation.
•• An
An anticipated
anticipated inflation
inflation avoids
avoids some
some of of the
the
costs of
costs of inflation.
inflation.
 COSTS OF INFLATION
Anticipated Unanticipated
Inflation Inflation
Institutions do Distortions in the Unfair redistributions
not adjust tax system,
Problems in
financial markets
Institutions Cost of changing Institutional
adjust prices, disintegration
Shoe-leather
costs
 THE PHILLIPS
THE PHILLIPS CURVE
CURVE -- 11
• The
The Phillips
Phillips Curve
Curve is
is aa graph
graph depicting
depicting aa
relationship between the unemployment
rate and the inflation rate. The figure below
shows a typical SHORT-RUN Phillips Curve.
 THE PHILLIPS
THE PHILLIPS CURVE
CURVE -- 22
•• The
The implication
implication of
of the
the negative
negative slope
slope is
is that
that the
the
unemployment rate
unemployment rate andand the
the inflation
inflation rate
rate are
are
inversely related
inversely related -- in
in other
other words,
words, there
there is
is aa trade-
trade-
off between
off between the
the two.
two.

•• At
At the
the beginning
beginning of
of the
the course,
course, one
one things
things we
we said
said
was that
was that society
society faces
faces aa short-run
short-run trade-off
trade-off
between inflation
between inflation and
and unemployment.
unemployment. This
This trade-
trade-
off is
off is embodied
embodied inin the
the short-run
short-run Phillips
Phillips Curve.
Curve.
 THE PHILLIPS
THE PHILLIPS CURVE
CURVE -- 33
•• Since
Since inflation
inflation and
and unemployment
unemployment areare BOTH
BOTH
things we
things we don't
don't like,
like, the
the relationship
relationship between
between the
the
AD-AS (short-run)
AD-AS (short-run) macroeconomic
macroeconomic model
model and
and the
the
Phillips Curve
Phillips Curve are
are important.
important.

•• Understanding
Understanding the the relationship
relationship between
between economic
economic
policy and
policy and the
the inflation-unemployment
inflation-unemployment trade-off
trade-off is
is
key to
key to your
your understanding
understanding ofof macroeconomics.
macroeconomics.
 SHIFTS IN
SHIFTS IN AD
AD &
& THE
THE PHILLIPS
PHILLIPS
CURVE - 1
Q: What
Q: What happens
happens in
in the
the Phillips
Phillips Curve
Curve
diagram when there is a shift in AD?

A: There is a movement along the short-run

Phillips Curve and a trade-off between
inflation and
inflation and unemployment.
unemployment.
SHIFTS IN
SHIFTS IN AD
AD &
& THE
THE PHILLIPS
PHILLIPS
CURVE - 2
 SHIFTS IN
SHIFTS IN AD
AD &
& THE
THE PHILLIPS
PHILLIPS
CURVE - 3
•• In the
In the previous
previous slide,
slide, AD
AD increases
increases from
from AD1
AD1 to
to AD2.
AD2.
As aa result,
As result, the
the equilibrium
equilibrium in in the
the economy
economy moves
moves from
from
point A
point A to
to point
point B.
B.
•• There are
There are two
two important
important things
things toto notice
notice about
about the
the new
new
equilibrium (relative
equilibrium (relative to
to the
the old
old one):
one):
–– First,
First, notice
notice that
that the
the price
price level
level in
in the
the economy
economy has has increased
increased
(from 102
(from 102 to
to 106)
106) -- therefore,
therefore, the
the rate
rate of
of inflation
inflation has
has risen.
risen.
–– Second,
Second, thethe level
level of
of output
output produced
produced in in the
the economy
economy hashas
risen (from
risen (from Y1
Y1 to
to Y2).
Y2). When
When thethe level
level of
of output
output increases,
increases, the
the
number of
number of people
people employed
employed also
also rises,
rises, indicating
indicating that
that the
the
unemployment rate
unemployment rate MUST
MUST have
have fallen.
fallen.
 SHIFTS IN
SHIFTS IN AD
AD &
& THE
THE PHILLIPS
PHILLIPS
CURVE - 4
•• Relative to
Relative to point
point A A in
in the
the figure
figure on
on the
the right,
right,
point B
point B MUST
MUST be be aa point
point where
where there
there isis higher
higher
inflation and
inflation and lower
lower unemployment
unemployment -- but but this
this just
just
represents aa movement
represents movement ALONG ALONG the the short-run
short-run
Phillips Curve.
Phillips Curve. Also,
Also, if
if AD
AD were
were to
to shift
shift in
in the
the
opposite direction,
opposite direction, there
there would
would have
have been
been aa
movement along
movement along thethe Phillips
Phillips Curve
Curve in in the
the
opposite direction.
opposite direction.
 THE LONG-RUN
THE LONG-RUN PHILLIPS
PHILLIPS
CURVE - 1
The figure below depicts the long-run Phillips
Curve:
Curve:
 THE LONG-RUN
THE LONG-RUN PHILLIPS
PHILLIPS
CURVE - 2
• Earlier in the course, we discussed the
natural rate of unemployment. This was
defined to be about 6% in the long-run, and
it was shown that the economy tends to
automatically return
automatically return to
to this
this level
level on
on its
its own.
own.
• If this is true, then the long-run Phillips
Curve is quite easy to draw - it MUST be a
vertical line at 6% unemployment!
 THE LONG-RUN
THE LONG-RUN PHILLIPS
PHILLIPS
CURVE - 3
• IfIf the
the long-run
long-run Phillips
Phillips Curve
Curve is
is vertical
vertical at
at 6%,
6%,
then policymakers
then must be
policymakers must be able
able to
to choose
choose
any inflation
any inflation rate
rate they
they desire
desire along
along this
this line.
line.

Q: What is the cost of

of reducing
reducing inflation
inflation in
in the
the
long-run?

A: In the long-run, there is NO cost to reducing

inflation.
 THE LONG-RUN
THE LONG-RUN PHILLIPS
PHILLIPS
CURVE - 4
This is demonstrated in the figures below:
 THE LONG-RUN
THE LONG-RUN PHILLIPS
PHILLIPS
CURVE - 5
•• On the
On the left,
left, if
if the
the Fed
Fed reduces
reduces the
the growth
growth ofof the
the
money supply
money supply in in the
the long-run,
long-run, the
the AD
AD curve
curve will
will
shift to
shift to the
the left,
left, causing
causing the
the price
price level
level to
to fall
fall from
from
P0 to
P0 to P1.
P1.

•• However, output
However, output isis NOT
NOT affected
affected by
by changes
changes inin
the money
the money supply
supply inin the
the long-run
long-run (because
(because ofof
monetary neutrality).
monetary neutrality). Since
Since output
output remains
remains at
at the
the
natural rate
natural rate of
of output,
output, unemployment
unemployment remains
remains at
at
the natural
the natural rate
rate of
of unemployment.
unemployment.
 THE LONG-RUN
THE LONG-RUN PHILLIPS
PHILLIPS
CURVE - 6
•• On the
On the right,
right, the
the reduction
reduction in
in the
the growth
growth of
of the
the
money supply
money supply has
has lowered
lowered the
the long-run
long-run rate
rate of
of
inflation and
inflation and has
has NOT NOT affected
affected the
the long-run
long-run
unemployment rate.
unemployment rate.
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 1

• While there is not a trade-off between

inflation and
inflation and unemployment
unemployment in in the
the long-
long-
run, there IS a short-run trade-off.
• From the work of Milton Friedman and
Edmund
Edmund Phelps,
Phelps, we
we know
know that
that
expectations of future inflation plays an
important role in the short-run trade-off.
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 2
The figure
The figure below
below demonstrates
demonstrates the
the relationship
relationship
between the
between the short-run
short-run Phillips
Phillips Curve
Curve andand
inflationary expectations:
inflationary expectations:
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 3
• Suppose the economy is initially at point ‘A’.
Earlier we
Earlier we said
said that
that aa shift
shift in
in the
the AD
AD curve
curve
will cause
will cause aa movement
movement along
along thethe short-run
short-run
Phillips Curve.

• An increase in the money supply, an

increase in
increase in government
government spending
spending oror aa tax
tax
cut could all shift the AD curve to the right -
suppose one of these three occurs.
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 4
•• The rightward
The rightward shift
shift in
in AD
AD is
is associated
associated withwith rising
rising
output and
output and aa rising
rising price
price level.
level.
•• The rising
The rising price
price level
level IS
IS an
an increase
increase in in the
the rate
rate ofof
inflation.
inflation.
•• Rising output
Rising output goes
goes along
along with
with rising
rising employment
employment
(and falling
(and falling unemployment).
unemployment).
•• For these
For these reasons,
reasons, the the rightward
rightward shift
shift inin AD
AD will
will
cause aa movement
cause movement to to point
point ‘B’
‘B’ in
in this
this figure
figure (higher
(higher
inflation and
inflation and lower
lower unemployment
unemployment than than point
point ‘A’).
‘A’).
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 5

• Now, according to Friedman and Phelps,

the higher
the higher ACTUAL
ACTUAL inflation
inflation will
will eventually
eventually
cause EXPECTED inflation to rise as well.

• The
The increase
increase in
in EXPECTED
EXPECTED inflation
inflation shifts
shifts
the short-run Phillips Curve to the right (to
SR-PC2), and the economy ends up at
point ‘C’.
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 6
•• We can
We can describe
describe SR-PC2
SR-PC2 as as aa ‘short-run
‘short-run Phillips
Phillips
Curve with
Curve with high
high expected
expected inflation’,
inflation’, while
while thethe
original curve,
original curve, SR-PC1
SR-PC1 can
can be
be described
described as as aa ‘short-
‘short-
run Phillips
run Phillips Curve
Curve with
with low
low expected
expected inflation’.
inflation’.

•• The result
The result you
you should
should take
take from
from the
the previous
previous figure
figure
is that
is that government
government policies
policies attempting
attempting to
to EXPAND
EXPAND
aggregate demand
aggregate demand are
are likely
likely to
to cause
cause permanently
permanently
HIGHER rates
HIGHER rates of
of inflation,
inflation, without
without affecting
affecting the
the
long-run unemployment
long-run unemployment rate.
rate.
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 7
•• The relationship
The relationship between
between the
the short-run
short-run Phillips
Phillips
Curve and
Curve and inflationary
inflationary expectations
expectations described
described
by Friedman
by Friedman and and Phelps
Phelps isis stated
stated inin the
the
following formula:
following formula:
 THE SHORT-RUN
THE SHORT-RUN PHILLIPS
PHILLIPS
CURVE & EXPECTATIONS - 8
•• In the
In the previous
previous example,
example, when
when ACTUAL
ACTUAL inflation
inflation
exceed EXPECTED
exceed EXPECTED inflation
inflation (at
(at point
point ‘B’),
‘B’),
unemployment was
unemployment was LESS
LESS THAN
THAN the
the natural
natural rate.
rate.
In the
In the long-run,
long-run, actual
actual and
and expected
expected inflation
inflation will
will
be equal,
be equal, and
and unemployment
unemployment will
will equal
equal thethe
natural rate
natural rate (and
(and the
the economy
economy will
will be
be back
back onon
the long-run
the long-run Phillips
Phillips Curve).
Curve).
 SUPPLY SHOCKS
SUPPLY SHOCKS &
& THE
THE
PHILLIPS CURVE - 1
Q: What
Q: What happens
happens in
in the
the Phillips
Phillips Curve
Curve
diagram when the AS curve shifts?

A: The short-run Phillips Curve shifts,

changing the attractiveness of the trade-
off between
off between inflation
inflation and
and unemployment.
unemployment.
SUPPLY SHOCKS
SUPPLY SHOCKS &
& THE
THE
PHILLIPS CURVE - 2
 SUPPLY SHOCKS
SUPPLY SHOCKS &
& THE
THE
PHILLIPS CURVE - 3
• The
The figure
figure on
on the
the left
left in
in the
the previous
previous slide
slide
depicts a typical supply shock in the
economy (like the OPEC shocks in the
1970s).

• As
As the
the AS
AS curve
curve shifts
shifts to
to the
the left,
left, the
the
equilibrium in the marcoeconomy moves
from point A to point B.
 SUPPLY SHOCKS
SUPPLY SHOCKS &
& THE
THE
PHILLIPS CURVE - 4
•• As with
As with aa shift
shift in
in the
the AD
AD curve,
curve, there
there are
are two
two things
things
you should
you should watch
watch for
for when
when AS
AS shifts:
shifts:

–– First,
First, notice
notice that
that the
the equilibrium
equilibrium price
price level
level rises
rises (from
(from P1
P1
to P2),
to P2), indicating
indicating that
that the
the level
level of
of inflation
inflation in
in the
the economy
economy
has risen.
has risen.

–– Second,
Second, notice
notice that
that the
the level
level of
of output
output produced
produced hashas
FALLEN from
FALLEN from Y1
Y1 to
to Y2.
Y2. As
As output
output falls
falls the
the number
number of of
labourers required
labourers required to
to produce
produce this
this output
output also
also falls.
falls. When
When
these workers
these workers get
get laid
laid off,
off, the
the unemployment
unemployment rate rate RISES.
RISES.
 SUPPLY SHOCKS
SUPPLY SHOCKS &
& THE
THE
PHILLIPS CURVE - 5
•• In the
In the figure
figure onon the
the right,
right, point
point BB MUST
MUST be be aa
point with
point with aa higher
higher inflation
inflation rate
rate AND
AND aa higher
higher
unemployment rate.
unemployment rate.
•• Point B
Point B MUST
MUST be be up
up and
and to
to the
the right
right of
of point
point A.
A.
Because of
Because of this,
this, economists
economists say say that
that the
the short-
short-
run Phillips
run Phillips Curve
Curve must
must have
have shifted
shifted to
to the
the right.
right.
•• This means
This means that
that the
the trade-off
trade-off between
between inflation
inflation
and unemployment
and unemployment is is LESS
LESS attractive,
attractive, because
because
BOTH rates
BOTH rates have
have risen.
risen.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 1
•• The figure
The figure below
below illustrates
illustrates the
the cost
cost of
of reducing
reducing
inflation in
inflation in the
the short-run:
short-run:
 COSTS OF
COSTS OF REDUCING
REDUCING
INFLATION IN THE S/RUN - 2
•• To reduce
To reduce inflation,
inflation, the the Fed
Fed will
will run
run aa
contractionary monetary
contractionary monetary policy.
policy.
•• The reduction
The reduction inin the
the money
money supply
supply will
will shift
shift AD
AD
to the
to the left.
left.
•• Recall that
Recall that aa leftward
leftward shift
shift in
in AD
AD will
will cause
cause
falling output
falling output and
and aa falling
falling price
price level.
level. The
The falling
falling
price level
price level means
means aa falling
falling rate
rate of
of inflation,
inflation, while
while
falling output
falling output means
means falling
falling employment
employment (which,
(which,
in turn,
in turn, means
means rising
rising unemployment).
unemployment).
 COSTS OF
COSTS OF REDUCING
REDUCING
INFLATION IN THE S/RUN - 3
•• The contractionary
The contractionary monetary
monetary policy
policy has
has the
the effect
effect of
of
moving the
moving the economy
economy fromfrom point
point ‘A’
‘A’ to
to point
point ‘B’
‘B’ in
in the
the
figure. You
figure. You should
should think
think of
of SR-PC1
SR-PC1 as as the
the ‘short-run
‘short-run
Phillips Curve
Phillips Curve with
with HIGH
HIGH inflationary
inflationary expectations’.
expectations’.
•• At point
At point ‘B’‘B’ inflation
inflation is
is lower
lower and,
and, inin the
the long-run,
long-run,
inflationary expectations
inflationary expectations will will adjust
adjust downwards
downwards to to
match the
match the lower
lower ACTUAL
ACTUAL inflation.
inflation. When
When thisthis occurs,
occurs,
the short-run
the short-run Phillips
Phillips Curve
Curve will
will shift
shift INWARD
INWARD to to SR-
SR-
PC0 (think
PC0 (think ofof SR-PC0
SR-PC0 as as the
the ‘short-run
‘short-run Phillips
Phillips Curve
Curve
with low
with low inflationary
inflationary expectations’.
expectations’.
 COSTS OF
COSTS OF REDUCING
REDUCING
INFLATION IN THE S/RUN - 4
Q: In
Q: In this
this example,
example, what WAS the
what WAS the short-run
short-run cost
cost
of reducing
of reducing inflation?
inflation?

A: Temporarily higher
higher unemployment. However,
However,
as stated
as before, there
stated before, there is
is NO
NO long-run
long-run cost
cost to
to
reducing inflation,
reducing inflation, because
because the the economy
economy
returned to
returned to the
the natural
natural rate of unemployment
rate of unemployment
as inflationary
as inflationary expectations
expectations adjusted.
adjusted.
 COSTS OF
COSTS OF REDUCING
REDUCING
INFLATION IN THE S/RUN - 5
Q: How
Q: How big
big is
is the
the cost
cost of
of reducing
reducing inflation
inflation in
in
reality?
reality?

A: There
A: There are
are two
two schools
schools of
of thought:
thought:
–– The
The Sacrifice
Sacrifice Ratio.
Ratio.
–– Rational
Rational Expectations.
Expectations.
 THE SACRIFICE
THE SACRIFICE RATIO
RATIO
•• The Sacrifice
The Sacrifice Ratio
Ratio isis the
the number
number of of percentage
percentage points
points of
of
annual output
annual output lost
lost in
in the
the process
process ofof reducing
reducing inflation
inflation by
by 11
percentage point.
percentage point. AA typical
typical sacrifice
sacrifice ratio
ratio is
is 5,
5, meaning
meaning that
that
reducing inflation
reducing inflation byby 1%1% will
will reduce
reduce thethe output
output of of the
the
economy by
economy by 5%.
5%.

•• When Paul
When Paul Volcker
Volcker waswas the
the Chairman
Chairman of of the
the Federal
Federal Reserve,
Reserve,
he wanted
he wanted to
to reduce
reduce inflation
inflation from
from about
about 10%
10% toto about
about 4%,4%,
meaning that
meaning that the
the output
output of
of the
the economy
economy might
might drop
drop byby as
as
much as
much as 30%
30% (that's
(that's as
as large
large as
as the
the drop
drop during
during the
the Great
Great
Depression from
Depression from 1929-1933).
1929-1933). This
This school
school ofof thought
thought indicates
indicates
that the
that the short-run
short-run cost
cost of
of reducing
reducing inflation
inflation is
is rather
rather large.
large.
 RATIONAL EXPECTATIONS
RATIONAL EXPECTATIONS -- 11
•• Rational Expectations
Rational Expectations isis aa theory
theory according
according to
to which
which people
people
optimally use
optimally use all
all the
the information
information they
they have
have when
when forecasting
forecasting the
the
future.
future.

•• Drawing on
Drawing on thethe analysis
analysis of of Friedman
Friedman and and Phelps,
Phelps, rational
rational
expectations (which
expectations (which isis attributed
attributed to to Lucas,
Lucas, Sargent
Sargent and and Barro)
Barro)
claims that
claims that the
the short-run
short-run cost
cost ofof reducing
reducing inflation
inflation will
will be
be related
related to
to
the speed
the speed withwith which
which inflationary
inflationary expectations
expectations adjust.
adjust. Rational
Rational
expectations implies
expectations implies that
that the
the sacrifice
sacrifice ratio
ratio could
could be
be much
much lower
lower
than 55 ifif the
than the commitment
commitment to to lower
lower inflation
inflation byby the
the Fed
Fed is is seen
seen as
as
‘CREDIBLE’. In
‘CREDIBLE’. In other
other words,
words, ifif people
people in in the
the economy
economy immediately
immediately
believe that
believe that the
the Fed
Fed WILL
WILL reduce
reduce inflation,
inflation, inflationary
inflationary expectations
expectations
could adjust
could adjust downwards
downwards immediately,
immediately, and and the
the sacrifice
sacrifice ratio
ratio could
could
be 0.
be 0.
 RATIONAL EXPECTATIONS
RATIONAL EXPECTATIONS -- 22
•• When Paul
When Paul Volcker
Volcker implemented
implemented hishis disinflation
disinflation
policies in
policies in the
the early
early 1980s,
1980s, there
there was
was neither
neither aa 30%
30%
drop in
drop in economic
economic output,
output, nor
nor aa 0%
0% drop
drop in
in economic
economic
output.
output.

•• The fact
The fact that
that the
the drop
drop was
was greater
greater than
than 0%
0% caused
caused
many economists
many economists toto refute
refute the
the conclusions
conclusions ofof rational
rational
expectations, while
expectations, while the
the much
much less
less than
than 30%
30% drop
drop in
in
output caused
output caused proponents
proponents of of rational
rational expectations
expectations toto
claim success
claim success (stating
(stating that
that people
people reacted
reacted to
to the
the Fed’s
Fed’s
policy, but
policy, but NOT
NOT immediately).
immediately).
 CONSIDERING ONGOING
INFLATION
INFLATION
• Wages and prices can change for two
reasons:
reasons:
– Wages and prices will tend to rise
during booms and fall during
recessions
recessions
– Workers and firms will raise their
nominal wages and prices to the extent
they expect ongoing inflation to
maintain the same level of real wages
and real
and real prices
prices
 ECONOMY OPERATING AT
FULL EMPLOYMENT
FULL EMPLOYMENT
•• Wages
Wages and and prices
prices will
will rise
rise at
at the
the rate
rate of
of inflation
inflation
expected by
expected by workers
workers and
and firms
firms
•• If
If unemployment
unemployment exceeds
exceeds the the natural
natural rate,
rate, the
the
high level
high level of
of unemployment
unemployment will will put
put downward
downward
pressure on
pressure on wages
wages and
and prices,
prices, and
and inflation
inflation will
will
falll relative
fal relative to
to what
what is
is expected
expected
•• If
If unemployment
unemployment were were below
below the
the natural
natural rate,
rate,
employers would
employers would bid
bid aggressively
aggressively for for workers,
workers,
and wages
and wages and
and prices
prices would
would rise
rise faster
faster than
than
previously expected
previously expected
 CHOICES FOR THE FED
Price, p

E AS0

AD0

yF Output, y
 CHOICES FOR THE FED
Price, p

AS1

E AS0

AD0 AD1

yF Output, y
If workers push up their normal wages, the aggregate supply curve will shift from
AS0 to AS1.
 CHOICES FOR THE FED
Price, p

A
AS1

E AS0

AD0

yF Output, y
If workers push up their normal wages, the aggregate supply curve will shift from
AS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will
occur at A and eventually the economy will return to full employment at E.
 CHOICES FOR THE FED
Price, p

A F
AS1

E AS0

AD1
AD0

yF Output, y
If workers push up their normal wages, the aggregate supply curve will shift from
AS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will
occur at A and eventually the economy will return to full employment at E.
If the Fed increases aggregate demand , the economy remains at full
 EXPECTATIONS OF THE UNION
•• The
The actions
actions of
of aa union
union will
will depend
depend on
on what
what its
its
leaders expect
leaders expect the
the Fed
Fed to
to do:
do:

–– IfIf they
they expect
expect the
the Fed
Fed will
will not
not increase
increase aggregate
aggregate
demand, their
demand, their actions
actions will
will trigger
trigger aa recession
recession
–– The
The union
union may
may be be reluctant
reluctant toto negotiate
negotiate aa high
high wage,
wage,
permitting the
permitting the economy
economy to to remain
remain at at full
full employment
employment
and experience
and experience no no increase
increase in in prices
prices
–– IfIf the
the leaders
leaders believe
believe the
the Fed
Fed will
will increase
increase aggregate
aggregate
demand, the
demand, the union
union will
will increase
increase thethe nominal
nominal wage
wage
–– The
The result
result will
will be
be higher
higher prices
prices inin the
the economy
economy
 EXPECTATIONS ABOUT THE
FED
•• Expectations
Expectations about about the
the Fed’s
Fed’s determination
determination to to fight
fight
inflation will
inflation will affect
affect the
the behavior
behavior in in the
the private
private sector
sector
•• IfIf the
the Fed
Fed is
is credible
credible oror believable
believable in in its
its desire
desire toto
fight inflation,
fight inflation, it
it can
can deter
deter the
the private
private sector
sector from
from
taking aggressive
taking aggressive actions
actions that
that drive
drive up
up prices
prices
•• Some
Some political
political scientists
scientists and
and economists
economists have have
suggested that
suggested that central
central banks
banks which
which have
have true
true
independence from
independence from the
the rest
rest of
of government,
government, and and are
are
less subject
less subject to to political
political influence,
influence, will
will be
be more
more
credible in
credible in their
their commitment
commitment to to fight
fight inflation
inflation