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Chapter 12

Chapter 12. Unemployment and Inflation. I. Unemployment and Inflation: Is There a Trade-off? (Sec. 12.1). A) Many people think there is a trade-off between inflation and unemployment

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Chapter 12

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  1. Chapter 12 Unemployment and Inflation

  2. I. Unemployment and Inflation: Is There a Trade-off? (Sec. 12.1) • A) Many people think there is a trade-off between inflation and unemployment • 1. The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain • 2. Since then economists have looked at the relationship between unemployment and inflation • 3. In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables • 4. The United States appears to be on one Phillips curve in the 1960s (text Figure 12.1)

  3. B) The expectations-augmented Phillips curve • Friedman and Phelps: The cyclical unemployment rate depends only on unanticipated inflation

  4. a.First case: anticipated increase in money supply • (1) AD shifts up and SRAS shifts up, with no misperceptions • (2) Result: P rises, Y unchanged • (3) Inflation rises with no change in unemployment

  5. b. Second case: unanticipated increase in money supply • Result: P rises and Y rises as misperceptions occur • So higher inflation occurs with lower unemployment • Long run: P rises further, Y declines to full-employment level

  6. c. Expectations-augmented Phillips curve: • = e – h(u –un ) (12.1) • (1) When  = e, u =un • (2)When  < e, u > un • (3) When  > e, u < un

  7. C) The shifting Phillips curve • 1. The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment • 2. Changes in the expected rate of inflation

  8. 3. Changes in the natural rate of unemployment • a. For a given natural rate of unemployment, the Phillips curve shows the trade-off between unemployment and unanticipated inflation • b. A higher natural rate of unemployment shifts the Phillips curve to the right

  9. 4. Supply shocks and the Phillips curve • a. A supply shock increases both expected inflation and the natural rate of unemployment • b. So an adverse supply shock shifts the Phillips curve up and to the right • c. The Phillips curve will be unstable in periods with many supply shocks

  10. 5. The shifting Phillips curve in practice • a. Why did the original Phillips curve relationship apply to many historical cases? • b. Why did the U.S. Phillips curve disappear after 1970?

  11. D) Macroeconomic policy and the Phillips curve • 1. Can the Phillips curve be exploited by policymakers? Can they choose the optimal combination of unemployment and inflation? • a. Classical model: NO • b. Keynesian model: YES, temporarily

  12. 2. Box 12.1: The Lucas critique • When the rules of the game change, behavior changes • Lucas applied this idea to macroeconomics, arguing that historical relationships between variables won’t hold up if there’s been a major policy change • Evaluating policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary

  13. E) The long-run Phillips curve • 1. Long run: u = un for both Keynesians and classicals • 2. The long-run Phillips curve is vertical, since when  = e, u = un (Figure 12.5; like text Figure 12.8) • 3. Changes in the level of money supply have no long-run real effects; changes in the growth rate of money supply have no long-run real effects, either

  14. II. The Problem of Unemployment • A) The costs of unemployment • 1. Loss in output from idle resources • 2. Personal or psychological cost to workers and their families • 3. There are some offsetting factors

  15. B) The long-term behavior of the unemployment rate • 1. The changing natural rate • a. How do we calculate the natural rate of unemployment? • b. CBO’s estimates: 5% to 5½% today, similar to 1950s and 1960s; over 6% in 1970s and 1980s • c. Why did the natural rate rise from the 1950s to the late 1970s? • d. Since 1980, demographic forces have reduced the natural rate of unemployment • e. Some economists think the natural rate of unemployment is 4.5% or even lower • f. Increased labor productivity may increase the natural rate of unemployment

  16. 2. Hysteresis in unemployment • a. Europe’s unemployment rates rose dramatically from the 1970s to the 1980s • b. Hysteresis: The natural rate of unemployment rises as the actual unemployment rate rises • c. Caused partly by deteriorating skills of the unemployed, which increases the mismatch problem • d. Caused partly by restrictions on firms’ ability to fire workers, making them reluctant to hire workers in good times • e. Caused partly by union-firm bargaining, as suggested by insider-outsider theory

  17. f. Box 12.2: The effect of unemployment insurance on unemployment • (1) The rise in the natural rate of unemployment is caused partly by the unemployment insurance (UI) system • (2) The longer duration of UI benefits in Europe than in the United States accounts • (3) But it doesn’t look like there’s much evidence that higher UI benefits increase the unemployment rate

  18. C) Policies to reduce the natural rate of unemployment • 1. Government support for job training and worker relocation • 2. Increased labor market flexibility • 3. Unemployment insurance reform • 4. A high-pressure economy?

  19. III. The Problem of Inflation (Sec. 12.3) • A) The costs of inflation • 1. Perfectly anticipated inflation • a. No effects if all prices and wages keep up with inflation • b. Even returns on assets may rise exactly with inflation • c. Shoe-leather costs: People spend resources to economize on currency holdings; the estimated cost of 10% inflation is 0.3% of GNP • d. Menu costs: the costs of changing prices (but technology may mitigate this somewhat sun as the introduction of electronic scanners)

  20. 2. Unanticipated inflation ( – e) • a. Realized real returns differ from expected real returns • b. Similar effect on wages and salaries ( set in advance) • c. Result: transfer of wealth • d. So people want to avoid risk of unanticipated inflation

  21. (2) Box 12.3: Indexed contracts • (a) People could use indexed contracts to avoid the risk of transferring wealth • (b) Most U.S. financial contracts are not indexed, with the exception of some long-term contracts • (c) Many U.S. labor contracts are indexed by COLAs (cost-of-living adjustments) • (d) Indexed contracts are more prevalent in countries with high inflation • (e.) Loss of valuable signals provided by prices

  22. 3. The costs of hyperinflation • a. Hyperinflation is a very high, sustained inflation (for example, 50% or more per month) • b. There are large shoe-leather costs, as people minimize cash balances • c. People spend many resources getting rid of money as fast as possible • d. Tax collections fall, as people pay taxes with money whose value has declined sharply • e. Prices become worthless as signals, so markets become inefficient

  23. B) Fighting inflation: The role of inflationary expectations • 1. If rapid money growth causes inflation, why do central banks allow the money supply to grow rapidly? • 2. Disinflation is a reduction in the rate of inflation

  24. 3. The costs of disinflation could be reduced if expected inflation fell at the same time actual inflation fell • 4. Rapid versus gradual disinflation • a. The classical prescription for disinflation is cold turkey • (2) Keynesians disagree • b. The Keynesian prescription for disinflation is gradualism

  25. 5. The sacrifice ratio • a. When unanticipated tight monetary and fiscal policies are used to reduce inflation, they reduce output and employment for a time, a cost that must be weighed against the benefits of lower inflation • b. Economists use the sacrifice ratio as a measure of the costs • c. Ball studied the sacrifice ratios for many different disinflations around the world • d. Ball’s results should be interpreted with caution,

  26. 6. Wage and price controls • a. Pro: Controls would hold down inflation, thus lowering expected inflation and reducing the costs of disinflation • b. Con: Controls lead to shortages and inefficiency; once controls are lifted, prices will rise again • c. The outcome of wage and price controls may depend on what happens with fiscal and monetary policy • d. The Nixon

  27. 7. Credibility and reputation • a. Key determinant of the costs of disinflation: how quickly expected inflation adjusts • b. This depends on credibility of disinflation policy • c. Credibility can be enhanced if the government gets a reputation for carrying out its promises • d. Also, having a strong and independent central bank that is committed to low inflation provides credibility

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