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## Inflation, Activity, and Nominal Money Growth

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**The Volcker Disinflation**• In October 1979, the Fed, under Paul Volcker, decided to reduce nominal money growth and decrease inflation, then close to 14% per year. • Five years later, after a deep recession, inflation was down to 4% per year.**The Volcker Disinflation**• How did the Fed reduce inflation? • It did it by changing the relationship between inflation and unemployment • It caused a recession to prove it was serious about inflation. This changed expectations of inflation.**Output, Unemployment,and Inflation**9-1 • This chapter builds on three relations: • Okun’s Law, which relates the change in unemployment to output growth. • The Phillips curve, which relates the changes in inflation to unemployment. • The aggregate demand relation, which relates output growth to both nominal money growth and inflation.**Output Growth, Unemployment, Inflation, and Nominal Money**Growth**Output Growth, Unemployment, Inflation, and Nominal Money**Growth • We are used to thinking in terms of AS-AD • AS, which shows the effect of output on prices, is split in this chapter into two parts: • Output affects unemployment through Okun’s Law. • A higher growth rate of output reduces unemployment. • Previously, we assumed Y = N = L(1-u), but life is richer and more complicated. • Unemployment affects inflation through the Phillips Curve. • A lower unemployment rate causes inflation to rise.**Output Growth, Unemployment, Inflation, and Nominal Money**Growth • We are still using AD. • Higher prices lower output demanded. • Suppose the Central Bank increases the nominal money supply at a constant, positive rate = 5%. • Inflation = 3%, so the rate of growth of real money supply is 2% = 5% – 3%. • Suppose inflation rises unexpectedly to 4%. • Then the real money supply will rise more slowly, at 1% per year. • Higher inflation reduces the rate of growth of real money, which reduces the output growth rate.**Okun’s Law: FromOutput Growth to Unemployment**• If output grows, unemployment should fall, right? • Assume Y = N Y = L – U. Yt – Yt-1 = (Lt – Lt-1) – (Ut – Ut-1) • Assume the labor force doesn’t grow (Lt – Lt-1=0). Then Yt – Yt-1 = – (Ut – Ut-1)**Okun’s Law: FromOutput Growth to Unemployment**• Yt – Yt-1 = – (Ut – Ut-1) • This also implies that the unemployment rate (u) is negatively related to the output growth rate (g): • We’ve made a lot of assumptions: no inputs besides labor, no diminishing returns • Particularly, we assumed no changes in labor productivity, constant labor force, etc.**Okun’s Law: FromOutput Growth to Unemployment**• The change in the unemployment rate could be equal to the negative of the growth rate of output. • For example, if output growth is 4%, then the unemployment rate should decline by 4%. • Now, let’s be more realistic.**Okun’s Law: FromOutput Growth to Unemployment**• The actual relation between output growth and the change in the unemployment rate is known as Okun’s law. • This relation allows for more realistic production functions, labor market behavior, etc. • Particularly, it allows for changes in labor productivity, and a growing labor force, etc, so the economy can be expected to be growing constantly.**Okun’s Law: FromOutput Growth to Unemployment**High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate. Changes in the Unemployment Rate Versus Output Growth in the United States, 1970-2000 • Using thirty years of data, the line that best fits the data is given by:**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 1 year decreases the unemployment rate by 0.4%.**Okun’s Law: FromOutput Growth to Unemployment**• According to the equation above,**Okun’s Law: FromOutput Growth to Unemployment**• To maintain the unemployment rate constant, output growth must be 3% per year. This growth rate of output is called the normal growth rate. • Output growth 1% above normal leads only to a b%<1 reduction in unemployment.**Okun’s Law: FromOutput Growth to Unemployment**• Output growth above normal leads to a decrease in the unemployment rate. • If output grows below normal, the unemployment rate. Increases. • This is Okun’s law:**Okun’s Law: FromOutput Growth to Unemployment**Assume ut-1 = 6%**The Phillips Curve: From Unemployment to Inflation**• Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. Suppose et is well approximated by t-1. Then: • The Phillips curve implies that**The Aggregate Demand RelationFromNominal Money Growth and**InflationToOutput Growth**The Aggregate Demand Relation:From Nominal Money Growth and**Inflation to Output Growth • If the IS curve is • And the LM curve is • Then the AD curve is • Aggregate Expenditure depends on all sorts of parameters (the c’s, the b’s, the d’s, t, and G), positively on M and negatively on P.**The Aggregate Demand Relation:From Nominal Money Growth and**Inflation to Output Growth • More simply, we can say that • Even more simply, suppose that changes in output are caused only changes in the real money stock, then:**The Aggregate Demand Relation:From Nominal Money Growth and**Inflation to Output Growth • Let’s put this in terms of growth rates: • gyt = (Yt-Yt-1)/Yt-1 • gmt = (Mt-Mt-1)/Mt-1 • p = (Pt-Pt-1)/Pt-1 • And since g is a parameter (gt-gt-1)/gt-1=0. • From this we can derive**The Aggregate Demand Relation:From Nominal Money Growth and**Inflation to Output Growth • How do we go from to ? • The easiest way is to use logarithms and calculus: Log Y = log (gM/P) Log Y = log g + log M - log P Taking a total derivative**The Aggregate Demand Relation:From Nominal Money Growth and**Inflation to Output Growth • In terms of the growth rates of output, money, and the price level: • According to the aggregate demand relation: • Given inflation, expansionary monetary policy leads to high output growth.**The Aggregate Demand Relation:From Nominal Money Growth and**Inflation to Output Growth Assume pt = 3% Assume gmt = 6%**The Three Relations**• Okun’s Law • Phillips Curve • AD Relation**Output Growth, Unemployment, Inflation, and Nominal Money**Growth**9-2**The Medium Run**The Medium Run**• In chapter 6 we defined the medium run as the time when Pe=Pt-1=Pt. • This meant that there was no reason for Pe to change. • No changes in Pe meant that the WS would stay put, yielding a “steady-state”, medium-run level of unemployment, the natural rate of unemployment.**The Medium Run**• The medium run: Pe=Pt-1=Pt. • In growth rates rather than levels, t = e. • Then, by the Phillips curve, u = un. • So inflation is constant. • Because un is constant, so is unemployment.**The Medium Run**• Inflation is constant. • Because nominal money growth is a policy variable, it changes exogenously and it is more natural to imagine that its constant. • Then, by the aggregate demand curve,output growth must be constant.**The Medium Run**• Is this constant equal towhich is normal output growth? • It has to be. If it weren’t, u would have to be changing, which is inconsistent withu = un.**The Medium Run**• t = t-1. • t = e. • ut = ut-1. • ut = un . • For any level of gm.**The Medium Run**• Alternatively, • Start by assuming that • This makes sense as a definition of the medium run because we want the MR to be a time of rest, stability, constancy.**The Medium Run**• So Okun’s Law implies that output grows at its normal rate.**The Medium Run**• Assume nominal money growth is • We know output growth is equal to its normal rate • Then the aggregate demand relation ( ) • implies that inflation is constant:**The Medium Run**• According to the equation above, in the medium run, inflation equals the difference between nominal money growth and normal output growth. • Call adjusted nominal money growth.**The Medium Run**• If inflation is constant, then t = t-1, if this is true, the Phillips curve implies that ut = un. Therefore, in the medium run, the unemployment rate must equal the natural rate of unemployment.**The Medium Run**• Changes in nominal money growth have no effect on output or unemployment in the medium run, because in the medium runut = un and , and neither un nor normal output growth depend on the money supply. • So changes in nominal money growth must be reflected one for one in changes in the rate of inflation.**The Medium Run**In the medium run, unemployment is equal to the natural rate of unemployment, at any level of inflation. Inflation and Unemploymentin the Medium Run**The Medium Run**In the medium run, inflation is equal to adjusted nominal money growth. Inflation and Unemploymentin the Medium Run**The Medium Run**In the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment. Inflation and Unemploymentin the Medium Run**The Medium Run**• Suppose • In the medium run, gyt = • ut = • pt = • Adjusted money growth =**From the Short Run to the Medium Run**• Above we defined Okun’s Law as • “Unemployment falls if output grows above the normal growth rate of output.” • But other authors define it as • “Cyclical unemployment arises if if output grows below the normal growth rate of output.”**From the Short Run to the Medium Run**• If we use this definition of Okun’s Law • And we remember that the Phillips curve is • Then we can write an “Inflation Adjustment” curve. • It will say that inflation rises when output is above normal.**From the Short Run to the Medium Run**Okun’s Law Phillips’ Curve Inflation-Adjustment curve • An “Inflation Adjustment” curve. • It says that inflation rises when output is above normal.