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Output, Unemployment, & Inflation

Output, Unemployment, & Inflation. Three Relations:. Phillips Curve: unemployment and the change in inflation Okun’s Law: growth and the change in unemployment Aggregate Demand: Money, output, and prices. Assuming: equals last year’s inflation, , then:.

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Output, Unemployment, & Inflation

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  1. Output, Unemployment, & Inflation Three Relations: • Phillips Curve: unemployment and the change in inflation • Okun’s Law: growth and the change in unemployment • Aggregate Demand: Money, output, and prices

  2. Assuming: equals last year’s inflation, , then: Output, Unemployment, & Inflation The Phillips Curve: Unemployment and the Change in Inflation

  3. Output, Unemployment, & Inflation Okun’s Law: The Data

  4. Output, Unemployment, & Inflation Okun’s Law: The Equation ut-ut-1 = -0.4(gyt-3%) • gyt must be at least 3% to keep • unemployment from rising • WHY? • Two factors: • Growth in the labor force • Increases in the productivity of labor

  5. Output, Unemployment, & Inflation Δu = ut - ut-1= - 0.4(gyt - 3%) • Why is the coefficient only 0.4? • Firms hoard labor and there is a minimum number of workers • Changes in labor force participation • Okun’s Law Coefficients Across Countries • Country 1960-1980 1981-1998 • United States 0.39 0.42United Kingdom 0.15 0.51Germany* 0.20 0.32Japan 0.10 0.20

  6. : how growth in excess of normal growth impacts the unemployment rate : normal growth rate Output, Unemployment, & Inflation Okun’s Law In general, the relation between changes in unem-ployment and output growth is:

  7. How does a change in impact AD? Output, Unemployment, & Inflation The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth

  8. Or going straight to the equation of exchange: • MV = PY • VdM + MdV = YdP + PdY • dM/M + dV/V = dP/P + dY/Y • gmt + dV/V = πt + gyt

  9. nominal money growth rate growth rate in prices Output, Unemployment, & Inflation The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth When velocity is constant, dV/V = 0

  10. Our Three Relations • Phillips Curve (AS): • Δt = - α (ut – ut) • Okun’s Law: • Δ ut = - β (gyt - gn) • Equation of exchange (AD): • gyt = gmt - πt

  11. Output, Unemployment, & Inflation A Scenario: The money growth rate falls (short-run) According to: • The AD relation, given inflation, output will fall • From Okun’s Law, a decrease in growth will increase unemployment • From the Phillip’s Curve, higher unemployment implies lower inflation Will the impact end here—what about the medium run?

  12. IN MEDIUM RUN: ut = un Assume a constant growth in the nominal money supply Medium Run: (Okun’s Law) (Aggregate Demand) Output, Unemployment, & Inflation

  13. If decreases to : u remains at un & falls A Adjusted money growth B Adjusted money growth Natural unemployment rate un Output, Unemployment, & Inflation:The Medium Run Adjusting to a decrease in nominal money growth Inflation Rate,  Unemployment Rate, u

  14. = Time period: 1 yr: 2 yrs: Year 1, -5% = -5% Year 2, -5% = -5% 5 yrs: 5 yrs of unemployment 2% above un 10 yrs: 10 yr of unemployment 1% above un Output, Unemployment, & Inflation Disinflation: How much unemployment? And for how long? Scenario: Reduce inflation from 14 to 4 percent &  = 1 Conclusion: Point years of excess unemployment equals 10

  15. Excess point years of unemploymentDecrease in Inflation The Sacrifice Ratio: Output, Unemployment, & Inflation Disinflation: How much unemployment? And for how long? If  = 1, what is the sacrifice ratio?

  16. Year Before Disinflation After 0 1 2 3 4 5 6 7 8 Inflation (%) 14 12 10 8 6 4 4 4 4 Unemployment rate (%) 6.5 8.5 8.5 8.5 8.5 8.5 6.5 6.5 6.5 Output growth (%) 3 -2 3 3 3 3 8 3 3 Nominal money growth (%) 17 10 13 11 9 7 12 7 7 Output, Unemployment, & Inflation Working on the required path of money growth A Scenario: Reduce inflation from 14% to 4% in 5 years

  17. Year 0 A Year 1 Year 2 Inflation Rate (percent) Year 3 Year 4 Year 5 C B Year 6+ Unemployment Rate (percent) Output, Unemployment, & Inflation The disinflation path

  18. Output, Unemployment, & Inflation The Disinflation Path Conclusions: • The transition to lower money growth and inflation is associated with a period of higher unemployment • Regardless of the path, the number of point-years of excess unemployment is the same • In the medium run: output and unemployment return to normal

  19. Output, Unemployment, & Inflation This model indicates that policy can change the timing but not number of point-years of excess unemployment. • Two challenges to this model: • Expectations, credibility • Lucas – Rat-X • Sargent – Low sacrifice in history • Nominal rigidities and contracts • Fischer – sticky wages • Taylor – staggered contracts

  20. Output, Unemployment, & Inflation Expectations & Credibility: The Lucas Critique • The previous model assumed: te = t-1 • What if teis based on an expectation that Fed policy would reduce inflation from 14% to 4%. Then: 4% = 4% - 0% • Inflation falls to 4% and unemployment remains at the natural rate • Reduction in money growth could be neutral

  21. Output, Unemployment, & Inflation Disinflation Without Unemployment in the Taylor Model

  22. Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1985 • Unemployment = 5.8% • GDP growth = 2.5% • Inflation = 13.3% • The Fed shifted from targeting interest to targeting the growth rate of nominal money 1979

  23. Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1984

  24. Did Fed credibility reduce the sacrifice ratio? 1979 1980 1981 1982 1983 1984 1985 • GDP growth (%) 2.5 -0.5 1.8 -2.2 3.9 6.2 3.2 • Unemployment rate(%) 5.8 7.1 7.6 9.7 9.6 7.5 7.2 • CPI Inflation (%) 13.3 12.5 8.9 3.8 3.8 3.9 3.8 • Cumulative unemployment 0.6 1.7 4.9 8.0 9.0 9.7 • Cumulative disinflation 0.8 4.4 9.5 9.5 9.4 9.5 • Sacrifice ratio 0.75 0.39 0.51 0.84 0.95 1.02 Cumulative unemployment is the sun of point-years of excess unemployment from 1980 on, assuming a natural rate of 6.5%. Cumulative disinflation is the difference between inflation in a given year and inflation in 1979. The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation. Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1984

  25. Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1984 • Disinflation was associated with high unemployment • The sacrifice ratio was very close to 10% disinflation with 10 point-years of excess unemployment • Phillips Curve relation was very robust Observations

  26. Output, Unemployment, & Inflation Disinflation Experiences in 19 OECD Countries • Disinflation leads to higher unemployment • Faster disinflations are associated with small sacrifice ratios (Lucas/Sargent) • Sacrifice ratios are smaller in countries that have shorter wage contracts (Fischer & Taylor)

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