Download The Dynamics of Inflation and Unemployment

Economics
NINTH EDITION
Chapter 16
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The Dynamics of
Inflation and
Unemployment
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Learning Objectives
16.1 Describe how an economy at full unemployment with
inflation differs from one without inflation.
16.2 Explain the relationship between inflation and
unemployment in the short run and long run.
16.3 Discuss why increasing the credibility of a central bank
can reduce inflation.
16.4 Define the velocity of money.
16.5 Identify the origins and causes of hyperinflation.
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16.1 MONEY GROWTH, INFLATION, AND
INTEREST RATES (1 of 3)
Inflation in a Steady State
● Nominal wages
Wages expressed in current dollars.
● Real wages
Wage rates paid to employees adjusted for changes in the price level.
● Money illusion
Confusion of real and nominal magnitudes.
● Expectations of inflation
The beliefs held by the public about the likely path of inflation in the future.
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16.1 MONEY GROWTH, INFLATION, AND
INTEREST RATES (2 of 3)
Inflation in a Steady State
INFLATION EXPECTATIONS AND INTEREST RATES
When the public expects inflation, real and nominal rates of interest will differ because we need to
account for inflation in calculating the real return from lending and borrowing.
INFLATION EXPECTATIONS AND MONEY DEMAND
REAL – NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing power—not its
“face” value.
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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN
UNEMPLOYMENT AND INFLATION (1 of 4)
● Expectations Phillips curve
The relationship between unemployment and inflation when taking into account expectations of
inflation.
TABLE 16.2 Expectations and Business Fluctuations
When the economy experiences a …
Unemployment is…
Inflation is …
boom
below the natural rate.
higher than expected.
Recession
above the natural rate.
lower than expected.
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16.1 MONEY GROWTH, INFLATION, AND
INTEREST RATES (3 of 3)
How Changes in the Growth Rate of Money Affect the Steady
State
TABLE 16.1 Money, Inflation, and Interest Rates in a Steady-State Economy
Money
Growth Rate
Inflation
Growth in
Money Demand
Real Interest
Rate
Nominal
Interest
4%
4%
4%
2%
6%
5%
5%
5%
2%
7%
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APPLICATION 1
SHIFTS IN THE NATURAL RATE OF UNEMPLOYMENT
APPLYING THE CONCEPTS #1: How can data on vacancies and unemployment be
used to measure shifts in the natural rate?
•
•
•
The natural rate of unemployment changes over time.
•
Policy makers need to know what the natural rate is to avoid unnecessary
unemployment and inflation.
•
One way to estimate is to look at the Beveridge Curve, the relationship between job
vacancies and the unemployment rate.
•
Economist William Dickens tracked the natural rate in recent decades:
Five percent in the mid 1960s
Peaked near seven percent in the late 1970s and early 1980s
Falling through the 1990s and reached five percent in 2000
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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN
UNEMPLOYMENT AND INFLATION (2 of 4)
Are the Public’s Expectations About Inflation Rational?
● Rational expectations
The economic theory that analyzes how the public forms expectations in such a manner that, on
average, they forecast the future correctly.
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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN
UNEMPLOYMENT AND INFLATION (3 of 4)
U.S. Inflation and
Unemployment in the 1980s
Inflation rose and the unemployment rate
fell below the natural rate.
Inflation later fell as unemployment
exceeded the natural rate.
SOURCE: Economic Report of the
President (Washington, D.C.: U.S.
Government Printing Office, yearly).
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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN
UNEMPLOYMENT AND INFLATION (4 of 4)
Shifts in the Natural Rate of Unemployment in the 1990s
•
What factors can shift the natural rate of unemployment?
• Demographics
• Institutional changes
• The recent history of the economy
• Changes in growth of labor productivity
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16.3 HOW THE CREDIBILITY OF A NATION’S
CENTRAL BANK AFFECTS INFLATION (1 of 2)
If workers push up their nominal 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
point a, and the economy will eventually
return to full employment at point c.
If the Fed increases aggregate demand,
the economy remains at full employment
at b, but with a higher price level.
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16.3 HOW THE CREDIBILITY OF A NATION’S
CENTRAL BANK AFFECTS INFLATION (2 of 2)
Countries in which central banks are more
independent from the rest of the government
have, on average, lower inflation rates.
SOURCE: Based on selected data in Table 5
of “Measuring the Independence of Central
Banks and Its Effect on Policy Outcomes,”
Alex Cukierman, Steven Webb, and Bilin
Neyapti, The World Bank Economic Review,
6:3, 353–398.
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APPLICATION 2
ESTIMATING THE NATURAL REAL INTEREST RATE
APPLYING THE CONCEPTS #2: How does the Fed use the concept of the natural
interest rate to conduct monetary policy?
•
•
In addition to being concerned about shifts in the natural rate of unemployment, the Fed also worries
about shifts in the natural rate of interest.
The natural rate of interest is defined as the real interest rate consistent with full employment
after temporary demand and supply shocks have subsided.
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16.4 INFLATION AND THE VELOCITY
OF MONEY (1 of 3)
● Velocity of money
The rate at which money turns over during the year. It is calculated as nominal GDP divided by
the money supply.
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16.4 INFLATION AND THE VELOCITY
OF MONEY (2 of 3)
● Quantity equation
The equation that links money, velocity, prices, and real output. In symbols, we have M ×
V = P × y.
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▼FIGURE 16.4
The Velocity of M2, 1959–2011
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16.4 INFLATION AND THE VELOCITY
OF MONEY (3 of 3)
● Growth version of the quantity equation
An equation that links the growth rates of money, velocity, prices, and real output.
•
•
growth rate of money + growth rate of velocity
= growth rate of prices + growth rate of real output
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16.5 HYPERINFLATION (1 of 2)
● Hyperinflation
An inflation rate exceeding 50 percent per month.
TABLE 16.3 Hyperinflations and Velocity
Country
Dates
Greece
November 1943 to
November 1944
August 1945 to July 1946
December 1921 to
January 1924
Hungary
Russia
Monthly Rate
of Inflation
Monthly Rate of
Money Growth
Approximate
Increase in Velocity
365%
220%
14.00
19,800%
57%
12,200%
49%
333.00
3.70
SOURCE: Adapted from Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity
Theory of Money, ed. Milton Friedman (Chicago: University of Chocago Press, 1956), 26
TABLE 16.4 Hyperinflation in the 1980s
Country
Bolivia
Argentina
Nicaragua
Year
1985
1989
1988
Yearly Rate of Inflation
1,152,200%
302,200
975,500
Monthly Rate of
Inflation
Monthly Money
Growth Rate
118%
95
115
91%
93
66
SOURCE: International Financial Statistics, International Monetary Fund.
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16.5 HYPERINFLATION (2 of 2)
How Budget Deficits Lead to Hyperinflation
● Seignorage
Revenue raised from money creation.
Government deficit = new borrowing from the public + new money created
● Monetarists
Economists who emphasize the role that the supply of money plays in determining nominal
income and inflation.
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APPLICATION 3
THE END OF HYPERINFLATIONS
APPLYING THE CONCEPTS #3: Why do hyperinflations end suddenly?
•
•
•
In a classic study of four major hyperinflations, Nobel Laureate Thomas J. Sargent noticed that
they ended rather quickly and the ends all followed similar patterns. He studied the
hyperinflations after World War I in Germany, Austria, Hungary, and Poland, some of the most
dramatic in world history. In each case, the hyperinflation ended with the creation of a central
bank and change in the way that governments were financed. No longer would the country rely
on its central bank to finance its debt. Instead, debt was sold to private parties who would
value the debt based on the ability of the government to meet interest and principal payments
from taxes. Once the governments made these reforms, there was an abrupt end to the
hyperinflations and an actual increase in the demand for money in real terms by the private
sector.
•
Sargent said hyperinflations were ultimately caused by fiscal policy that was financed by
money creation and not taxes. He also suggested that inflation could be tamed rather easily
once fiscal reforms were made. While most economists agree with Sargent’s views on the
ends of hyperinflation, there is less agreement that moderate inflations can be ended simply by
changing fiscal regimes and not enduring a recession.
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KEY TERMS
Expectations of inflation
Expectations Phillips curve
Growth version of the quantity equation
Hyperinflation
Monetarists
Money illusion
Nominal wages
Quantity equation
Rational expectations
Real wages
Seignorage
Velocity of money
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