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Chapter 10
The Goals of Stabilization Policy:
Low Inflation and Low Unemployment
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Chapter Outline
Introduction
Box: Global Economic Crisis Focus: Inflation versus Unemployment in the Crisis
10-1
The Costs and Causes of Inflation
10-2
Money and Inflation
a. Definitions Linking Money, Velocity, Inflation, and Output
b. Why Do Central Banks Allow Excessive Monetary Growth?
IP Box: Money Growth and Inflation
10-3
Why Inflation Is Not Harmless
a. Nominal and Real Interest Rates
b. Four Conditions Necessary for Inflation to Be Harmless
c. Violation of Condition 1: Interest Rates in a Surprise Inflation
Box: Global Economic Crisis Focus: Hosing Bubble as Surprise Inflation Followed by Surprise
Deflation
d. Violation of Condition 2: Expected Inflation and the Fisher Effect
Box: The Wizard of Oz as a Monetary Allegory
e. Violation of Condition 3: Money Does Not Pay Interest
f. Violation of Condition 4: Taxes are Levied on Nominal Interest, Not Real Interest
10-4
Indexation and Other Reforms to Reduce the Costs of Inflation
a. Deregulations of Financial Institutions
b. Indexed Bonds
Box: The Indexed Bonds (TIPS) Protects Investors from Inflation
c. Indexed Tax System
10-5
The Government Budget Constraint and the Inflation Tax
a. The Government Budget Constraint Equation
b. Bond Creation Versus Money Creation
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Chapter Overview
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Box: Understanding The Global Economic Crisis: How a Large Recession Can Create A Large
Fiscal Deficit
c. Effects of Inflation
d. Why Inflation Is Tempting to Governments
e. An Example Showing That the Government Gains
10-6
Starting and Stopping a Hyperinflation
a. Costs of an Anticipated Hyperinflation
b. How Hyperinflation Begins
c. How to End a Hyperinflation
10-7
Why the Unemployment Rate Cannot Be Reduced to Zero
a. The Actual and Natural Rates of Unemployment
b. Distinguishing the Three Types of Unemployment
10-8
Sources of Mismatch Unemployment
a. Vacancies and Unemployment in an Imaginary Economy
b. Causes of and Cures for Mismatch Unemployment: Mismatch Skills
Box: Global Economic Crisis Focus: The Crisis Raises the Incidence of Structural
Unemployment
10-9
Turnover Unemployment and Job Search
a. Reasons for Turnover Unemployment
b. The Human Costs of Recessions
c. Why Did the Natural Rate of Unemployment Decline after 1990?
10-10 The Costs of Persistently High Unemployment
a. Dimensions of Persistent Unemployment
b. Will There Be a “New Normal”?
c. The Costs of Persistent Unemployment
Box: Understanding The Global Economic Crisis: Why Did Unemployment Rise Less in Europe
Than in the United States after 2007?
10-11 Conclusion: Solutions to the Inflation and Unemployment Dilemma
Summary
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Chapter Overview
The previous chapter of the text considered the causes of unemployment and inflation as well as the
associated policy implications. This chapter analyzes the effects and costs of inflation and
unemployment. It also considers alternative policy options to reduce these costs. Comparing the
recession of 1981–82 with the great recession of 2007–09, Gordon informs us that reasoning
behind two recessions are different and cautions us that persistent unemployment after 2008 may
not be cured by easy fiscal or monetary policies.
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The Goals of Stabilization Policy: Low Inflation and Low Unemployment
In Section 10-1, Gordon notes the disagreement among economists (such as Okun and Tobin,
among others) over the costs of inflation and distinguishes between moderate or “crawling”
inflation and hyperinflation. The discussion then turns, in Section 10-2, to the issue of why
governments are prone to inflation. Gordon first shows the connection between the growth rate of
money and inflation. He begins by using the quantity equation to show that nominal GDP must rise
if there is an increase in either the money supply or the velocity of money. He then converts the
quantity equation from levels to growth rates. This leads to identity (Equation 10.3) in which
inflation is seen to be (1) the growth rate of nominal GDP minus the growth rate of real GDP and
(2) the sum of the growth rates of the money supply and velocity minus the growth rate of real
GDP, or p = x – y = ms + v – y. Assuming y = yN leads to the conclusions that (1) inflation equals
the difference between nominal GDP growth and the long-run growth rate of real GDP and (2)
inflation equals the excess growth of money plus velocity relative to the long-run growth rate of
real GDP (shown in Footnote 4). Furthermore, if the growth rate of velocity is assumed constant, as
it appears to be over the long run, inflation is due to the excess of money supply growth over the
long-run growth rate of real GDP. Thus, in the long run, inflation can be controlled by letting the
money supply grow no faster than natural real GDP growth. Since the central bank controls the
money supply, the central bank is seen as both the culprit and savior when it comes to inflation.
Gordon then turns to a discussion of why central banks allow excessive money growth. He notes
four basic reasons: (1) temptation to demand stimulation, (2) fear of recession and job loss, (3)
adverse supply shocks, and (4) inflation-assisted government finance. Gordon argues that ignorance
of the temporary nature of the effects of demand stimulation may lead to inflation. In addition,
given the knowledge that the output effects of the demand stimulus are temporary, central banks
may inflate for political reasons. Similarly, temporary unpleasant effects may prevent action
necessary to reduce inflation. For the same reason, the central bank may choose an accommodative
policy in response to an adverse supply shock, which may lead to a permanent acceleration in
inflation, or a neutral policy, which may lead to a temporary upsurge in inflation. The fourth reason
for inflation is that it is a source of government revenue. Here Gordon emphasizes only the
government’s monopoly on the printing of money, but later he goes into the issue of seignorage in
detail. Since your students have been exposed to the inflation model of Chapter 9, the first three
reasons for inflation will probably be readily understood by them. The fourth reason for inflation
will require more careful explication later, however.
Section 10-3 analyzes the costs of inflation by considering separately the case of a surprise or
unanticipated inflation and the case of a fully anticipated inflation. The text begins with the
distinction between the nominal and real interest rate. Tell students that this distinction is the same
as that between any other real and nominal magnitude: real interest payments are adjusted for the
rate of inflation. However, stress that because we are talking about rates of change (just as in the
growth equation), the real interest rate is obtained by subtracting the rate of inflation from the
nominal interest rate (r = i – p). Also note that because the inflation rate of the next period is not
directly observed, the expected real interest rate, which is based on the expected inflation rate, is
what matters for current saving and investment decisions.
Gordon illustrates the relationship among the expected real interest rate, the nominal interest rate,
and the expected inflation rate as well as the absence of redistributive effects of fully anticipated
inflation. He presents four conditions that must hold for inflation to be harmless. The first
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condition, that inflation is accurately anticipated is violated in a “surprise” inflation situation. The
main point to stress is that surprise inflations will redistribute wealth from creditors to debtors
because nominal interest rates will fail to adjust to the unanticipated rise in inflation. This reduces
the real interest income received by creditors while reducing the real interest expenditures of
debtors. The Fisher equation, i = re + pe, is discussed in conjunction with the second condition
required for inflation to be harmless, that the expected real interest rate does not vary with inflation.
Gordon shows that this condition is often violated as depicted in Figure 10-1, in which the nominal
interest rate on 10-year Treasury bonds is plotted together with the expected rate of inflation. It is
clear from the graph that the expected real interest rate changes when there is a sudden increase or
decrease in expected inflation. The third condition required for inflation to be harmless is that
money does not pay interest. Gordon explains that this condition has been violated because
financial deregulation has allowed the banking system to pay interest on checking accounts, so that
it is only currency that does not pay interest. The fourth condition for inflation to be harmless is that
only real interest is taxable. But tax rules are always based on nominal interest. Gordon then
presents an example in which inflation reduces the after-tax real interest rate when the nominal
interest rate is taxed, even if the Fisher Effect is obeyed and the nominal interest rate rises by the
inflation rate.
Section 10-4 examines some of the reforms recommended to reduce the costs of unanticipated
inflation. One major change was the financial deregulation of the early 1980s that eliminated the
Regulation Q interest rate ceiling on deposits at commercial banks and savings institutions. This
permitted nominal interest rates to adjust with the inflation rate and reduced the redistribution
effect of unanticipated inflation. Another important reform implemented in 1985 was the partial
indexation of the personal income tax system. This considerably reduced the problem of “bracket
creep,” in which inflation pushed individuals to higher tax brackets by increasing their nominal
incomes. (The problem is not eliminated because the brackets are indexed only with a lag and
because some deductions, credits, or adjustments to income have nominal dollar ceilings that are
not indexed.) The other reform is the government’s offering of an indexed bond, beginning in 1997,
which protects savers who lend to the government from surprise inflation. Emphasize that
indexation is no cure for inflation itself. It is simply designed to reduce the costs associated with
unanticipated inflation by making unanticipated inflation irrelevant to savers and borrowers.
However, also explain that indexation will magnify the sensitivity of prices and inflation to supply
and demand shocks by reminding students of the discussion of COLAs in Chapter 9. When doing
this, you may also stress the differences between wage indexation and the indexation of taxes and
saving bonds (TIPS, for example, in the Box on page 329).
Section 10-5 deals with the government budget constraint, seignorage, and the inflation tax. The
section begins with the government budget constraint. Explain that, like any household, the
government is “constrained” to spend only as much as its budget, or sources of funding, allows.
However, the sources of funding available to the government are very different from those
available to households. In addition to (net) tax revenues (T), the government can also finance its
expenditures with bonds (borrowing from the public), B/P, or money creation (borrowing from
the central bank), H/P. This is seen from the government’s budget constraint in Equation (10.8).
You may want to rewrite this equation to equate actual expenditures, which also include interest
payments on outstanding bonds, to the total sources of revenue:
G + (iB/P) = T + (B/P) + (H/P),
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where iB/P represents the interest payment on the existing debt, and H is “high-powered” money.
This equation can be reformulated as in Equation (10.9)
G – T + (iB/P) = (B/B)(B/P) + (H/H)(H/P),
For now, explain that high-powered money (currency and bank reserves) is simply the base
component of the money supply that the Fed can influence. The detailed analysis of the money
supply and of the various instruments of monetary control available to the Federal Reserve is
presented in Chapter 13. The main policy implication to stress here is that both bond-financed
deficits and money-financed deficits have different side-effects on long-term economic growth.
Money creation, though not associated with the “burden” on private investment, will eventually
lead to inflation through its relatively stronger expansionary effects on aggregate demand.
Therefore, governments may choose bond financing when the economy is strong and money
financing when the economy is weak. Show students that this follows directly from the IS-LM and
SAS-AD models of Chapters 4 and 7. When rewriting the government budget constraint in terms of
the inflation rate, emphasize that Equation (10.11) assumes a steady-state condition: the growth rate
of high-powered money and of bond creation is equal to the inflation rate (i.e., H/P and B/P are
constant). The main result here is that inflation actually benefits the government in two ways. First,
because individuals desire to maintain a constant real stock of money, the government can induce
them to accept money in exchange for goods; thus, the government collects inflation tax or
“seignorage” revenue from increasing the monetary growth rate. Secondly, inflation redistributes
wealth to the government by reducing its real interest payments on outstanding nominal fixed
bonds if nominal interest rates rise by less than the inflation rate.
Section 10-6 analyzes the issue of hyperinflation. Hyperinflation was defined in the introduction to
this chapter, and in Table 10-1 he has given the examples of real world hyperinflation for several
countries across the world. You may illustrate here the power of compounding to explain the
hyperinflation, and you may also want to explain the difference between discrete and continuous
compounding regarding inflation measurement.
Gordon explains that causes of hyperinflation may originate from some initial policy factor that is
exacerbated by other subsequent policies and institutional regulations. One such cause is monetary
accommodation to an adverse supply shock, which is exacerbated by wage indexation and
consequent exchange rate depreciation. Another is deficit financing accompanied by explosive
monetary growth. Students usually find hyperinflation fascinating, but most U.S. students will
never have experienced one, so you may want to tell them anecdotes about carrying a suitcase full
of money in order to engage in everyday transactions or about workers being paid several times a
day and taking time from work to shop before the money lost more purchasing power.
Gordon discusses stabilization policy as a way to end hyperinflation. Examples of stabilization
policy include reducing the budget deficit, changing tax policy, and possibly wage controls. Note
that these policies don’t always work (cite examples of countries in which they have and have not).
People must believe that the government intends to carry through on its promise to end
hyperinflation. Again, since most U.S. students are unfamiliar with hyperinflation, you might
illustrate your lecture with examples of how countries suffering from hyperinflation fared.
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Section 10-7 addresses the natural rate of unemployment and explains why the unemployment rate
cannot be reduced to zero. From the discussion in Chapter 9, it was seen that both the inflation rates
and the unemployment rates of the 1970s and 1980s were high and variable. This motivates the
student for a discussion of the causes of natural unemployment. Stress that there is nothing
“natural” about the factors that determine the natural rate of unemployment. Also note that the
natural unemployment rate cannot be permanently altered by demand-management policies since
these affect only cyclical unemployment. Instead, reducing the natural unemployment rate requires
institutional changes directly affecting the labor market.
Sections 10-8 and 10-9 examine the factors that determine the natural rate of unemployment. These
sections consider, separately, the reasons for mismatch (structural) and turnover (frictional)
unemployment. Mismatch unemployment is a part of the natural unemployment rate. Workers are
unemployed not because job vacancies are unavailable for those who want to work, but because
they are somehow prevented from filling the available vacancies. The main reasons for this
mismatch are lack of skills, race and sex discrimination, and geographical disparity. Turnover
unemployment consists of those individuals in the work force who are “between jobs,” usually by
choice, and are searching for jobs. The “search theory” of unemployment explains turnover
unemployment as due to productive search activity. The unemployed search for the best or
“optimal” job offer. This activity is part of the economy’s normal functioning. While stressing the
distinction between mismatch and turnover unemployment, also note that they are not mutually
exclusive. Job search activity may be prolonged because of mismatched location or skills, and high
levels of turnover unemployment may imply greater labor mobility and lead to a lower mismatch
unemployment rate.
The costs of mismatch and cyclical unemployment are similar in that they both result in lost income
and increased physical and mental anguish. However, the costs of cyclical unemployment to society
as a whole are much greater. The reduction in GDP due to the multiplier effect of a reduction in
consumption and investment spending accompanying higher unemployment imposes the costs of
lost income on both business and workers. In addition, widespread cyclical unemployment imposes
psychic costs on employed individuals who worry about their own job security. In your classroom
discussion about which government policies may help to reduce the natural rate of unemployment,
you may want to introduce policy debates over such issues as increasing unemployment insurance
benefits and reducing the minimum wage rate. Gordon includes a discussion of the decline in the
natural rate of unemployment in the decade of 1990s.
In Section 10-10, Gordon explains the current unemployment situation in the United States. He has
pointed out that current unemployment is not only high compared to historical standard, but more
worrisome is its persistence. Unemployment rate reached the highest level in the early 2009 to
about 10.2 percent and it went down to 9.5 percent in June 2009 and still has not declined much in
the next 18 months. He opines the possibility of new higher normal rate as natural rate of
unemployment around 8 percent and consequent economic hardships for the unemployed populace.
In Section 10-11, Gordon sums up the inflation and unemployment problems in Section 10-10. He
reviews the costs of inflation (hyper inflation and creeping inflation, anticipated inflation and
unanticipated inflation) and unemployment (mismatch and turnover). He concludes with a review
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of the policy options. Although the text presents nothing new here, it would still be a good idea to
devote some time to this wrap-up because it brings together the theory and the policy options that
are at the core of the course.

Changes in the Twelfth Edition
The content of Chapter 10 remains more or less unchanged with a few important exceptions. In the
introduction there is a new Box for Global Economic Crisis Focus: Inflation vs. Unemployment in
the Crisis. The IP Box in Section 10-2 has been modified with different scaling of the axes and with
newer data (change from 1990–2006 to 1990–2009) and expanded explanation about Ukraine in
this context. Section 10-3 has been changed moderately with a new box on Global Economic Crisis
Focus: Hosing Bubble As Surprise Inflation Followed by Surprise Deflation. Figure 10-1, where
the 10-year Treasury bond rate is mapped with the expected rate of inflation to demonstrate that the
interest rate does not mimic expected inflation, has been updated to include the time period
1990–2010. Footnotes have been eliminated. The IP Box titled The Index Bonds (TIPS) Protects
Investors from Inflation in Section 10-4 has been updated with new data about inflation. The
explanation time period for TIPS has been extended to the year 2010. In Section 10-5, the
explanation about the government budget constraint equation (Subsection 10-5a) has been modified
significantly with a new explanation, and the numerical examples for basic deficit, interest cost and
total deficit have been changed. A new box on Understanding The Global Economic Crisis: How a
Large Recession Can Create A Large Fiscal Deficit has been added. This box has data about
budget deficits and surplus up to the year 2009. In Section 10-6, Table 10-1 Annual Rates of
Inflation in Selected High Inflation Countries has been updated with more recent examples and
numerical data. The time period has been extended from 1975–2008 to 1975–2010.
In Section 10-7, an historical comparison of the actual rate and natural rate of unemployment for
the United States (as shown in Figure 10-2) has been modified by incorporating new data. It shows
the actual unemployment rate and the natural rate of unemployment over the period 1980–2010
instead of 1980–2007. The explanation beneath the figure has been rewritten.
In Section 10-8, a new box on Global Economic Crisis Focus: The Crisis Raises the Incidence of
Structural Unemployment has been added. Table 10-2 in section 10-9 has been updated with new
unemployment data by reason, sex, and age, including the time period August 2010.
A new Section 10-10 about the Costs of Persistently High Unemployment has been added in this
chapter. It explains adverse consequences of high unemployment for a long duration on the U.S.
economy.
The concluding section is unchanged from the concluding section of the 11th edition.
©2012 Pearson Education, Inc. Publishing as Addison Wesley
Answers to Questions in Textbook
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Answers to Questions in Textbook
1. The misery index is the sum of the inflation and unemployment rates. A criticism is that it weighs one
percentage point of inflation as equal to one percentage point of unemployment, whereas the costs of
one percentage point of inflation and unemployment are unsettled issues and are not likely to be equal.
2. A hyperinflation is a very rapid rate of inflation; Gordon defines it as at least 1,000 percent per year. A
moderate (or creeping) inflation, on the other hand, implies a “moderate” rate of inflation, presumably
an inflation rate less than 1,000 percent per year.
3. Yes, simple percentage changes are misleading as measures of inflation at high rates inflation; in
particular, they overstate the rate of inflation. If inflation is a continuous process (i.e., prices rising
daily or even hourly, as in a hyperinflation), calculating inflation rates at discrete intervals (such as
months, quarters, or years) may be misleading. As Gordon says in Footnote 1, a simple percentage rate
of change at 50 percent per month compounds to an annual rate of 12,975 percent, whereas the very
same implied absolute price increase when compounded continuously produces an inflation rate of
40.5 percent per month or 487 percent per year. End-of-chapter Problems 1 and 2 also deal with this
issue.
4. Excess nominal GDP growth relative to natural real GDP growth is simply the difference between
nominal GDP growth and natural real GDP growth, or x – yN. It is equal to the inflation rate when
actual real GDP growth is equal to natural real GDP growth, or when y – yN = 0. (See Footnote 4.)
5. The four main reasons for inflation are the temptation of demand stimulation to reduce unemployment,
the fear of the recession and job loss needed to reduce inflation, an adverse supply shock, and
financing government deficits by printing money. The temptation to reduce unemployment results in
an excessive growth rate of nominal GDP because in the short run, the excessive growth does result in
an increase in the output ratio and therefore a decline in the unemployment rate. It is only in the long
run that the excessive growth results in no change in the unemployment rate. A permanent reduction in
inflation requires a reduction in the growth rate of nominal GDP. That reduction results in a recession
in the short run as the output ratio falls and the unemployment rate rises. It is the fear of that recession
which often results in excessive nominal GDP growth and inflation. If there is an adverse supply
shock, then even in the short run, inflation rises unless nominal GDP growth is reduced via an
extinguishing policy. Finally, government deficits are often financed by printing money or increasing
the money supply, particularly if countries do not have well-developed financial markets in which the
government can sell its bonds. Also recall from Chapter 7 that in a small open economy with a fixed
exchange-rate system, a fiscal expansion must result in an increase in the money supply. Therefore,
that fiscal expansion results in excessive nominal GDP growth no matter how well developed the
economy’s financial markets are.
6. The nominal interest rate (i) is the rate actually paid in the financial markets. The expected real interest
rate (re = i – pe) is what people expect to pay on borrowings or earn on their savings after deducting
expected inflation. The actual real interest rate (r = i – p) is what people actually pay or earn after
taking into account the actual inflation rate. The rate that people expect to exist affects their borrowing
and saving decisions, and the actual real interest rate determines what people actually pay or earn.
7. In an unanticipated inflation, whether a person is a net debtor or net creditor determines whether he
wins or loses. Net debtors gain because their debts shrink in real terms, while their real and financial
assets are not indexed for inflation. Wealthy individuals are net creditors, so they tend to lose. Middleincome homeowners and farmers are net debtors; they own assets that can vary in price (e.g., homes
and land) and debts that are fixed in nominal terms (e.g., mortgages), so they tend to gain. The poor are
neither net creditors nor net debtors because they neither save nor borrow much. They don’t save for
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obvious reasons, and they can’t borrow because they lack collateral. Poor people near retirement who
rely entirely on Social Security are protected by the indexation of Social Security benefits.
8. The nominal interest rate:
a. falls;
b. rises;
c. falls;
d. falls.
9. The Fisher equation states that the nominal interest rate is the sum of the expected real rate of interest
and the expected inflation rate. The Fisher Effect states that the nominal interest rate changes by the
same number of percentage points that the expected rate of inflation changes. The Fisher equation is
true by its definition, whereas the Fisher Effect is a testable hypothesis. Figure 10-1 shows that in the
period 1975–76, the rise in the nominal interest rate was much less than the rise in the expected rate of
inflation, whereas in the early 1980s, the rise in the nominal interest rate was much larger than the rise
in the expected rate of inflation. Figure 10-1 also shows that between 1983 and 1985, the nominal
interest rate rose during a period when the expected inflation rate was falling, and that during the early
1990s, the decline in the nominal interest rate was much larger than the decline in the expected rate of
inflation. Therefore, the data presented in Figure 10-1 refute the Fisher Effect. The graph in the box on
page 329 shows that the gap between real and nominal interest rates on 10-year Treasury bonds
widened considerably during 2002–04. This could be consistent with the Fisher Effect if at the same
time the real interest rate was falling, expected inflation was rising. But falling real interest rates
typically are associated with a weakening economy, which would lead to a lower, not a higher inflation
rate. The other explanation of a falling real interest rate and a stable nominal interest rate that is
consistent with a Fisher Effect is that the TIPS bonds were overbought. But if that were the case, then
the return on the un-indexed bonds would have been high relative to the indexed bonds, which should
have resulted in a narrowing of the prices and therefore the two interest rates on the two types of
bonds. The data in the box do not show that happening. Therefore, the data in the box on page 329 do
not provide support for the Fisher Effect.
10. The shoe-leather cost of inflation is due to higher inflation resulting in higher interest rates. Those
higher interest rates cause people to hold less of their funds in cash and more in interest-bearing
accounts. Therefore, higher inflation causes people to make more trips to banks and ATMs to
withdraw cash from these accounts. The menu costs of inflation are the costs of changing prices, such
as restaurants printing new menus or mail-order firms publishing new catalogs or Internet companies
updating the prices listed on their websites. In addition, the prices of goods and services subject to
menu costs don’t change as rapidly as those not subject to menu costs, resulting in changes in the
relative prices of goods and services in the different categories. Those changes in relative prices create
economic inefficiencies and unfair redistribution of incomes.
The amount of shoe-leather and menu costs increase as the rate of inflation increases. For example, at
low inflation rates, households are not likely to consider the amount of interest lost in deciding how
often to go to the bank to withdraw cash. But at high rates of inflation, significant interest income
could be lost by carrying around more than the minimum amount of cash needed to meet daily
expenses.
Similarly at low rates of inflation, the cost to a restaurant of printing a new menu is likely to outweigh
the additional revenue obtained by higher prices listed on the new menu. New menus are likely to be
printed up only when the items on the menu change. However, as the inflation rate rises, the additional
revenues eventually outweigh the additional printing costs.
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11. If real interest income is taxed, whereas nominal interest expense is allowed as a deduction, then the
tax laws are subsidizing borrowing in the sense that borrowers are paying less after taxes than lenders
are receiving. That results in too much borrowing, not enough saving, and too much spending.
12. In Equation (10.8), the left-hand side represents governmental expenditures. It consists of the real
“basic deficit,” that is, G – T, or real government expenditures on goods and services minus real net
taxes (taxes minus transfers), plus real interest payments on government bonds outstanding. The righthand side represents government revenue sources (exclusive of T, which is subtracted from G on the
left-hand side). It consists of the real value of new bond issues and the real value of new issues of
high-powered money.
13. The conditions for a “steady state” are that nominal government bonds, B, nominal high-powered
money, H, and the price level, P, all grow at the same rate. This implies that real government bonds,
B/P, and real high-powered money, H/P, are constant. If this is so, then the government budget
constraint can be written as Equation (10.11). This equation shows that the government benefits from
inflation in two ways. First, when the government raises the amount of high-powered money, it
receives revenue called seignorage or the inflation tax. Second, when the government raises the
amount of real bonds outstanding, it pays only real, rather than nominal, interest on its bonds; in
addition, if the nominal interest rate does not rise one percentage point for every percentage-point
increase in inflation, then the real interest rate falls, and the government gains by financing its debt
with a lower real interest rate.
14. The deficit must be financed by either an increase in the government debt held by the public or an
increase in the government debt held by the Fed (which results in the creation of high-powered
money). If the economy starts at YN and there is no change in monetary policy, then the increase in
high-powered money would lead to increased growth in the money supply and in nominal GDP, which
would be inflationary. If the government adjusted its monetary policy and kept the growth of nominal
GDP constant, however, there would be no inflationary pressures.
15. A mild inflation can be converted into a hyperinflation by frequent wage indexation. Wage indexation
leads to wage increases, which set off further price increases. At a given exchange rate, price increases
will reduce the demand for the country’s exports. The reduced demand for exports will reduce the
demand for the country’s currency, which will cause depreciation in the exchange rate. A decrease in
the exchange rate will raise the domestic-currency price of imports, which acts as an adverse supply
shock and further exacerbates inflation.
16. To stop a hyperinflation, a government should do several or all of the following depending on its
circumstances: reduce its budget deficit by cutting its expenditures and transfers and by raising taxes;
reduce the growth of the money supply; reform its tax system if tax evasion is a problem and if there is
no broad-based tax that is easy to collect, such as a value-added tax; stop or slow wage increases by
mandating a wage freeze, introducing a wage control policy, or reducing the frequency of indexation;
seek an international agreement to suspend interest payments on its international debt; and move from
a flexible exchange rate to a fixed exchange rate.
17. Each dollar gives certain advantages, such as purchasing convenience, to the holder; these advantages
are called extra convenience services (ECS). Holding a dollar, however, means that an individual is
foregoing the interest he could be earning. A rational individual would hold money only until the last
dollar held gives ECS greater than or equal to the nominal interest rate. If an expected inflation occurs
and the nominal interest rate rises, people will give up holding some amount of money for which the
ECS is less than the nominal interest rate. As a result, society is “losing” the extra convenience
services of this additional amount of money.
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18. No. Expansionary monetary policy would increase the ratio, Y/YN, and therefore lower actual
unemployment. This will have no effect on the natural rate of unemployment, however. The natural
rate of unemployment is sensitive to long-run, supply-oriented policies.
19. If workers do not have the necessary skills, they do not know about vacancies, or they are not in the
correct geographic locations, they can remain unemployed even while vacancies exist. If policymakers
follow an expansionary policy, output will increase, requiring more workers. If the labor supply is
fixed, the number of unemployed workers will decrease. If the labor supply increases (e.g., due to an
influx of previously “discouraged” workers), the total number of unemployed could actually increase.
Eventually, however, continued expansionary policy will lead to a decrease in unemployed workers.
Expansionary policy will also lead to an increase in the number of vacancies. It is likely that the
increased demand for some types of goods will not be filled due to a shortage of workers who can
produce that type of good.
20. As real output increases, there occur serious shortages of labor in some occupations or in some
geographic locations. These shortages cause wage rates to be bid up. A continuing expansion causes
these shortages to become relatively more severe and wages to rise at a relatively faster rate.
21. If the worker faces turnover unemployment, that worker can find a suitable job in the local community
after a relatively short “job search.” On the other hand, if the worker faces mismatch unemployment,
that worker may have to be retrained or move to another location. In this case, the time before work is
found will be much longer.
22. Turnover unemployment is due to people who have quit their jobs, are re-entering the labor force, or
are looking for their first jobs. People who quit their jobs do so because they feel they are better off
spending their time looking for what they hope will be a better job rather than working at their current
job. Similarly people who re-enter the work force do so because they feel they will be better off
working than continuing to do whatever it was they were doing while they were out of the work force.
Similarly, people who enter the work force for the first time do so because they feel they will be better
off working than continuing to do whatever they were doing prior to entering the workforce. To
summarize, the benefits of turnover unemployment are that people spend time searching for jobs that
will resul in a better use of their time than previously.
A mismatch of skills requires that people first acquire skills that are in demand and then find particular
employers who need the new skills the people have acquired. That may or may not require people to
relocate. On the other hand, the problem of mismatch of location “simply” requires that people find
particular employers in a new location that need the skills that they already have. Thus, at the
conceptual level, the problem of mismatch of location is less severe than the mismatch of skills. The
complicating factor is that a person who needs to acquire new skills may be able to do so without
relocating his or her family. On the other hand, if a family must relocate, then the problem of
overcoming a mismatch of location could be quite high if a spouse must find a new job and/or children
must give up old friends and schools and find new ones. Finally, A mismatch of locations may present
difficulties on finding new employment if a poor housing market where the unemployed are located
makes it difficult for the unemployed to sell their homes before relocating. This issue will be discussed
in greater detail in Question 28.
Being able to use the Internet to obtain information concerning employment opportunities reduces the
cost of searching for a new job, particularly a job in a distant geographical area. That results in a
reduction in the amounts of turnover unemployment and unemployment due to a mismatch of location.
The only possible way that the Internet could reduce the amount of unemployment due to a mismatch
of skills is if people are able to obtain better information concerning which skills are most in demand
via the Internet. If so, then they might be able to find a job more quickly once they have acquired those
new skills.
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23. People who are unemployed for a long period of time often find their skills eroding as they remain
unemployed. For example, office workers who have been out of work for long periods of time are less
likely to be familiar with the latest versions of the software used in office jobs. This illustrates how
long-term unemployment can contribute to the amount of structural unemployment caused by a
mismatch of skills.
24. Monetary policy in 1981–82 was aimed at reducing inflation. The cost of this battle against inflation
was that the unemployment rate rose to its highest level since the Great Depression, a level not reached
even during the Global Economic Crisis. However, reversal of that tight monetary policy in the
summer of 1982 resulted in a 3.3 percentage point drop in the unemployment rate within a year-and-ahalf of the end of the 1981–82 recession.
25. The “new normal” refers to a substantial rise in the natural unemployment rate to a level not seen in
the last 50 years. This pessimistic view of the future path of unemployment is based on first, the longer
workers remain unemployed, the greater is their erosion of skills, resulting in a rise in the amount of
unemployment due to a mismatch of skills and second, the experience of Europe from 1985–98 when
the idea took hold that if actual unemployment remains high for long enough, the natural
unemployment rate rises to meet the actual rate of unemployment.
26. There are at least five aspects of the human costs of persistently high unemployment. The first is that
the loss of income for a sufficiently long period of time can result in the losses of homes and/or cars
and that the loss of either would mark the end of a middle class lifestyle which is a hallmark of
American identity. Second, young people find it very difficult to find jobs, which leaves gaps in their
resumes as well as making it hard for them to move away from their parents or to marry and start
families. Third, those over 50 who have been unemployed for a long period of time may find
themselves subject to age discrimination or be concerned as to whether they will ever work again.
Fourth, persistently high unemployment results in higher rates of suicide and homicide, increased
incidences of physical and mental illnesses, and an increase in the prison population. Finally, our
society values work highly, as exemplified by the first question that is often asked when meeting a
person for the first time concerns what is person’s occupation. As a result many of the long-term
unemployed find themselves losing their self-esteem as well.
27. The difference in the behaviors of unemployment rates in Germany and the United States was not the
result of a difference in the behavior of the output gaps in the two countries, as they fall by almost the
same amounts between 2007 and 2009. Rather, German firms reduced hours of work rather than the
number of employees as did American businesses. Part of the behavior is the result of subsidies
provided to Germany firms by the German government for such “work-sharing” agreements and part
of the behavior is caused by greater cooperation between German firms and unions that is the result of
Germany’s labor markets and its laws.
28. The collapse of the housing bubble made the problem of solving high mismatch of unemployment
more difficult in two ways. First, the collapse of the housing bubble left many unemployed people
unable to either make their mortgage payments or allow them to sell their homes at a price that would
enable them to pay off their mortgages. Therefore if those unemployed wished to move to where they
could find work, they would have to default on their mortgages which would prevent them from
buying houses or perhaps even renting in their desired locations. Second, the collapse of the housing
bubble added to the number of construction workers who were unemployed and these workers did not
have the skills that were in demand, such as in the provision of health care. Therefore the collapse of
the housing bubble contributed to structural unemployment due to both a mismatch of locations and a
mismatch of skills.
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
Answers to Problems in Textbook
1. a. P1 = P0(1 + p)
P2 = P1(1 + p) = P0(1 + p)2
.
.
Pt = P0(1 + p)t.
b. P12 = $1.00 (1 + 0.50)12 = $129.75.
c. p = (P12 – P0)/P0 = 128.75, or 12,875%/yr.
2. a. dPt/dt = P0 ept(dpt/dt) = P0 eptp = p(P0 ept) = pPt
b.
c.
d.
3. a.
b.
c.
d.
(1/Pt)/(dPt/dt) = p.
Take natural logarithms of Pt = P0ept and solve for p.
ln Pt = ln P0 + pt
p = (ln Pt – ln P0)/t.
p = (ln 129.75 – ln 1.00)/12 = 4.86/12 = 0.405, or 40.5%.
p = (ln 129.75 – ln 1.00)/1 = 4.87, or 487%.
Footnote 4 on page 317 tells us that in the long run when actual and natural real GDP grow at the
same rate, the rate of inflation equals the difference between the growth rates of nominal GDP and
natural real GDP, given that the velocity of money is constant. In this problem, the rates of growth
of nominal GDP and natural real GDP equal 5 and 3 percent, respectively. Therefore, the rate of
inflation in the long run equals 5 – 3 = 2 percent.
Given no change in the money supply growth rate, the new rate of inflation in the long run equals
5 – 3.5 = 1.5 percent.
Given the increase in the growth rate of natural real GDP, monetary authorities need to increase the
growth rate of money supply to 5.5 percent per year in order to maintain the rate of inflation at 2
percent in the long run.
The effect of the adverse productivity shock on the growth rate of natural real GDP would cause
the inflation rate to rise to 2.5 percent per year. If monetary authorities wish to maintain an
inflation rate of 2 percent per year, they would need to reduce the growth of the money supply to
4.5 percent per year.
e. Among the arguments for maintaining a constant monetary growth rate and allowing the inflation
rate to vary in the face of changes in the growth rate of natural real GDP is the idea that the public
does not have to try to figure out why monetary authorities are changing their behavior. For
example, the public might perceive an increase in the growth rate of the money supply as an
attempt to drive down unemployment, rather than as a policy of accommodating a beneficial
productivity shock.
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On the other hand, maintaining the growth rate of the money supply at 5 percent means that not
only does the actual inflation rate change, but so also must the expected inflation rate. During the
time between when the actual and expected rates of inflation both change by .5 percentage point,
the output ratio deviates from 100 as the growth rate of actual real GDP differs from the growth
rate of natural real GDP. That change in the output ratio results in a change in the unemployment
rate in the short run. Thus, an argument in favor of maintaining a constant rate of inflation in the
face of a changing growth rate of natural real GDP is that it avoids short-run fluctuations in output
and the unemployment rate, resulting in a more stable macroeconomic environment for firms and
employees.
4. a. $200,000  exp(8  3/100)= $254,250; $254,250.
b. 1  exp(3  3/100) = 1.094; $254,250/1.094 =$232,367.
c. 11%; $200,000  exp(11  3/100)= $278,194; $278,194/1.094 = $254,250, the same as in part a.
5. a. Since the tax rate equals 25 percent, the after-tax nominal interest rate equal (1 – 0.25)8 = 6
percent. Therefore, the after-tax real interest rate equals 6 – 3 = 3 percent, given that the rate of
inflation equals 3 percent.
b. A three percentage point rise in the inflation rate from 3 to 6 percent means that the after-tax
nominal interest rate must also rise by three percentage points from 6 to 9 percent in order to keep
the after-tax real interest rate at 3 percent. Therefore, the nominal interest rate before taxes must
rise by four percentage points from 8 to 12 percent, given that the tax rate is 25 percent.
c. If real interest is taxed, then a real interest rate before taxes of 4 percent yields an after-rate real
interest rate of 3 percent, given that the tax rate is 25 percent.
d. If the Fisher Effect holds, then the nominal interest rate before taxes equals the inflation rate plus
the real interest rate before taxes. Therefore, given that real interest is taxed and the tax rate is 25
percent, nominal interest rates of 7 and 10 percent when the inflations rates equal 3 and 6 percent,
respectively, yield an after-tax real interest rate of 3 percent.
6. a. H/P = $4 billion; p(H/P) = $20 billion;  = – (5/4)( –0.8) = 1.
b. H/P = $4.8 billion; p(H/P) = $19.2 billion;  = – (4/4.8)(– 0.8) = 0.67.
c. H/P = $3.2 billion; p(H/P) = $19.2 billion;  = –(6/3.2)(–0.8) = 1.5.
d. Yes. When  < 1, a reduction in p reduces p(H/P). When  > 1, an increase in p reduces p(H/P).
When  = 1, p(H/P) is at its maximum.
7. a. The amount of seignorage equals the inflation rate times the amount of real high-powered money or
0.05(1,500) = 75.
b. The real interest rate equals 7.5 – 5 = 2.5 percent.
c. The real interest on bonds equals 0.025(2,000) = 50.
d. Equation (9.11) tells us that to keep the real value of bonds and high-powered money constant, the
government budget deficit must equal the amount of seignorage minus the real interest on bonds,
which in this example equals 75 – 50 = 25. Therefore, in order to keep the real value of bonds and
high-powered money constant, taxes must equal 675, given that real government spending equals
700.
e. A fall in the inflation rate from 5 to 4 percent reduces the amount of seignorage to
0.04(1,500) = 60. That is, the amount of seignorage decreases by 15 as the inflation rate fall from 5
to 4 percent.
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f. If the Fisher Effect holds, the nominal interest rate falls by the amount of the reduction in the
inflation rate, leaving the real interest rate and amount of real interest on bonds unchanged at 2.5
percent and 50 percent, respectively. That means that taxes must be increased by 15 percent or
government spending must be cut by 15 percent in order to keep the real value of bonds and highpowered money constant.
8. a. The natural rate of unemployment for the entire labor force is a weighted average of the natural
rates of employment for each of the groups in the labor force. Therefore, the natural rate of
unemployment for the entire labor force equals .55(4.8) + .3(4.5) + .15(13.4) = 6 percent.
b. The new natural rate of unemployment for the entire labor force equals .5(4.8) + .4(4.5) +
.1(13.4) = 5.5 percent. The natural rate of unemployment declined because the percentage of the
labor force that consists of adult females, the group with the lowest natural rate of unemployment,
rose and the percentages of the labor force made up of groups with higher natural rates of
unemployment, adult males and teenagers, fell.
c. The new natural rate of unemployment for the entire labor force equals .5(4.3) +
.4(4.0) + .1(12.5) = 5 percent.
d. Part b tells us that monetary authorities are likely to monitor demographic changes in the labor
force in an effort to decompose any change in the unemployment rate into a cyclical change and a
change in the natural unemployment rate. Part c tells us that monetary authorities are likely to look
for job search innovations and other changes in labor market conditions that would have an effect
on the natural rate of unemployment.
If the Fed had not been paying attention to changes in labor market condition in the 1990s, it would
not have recognized that the natural unemployment rate was declining over course of the decade. In
particular, it might well have taken actions to significantly slow the economy’s growth as the
unemployment rate fell well below 6 percent in the second half of the decade.
9. a. There are eight million people employed in any month when the output gap is zero since two
million people become unemployed in any month when the output gap is zero and they remain
unemployed for four months. Since the unemployment rate when the output gap is zero is the
natural rate of unemployment, the natural rate of unemployment equals 8/160  100 = 5 percent.
b. Since the mild recession increases the number of people who become unemployed in any month to
three million but does affect how long they are unemployed, twelve million people are unemployed
in any month during the mild recession. Therefore the unemployment rate rises to
12/160  100 = 7.5 percent during the mild recession.
c. Since a more severe recession not only increases the number of people who become unemployed in
any month to three million, but also increases how long they are unemployed to eight months, there
are 24 million people unemployed in any month. Therefore the unemployment rate rises to
24/160  100 = 15 percent during the severe recession.
d. There are ten million people now employed in any month when the output gap is zero since while
two million people become unemployed in any month when the output gap is zero as before the
severe recession, it now takes people five months to find new employment. Therefore the new
natural rate of unemployment equals 10/160  100 = 6.25 percent.
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