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CHAPTER 9. INFLATION, ACTIVITY, AND
NOMINAL MONEY GROWTH
I.
MOTIVATING QUESTIONS
How Are Output Growth, the Inflation Rate, and the Unemployment Rate
Determined in the Medium Run?
The medium-run economy consists of three relationships: Okun’s law, which links output growth and
unemployment; the aggregate supply relation (the Phillips curve), which links inflation and
unemployment; and the aggregate demand relation (expressed in growth rates and simplified to include
only the real money stock), which links money growth, inflation, and output growth. Medium-run
equilibrium is characterized by a constant unemployment rate (the natural rate), a constant growth rate of
output (the so-called normal growth rate), and an inflation rate that depends on the growth rate of money.
In the medium run, the natural rate of unemployment and the normal growth rate of output are
independent of the growth rate of money.
II.
WHY THE ANSWER MATTERS
Essentially, this chapter expresses the AD-AS analysis of Chapter 7 in terms of growth rates. This
exercise matches the equations of the model with the observed relationships in the data and yields a
fundamental result: in the medium run, money growth determines inflation, but does not affect output
growth or unemployment. This framework allows for analysis of monetary policy decisions more closely
related to real events than one-time changes in the money stock. The cost of disinflation and the scope
for monetary policy to affect output are ongoing questions facing macroeconomic policymakers.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
Okun’s law is a negative relationship between the change in the unemployment rate and the
difference between the growth rate of output and its normal rate, which is the sum of average annual
productivity growth and labor force growth.
ii.
A point-year of excess unemployment is one year of an unemployment rate one percentage point
above the natural rate. The sacrifice ratio is the number of point years of excess unemployment required
to reduce the inflation rate by one percent.
iii. The Lucas critique is the argument that historical relationships between macroeconomic variables
may provide a misleading guide to the effects of policy changes, since the relationships may depend upon
the policy environment.
IV. SUMMARY OF THE MATERIAL
1.
Output, Unemployment, and Inflation
The dynamic model presented in this chapter has three ingredients: Okun’s law, the aggregate supply
relation expressed in terms of growth rates and aggregate demand relation expressed in terms of growth
rates. The aggregate supply relation is the Phillips curve.
i.
Okun’s Law. Okun’s law is a relationship between changes in the unemployment rate and the
growth rate of output. The model presented in the text, with no productivity growth and a fixed labor
force, implies that the unemployment rate should fall when output growth is positive and rise when
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growth is negative (see Part VI below for a formal derivation). In fact, the empirical relationship
between the unemployment rate and output growth in the United States since 1960 is given by
ut-ut-1=-0.4(gy,t-3%),
(9.1)
where gy,t is the growth rate of output at time t. The observed relationship differs from the one implied
by the basic model of the text in two fundamental ways. First, output growth must exceed 3% in order
for the unemployment rate to fall. The growth rate required to maintain a constant unemployment rate is
called the normal growth rate. Second, the coefficient on output growth is not -1, but -0.4.
The 3% threshold for output growth arises from productivity growth and labor force growth. Productivity
growth implies that fewer workers are required to produce a given quantity of goods. Thus, for
employment to remain constant, output growth must match productivity growth. Labor force growth
implies that unemployment will increase unless employment grows correspondingly. In the United States,
the sum of productivity growth and labor force growth has been about 3% per year since 1960.
Therefore, output must grow by at least 3% to prevent an increase in the unemployment rate.
The coefficient of -0.4 arises for three reasons. First, firms do not adjust employment one for one with
output growth. Some workers are needed to operate a firm regardless of output. In addition, firms may
hoard (not fire) workers in bad times to avoid the cost of training new workers in good times. Second, an
increase in the employment rate tends to increase the labor force participation rate, which limits the
effect of output growth on the observed unemployment rate.
In symbols, Okun’s law can be written as
ut-ut-1=- (gy,t-gy),
(9.2)
ii.
The Aggregate Supply Relation. The aggregate supply relation is the Phillips curve. The text
uses the accelerationist Phillips curve from Chapter 8 for the medium-run model. If expected inflation
equals lagged inflation, then the Phillips curve is
πt-πt-1=-(ut –un).
(9.3)
iii.
The Aggregate Demand Relation. The final component of the medium-run model is aggregate
demand. For simplicity, the text focuses on real money and writes aggregate demand as follows:
Y=M/P.
(9.4)
Equation (9.2) implies
gy =gm-π,
(9.5)
where gm is the growth rate of money.
2.
The Effects of Money Growth
Assume that the central bank maintains a constant growth rate of money, g m . In the medium run, the
unemployment rate will be constant. From Okun’s law, a constant unemployment rate implies that
output grows at its normal rate. From the aggregate demand relation, inflation will equal the difference
between the growth rate of money and the normal rate of output growth. So, inflation is constant. From
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the Phillips curve, constant inflation implies that the unemployment rate equals the natural rate. In
medium run, the unemployoment rate is the natural rate, output growth equals its normal rate, and
inflation equals money growth minus the normal rate of growth.
The implication of this analysis is that money growth affects only the inflation rate in the medium run.
Money growth has no effect on medium-run output growth or unemployment. By the same token,
inflation is ultimately determined by monetary policy.
If the economy starts in a medium-run equilibrium, then a permanent decrease in money growth will lead
to a recession and a fall in inflation in the short run. From the aggregate demand relation, given inflation,
a fall in money growth leads to a fall in output growth, so that growth is below the normal rate. From
Okun’s law, a rate of growth below the normal rate leads to an increase in the unemployment rate, so that
unemployment is above the natural rate. From the Phillips curve, unemployment above the natural rate
leads to a fall in inflation. In the medium run, the lower rate of money growth will lead to lower
inflation, but have no effect on output growth or the unemployment rate. The path from the short run to
the medium run depends upon the path of monetary policy.
The text traces the dynamic effects of a particular path of monetary policy, assuming that the central
bank controls real money growth. This assumption is not limiting, since for any given inflation rate, the
central bank can adjust nominal money growth so as to achieve any rate of real money growth in the
short run.
3.
Disinflation
Suppose policymakers wish to reduce inflation. The Phillips curve implies that a reduction in inflation
will require an unemployment rate higher than the natural rate for some time. The issue is the size of the
unemployment cost and how the structure of a disinflation program affects the cost.
Define a point-year of excess unemployment as one year of an unemployment rate one point above the
natural rate. Define the sacrifice ratio as the number of point-years of excess unemployment required to
reduce the inflation rate by one percentage point. The accelerationist Phillips curve implies a sacrifice
ratio of 1/, where  is the coefficient on the unemployment rate. In the United States,  is roughly
equal to one, so the sacrifice ratio is roughly equal to one. Moreover, the linearity of the Phillips relation
implies that the sacrifice ratio is independent of the path of the inflation rate. Thus, in the United States,
a cumulative ten percentage point reduction in the inflation rate implies ten cumulative point-years of
excess unemployment. The actual trajectory of the unemployment rate depends upon the trajectory of the
inflation rate.
In the mid-1970s, Robert Lucas argued that the disinflation analysis described above was likely to
provide a misleading guide to the effects of policy. Necessarily, the estimated Phillips curve and Okun’s
law depend on historical data. Changes in policy, however, might change the historical relationships
between variables. In particular, the way inflation expectations are formed might vary with the policy
environment. This argument has come to be known as the Lucas critique.
The accelerationist Phillips curve assumes that expected inflation equals lagged inflation. In a
disinflation, however, if the central bank could actually convince wage setters that it intended to reduce
inflation, wage setters might expect inflation to be lower in the future than in the past. In the extreme, if
the central bank announced its inflation target, and wage setters believed it, disinflation could be
achieved without any increase in the unemployment rate above the natural rate.
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The Lucas critique implies that credibility is an important determinant of the costs of disinflation. If
policymakers can convince wage setters that a disinflation will be implemented, the policy can be carried
out with relatively little increase in unemployment.
In response to the credibility argument, Stanley Fischer and John Taylor argued that the presence of
nominal rigidities implied that even credible disinflations could be costly. Fischer emphasized that
inflation would already be built into existing wage agreements and could not be reduced without cost.
Taylor emphasized that wages were not all set at the same time. He argued that, assuming that workers
cared about their wages relative to the wages of other workers, the existence of staggered wage contracts
implied that wages (and hence prices) would adjust only slowly to changes in policy. As a result, a too
rapid reduction in nominal money growth would lead to a less than proportional decrease in inflation.
The real money stock would decline, leading to a recession and an increase in the unemployment rate.
In the late 1970s, using data on the pattern of wage contracts in the United States, Taylor estimated a path
of disinflation for the U.S. economy that would not increase the unemployment rate. The required
disinflation began relatively slowly and increased over time. A problem with such a policy course,
however, is that wage setters might not find it credible. Why should they believe a central bank that
promises disinflation in the future?
The Volcker disinflation, which is analyzed in a box in the text, provides a test of the credibility
argument. Over the period 1979-1985, the United States reduced inflation by 10% at a cost of 12 pointyears of excess unemployment. There were no obvious credibility gains, even though Volcker had (and
has) a reputation as a tough anti-inflation fighter. Credibility theorists, however, can argue that Volcker
lost his credibility when the Fed eased policy in 1980, in response to the recession. Or you could argue
correctly that the Fed got scared by double-digit unemployment and backed down. Remember they were
trying a new form of monetary policy that had not been used for quite some time (if ever). Impacts on
the economy were very uncertain.
More systematic evidence on the cost of disinflation is provided in work by Laurence Ball, who analyzes
65 disinflation episodes in OECD countries over the past 35 years. Ball concludes that disinflations
typically lead to a period of higher unemployment, that faster disinflations are associated with smaller
sacrifice ratios, and that sacrifice ratios are smaller in countries with shorter wage contracts. The results
provide some support for the credibility argument (since rapid disinflation is usually thought to be more
credible) and for the arguments of Fisher and Taylor about wage contracts.
V.
PEDAGOGY
Inflation is not a familiar phenomenon to U.S. students today. The Volcker disinflation episode is
ancient history to them. Many will have never heard of Volcker. The cost of the Volcker disinflation
can perhaps be cited as a factor that leads to fear of inflation—and the costs of disinflation—today.
VI. EXTENSIONS
Instructors could supplement the informal discussion of normal output growth with a formal derivation.
Suppose Y=AN. Then,
∆Y/Y ≈ ∆A/A+∆N/N.
(9.6)
The definition of the employment rate, N=L(1-u), implies that
∆N=∆L(1-u)-L∆u,
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or
∆u=-∆N/L –N∆L/(L2)=(N/L)[( ∆L/L)- (∆N/N)] ≈ (∆L/L)- (∆N/N),
(9.7)
where the last approximation is valid if u is small, so that N/L ≈ 1. Substituting equation 9.6 into
equation 9.7 implies
∆u =-(∆Y/Y-∆A/A-∆L/L).
Normal output growth is productivity growth (∆A/A) plus labor force growth (∆L/L). The unemployment
rate declines when output grows faster than its normal rate.
VII. OBSERVATIONS
Although the model in this chapter abstracts from fiscal policy, there is an important historical
mechanism by which fiscal policy has been linked to inflation. Governments that run persistent budget
deficits sometimes resort to money creation to finance them. The money creation leads to inflation.
Indeed, every historical episode of hyperinflation has been associated with monetary financing of budget
deficits. Chapter 23 discusses hyperinflation. Of course this, in turn, depends on the degree of central
bank independence.
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