Download Parkin-Bade Chapter 28

Ch. 13: U.S. Inflation, Unemployment
and Business Cycles
 Patterns in output and inflation in the evolving U.S.
economy
 Demand-pull and cost-push inflation.
 SR and LR tradeoff between inflation and
unemployment (Phillips Curve)
 Business cycle theories.
The Misery Index
MI proposed by Arthur Okun in 1970s
MI = inflation rate plus the unemployment rate.
MI peak: 21 in 1981
MI minimum: 6 in 1964 and 1999.
MI in 2007: 4.5% unempl + 4.0% inflation = 8.5%
We want both low inflation & low unemployment – are
there trade-offs between the two?
Real GDP and the Price Level: 1948-2008
The Evolving U.S. Economy
Inflation
The upward movement of
the dots shows inflation.
Recession
Leftward movement of
dots shows declining real
GDP
Economic Growth
The rightward movement
of the dots shows the
growth of real GDP.
Inflation Cycles
In the long run,
• inflation = %ch in M + % ch in V - %ch in y
• inflation occurs if money grows faster than potential GDP.
In the short run,
•Inflation can be caused by
–Increases in AD (demand pull inflation)
–Decreases in SAS (cost push inflation)
Inflation Cycles
Demand-Pull Inflation
•An inflation that starts because aggregate demand increases
•can begin with any factor that increases aggregate demand.
• Examples
–cut in the interest rate
–increase in the quantity of money
–increase in government expenditure
–tax cut
–increase in exports
–increase in investment
Inflation Cycles: Demand Pull
Starting from full
employment, an increase
in AD
•Increases P (inflation)
•Increases RGDP
•Creates inflationary gap
•increase in AD
Inflation Cycles: Demand Pull
Since
unempl < natural rate
• money wage rate rises
• SAS shifts left
• P rises
•RGDP falls until
GDP=potential GDP
Inflation Cycles: Demand Pull
Demand-Pull
Inflation Process:
•AD must continually increase
so that the process described
above repeats itself
•Although any of several factors
can increase aggregate demand
to start a demand-pull inflation,
only an ongoing increase in the
quantity of money can sustain
it.
Inflation Cycles: Cost Push
Cost-Push Inflation
•starts with an increase in costs
•Main sources of increased costs:
– An increase in the money wage rate
–An increase in the money price of raw materials (e.g. oil)
–Natural disasters
•Results in decrease in SAS
Inflation Cycles: Cost Push
Initial Effect of a
Decrease in Aggregate
Supply
A rise in the price of oil
decreases short-run
aggregate supply and
shifts the SAS curve
leftward.
Real GDP decreases
and the price level rises.
“stagflation”
Inflation Cycles: Cost Push
Aggregate Demand Response
The initial increase in costs creates a one-time rise in the
price level, not continued inflation.
To create inflation, aggregate demand must increase.
That is, the Fed must increase the quantity of money
persistently.
Inflation Cycles: Cost Push
Suppose that the Fed
stimulates AD to
counter the higher
unemployment rate
and lower level of real
GDP.
Real GDP increases
and the price level
rises again.
Inflation Cycles: Cost Push
A Cost-Push Inflation
Process
If oil producers raise the
price of oil & workers raise
wages to try to offset price
level increase, SAS shifts left
again
if Fed responds by
increasing M yet again,
cost-push inflation
continues.
Inflation Cycles & Inflation Expectations
Expected Inflation
If inflation is
expected,
• AD increases
• AS decreases as
workers negotiate wage
increases to offset
expected inflation.
Movement along LAS
curve
• No change in real GDP,
real wages, or
unemployment
Inflation Cycles & Inflation Expectations
Inflation and the Business Cycle
When the inflation forecast is correct, the economy
operates at full employment.
If AD grows faster than expected,
•Inflation > expected
•Real wages decrease
–Real GDP increases above potential
–Unemployment rate falls below natural rate
 If AD grows slower than expected
•Inflation < expected
–Real wages rise
–Unemployment rate rises above natural rate
The Phillips Curve
 Phillips curve
•shows the relationship between the inflation rate and the
unemployment rate.
SR Phillips curve
–Shows tradeoff between inflation and unemployment holding constant
»The expected inflation rate
» The natural unemployment rate
LR Phillips curve
•shows the relationship between inflation and unemployment when
the actual inflation rate equals expected inflation
• vertical at natural rate of unemployment
The Phillips Curve
The Short-Run Phillips Curve
The short-run Phillips curve shows the tradeoff
between the inflation rate and unemployment rate, holding
constant
1. The expected inflation rate
2. The natural unemployment rate
The Phillips Curve
A short-run Phillips curve
(SRPC)
• As inflation increases,
unemployment decreases
•AD/AS explanation.
If inflation=expected,
unemployment = natural rate.
 If inflation>expected,
unemployment<natural rate
If inflation < expected,
unemployment>natural rate
The Phillips Curve
The long-run Phillips
curve (LRPC)
•vertical at the natural
unemployment rate.
• intersects SRPC at
expected inflation rate.
• Shifts only if natural
unemployment rates rises
or falls
–Unemployment insurance
–Demographics of labor
force
The Phillips Curve
SRPC shifts
up/down as inflation
expectations rise/fall
The Phillips Curve in U.S.
Business Cycles
Two approaches to understanding business cycles are:
 Mainstream business cycle theory
 Real business cycle theory
Mainstream Business Cycle Theory
Because potential GDP grows at a steady pace while
aggregate demand grows at a fluctuating rate, real GDP
fluctuates around potential GDP.
Business Cycles
Initially, potential GDP is $9 trillion and the economy is at
full employment at point A.
Potential GDP increases to $12 trillion and the LAS curve
shifts rightward.
Business Cycles
Real Business Cycle Theory
Argues that random fluctuations in productivity are the
main source of economic fluctuations.
•productivity fluctuations result mainly from fluctuations in the pace
of technological change.
•other sources might be international disturbances, climate
fluctuations, or natural disasters.
• rapid productivity growth generates expansion; slow productivity
growth (or decreases in productivity) cause contraction.
– productivity growth affects
»Investment
»Labor
Business Cycles
Effect of a negative
productivity shock on
Investment & interest
rates.
•Decreased investment
demand decreases the
demand for loanable funds.
•real interest rate falls and the
quantity of loanable funds
decreases.
•Reverse happens when
there is an expansion caused
by rapid productivity increase
Business Cycles
Effect of a negative
productivity shock on real
wages & employment
•Decreases demand for labor
•The lower real interest rate
(above) causes labor supply to
decrease (intertemporal
substitution effect)
•Employment and the real wage
rate decrease (assuming LD shift
larger than LS).
• Reverse happens when there is
an expansion caused by rapid
productivity increase.