Download Parkin-Bade Chapter 28

Ch. 13: U.S. Inflation, Unemployment
and Business Cycles
 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?
0
20
The Misery Index
01jan1950 01jan1960 01jan1970 01jan1980 01jan1990 01jan2000 01jan2010
date5
Inflation and Unemployment in U.S. 1950-2008
According to the U.S. experience, inflation tends
to ___ during a recession and unemployment
tends to ___ during a recession.
25%
25%
25%
25%
Fo
ur
Ch
oi
ce
Th
re
e
Ch
oi
ce
Tw
o
Ch
oi
ce
Ch
oi
ce
On
e
1. Rise; rise
2. Rise; fall
3. Fall; fall
4. Fall; rise
20
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, according to equation of
exchange:
• 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 initiated by
–Increases in AD (demand pull inflation)
–Decreases in SAS (cost push inflation)
Inflation Cycles
Demand-Pull Inflation
•starts because AD increases
•can begin with any factor that increases AD.
• Examples
–Monetary policy & interest rates
–Fiscal policy: government spending or taxes
–Exports (value of $ or foreign income levels)
–Investment (expected profits, technological advances)
–Consumer expectations
Inflation Cycles: Demand Pull
Starting from full
employment, an
increase in AD
•Increases P (spell of
inflation)
•Increases RGDP
•Creates inflationary gap
Inflation Cycles: Demand Pull
Since
unempl < natural rate
• money wage rate rises
• SAS shifts left
• P rises (another spell of
inflation)
•RGDP falls until
GDP=potential GDP
• Inflation is finished unless
AD increases again.
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 AD to start a demandpull inflation, only an ongoing increase in the quantity of money can
sustain it.
If there is a decrease in AD, the short run
effect is to _____ prices, ____ real wages,
and cause unemployment to _____.
25%
Ch
oi
ce
Fo
ur
25%
Th
re
e
Tw
o
25%
Ch
oi
ce
On
e
25%
Ch
oi
ce
Decrease; decrease; increase
Decrease; increase; increase
Increase; decrease; decrease
None of the above
Ch
oi
ce
1.
2.
3.
4.
20
Inflation Cycles: Cost Push
Cost-Push Inflation
•starts with an increase in costs
•Possible 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
–Regulation (e.g. carbon taxes)
•Results in decrease in SAS
Inflation Cycles: Cost Push
Initial Effect of a
Decrease in AS
A rise in the price of oil
decreases SAS and shifts
the curve leftward.
Real GDP decreases
and the price level rises.
“stagflation” (higher
prices, less output)
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, AD must increase after AS
decreases.
Although any of several factors can increase AD to start
a demand-pull inflation, only an ongoing increase in the
quantity of money can sustain it.
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
If there is exceptionally good weather in
the U.S., this should cause SAS to _____.
The short run effect of this is to _____
prices and _____ real GDP.
25%
Ch
oi
ce
Fo
ur
25%
Th
re
e
Tw
o
25%
Ch
oi
ce
On
e
25%
Ch
oi
ce
Decrease; increase; increase
Increase; decrease; increase
Increase; increase; increase
None of the above
Ch
oi
ce
1.
2.
3.
4.
20
Inflation Cycles & Inflation Expectations
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
AD/AS representation of impact of
inflation > expected inflation
AD/AS representation of impact of
inflation < expected inflation
If the Federal Reserve creates more
money than people expected, in the short
run, this will cause real wages to ____
and unemployment to______.
25%
Ch
oi
ce
Fo
ur
25%
Th
re
e
Tw
o
25%
Ch
oi
ce
Ch
oi
ce
On
e
25%
Ch
oi
ce
1. Rise; rise
2. Rise; fall
3. Fall; fall
4. Fall; rise
20
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
A short-run Phillips
curve (SRPC)
• As inflation increases,
unemployment decreases
•AD/AS explanation.
If inflation=expected,
unempl= natural rate.
 If inflation>expected,
unempl<natural rate
If inflation < expected,
unempl>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
If the Federal Reserve cuts interest rates
unexpectedly, this should cause
25%
Ch
oi
ce
Fo
ur
25%
Th
re
e
Tw
o
25%
Ch
oi
ce
Ch
oi
ce
On
e
25%
Ch
oi
ce
1. A movement downward
along the Phillips curve
2. A movement upward
along the Phillips curve
3. An upward shift of the
Phillips curve
4. A downward shift of the
Phillips curve
20
If the general public begins to believe that
the Federal Reserve stimulus is going to
lead to higher inflation in the future, this
should cause:
Fo
ur
25%
Ch
oi
ce
Th
re
e
25%
Ch
oi
ce
Tw
o
25%
Ch
oi
ce
On
e
25%
Ch
oi
ce
1. A movement
downward along the
Phillips curve
2. A movement upward
along the Phillips
curve
3. An upward shift of the
Phillips curve
4. A downward shift of
the Phillips curve
20
The Phillips Curve in U.S.
Business Cycles
Two approaches to understanding business cycles are:
 Mainstream business cycle theory
 Real business cycle theory
Mainstream (Demand Side) 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
Real Business Cycle Theory
Argues that random fluctuations in productivity are the
main source of economic fluctuations.
•fluctuations in the pace of technological change.
•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 and interest rates
»Labor market and wages
Real Business Cycles: Investment
negative productivity
shock:
• investment demand
and loan demand falls
•Interest rates fall
 reverse happens for
positive productivity
shock
Real Business Cycles: Labor
Negative productivity
shock
•Labor demand decreases
•Labor supply decreases
because of lower interest
rates (above) and
intertemporal subst
•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.