2003-7-28 1
Chapter 11,Inflation,
activity,and Money Growth
11-1,Output,Unemployment,and Inflation
11-2,The Medium Run
11-3,Disinflation,A First Pass
11-4,Expectations,Credibility,and Nominal
Contracts
11-5,The U.S,Disinflation,1979 to 1985
2003-7-28 2
11-1,Output,Unemployment,and
Inflation
In thinking about the interactions between output,
unemployment,and inflation,you must keep in mind
three relations:
? 1.Okun’s law,which relates the change in unemployment to
the deviation of output growth from normal.
? 2.The Phillips curve,which relates the change in inflation to
the deviation of unemployment from natural rate.
? 3.The aggregate demand relation,which relates output
growth to the rate of growth of nominal money minus the
rate of inflation.
2003-7-28 3
Okun’s law:output growth and
changes in unemployment
We assumed that output and employment moved
together,so change in output led to equal changes in
employment,And we assumed the labor force was
constant,so changes in employment were reflected
one for one in opposite changes in unemployment,Let
gyt denote the growth rate of output,Then,under
these two assumptions,the following relation should
hold:
ut –ut-1=-gyt (11.1)
continue
2003-7-28 4
Okun’s law:output growth and
changes in unemployment
According to the experience,the relation actually
should be:
ut –ut-1= -0.4(gyt – 3%) (11.2)
Equation (11.2) differs in two ways from equation
(11.1)
? Annual output growth has to be at least 3% to prevent the
unemployment rate from rising
? The coefficient on the deviation of output growth from the
normal growth rate is –0.4 in equation (11.2),not –1.0 in
equation (11.1).
To continue
2003-7-28 5
Okun’s law:output growth and
changes in unemployment
There are two reasons why:
? 1.Firm adjust employment less than one for one in response
to deviations of output growth from the normal growth rate,
More specifically,output growth that is 1% above normal for
one year leads to only a 0.6% increase in the employment
rate.
? 2.An increase in the employment rate does not lead to a one
for one decrease in the unemployment rate,More
specifically,a 0.6% increase in the employment rate leads to
only a 0.4% decrease in the unemployment rate.
To continue
2003-7-28 6
Okun’s law:output growth and
changes in unemployment
Using letters rather than numbers,let us write the
relation between output growth and the change in the
unemployment rate as:
ut –ut-1= -β (gyt - gy ) (11.3)
? Where gy is the normal growth rate of the economy (about
3% for the United States),and β tells us how growth in
excess of normal growth translates into decrease in the
unemployment rate,
2003-7-28 7
The Phillips curve:Unemployment
and the change in inflation
We derived in chapter 10 the following relation:
π t-π te = -α(ut - un ) (11.4)
If expected inflation be well approximated by last
year’s inflation,so that we can replace π te by π t-1,
then it should hold:
π t-π t-1= -α(ut - un ) (11.5)
2003-7-28 8
The aggregate demand relation,Money
Growth,Inflation,and Output Growth
In chapter 9,we have the following relation:
Y=Y(M/P,G,T) (9.2)
( +,+,- )
In order to focus on the relation between the real
money stock and output,we shall ignore changes in
factors other than real money here,and write the
aggregate demand relation simply as:
Yt=γ (Mt/Pt ) (11.6)
You should keep in mind,however,that behind this
relation hides the set of steps we saw in the IS-LM
model,To continue
2003-7-28 9
The aggregate demand relation,Money
Growth,Inflation,and Output Growth
? An increase in the real money stock leads to a decrease in
the interest rate.
? The decrease in the interest rate leads to an increase in the
demand for goods and,to an increase in output.
Let gyt be the growth rate of output,Let gmt be the
growth rate of nominal money,and let π t be the
growth rate of prices—the rate of inflation,Then
equation (11.6),it follows that
gyt = gmt -π t (11.7)
2003-7-28 10
11-2,The Medium Run
By far,we have already got the following three relation:
ut –ut-1= -β(gyt - gy )
πt-πt-1= -α(ut - un )
gyt = gmt -πt
Our task is now to see what these three relation imply for the
effects of money growth on output,unemployment and
inflation,We can go some way already,Take for example a
decrease in money growth:
?From the aggregate demand relation,given inflation,lower
money growth implies a decrease in output growth.
?From Okun’s law,this decrease in growth leads to an
increase in unemployment
?From the Phillips curve,higher unemployment implies a
decrease in inflation.
2003-7-28 11
11-2,The Medium Run
We can already see that the initial effects of lower
money growth are to slow output growth,increase
unemployment,and decrease inflation,But what
happens after this initial response is harder to tell,
Does unemployment keep going up? What happens to
inflation? The easiest way to answer these questions
is to work backward in time,to start by looking at the
medium run—that is,where the economy ends when
all the dynamics have worked themselves out—and
then to return to the dynamic,We will first look at the
medium run,then looks at dynamics at the following
section.
2003-7-28 12
11-2,The Medium Run
Assume that the central bank maintain a constant growth rate
of nominal money,call it gm,What will be the values of output
growth,unemployment,and inflation in the medium run?
? In the medium run,unemployment must be constant;
unemployment cannot be increasing or decreasing
forever.Putting ut = ut-1 in Okun’s law implies that gyt = gy,In
the medium run,output grows at its normal rate of growth,gy.
? With money growth equal to gm and output growth equal to gy,
the aggregate demand relation implies that inflation is
constant and satisfies:
gy = gm – π or π = gm – gy
? If inflation is constant,then π t=π t-1,Putting π t-π t-1 in the
Phillips curve implies that ut = un,In the medium run,the
unemployment rate must be equal to the natural rate.
2003-7-28 13
11-3,Disinflation,A First Pass
Two Key Terms
How much unemployment? And for how
long?
Working out the required path of money
growth
2003-7-28 14
Define Two Key Terms
1.Point-year excess unemployment as a difference
between the actual and the natural unemployment rate
of one percentage point for one year,For example,if
the natural rate is 6.5%,an actual unemployment rate
is 9% four years in a row corresponds to 4х(9-6.5)=10
point-years of excess unemployment.
2.Sacrifice ratio as the number of point-year of
excess unemployment needed to achieved a decrease
in inflation of 1%.
2003-7-28 15
How much unemployment? And
for how long?
The Phillips curve relation π t-π t-1= -α(ut - un )
tell us disinflation can be achieved quickly,at
the cost of very high unemployment for a few
years; or it can be achieved more slowly,with a
smaller increase in unemployment spread over
more years,In both cases,the total amount of
unemployment,summing over the years,will be
the same.
2003-7-28 16
Working out the required path
of money growth
If we assume that the central bank decides to
decrease the inflation rate from 14% to 4% in five
years,The normal output growth is 3%,The natural
rate of unemployment is 6.5%,The parameter α in the
Phillips curve is equal to 1; β in Okun’s law is equal
to 0.4,Table 11-1 shows how to derive the path of
money growth needed to achieved 10% dieinflation
over five years,
2003-7-28 17
Table 11-1,Engineering Disinflation
Year
Before Disinflation After
0 1 2 3 4 5 6 7 8
Inflation(%) 14 12 10 8 6 4 4 4 4
Unemployment 6.5 8.5 8.5 8.5 8.5 8.5 6.5 6.5 6.5
rate(%)
Output 3 -2 3 3 3 3 8 3 3
rate(%)
Normal money 17 10 13 11 9 7 12 7 7
Growth (%)
2003-7-28 18
11-4,Expectations,Credibility,and
Nominal Contract
Expectations and Credibility,
The Lucas Critique
Nominal Rigidities and
contracts
2003-7-28 19
Expectations and Credibility,
The Lucas Critique
Lucas pointed out that when trying to predict the effects of a
major change in policy—such as the change considered by the
Fed at the time—it could be very misleading to take as given
the relations estimated from past data.
If people believed that the Fed was committed to lower inflation,
they might well expect inflation to be lower in the future than in
the past,If they lowered their expectations of inflation,then
actual inflation would decline without the need for a protracted
recession.
The logic of lucas’s argument can be seen by returning to
equation (11.4),π t=π te - α(ut - un )
To continue
2003-7-28 20
Expectations and Credibility,
The Lucas Critique
For example,if wage setters were convinced that inflation,
which had been running at 14%,in the past,would be only 4%
in the future,and if they formed expectations accordingly,then
inflation would be decrease to 4% even if unemployment
remained at the natural rate.
πt =πte - α(ut - un )
4% = 4% - 0%
Of cause,Lucas did not believed that disinflation could really
take place without some increase in unemployment,But they
believed in order to do so,it is very important to keep a
credibility of monetary policy—the belief by wage setters that
the central bank was truly committed to reducing inflation.
2003-7-28 21
Nominal Rigidities and
contracts
A contrary view was taken by Stanley Fisher and John
Taylor,They emphasized the presence of nominal
rigidities,meaning that in modern economies,many
wages and prices are set in nominal terms for some
time and are typically not readjusted when there is a
change in policy,
The reasons is,first,to change price needs costs,
some economists tell these costs as menu costs,
Second,in fact,in real world,an important
characteristic of wage contracts is that they are not all
signed at the same time.
2003-7-28 22
11-5,The U.S,Disinflation,1979 to 1985
Table 11-2 Inflation and unemployment,1979-1985
1979 1980 1981 1982 1983 1984 1985
1.GDP growth(%) 2.5 -0.5 1.8 -2.2 3.9 6.2 3.2
2.Unemployment rate 5.8 7.1 7.6 9.7 9.6 7.5 7.2
3.CPI inflation (%) 13.3 12.5 8.9 3.8 3.8 3.9 3.8
4.Cumulative unemployment 0.6 1.7 4.9 8.0 9.0 9.7
5.Cumulative disinflation 0.8 4.4 9.5 9.5 9.4 9.5
6.Sacrifice ratio 0.75 0.39 0.51 0.84 0.95 1.02
Note,Cumulative unemployment is the sum of point-year of
excess unemployment from 1980 on,assuming a natural rate of
6.5%,Cumulative disinflation is the difference between
inflation in a given year and inflation in 1979,The sacrifice
ratio is the ratio of cumulative unemployment to cumulative
disinflation.
2003-7-28 23
Summary for this part
Disinflations typically lead to higher unemployment for
some time,Put another way,even if it is neutral in the
medium run,a decrease in money growth leads to an
increase in unemployment for some time.
Faster disinflations are associated with smaller
sacrifice ratios,This conclusion provides some
evidence to support the expectation and credibility
effects emphasized by Lucas.
Sacrifice ratios are smaller in countries that have
shorter wage contracts,This provides some evidence
to support Fisher and Taylor’s emphasis on the
importance of the structure of wage settlements.
Chapter 11,Inflation,
activity,and Money Growth
11-1,Output,Unemployment,and Inflation
11-2,The Medium Run
11-3,Disinflation,A First Pass
11-4,Expectations,Credibility,and Nominal
Contracts
11-5,The U.S,Disinflation,1979 to 1985
2003-7-28 2
11-1,Output,Unemployment,and
Inflation
In thinking about the interactions between output,
unemployment,and inflation,you must keep in mind
three relations:
? 1.Okun’s law,which relates the change in unemployment to
the deviation of output growth from normal.
? 2.The Phillips curve,which relates the change in inflation to
the deviation of unemployment from natural rate.
? 3.The aggregate demand relation,which relates output
growth to the rate of growth of nominal money minus the
rate of inflation.
2003-7-28 3
Okun’s law:output growth and
changes in unemployment
We assumed that output and employment moved
together,so change in output led to equal changes in
employment,And we assumed the labor force was
constant,so changes in employment were reflected
one for one in opposite changes in unemployment,Let
gyt denote the growth rate of output,Then,under
these two assumptions,the following relation should
hold:
ut –ut-1=-gyt (11.1)
continue
2003-7-28 4
Okun’s law:output growth and
changes in unemployment
According to the experience,the relation actually
should be:
ut –ut-1= -0.4(gyt – 3%) (11.2)
Equation (11.2) differs in two ways from equation
(11.1)
? Annual output growth has to be at least 3% to prevent the
unemployment rate from rising
? The coefficient on the deviation of output growth from the
normal growth rate is –0.4 in equation (11.2),not –1.0 in
equation (11.1).
To continue
2003-7-28 5
Okun’s law:output growth and
changes in unemployment
There are two reasons why:
? 1.Firm adjust employment less than one for one in response
to deviations of output growth from the normal growth rate,
More specifically,output growth that is 1% above normal for
one year leads to only a 0.6% increase in the employment
rate.
? 2.An increase in the employment rate does not lead to a one
for one decrease in the unemployment rate,More
specifically,a 0.6% increase in the employment rate leads to
only a 0.4% decrease in the unemployment rate.
To continue
2003-7-28 6
Okun’s law:output growth and
changes in unemployment
Using letters rather than numbers,let us write the
relation between output growth and the change in the
unemployment rate as:
ut –ut-1= -β (gyt - gy ) (11.3)
? Where gy is the normal growth rate of the economy (about
3% for the United States),and β tells us how growth in
excess of normal growth translates into decrease in the
unemployment rate,
2003-7-28 7
The Phillips curve:Unemployment
and the change in inflation
We derived in chapter 10 the following relation:
π t-π te = -α(ut - un ) (11.4)
If expected inflation be well approximated by last
year’s inflation,so that we can replace π te by π t-1,
then it should hold:
π t-π t-1= -α(ut - un ) (11.5)
2003-7-28 8
The aggregate demand relation,Money
Growth,Inflation,and Output Growth
In chapter 9,we have the following relation:
Y=Y(M/P,G,T) (9.2)
( +,+,- )
In order to focus on the relation between the real
money stock and output,we shall ignore changes in
factors other than real money here,and write the
aggregate demand relation simply as:
Yt=γ (Mt/Pt ) (11.6)
You should keep in mind,however,that behind this
relation hides the set of steps we saw in the IS-LM
model,To continue
2003-7-28 9
The aggregate demand relation,Money
Growth,Inflation,and Output Growth
? An increase in the real money stock leads to a decrease in
the interest rate.
? The decrease in the interest rate leads to an increase in the
demand for goods and,to an increase in output.
Let gyt be the growth rate of output,Let gmt be the
growth rate of nominal money,and let π t be the
growth rate of prices—the rate of inflation,Then
equation (11.6),it follows that
gyt = gmt -π t (11.7)
2003-7-28 10
11-2,The Medium Run
By far,we have already got the following three relation:
ut –ut-1= -β(gyt - gy )
πt-πt-1= -α(ut - un )
gyt = gmt -πt
Our task is now to see what these three relation imply for the
effects of money growth on output,unemployment and
inflation,We can go some way already,Take for example a
decrease in money growth:
?From the aggregate demand relation,given inflation,lower
money growth implies a decrease in output growth.
?From Okun’s law,this decrease in growth leads to an
increase in unemployment
?From the Phillips curve,higher unemployment implies a
decrease in inflation.
2003-7-28 11
11-2,The Medium Run
We can already see that the initial effects of lower
money growth are to slow output growth,increase
unemployment,and decrease inflation,But what
happens after this initial response is harder to tell,
Does unemployment keep going up? What happens to
inflation? The easiest way to answer these questions
is to work backward in time,to start by looking at the
medium run—that is,where the economy ends when
all the dynamics have worked themselves out—and
then to return to the dynamic,We will first look at the
medium run,then looks at dynamics at the following
section.
2003-7-28 12
11-2,The Medium Run
Assume that the central bank maintain a constant growth rate
of nominal money,call it gm,What will be the values of output
growth,unemployment,and inflation in the medium run?
? In the medium run,unemployment must be constant;
unemployment cannot be increasing or decreasing
forever.Putting ut = ut-1 in Okun’s law implies that gyt = gy,In
the medium run,output grows at its normal rate of growth,gy.
? With money growth equal to gm and output growth equal to gy,
the aggregate demand relation implies that inflation is
constant and satisfies:
gy = gm – π or π = gm – gy
? If inflation is constant,then π t=π t-1,Putting π t-π t-1 in the
Phillips curve implies that ut = un,In the medium run,the
unemployment rate must be equal to the natural rate.
2003-7-28 13
11-3,Disinflation,A First Pass
Two Key Terms
How much unemployment? And for how
long?
Working out the required path of money
growth
2003-7-28 14
Define Two Key Terms
1.Point-year excess unemployment as a difference
between the actual and the natural unemployment rate
of one percentage point for one year,For example,if
the natural rate is 6.5%,an actual unemployment rate
is 9% four years in a row corresponds to 4х(9-6.5)=10
point-years of excess unemployment.
2.Sacrifice ratio as the number of point-year of
excess unemployment needed to achieved a decrease
in inflation of 1%.
2003-7-28 15
How much unemployment? And
for how long?
The Phillips curve relation π t-π t-1= -α(ut - un )
tell us disinflation can be achieved quickly,at
the cost of very high unemployment for a few
years; or it can be achieved more slowly,with a
smaller increase in unemployment spread over
more years,In both cases,the total amount of
unemployment,summing over the years,will be
the same.
2003-7-28 16
Working out the required path
of money growth
If we assume that the central bank decides to
decrease the inflation rate from 14% to 4% in five
years,The normal output growth is 3%,The natural
rate of unemployment is 6.5%,The parameter α in the
Phillips curve is equal to 1; β in Okun’s law is equal
to 0.4,Table 11-1 shows how to derive the path of
money growth needed to achieved 10% dieinflation
over five years,
2003-7-28 17
Table 11-1,Engineering Disinflation
Year
Before Disinflation After
0 1 2 3 4 5 6 7 8
Inflation(%) 14 12 10 8 6 4 4 4 4
Unemployment 6.5 8.5 8.5 8.5 8.5 8.5 6.5 6.5 6.5
rate(%)
Output 3 -2 3 3 3 3 8 3 3
rate(%)
Normal money 17 10 13 11 9 7 12 7 7
Growth (%)
2003-7-28 18
11-4,Expectations,Credibility,and
Nominal Contract
Expectations and Credibility,
The Lucas Critique
Nominal Rigidities and
contracts
2003-7-28 19
Expectations and Credibility,
The Lucas Critique
Lucas pointed out that when trying to predict the effects of a
major change in policy—such as the change considered by the
Fed at the time—it could be very misleading to take as given
the relations estimated from past data.
If people believed that the Fed was committed to lower inflation,
they might well expect inflation to be lower in the future than in
the past,If they lowered their expectations of inflation,then
actual inflation would decline without the need for a protracted
recession.
The logic of lucas’s argument can be seen by returning to
equation (11.4),π t=π te - α(ut - un )
To continue
2003-7-28 20
Expectations and Credibility,
The Lucas Critique
For example,if wage setters were convinced that inflation,
which had been running at 14%,in the past,would be only 4%
in the future,and if they formed expectations accordingly,then
inflation would be decrease to 4% even if unemployment
remained at the natural rate.
πt =πte - α(ut - un )
4% = 4% - 0%
Of cause,Lucas did not believed that disinflation could really
take place without some increase in unemployment,But they
believed in order to do so,it is very important to keep a
credibility of monetary policy—the belief by wage setters that
the central bank was truly committed to reducing inflation.
2003-7-28 21
Nominal Rigidities and
contracts
A contrary view was taken by Stanley Fisher and John
Taylor,They emphasized the presence of nominal
rigidities,meaning that in modern economies,many
wages and prices are set in nominal terms for some
time and are typically not readjusted when there is a
change in policy,
The reasons is,first,to change price needs costs,
some economists tell these costs as menu costs,
Second,in fact,in real world,an important
characteristic of wage contracts is that they are not all
signed at the same time.
2003-7-28 22
11-5,The U.S,Disinflation,1979 to 1985
Table 11-2 Inflation and unemployment,1979-1985
1979 1980 1981 1982 1983 1984 1985
1.GDP growth(%) 2.5 -0.5 1.8 -2.2 3.9 6.2 3.2
2.Unemployment rate 5.8 7.1 7.6 9.7 9.6 7.5 7.2
3.CPI inflation (%) 13.3 12.5 8.9 3.8 3.8 3.9 3.8
4.Cumulative unemployment 0.6 1.7 4.9 8.0 9.0 9.7
5.Cumulative disinflation 0.8 4.4 9.5 9.5 9.4 9.5
6.Sacrifice ratio 0.75 0.39 0.51 0.84 0.95 1.02
Note,Cumulative unemployment is the sum of point-year of
excess unemployment from 1980 on,assuming a natural rate of
6.5%,Cumulative disinflation is the difference between
inflation in a given year and inflation in 1979,The sacrifice
ratio is the ratio of cumulative unemployment to cumulative
disinflation.
2003-7-28 23
Summary for this part
Disinflations typically lead to higher unemployment for
some time,Put another way,even if it is neutral in the
medium run,a decrease in money growth leads to an
increase in unemployment for some time.
Faster disinflations are associated with smaller
sacrifice ratios,This conclusion provides some
evidence to support the expectation and credibility
effects emphasized by Lucas.
Sacrifice ratios are smaller in countries that have
shorter wage contracts,This provides some evidence
to support Fisher and Taylor’s emphasis on the
importance of the structure of wage settlements.
