1 / 45

Chapter 33

Chapter 33. The Trade-Off between Inflation and Unemployment. We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER. Trade-off: Inflation & Unemployment. High-growth policies Reduce unemployment Tend to raise inflation Slow-growth policies

hilde
Download Presentation

Chapter 33

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Chapter 33 The Trade-Off between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER

  2. Trade-off: Inflation & Unemployment • High-growth policies • Reduce unemployment • Tend to raise inflation • Slow-growth policies • Reduce inflation • Tend to raise unemployment • Aggregate supply curve • Fairly flat in short run • Quite steep in long run

  3. Demand-side vs. Supply-side Inflation • Major source of inflation • Rapid growth of aggregate demand • C, I, G, X-IM • Multiplier effect • Inflation & increased output • Demand-side inflation = rise in price level • Cause: rapid growth of aggregate demand • Accompanied: rapid growth in real GDP

  4. Figure 1 Inflation from the demand side D1 D0 S B A Price Level D0 D1 S Real GDP

  5. Demand-side vs. Supply-side Inflation • Source of inflation • Factors - retard growth of aggregate supply • Aggregate supply – inward shift • Inflation & decrease in output • Stagflation • Supply-side inflation = rise in price level • Cause: slow growth or decline of aggregate supply • Accompanied by stagnant/or falling GDP

  6. Figure 2 Inflation from the supply side D0 B S0 S1 A Price Level D0 S0 S1 Real GDP

  7. Origins of the Phillips Curve • Business fluctuations – from demand • Inverse relationship • Unemployment • Inflation • Faster growth of real output • Faster growth - number of jobs • Lower unemployment • Slower growth of real output • Slower growth - number of jobs • Higher unemployment

  8. Figure 3 Origins of the Phillips Curve B A C Inflation Rate 2 1 3 0 4% 6% 5% Unemployment rate

  9. Origins of the Phillips Curve • Phillips curve - graph • Horizontal axis - rate of unemployment • Vertical axis • Rate of inflation • Rate of change in money wages • Downward-sloping • Higher inflation rates • Lower unemployment rates

  10. Figure 4 The original Phillips Curve

  11. Origins of the Phillips Curve • Phillips curve • Short-run trade-off • Inflation & unemployment • Fits data • U.S. post WWII • 1960s and 1970s • Doesn’t fit data: 1970s, 1980s • High unemployment • High inflation

  12. Figure 5 A Phillips Curve for the United States, 1954–1969

  13. Figure 6 A Phillips Curve for the United States?

  14. Supply-side Inflation & Phillips Curve • Inflation 1972 – 1982 • Adverse supply shocks • Crop failures 1972-1973 • Oil price increases • 1973-1974 • 1979-1980 • Prices rise • Output falls • Rise in unemployment

  15. Supply-side Inflation & Phillips Curve • Business fluctuations – from supply • Higher rates of inflation • Higher rates of unemployment • Lower rates of inflation • Lower rates of unemployment

  16. Supply-side Inflation & Phillips Curve • 1996-1998 • Favorable supply shocks • Oil prices – plummeted • Advances in technology • Value of U.S. dollar – rise • Aggregate demand – shift outward • Aggregate supply – shift outward more • Rapid growth • Reduce unemployment • Inflation – falls

  17. Figure 7 S0 The effects of a favorable supply shock S1 Normal growth of aggregate supply Effect of favorable supply shock C A B D0 D1 Price Level D0 D1 S1 S0 Real GDP

  18. What the Phillips Curve is Not • Phillips curve • Statistical relationship • Inflation & unemployment • Business fluctuations – from demand • 1970s, 1980s • Misinterpretation • Alternative equilibrium points

  19. What the Phillips Curve is Not • Self-correcting mechanism • No government intervention • Corrects inflationary gap • Inward shift – aggregate supply • Corrects recessionary gap • Outward shift – aggregate supply

  20. Figure 8 The elimination of a recessionary gap Potential GDP S0 S1 S2 A B C Price Level D D S0 S1 S2 Real GDP

  21. What the Phillips Curve is Not • Phillips curve diagram • Inflationary gap points • High inflation & low unemployment • Cannot be maintained indefinitely • Lead: rising unemployment & rising inflation • Recessionary gap points • Low inflation & high unemployment • Cannot be maintained indefinitely • Lead: falling inflation & falling unemployment

  22. Figure 9 The vertical long-run Phillips Curve 8% 7 6 5 Inflation Rate 4 d a e f g 3 c 2 1 0 3.5 4 4.5 5 5.5 6 6.5 7 Unemployment Rate in Percent

  23. What the Phillips Curve is Not • Economy’s self-correcting mechanism • Push unemployment rate • Toward a specific rate of unemployment • “Natural rate of unemployment” • Vertical (long-run) Phillips curve • Points: inflation & unemployment • Choices available to society in long run • Vertical straight line • At natural rate of unemployment

  24. Trade-off: inflation & unemployment • Short run • “Ride up the Phillips curve” • Lower levels of unemployment • Stimulate aggregate demand • “Ride down the Phillips curve” • Lower rates of inflation • Restrict growth of aggregate demand

  25. Trade-off: inflation & unemployment • Short run • Trade-off between unemployment & inflation • Stimulate demand • Lower unemployment • Worsen inflation • Restricting demand • Lower inflation • Worsen unemployment problem

  26. Trade-off: inflation & unemployment • Long run • No trade-off • Economy’s self-correcting mechanism • Unemployment - Natural rate • Faster growth of demand • Higher inflation • Not lower unemployment • Slower growth of demand • Lower inflation • Not higher unemployment

  27. Fighting Unemployment: Fiscal & Monetary • Recessionary gap, 2001 • Self-correcting mechanism • Decline unemployment & inflation • May take too long • Expansionary monetary policy • The Fed – cut interest rates • Expansionary fiscal policy • Increase spending (defense & security) • Tax cut • Faster recovery & higher inflation rate

  28. What Should Be Done ? • Reduce unemployment more rapidly • Expansionary fiscal & monetary policies • Permanently higher inflation rate • Policy makers • Costs of inflation & unemployment • Slope of short run Phillips curve • Efficiency of economy’s self-correcting mechanism

  29. Inflationary Expectations & Phillips Curve • Aggregate supply curve – slopes upward • Business • Long-term contacts: labor, inputs • Fixed input cost (money) • Prices of goods – rise • Real wages – fall • Labor – cheaper in real terms • Expand employment & output

  30. Table 1 Money and real wages under unexpected inflation

  31. Inflationary Expectations & Phillips Curve • Fixed money wage – long-term contract • Inflation: Lower real wage • Firms: increase production & employment • Compensation for inflation • Increasing real wage • Firms: no incentive to increase production • Aggregate supply: vertical line • Potential GDP

  32. Table 2 Money and real wages under expected inflation

  33. Figure 10 Vertical aggregate supply curve & corresponding vertical Phillips Curve S Vertical short-run Phillips curve Vertical aggregate supply curve Price Level Inflation Rate S 5 Real GDP Unemployment Rate (b) (a)

  34. Inflationary Expectations & Phillips Curve • Vertical aggregate supply curve • Leads: vertical Phillips curve • Short-run Phillips curve - vertical • Inflation – predicted accurately • Short-run aggregate supply curve • Vertical

  35. Inflationary Expectations & Phillips Curve • Inflation – underestimated • Aggregate supply curve – upward sloping • Unexpectedly high inflation • Reduce real wages • Raise output • Unexpected decline in inflation • Recession

  36. Inflationary Expectations & Phillips Curve • Fail to anticipate inflation correctly • Phillips curve • Slopes downward in short run • Vertical in long run

  37. Theory of Rational Expectations • Rational expectations • Forecasts • Not necessarily correct • Best that can be made • Given - available data • Cannot err systematically • Forecasting errors • Pure random numbers

  38. Theory of Rational Expectations • Rational expectations • Optimal use • Available information • If expectations are rational • Inflation-Expected inflation= A random number • Short run Phillips curve – vertical • Reduce inflation • No decrease in output • No high unemployment • No trade-off (inflation & unemployment)

  39. Theory of Rational Expectations • Reject extreme rational expectations • Contacts – outdated expectations • Expectations – adjust slow • Wages – catch up with inflation • Facts

  40. Why Economists (& Politicians) Disagree • Believers in rational expectations • Believes • Inflation - more costly than unemployment • Short-run Phillips curve – steep • Expectations react quickly • Self-correcting mechanism of economy • Works smoothly and rapidly • Government intervention • Prevent / reduce inflation • Don’t want to fight recessions

  41. Why Economists (& Politicians) Disagree • Keynesian economists • Believes • Unemployment - more costly than inflation • Short-run Phillips curve – flat • Expectations react sluggishly • Self-correcting mechanism • Slow & unreliable • No government intervention • Prevent / reduce inflation (inflationary gap) • Eager to fight recessions

  42. Dilemma of Demand Management • Shifts of aggregate supply curve • Inflation & unemployment • Rise or fall together • Destroy statistical Phillips curve relationship • Monetary & fiscal policy • Shifts aggregate demand curve • Unemployment & inflation • Move in opposite directions

  43. Dilemma of Demand Management • Monetary & fiscal policy authorities • Trade-off: inflation & unemployment • No matter – source of inflation • No matter – Phillips curve

  44. Reduce Natural Rate of Unemployment • Reduce natural rate of unemployment • Lower unemployment • No increase in inflation • Education, training, job placement • Problems • Look better on paper • High cost • Work experience

  45. Indexing • Indexing - provisions in a law / contract • Monetary payments • Automatically adjusted • When price index – changes • Escalator clauses • Wage rates, pensions, • Interest payments on bonds, income taxes • Seeks to reduce: social costs of inflation

More Related