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Chapter 13 Unemployment and Inflation. Economics 282 University of Alberta. Unemployment and Inflation. The Phillips curve is a negative empirical relationship between unemployment and inflation. In 1970-2003 there seemed to be no reliable relationship between unemployment and inflation.

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Chapter 13 unemployment and inflation l.jpg

Chapter 13Unemployment and Inflation

Economics 282

University of Alberta


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Unemployment and Inflation

  • The Phillips curve is a negative empirical relationship between unemployment and inflation.

  • In 1970-2003 there seemed to be no reliable relationship between unemployment and inflation.


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The Expectations Augmented Phillips Curve

  • A negative relationship should exist between unanticipated inflation and cyclical unemployment.


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The Phillips Curve (continued)

  • If increase in M is anticipated, there is no misperception, the economy remains at , unemployment remains at , cyclical unemployment is zero.


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The Phillips Curve (continued)

  • If increase in M is unanticipated, unanticipated inflation is created, Y is above , u is below .


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The Phillips Curve (continued)

  • h measures the strength of the relationship between unanticipated inflation and cyclical unemployment.


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The Phillips Curve (continued)

  • The expectation-augmented Phillips curve states that π exceeds πeif u is less than .

    h is related to the slope of the SRAS curve.


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Shifting of the Philips Curve

  • The Phillips curve depends on the expected rate of inflation and the natural rate of unemployment. If either factor changes the Phillips curve will shift.


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Changes in the Expected Rate of Inflation

  • If households anticipate a change in the price level they respond by their expectations of the price level (the rate of inflation) one-for-one.

  • The Phillips curve shifts up by the amount of the increase in the expected rate of inflation.


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Changes in the Natural Rate of Unemployment

  • An increase in the natural unemployment rate causes the Phillips curve to shift up and to the right.


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Supply Shocks and the Phillips Curve

  • An adverse supply shock causes a burst of inflation and raises the natural rate of unemployment:

    • by increasing the degree of mismatch between workers and jobs (classical economists);

    • by reducing MPN and labour demanded at full employment (Keynesian economists).


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Supply Shocks and the Phillips Curve

  • An adverse supply shock should shift the Phillips curve up and to the right.

  • The Phillips curve should be particular unstable during periods of supply shocks.


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The Shifting Phillips Curve in Practice

  • The Friedman-Phelps analysis shows that a negative relationship between the levels of inflation and unemployment holds as long as expected inflation and the natural unemployment rate are approximately constant.


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The Shifting Phillips Curve in Practice (continued)

  • During 1970-2003 there was a number of productivity shocks as well as changes in government and macroeconomic policies.

  • A negative relationship between unanticipated inflation and cyclical unemployment does appear in the data.


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Macroeconomic Policy and the Phillips Curve

  • Keynesians believe that in a recession expansionary AD policy can increase inflation back to anticipated levels used as a basis for nominal wage contracts and pricing.


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The Lucas Critique

  • Because new policies change the economic “rules” and, thus, affect economic behaviour, no one can safely assume that historical relationships between variables will hold when policies change.


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The Long-Run Phillips Curve

  • Economists agree that in the long run economy will adjust to the general equilibrium in which π=πe and u= .

  • The long-run Phillips curve is vertical line at u= . It is related to the long-run neutrality of money.


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The Cost of Unemployment

  • The output is lost because fewer people are productively employed.

  • Unemployed workers and their families face psychological cost.

  • The offsetting factors are acquiring new skills and more leisure time.


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The Long-Term Behaviour of the Unemployment Rate

  • The overall unemployment rate may have risen due to:

    • changes in the composition of the labour force by age and sex;

    • structural changes in the economy;

    • changes in employment insurance.


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Hysteresis in Unemployment

  • Hysteresis in unemployment means that the natural unemployment rate changes in response to the actual unemployment rate.

  • If workers are idle for long periods of time their skills deteriorate and the mismatch increases.


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Hysteresis in Unemployment (continued)

  • Due to regulations firms are more cautious to hire workers because it is difficult to fire them.

  • The insider-outsider theory suggests that unionized labour increases wages for insiders and leaves outsiders unemployed.


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How to Reduce the Natural Rate of Unemployment

  • Increase government support for job training and reallocation.

  • Increase labour market flexibility.

  • Reform Employment Insurance program.

  • Use aggressive policy to keep actual unemployment rate low.


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Perfectly Anticipated Inflation

  • Because nominal wages are rising together with prices, the purchasing power is not hurt by the perfectly anticipated inflation.

  • Perfectly anticipated inflation would not hurt the value of savings accounts.


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The Cost of Perfectly Anticipated Inflation

  • Shoe leather costs of inflation is time and effort incurred by people and firms who are trying to minimize their holdings of cash.

  • Menu costs of inflation.

  • Welfare costs of inflation-induced tax distortions.


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The Cost of Unanticipated Inflation

  • Creditors and those with incomes set in nominal terms are hurt, whereas debtors and those who make fixed nominal payments are helped by unanticipated inflation.


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The Cost of Unanticipated Inflation (continued)

  • People are made worse off by increasing risk of gaining or losing wealth as a result of unanticipated inflation.

  • People must spend time and effort learning about different prices.


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The Cost of Hyperinflation

  • Hyperinflation occurs when the inflation rate is extremely high for a sustained period of time.

    • The shoe leather costs are enormous.

    • The government’s ability to collect taxes is undermined.

    • The market efficiency is disrupted.


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Fighting Inflation: The Role of Inflationary Expectations

  • The only factor that can create sustained rises in aggregate demand and ongoing inflation is a high rate of money growth.

  • Governments may print money to finance their spending or use unbalanced monetary policy to fight recession.


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Fighting Inflation (continued)

  • The process of disinflation – the reduction of money growth – leads to a serious recession.

  • If inflation falls below the expected rate, unemployment will rise above the natural rate.

  • A recession can be avoided if expected inflation rate can fall.


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Rapid versus Gradual Disinflation

  • A cold turkey strategy is a rapid and decisive reduction in the growth rate of the money supply.

  • It may lead to a significant increase in cyclical unemployment.


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Rapid versus Gradual Disinflation (continued)

  • Inflation expectations may not lower if the government is expected to abandon the policy under political pressure.


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Rapid versus Gradual Disinflation (continued)

  • A policy of gradualism is a policy of reducing the rate of money growth gradually over a period of time.


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Rapid versus Gradual Disinflation (continued)

  • This policy will raise unemployment by less than the cold-turkey strategy, but the period of higher unemployment will be longer.


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Wage and Price Controls

  • Wage and price controls (income policies) are legal limits on the ability of firms to raise wages or prices.

  • Price controls are likely to make shortages.

  • Wage-price controls have a major effect on the public’s expectations.


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Credibility and Reputation

  • The expected inflation adjusts quickly if government’s announced disinflationary policy is credible.

  • Policymakers increase their credibility by developing reputation for carrying through on their promises.


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Credibility and Reputation (continued)

  • A strong and independent central bank creates credibility of monetary policy with the public.