Lecture 5. Inflation, output and unemployment.
Carlos Llano (P)& Nuria Gallego (TA)
References: these slides have been developed based on the ones provided byBeatriz de Blas and Julián Moral (UAM), as well as the official materials fromMankiw, 2009 and Blanchard, 2007 books. We are grateful for that.
Outline
1. Employment and production: Okun’s Law.2. Deriving the Phillips curve from the
aggregate supply curve3. The role of inflation expectations4. Inflation as a monetary phenomenon5. Hyperinflation and budget deficit:
seigniorage6. Central banks and inflation targeting
2
1. EMPLOYMENT AND PRODUCTION: OKUN’S LAW
3
References:• Mankiw, 2009 (Capítulo 9; pp. 260);• Blanchard, 2007 (Capítulo 8 y 9)
( , , )Y F A K L
)( EY gfg
A: technologyK: CapitalL: Employment
Short Run Production function
)( EY gg
4
-8
-6
-4
-2
0
2
4
6
8
1996
TI
1997
TI
1998
TI
1999
TI
2000
TI
2001
TI
2002
TI
2003
TI
2004
TI
2005
TI
2006
TI
2007
TI
2008
TI
2009
TI
2010
TI
Ocupados. Total
Producto interior bruto aprecios de mercado
1. Active Population = constant.2. Productivity = constant. Thus, variations in output leads to proportional variations in employment (A=cte=1).
Okun’s Law: the positive relationship between the output growth and the variation of u.
Assumptions in the AS‐AD model:
Therefore:yttt guu 1
If gyt = 4%, the unemployment rate deacreases also in 4%
Is this true in reality?
2. The Okun’s Law
USA
2. The Okun’s Law
ut‐ut‐1 = ‐0,4(gyt‐3%)
gyt should be at least equal to 3% in order to avoid a rise in unemployment
Why is so?Two main reasons:
1. Active Population could increase.
2. Labor productivity could also increase.Natural output growth : (gy=3%)
• It is the output growth rate that keeps u=cte.
• In USA, since 1960, the average growth rate of the Active Population + productivity has been = 3%.
2. The Okun’s Law
ut-ut-1 = - 0,4(gyt - 3%)
If gyt is 1% higher than the normal output growth:• In the SA-DA model (Act Pop=cte), u decreases in 1%.
• However, the US data shows a 0,4% decrease instead.
What does the ‐0,4 coefficient means?
Why this coefficient of -0,4?• Firms “keep labor” (atesoran el trabajo).• A number of employees (hours) do not depend on
production (i.e. accounting, finance, back-office).
• Variations in the active population: u decreases in a lower extent (%) than employment.
2. The Okun’s Law
How is the Okun’s law coefficient for each country?
Country 1960-1980 1981-1998
Estados Unidos 0,39 0,42Reino Unido 0,15 0,51Alemania* 0,20 0,32Japón 0,10 0,20
*For Germany, the second period is 1981‐1989
Spain (1981‐88): 0,98
2. The Okun’s Law
)(1 yyttt gguu
In general, variations between unemployment and economic growth are given by:
yg : normal growth rate of output.
: coefficient that determines how large is the variation in the unemployment rate for each point of excessive output growth with regards to the “normal growth rate”.
2. The Okun’s Law
1 ttyyt uugg• In the 80’, Spain had to grow above 3% in order to create
jobs. • In the 90, and until the crisis, just by growing at 2% rates
employment was rising (yes, but in construction and services, mainly).
• During the crisis, Spain destroyed 7 times more employment than Germany, even facing lower contractions in output.
• How large does the growth rate in Spain should be in order to create jobs in the next years? And in order to re-absorb the more than 5 million people actually unemployed?
2. The Okun’s Law
2. INFLATION, UNEMPLOYMENT, AND THE PHILLIPS CURVE
12
References:• Mankiw, 2009 (Capítulo 13);• Blanchard, 2007 (Capítulo 8 y 9)
EEUU
13
La Inflación
Inflación = (Pt/Pt‐1)‐1 = log(Pt) ‐ log(Pt‐1)
14
La Inflación
The Phillips curve
• 1958: A.W. Phillips found a negative relationship between unemployment rate and nominal wages in the UK for 1861‐1957.
• 1962: Samuelson and Solow found a negativerelationship between inflation and unemployment.
• Considered as a stable relationship during the 1960s: – In the absence of shocks, the economy stays at a given combination of inflation and unemployment
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Inflation, Unemployment, and the Phillips Curve
The Phillips curve states that depends on– expected inflation, e.
– cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate
– supply shocks, (Greek letter “nu”).
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( ) e nu u ( ) e nu u
where > 0 is an exogenous constant.
Deriving the Phillips Curve from SRAS
17
(1) ( )eY Y P P
(2) (1 ) ( )eP P Y Y
1 1(4) ( ) ( ) (1 )( )eP P P P Y Y
(5) (1 )( )e Y Y
(6) (1 )( ) ( )nY Y u u
(7) ( )ne u u
(3) (1 ) ( )eP P Y Y
AS
AS + Supply shock (non‐Permanent)
Okun’s Law
Phillips Curve
The Phillips Curve and SRAS
• SRAS curve: Output is related to unexpected movements in the price level.
• Phillips curve: [Cyclical] Unemployment is related to unexpected movements in the inflation rate.
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SRAS: ( )eY Y P P
Phillips curve: e nu u ( )
Graphing the Phillips curve
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In the short run, policymakers face a tradeoff between and u.
In the short run, policymakers face a tradeoff between and u.
u
nu
1
The short‐run Phillips curvee
( )e nu u
0
5
10
15
20
25
2005TII 2006TII 2007TII 2008TII 2009TII 2010TII
Tasa de paroinflacion (deflactor PIB)
20
Graphing the Phillips curve (in Spain)
CPhillips España (2005-2010)
0
1
2
3
4
5
6
0 5 10 15 20 25
Tasa de Paro
Infla
ción
(Def
lact
or P
IB)
21
Graphing the Phillips curve (in Spain)
Two causes of rising & falling inflation
• cost‐push inflation: inflation resulting from supply shocks.Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up.
• demand‐pull inflation: inflation resulting from demand shocks.Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up.
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First version (around 1960)
• Average inflation close to zero:
– low unemployment high nominal wages– in response, firms increase prices– higher prices higher wages– higher wages leads to higher prices, and so on…
wage and price spiral
23
0e
This is theoriginal Phillips curve
Shifting the Phillips curve
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People adjust their expectations over time, so the trade off only holds in the short run.
People adjust their expectations over time, so the trade off only holds in the short run.
u
nu
1e
( )e nu u
2e
E.g., an increase in e shifts the short‐run P.C. upward.
E.g., an increase in e shifts the short‐run P.C. upward.
USA 1948‐1969
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Inflatio
nrate
(%)
Unemployment rate (%)
( )nu u
Expectations: The History of the Phillips curve
What happened to the Phillips curve?
• 1970: increases in prices due to oil shocks– Inflation became positive and persistent
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Inflatio
n rate (%
)
Changes, USA 1970‐1998
27
Inflatio
nrate
(%)
Unemployment rate (%)
Expectations: The History of the Phillips curve
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Varia
ción
de la ta
sa de infla
ción
Tasa de desempleo (%)
‐5,0
5,0
‐2,5
2,5
0,0
6,5% = ‐ 1,0 Ut
EEUU-(1970-1998): t – t-1 = 6,5% – 1,0ut
1 ( )nu u
Expectations: The History of the Phillips curve
29
Phillips curve: Summary
Original Phillips curve:
Modified Phillips curve (with expectatives):
( )nu u
SRAS: ( )eY Y P P
Phillips curve: e nu u ( )
( -1 = e ); = 0
( )e nu u ( )n
e u u
1 ( )nu u
( -1 = e ); = 1
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La tasa de desempleo no aceleradora de la inflación (NAIRU=NON‐ACCELERATING‐INFLATION‐RATE OF
UNEMPLOYMENT)
• The inflation decreases (slow down) when the actual unemployment rate (ut) is higher than the natural unemployment rate (un).
• Inflation increases (speed up) when ut < un
t – te = ‐(ut – un)
Phillips curve: Summary
2. THE ROLE OF INFLATION EXPECTATIONS
31
References:• Mankiw, 2009 (Capítulo 13);• Blanchard, 2007 (Capítulo 8 y 9)
Expectations
Ways of modeling the formation of expectations:
– adaptive expectations: People base their expectations of future inflation on recently observed inflation.
– rational expectations:People base their expectations on all available information, including information about current and prospective future policies.
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( )e nu u
Adaptive expectations
• Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.
• A simple example: Expected inflation = last year’s actual inflation
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1 ( )nu u
1e
Then, the P.C. becomes
Inflation inertia
In this form, the Phillips curve implies that inflation has inertia:
– In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.
– Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.
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1 ( )nu u
Expectations, Friedman and Phelps (1968)
Assume , where– : effect of last year’s inflation on this year’s expected inflation,
– the higher the higher expected inflation.
• 1900‐1960: low and not persistent inflation– =0, =0, =0– The original Phillips curve:
• 1970s: high and persistent inflation– began to increase, getting close to 1– The Phillips curve augmented with expectations
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The sacrifice ratio
• To reduce inflation, policymakers can contract agg. Demand (AD), causing unemployment to rise above the natural rate.
• The sacrifice ratiomeasures the percentage of a year’s real GDP that must be foregone to reduce inflation by 1 percentage point.
• A typical estimate of the ratio is 5.
36
The sacrifice ratio
• Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year’s GDP:GDP loss = (inflation reduction) x (sacrifice ratio)
= 4 x 5• This loss could be incurred in one year or spread over several, e.g., 5% loss for each of four years.
• The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment.
37
Calculating the sacrifice ratio for the Volcker disinflation
38
1981: = 9.7%1985: = 3.0%
year u u n uun
1982 9.5% 6.0% 3.5%
1983 9.5 6.0 3.5
1984 7.4 6.0 1.4
1985 7.1 6.0 1.1
Total 9.5%
Total disinflation = 6.7%
Calculating the sacrifice ratio for the Volcker disinflation
• From previous slide: Inflation fell by 6.7%, total cyclical unemployment was 9.5%.
• Okun’s law (in US): 1% of unemployment = 2% of lost output.
• So, 9.5% cyclical unemployment = 19.0% of a year’s real GDP.
• Sacrifice ratio = (lost GDP)/(total disinflation)= 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation.
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Painless disinflation?
• Proponents of rational expectations believe that the sacrifice ratio may be very small:
• Suppose u = u n and = e = 6%,and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 % (4 points) as soon as possible.
• If the announcement is credible, then e will fall, perhaps by the full 4 points.
• Then, can fall without an increase in u.
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The natural rate hypothesis
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Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis:
Changes in aggregate demand affect output and employment only in the short run.
In the long run, the economy returns to the levels of output, employment,
and unemployment.
An alternative hypothesis: Hysteresis
• Hysteresis: the long‐lasting influence of history on variables such as the natural rate of unemployment.
• Negative shocks may increase un, so economy may not fully recover.
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Hysteresis: Why negative shocks may increase the natural rate
• The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends.
• Cyclically unemployed workers may lose their influence on wage‐setting (because their lack of employability reduce their capacity of substituting the current workers); then, insiders (employed workers) may bargain for higher wages for themselves.– Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends.
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3. INFLATION AS A MONETARY PHENOMENON
44
References:• Mankiw, 2009 (Capítulo 4)
Otras explicaciones http://www.libremercado.com/2012‐04‐07/bernanke‐alecciona‐a‐los‐universitarios‐sobre‐la‐bondad‐de‐la‐banca‐central‐1276454704/
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La Inflación
…back to the Quantity Theory of Money
• starts with quantity equation
• assumes V is constant & exogenous:
46
V V
• With this assumption, the quantity equation can be written as:
M V P Y
The Quantity Theory of Money, cont.
How the price level is determined:• With V constant, the money supply determines nominal GDP (P Y )
• Real GDP is determined by the economy’s supplies of K and L and the production function (chap 3)
• The price level is P = (nominal GDP)/(real GDP)
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M V P Y
The Quantity Theory of Money, cont.
• Recall from Macroeconomics I: The growth rate of a product equals the sum of the growth rates.
• The quantity equation in growth rates:
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M V P YM V P Y
The quantity theory of money assumes
is constant, so = 0.VV
V
The Quantity Theory of Money, cont.
Let (Greek letter “pi”) denote the inflation rate:
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M P YM P Y
PP
M YM Y
M YM Y
The result from the preceding slide was:
Solve this result for to get
The Quantity Theory of Money, cont.
• Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions.
• Money growth in excess of this amount leads to inflation.
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M YM Y
M YM Y
The Quantity Theory of Money, cont.
Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now).
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M YM Y
M YM Y
Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.
International data on inflation and money growth
52
Inflation rate(percent, logarithmicscale)
1,000
10,000
100
10
1
0.1
Money supply growth (percent, logarithmic scale)0.1 1 10 100 1,000 10,000
Nicaragua
AngolaBrazil
Bulgaria
Georgia
Kuwait
USA
Japan Canada
Germany
Oman
Democratic Repubof Congo
U.S. data on inflation and money growth
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0 2 4 6Growth in money supply (percent)
8 10 12
8
6
4
2
0
- 2
- 4
1970s1910s
1940s
1980s
1960s1950s
1990s
1930s1920s
1870s
1890s
1880s
1900s
Inflationrate(percent)
4. HYPERINFLATION AND BUDGET DEFICIT: SEIGNIORAGE
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References:• Mankiw, 2009 (Capítulo 4)• Blanchard (Capítulo 22)
Seigniorage
• To spend more without raising taxes or selling bonds, the govt can print money.
• The “revenue” raised from printing money is called seigniorage
• The inflation tax:Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.
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Inflation and interest rates
• Nominal interest rate, inot adjusted for inflation
• Real interest rate, radjusted for inflation:
r = i
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The Fisher Effect
• The Fisher equation: i = r +
• Recall: S = I determines r .
• Hence, an increase in causes an equal increase in i.
• This one‐for‐one relationship is called the Fisher effect.
57
UK inflation and nominal interest rates: 1975‐2005
0
5
10
15
20
25
30
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
Nominal interest rate Inflation Rate
in p
erce
ntag
e po
ints
58
Inflation and nominal interest rates across countries: 1996‐2004
1
10
100
0.1 1 10 100 1000Inflation Rate (percent, logarithmic scale)
Nom
inal
Inte
rest
Rat
e (p
erce
nt, l
ogar
ithm
ic s
cale
)
United States
Bulgaria
Romania
Germany
Brazil
Zimbabwe
Turkey
Israel
SwitzerlandSingapore
UK
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Two real interest rates
• = actual inflation rate (not known until after it has occurred)
• e = expected inflation rate
• i – e = ex ante real interest rate: what people expect at the time they buy a bond or take out a loan
• i – = ex post real interest rate:what people actually end up earning on their bond or paying on their loan
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Money demand and the nominal interest rate
• The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y.
• We now consider another determinant of money demand: the nominal interest rate.
• The nominal interest rate i is the opportunity cost of holding money (instead of bonds or other interest‐earning assets).
• Hence, i in money demand.
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The money demand function
(M/P )d = real money demand, depends negatively on i
i is the opportunity cost of holding money
positively on Y higher Y more spending
so, need more money
(L is used for the money demand function because money is the most liquid asset.)
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( ) ( , )dM P L i Y
The money demand function
When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + e.
63
( ) ( , )dM P L i Y
( , )eL r Y
Equilibrium
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( , )eM L r YP
The supply of real money balances Real money
demand
What determines what
65
variable how determined (in the long run)
M exogenous (ECB, BoE or FED)
r adjusts to make S = I
Y
( , )eM L r YP
( , )Y F K L
P adjusts to make ( , )M L i YP
How P responds to M
• For given values of r, Y, and e, a change in M causes P to change by the same percentage ‐‐‐ just like in the Quantity Theory of Money.
66
( , )eM L r YP
What about expected inflation?
• Over the long run, people don’t consistently over‐ or under‐forecast inflation, so e = on average.
• In the short run, e may change when people get new information.
• EX: Suppose ECB announces it will increase M next year. People will expect next year’s P to be higher, so e rises.
• This will affect P now, even though M hasn’t changed yet. (continued…)
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How P responds to e
• For given values of r, Y, and M ,
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( , )eM L r YP
(the Fisher effect)e i d M P
to make fall to re-establish eq'm
P M P
Discussion Question
Why is inflation bad?• What costs does inflation impose on society? List all the ones you can think of.
• Focus on the long run.
• Think like an economist.
69
A common misperception
• Common misperception: inflation reduces real wages
• This is true only in the short run, when nominal wages are fixed by contracts.
• In the long run, the real wage is determined by labour supply and the marginal product of labour, not the price level or inflation rate.
• Consider the data…
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Average earnings vs. the price level
0
500
1000
1500
2000
2500
3000
3500
1963 1969 1975 1981 1987 1993 1999 2005
Inde
x (1
963=
100)
average earnings RPI chained index
71
The classical view of inflation
• The classical view: A change in the price level is merely a change in the units of measurement.
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So why, then, is inflation a social problem?
The social costs of inflation
…fall into two categories:1. costs when inflation is expected2. additional costs when inflation differs
from what people had expected.
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1. The Costs of expected inflation:a. Shoeleather cost (Suela de zapatos)b. Menu costs (Coste de menú)c. The higher the inflation rate the higher the
variability in relative prices: distortion and ineffiencies in microeconomic decisions.
d. Inflation alters individual Tax liabilities.e. Inconvenience of living in a world with changing
prices (planification, comparability)2. The costs of Unexpected inflation:
a. It arbitrarily redistributes wealth among individuals: with π> πe, debtors win and creditor loss.
b. Uncertainty.74
The social costs of inflation
One benefit of inflation
• Nominal wages are rarely reduced, even when the equilibrium real wage falls.
• Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.
• Therefore, moderate inflation improves the functioning of labour markets.
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Hyperinflation
• def: 50% per month
• All the costs of moderate inflation described above become HUGE under hyperinflation.
• Money looses its store of value function, and may not serve its other functions (unit of account, medium of exchange).
• People may conduct transactions with barter or a stable foreign currency.
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What causes hyperinflation?
• Hyperinflation is caused by excessive money supply growth:
– When the central bank prints money, the price level rises.
– If it prints money rapidly enough, the result is hyperinflation.
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Some recent episodes of hyperinflation
78
1
10
100
1000
10000pe
rcen
t gr
owth
Israel1983-85
Poland1989-90
Brazil1987-94
Argentina1988-90
Peru1988-90
Nicaragua1987-91
Bolivia1984-85
inflation growth of money supply
slide 78
Why governments create hyperinflation
• When a government cannot raise taxes or sell bonds,
• It must finance spending increases by printing money.
• In theory, the solution to hyperinflation is simple: stop printing money.
• In the real world, this requires drastic and painful fiscal restraint.
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The Classical Dichotomy
Real variables are measured in physical units: quantities and relative prices, e.g.
• quantity of output produced• real wage: output earned per hour of work• real interest rate: output earned in the future
by lending one unit of output today
Nominal variables: measured in money units, e.g.• nominal wage: euros or pounds / hour of work• nominal interest rate: euros or pounds earned in future by lending one
euro or pound today• the price level: the amount of euros or pounds needed to buy a
representative basket of goods
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The Classical Dichotomy
• Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.
• Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run.
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5. CENTRAL BANKS AND INFLATION TARGETING
82
References:• Mankiw, 2009 (Capítulo 4)
