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Macroeconomics
Lecture 12
Inflation and unemployment
Goods marketKeynesian Cross (IS)
Financial markets (LM)
IS-LM(R, Y)
AD
Labour market(AS)
AD-AS(R,P,Y)
Foreign exchange markets
AD*
(R*,Y,e, CA)
DAD-SAS(R,,u)
Outline
• Empirical facts
• The dynamic AD-AS model (the Phillips Curve Model).
• Using the Phillips Curve Model to make sense of the 80ies.
The Phillips curveProf. A W Phillips demonstrated a statistical relationshipbetween annual inflation and unemployment in the UK
Unemployment rate (%)
Infla
tion
rate
(%
)
The Phillips curve showsthat a higher inflation rateis accompanied by a lower unemployment rate.
Phillips curve
It suggests we can trade-off more inflation forless unemployment orvice versa.
024681012
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
Un
em
plo
ym
en
tUnemployment as a % of the labour force,
United Kingdom
OECD, Main indicators.
0
5
10
15
20
25
30
1950 1960 1970 1980 1990 2000
Infl
ati
on
Inflation, GDP deflator (annual, %) United Kingdom
OECD. Main indicators.
Inflation and unemploymentin the UK 1978-99
02468
101214161820
4 5 6 7 8 9 10 11 12
Unemployment
Infl
atio
n
1978
1980
1986
1990
1999 1993
Inflation and unemployment inthe short-run
Static model Dynamic model
Aggregate demand(AD)
Dynamic Aggregate demand (DAD)
Short-run aggregatesupply (SAS)
Short-run Phillips Curve (SPC)
P and Y Inflation and
unemployment
Long-run aggregatesupply (LAS)
Long-run Phillipscurve (LPC)
The Phillips Curve
)( ePPYY Aggregate supply:
)(1 YYPP e Rewrite:
Subtract P-1: )(111 YYPPPP e
)(1 YYe Inflation
Okun’s law
The deviation of output from its equilibrium level is inversely related to the deviation of
unemployment from its equilibrium level
)()( NuuYY 1 percentage point of unemployment gap = 2 percentage points of GDP gap.
SNe uu
)(
Expected inflation Cyclical
unemployment
Randomsupply shocks
Slopeof the Phillips
curve
U
UN
)( 0eSPC
)( 1eSPC
0e
1e
SNe uu
)(
01ee
Y
P
M up
AD0AD1
The static AD curve
Dynamic Aggregate demand (DAD)
)( SmYY
Growth in real money supply
)(1 YYmS
Dynamic multiplier
Use Okun’s Law
DNS uum
)(
Moneygrowth Cyclical
unemployment
Slopeof the DAD
curve
Demandshock
U
UN
0Sm
1Sm )( 0
SmDAD
)( 1SmDAD
dNS uum
)(
Long-run equilibrium
• Stable (constant) inflation.
• Expectations are fulfilled.
• No shocks.
Steady state equilibrium
Characterization of long-runequilibrium
Sm
)( 0eSPC
eNuu
The natural rate of unemployment
)( 0SmDAD
00eSm
u
• Disinflation in the 80ies.
Short-run analysis
The model in action
U
UN
)( 0eSPC
1
)( 1SmDAD
LPC
A)( 2
SmDAD
B
C
B
211 Se m
)( 1eSPC
UB
Dis-inflation in the beginning of the 1980s
0
1
u
uN
Time
Time
Fig
Inflation and unemployment in the UK is the early 1980s
05
1015
20
%
Inflation Unemployment
Sacrifice ratio (SR) = the percentage points loss in a year’s GDP as a consequence of a one percentage pointreduction in inflation.
Inflation reduced from 20 to 5 percent in 6 years
Suppose the natural rate is 3 percent.
The unemployment gap is: 2+5+7+7+7+7=35
Okun’s Law suggests that this translated intoa 70 percentage point accumulated loss over 6 years.
SR = 70/15=4.6.
Defeating inflation
• In the long run, inflation will be low if the rate of money growth is low.
• The transition from high to low inflation may be painful if expectations are slow to adjust
• Adaptive expectations and the sacrifice ratio.
• Rational expectations and painless disinflation.
• Wage contracts take time to adjust
• Policy credibility may speed the adjustment process
What is next?
• The open economy