Old CHAPTER 32

Labor Markets, Unemployment and Inflation

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© 2005 Worth Publishers, all rights reserved

READ Krugman Section 6 Module 31-36

Mankiw Ch 28,35

DO Morton Unit 5

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What you will learn in this chapter:

The meaning of the natural rate of unemployment, and why it isn’t zero

Why cyclical unemployment changes over the business cycle

How factors such as a minimum wage and efficiency wages can lead to structural unemployment

The reasons that unemployment can be higher or lower than the natural rate for extended periods

The existence of a short-run trade-off between unemployment and inflation, called the short-run Phillips curve, that disappears in the long run

Why the NAIRU, the nonaccelerating inflation rate of unemployment, is an important measure for policy-making

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The Nature of Unemployment

Workers who spend time looking for employment are engaged in job search.

Frictional unemployment is unemployment due to the time workers spend in job search.

Structural unemployment is unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage.

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Distribution of the Unemployedby Duration of Unemployment, 2000

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The Effect of a Minimum Wage on the Labor Market

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Causes of Structural UnemploymentMinimum wages

Unions

Efficiency wages

Side effects of government policies

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The Natural Rate of Unemployment

The natural rate of unemployment

Cyclical unemployment

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The Changing Makeup of the U.S. Labor Force

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Changes in the Natural Rate of Unemployment

Changes in Labor Force Characteristics

Changes in Labor Market Institutions

Changes in Government Policies

Changes in Productivity

OUTPUT GAP: The percentage difference between the actual level of real GDP and potential output.

OKUN’s LAW: Each additional percentage point of output gap reduces the unemployment rate by less than 1 percentage point.

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The Actual Unemployment Rate FluctuatesAround the Natural Rate

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These Fluctuations Correspond to the Output Gap

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Okun’s Law

Each additional percentage point of output gap reduces the unemployment rate by less than 1 percentage point.

Unemployment rate = Natural rate of unemployment – (0.5 x Output gap)For example:

Suppose that the natural rate of unemployment is 5.2% and that the economy is currently producing only 98% of potential output. In that case, the output gap is -2% and Okun’s Law predicts an unemployment rate of 5.2% - (0.5 x (-2%)) = 6.2%

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Unemployment and Inflation, 1961–1990

CHAPTER 33

Inflation, Disinflation, and Deflation

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© 2005 Worth Publishers, all rights reserved

15

What you will learn in this chapter:

Why efforts to collect an inflation tax by printing money can lead to high rates of inflation

How high inflation can spiral into hyperinflation as the public tries to avoid paying the inflation tax

The economy-wide costs of inflation and disinflation, and the debate over the optimal rate of inflation

Why even moderate levels of inflation can be hard to end

Why deflation is a problem for economic policy

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Money and Prices

According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium level.

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Money Supply Growth and Inflation in Brazil

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The Inflation Tax and HyperinflationThe inflation tax is the reduction in the real value of money held by the public caused by inflation, equal to the inflation rate times the money supply, on those who hold money.

The real value of resources captured by the government is reflected by the real inflation tax, the inflation rate times the real money supply.

A vicious circle of a shrinking real money supply and a rising rate of inflation, leads to hyperinflation and a fiscal crisis.

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Money and Prices in Brazil, 1985–1995

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According to the FISHER EFFECT, an increase in expected inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.

(Krugman)

The 1 for 1 adjustment of the nominal interest rate to the inflation rate. (Mankiw)

Real Interest Rate = Nominal interest rate – inflation rate

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The Fisher Effect

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The Costs of Inflation

Shoe-leather costs of inflation

The increased costs of making transactions that arise from the public’s efforts to avoid the inflation tax. (using more money to buy the same product)

Menu costs

Small costs associated with the act of changing prices.

Unit-of-account costs

Costs arising from the way inflation makes money a less reliable unit of measurement.

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Inflation and Nominal Interest Rates in the U.S.

ModuleMoney,Output, andPrices in the Long Run

KRUGMAN'SMACROECONOMICS for AP*

32

Margaret Ray and David Anderson

What you will learnWhat you will learn

in thisin this ModuleModule::• The effects of an inappropriate monetary

policy

• The concept of monetary neutrality and its relationship to the long-term economic effects of monetary policy

Short-Run and Long-Run Effects ofShort-Run and Long-Run Effects of an Increase in the Money Supply an Increase in the Money Supply

Increases in Increases in the money the money supply initially supply initially lead to an lead to an increase in increase in output, output,

but in the long but in the long run increased run increased nominal nominal wages reduce wages reduce SRAS and SRAS and lead only to an lead only to an increased increased price level.price level.

Money NeutralityMoney Neutrality

Changes in the money supply have no real effects in the economy. In the long run, the only effect of an increase in the money supply is to raise the aggregate price level.

Money is neutral in the long run.

Changes in the Money Supply and Changes in the Money Supply and the Interest Rate in the Long Runthe Interest Rate in the Long Run

1) An increase in the MS lowers the IR in the short run

2) But in the long run, higher prices lead to greater Mdem, raising the IR to original level

ModuleTypes ofInflation, Disinflation,and Deflation

KRUGMAN’S MACROECONOMICS for AP*

33

Margaret Ray and David Anderson

What you will learnWhat you will learn

in thisin this ModuleModule::• The classical model of the price level

• Why efforts to collect an inflation tax by printing money can lead to high rates of inflation and even hyperinflation

• The types of inflation: cost-push and demand-pull

The Classical Model of MoneyThe Classical Model of Money and Prices and Prices

Increase in MS shifts demand rightward (AD1 to AD2). Creates new SR equilibrium at E2 and higher PL at P2.

In LR, nominal wages adjust upward and push the SRAS curve leftward to SRAS2.

The total percent change in PL from P1 to P2 is equal to the percent increase in MS.

In the classical model of the price level, we ignore the transition period and think of the price level as rising to P3 immediately. This is a good approximation under conditions of high inflation.

The Classical Model of MoneyThe Classical Model of Money and Prices and Prices

• %∆ M = %∆ PL

• Classical Model of the Price Level (E to E’’)...Good assumption given high inflation

•Classical Model ignores short-run changes ( E to E’)... Poor assumption given low inflation.

The Inflation TaxThe Inflation Tax

•Independent central banks issue fiat money

•Monetizing the debt (turning the debt (bonds) into money)

•Seignorage (revenue generated by the FEDs right to print money)

•Inflation Tax (financial loss of value suffered by holders of cash and fixed-rate bonds, as well those on fixed income (not indexed to inflation), due to the effects of inflation)

The Treasury issues debt to finance the government’s purchases of goods and

services.

The FED monetizes the debt by creating money and buying the debt back from the public through open-market purchases of

Treasury Bills.

In effect, the government can and does raise revenue by printing money.

Seignorage = M

Real Seignorage = M/P

Real Seignorage = ( M/M) x (M/P)

M = Money Supply

= monthly change in

The Logic of HyperinflationThe Logic of Hyperinflation

•Impact of inflation tax on people’s decision to hold money

•Why print large sums of money?

•Taxi analogy (if gov taxes taxi rides, people will find substitutes, and gov will have to raise taxes on taxi rides to gain more revenue)

•Substituting commodities for currency

In the 1920s, hyperinflation made German currency worth so little that children made kites from the banknotes.

Moderate Inflation and Moderate Inflation and DisinflationDisinflation• Cost-push inflation (inflation

caused by an increase in the price of inputs)

• Demand-pull inflation (inflation caused by an increase in aggregate demand)

• Politically motivated inflation (policies that produce a booming economy may also increase inflation)

• Disinflation? Former Federal Reserve Chairman, Alan Greenspan

The Output Gap and the The Output Gap and the Unemployment RateUnemployment Rate

•Output Gap

•Actual Output = Potential Output .: Actual Unemployment = Natural Rate of Unemployment

•Actual Output > Potential Output .: Actual Unemployment < Natural Rate of Unemployment

•Actual Output < Potential Output .: Actual Unemployment > Natural Rate of Unemployment

ModuleInflation andUnemployment:The Phillips Curve

KRUGMAN’S MACROECONOMICS for AP*

34

Margaret Ray and David Anderson

What you will learnWhat you will learn

in thisin this ModuleModule::• What the Phillips curve is and the nature of

the short-run trade-off between inflation and unemployment

• Why there is no long-run trade-off between inflation and unemployment

• Why expansionary policies are limited due to the effects of expected inflation

• Why even moderate levels of inflation can be hard to end

• Why deflation is a problem for economic policy and leads policy makers to prefer a low but positive inflation rate

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Why Doesn’t the Labor Market Move Quickly toEquilibrium?

Misperceptions

Sticky Wages

Menu Costs

The Short-Run Phillips CurveThe Short-Run Phillips Curve

•Phillips Curve

•Short-Run Phillips Curve (negative short-run relationship between inflation and unemployment)

•The role of supply shocks

•Friedman and Phelps: (1968) crucial hypothesis: expectations about future inflation directly influences the present inflation rate. Today this is the most important factor affecting inflation (other than the unemployment rate).

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Unemployment and Inflation in the 1960s

Inflation Expectations and theInflation Expectations and the Short-Run Phillips Curve Short-Run Phillips Curve

•Expected Inflation

•Relationship between actual and expected inflation

•What determines expected inflation?

•Why was expected inflation not included initially?

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Unemployment and Inflation: The Phillips Curve

Hypothetically…..

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Expected Inflation and the Short-Run Phillips Curve

Inflation and Unemployment in Inflation and Unemployment in the Long Runthe Long Run

• The SRPC of the 1960s (click)

• The experience of the 1970s (if inflation is consistently high, then people will expect more of the same)

• The trade-off between inflation and unemployment

Most economists believe there is no long-run tradeoff……

•The short run and long run effects of expansionary policies

The Long-Run Phillips CurveThe Long-Run Phillips Curve

The unemployment rate at which inflation does NOT change over time….. LRPC = 5% or NAIRU (non-accelerating inflation rate of unemployment)

…..keeping the Infl Rate below 5% leads to ever-accelerating inflation and cannot be maintained.

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The NAIRU and the Long-Run Phillips Curve

NAIRU: non-accelerating inflation rate for unemployment.

***the unemployment rate at which inflation does not change over time.

The Long-Run Phillips CurveThe Long-Run Phillips Curve

•NAIRU = 5% (non-accelerating inflation rate for unemployment)

•LRPC = 5%

•Natural Rate Hypothesis– another name for the NAIRU

•Natural Rate = NAIRU

The Costs of DisinflationThe Costs of Disinflation

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The Great Disinflation of the 1980s

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Stock Market Crash of 1987 (Oct 19) BLACK MONDAY. DJIA dropped by 508 points to 1738.74 (22.61%).

Potential causes for the decline include program trading, overvaluation, illiquidity, and market psychology.

In program trading, computers perform rapid stock executions based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage and portfolio insurance strategies.

Program trading (LTCM) was also responsible for the crash in 2007.

DeflationDeflation• Deflation: falling price level

• Debt Deflation: borrowers—short of cash—forced to cut spending….result is decrease in AD.

• Effects of Expected Deflation: Lenders gain; borrowers lose

• Zero Bound: IR very low—can’t go below zero

• Liquidity Trap: when conventional monetary policy can’t be used because nominal IR are up against zero bound

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Effects of DeflationEffects of Unexpected Deflation:

-Debt deflation-**The reduction in AD arising from the increase in the real burden of outstanding debt caused by deflation.

Effects of Expected Deflation:

-Zero bound-**on the nominal interest rate; it cannot go below zero.

-Liquidity trap-**a situation in which monetary policy can’t be used because the nominal interest rates cannot fall below zero

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Japan’s Trap