Chapter 13
Unemployment and Inflation
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Main Questions
■ Is there a trade-off between unemployment and inflation?
■ What are the problems that stem from unemployment and inflation?
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Unemployment and Inflation
■ The Phillips curve is a negative empirical relationship between unemployment and inflation.
■ In 1970-2009 there seemed to be no reliable relationship between unemployment and inflation.
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Unemployment and Inflation
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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, and if there is
no misperception, the economy remains at , unemployment remains at , and cyclical unemployment is zero.
Y u
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The Phillips Curve (continued)
■ If increase in M is unanticipated, unanticipated inflation is created, Y is above , and u is below .
■ h measures the strength of the relationship between unanticipated inflation and cyclical unemployment.
Y u)uh(uππ e
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The Phillips Curve (continued)
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The Phillips Curve (continued)
■ The expectation-augmented Phillips curve states that if π exceeds πe then u is less than .
h is related to the slope of the SRAS curve.
u
)uh(uππ e
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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.
huuhππ e
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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.
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Changes in the Expected Rate of Inflation■ 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 unstable particularly 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 1970-2009 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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The Shifting Phillips Curve in Practice (continued)
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Macroeconomic Policy and the Phillips Curve
■ Keynesians believe that, in a recession, expansionary AD policy can increase inflation back to the anticipated levels that were 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 where π=πe and u= .
■ The long-run Phillips curve is vertical line at u= . It is related to the long-run neutrality of money.
u
u
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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 long-term unemployment rate may be influenced by:■ changes in the composition of the
labour force by age and sex;■ structural changes in the economy
brought about by technological change.
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The Long-Term Behaviour of the Unemployment Rate
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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)■ Some regulations on firms may
cause them to be cautious about hiring workers, because the regulations make it difficult to fire them.
■ 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■ Tax credits or subsidies for
training and relocating unemployed workers.
■ Minimize payroll taxes and the “tax wedge” by reforming the 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 monetary policy to fight recession.
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Fighting Inflation (continued)■ The process of disinflation – the
reduction of money growth – can lead to a recession.
■ If inflation falls below the expected rate, unemployment will rise above the natural rate.
■ A recession can be avoided if the expected inflation rate can be made to 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.
■ 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 create shortages.
■ Wage-price controls are intended to affect the public’s expectations of inflation.
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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 a reputation for carrying through on promises.
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Credibility and Reputation (continued)
■ A strong and independent central bank is more likely to be deemed a credible policymaker by the public.
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