Transcript Lecture 11. Chapter 12 - Henry W. Chappell Jr.

No 11. Chapter 12
Inflation and Unemployment
Introduction
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Thus far we have only tangentially discussed
inflation and unemployment, despite the
political attention received by these two
variables
This chapter examines the implications of our
theory for these two variables, as well as their
importance for society
Steady Inflation Revisited
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First recall our money neutrality proposition: In the
long run, an increase in M leads to a proportionate
rise in P, with real variables in our model left
unchanged.
We would expect that steady growth of M would
result in steady growth of P, other things held
equal. If P rises steadily, this is inflation.
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I often like to distinguish a one-time increase in P
from steady increases in P
For conceptual purposes, I think of inflation as a
sustained increase in P, not a one-time increase
More on Steady Inflation
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Recall the equation for the LM Curve in our model:
M
e
 L Y , r   
P
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In the classical model (or the Keynesian long-run)
both output and the interest rate are will not be
affected by changes in the money supply (money
neutrality again), and if inflation is steady, expected
inflation will also be constant
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In a steady inflation, M and P are going up in proportion,
and all variables on the right-hand side of the LM equation
are constant.
A Change in the Steady
Inflation Rate
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If money grows at 3% per year in our model, the
inflation rate will be 3% per year; if money grows at 7%
per year, the inflation rate will be 7% per year.
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Note: This does assume that output is not changing.
However, if we have been having steady money growth
of 3% and then change to steady money growth of 7%,
once we reach a new steady state with 7% inflation,
the real money supply must be smaller (since expected
inflation is larger on the RHS below):
M
 L Y , r   e 
P
A One-Time Jump in P
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When the expected inflation rate rises (as it
eventually must when the steady inflation rate
changes), the LM curve shifts to the right, putting
upward pressure on price.
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This effect is above and beyond the direct proportional
effect of M on P.
Illustrate with a diagram! As the economy moves to
the new steady inflation path, measured inflation
must temporarily exceed the new higher steady rate.
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This extra price rise is what produces the lower real money
supply in the higher inflation steady state.
A Change in Steady Inflation
Log P
t*
Time
Steady Inflation: IS-LM and
AD-AS
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With steady money growth and steady
inflation, IS and LM are not moving
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LM is subject to offsetting effects of money and
price movements.
AD steadily shifts up and to the right, so that
P rises. So long as the inflation is expected,
we are heading straight up the vertical LRAS
curve.
AD-AS with Steady Inflation
P
LRAS
P3
P2
AD3
P1
AD2
AD1
Y
Can We Have Inflation in a
Keynesian Model?
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We have interpreted the Keynesian model as a fixed
price model. In the short-run price is “stuck” so there
is no price movement.
However, Keynesian economists know that prices
eventually change
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The model can be modified to even permit ongoing inflation
Prices might be set at the beginning of a period, and then
remain stuck until the next period starts
However, prices could steadily rise from period to period,
even though they are inflexible for long times within
periods.
The Keynesian Model with
Steady Inflation
P
LRAS
P3
SRAS3
P2
SRAS2
AD3
P1
SRAS1
AD2
AD1
Y
The Classical Model with
Monetary Misperceptions
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Recall the “misperceptions” extension of the
classical model. In this model, SRAS curves
are upward sloping, not horizontal.
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Some variants of Keynesian models might also
have SRAS curves that slope upward, so the
following analysis does not really require that we
adopt all of the classical model assumptions
Lucas Misperceptions Model
with Steady Inflation
P
LRAS
SRAS3 [Pe=P3]
SRAS2 [Pe=P2]
P3
SRAS1 [Pe=P1]
P2
AD3
P1
AD2
AD1
Y
The Classical Model with
Monetary Misperceptions
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In the misperceptions model:
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If aggregate demand rises faster than expected,
inflation is higher than was expected, and we
move up the SRAS curve
If aggregate demand rises more slowly than
expected, then inflation is lower than expected,
and we move down the SRAS.
Expected Money Growth
Unexpected Money Growth
Output and Unemployment in
the Misperceptions Model
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When price rises faster than expected, some
workers misinterpret this as a relative price increase
rather than a general price increase
If a baker thinks the relative price of bread has risen,
he will work harder; he also finds it worthwhile to hire
more workers (perhaps offering a higher nominal
wage)
Job seekers begin to find acceptable wage offers
more quickly and take jobs faster and the number
unemployed falls.
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Workers initially see these job offers as attractive, because
they have not yet perceived the higher price level (they
incorrectly perceive the “real wage offer)
Inflation and Unemployment
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The preceding story suggests that as long as
inflation is expected, unemployment will be at
its normal rate (consistent with normal
searching and turnover in the job market).
But when the general price level rises faster
than expected, the higher inflation is
accompanied by lower unemployment.
Unemployment and inflation are inversely
related as aggregate demand fluctuates
(holding expected inflation fixed).
An Expectational Phillips
Curve: Equation Form
Phillips Curve Facts
A Menu of Possible Choices?
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Can we exploit this curve? Can we obtain
lower unemployment if we are just willing to
tolerate higher inflation?
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Our earlier discussion of inflation and output
suggests not—output gains associated with
inflation, and the employment fluctuations
associated with output, only occurred when
expectations were incorrect
Expectations eventually change, so one can not
permanently lower unemployment by going from
low steady inflation to high steady inflation
Long and Short-Run Phillips
Curves
Short-run Phillips Curves
Long-run Phillips Curve
More Data
Can the Natural Rate of
Unemployment Change?
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Yes. Classical economists might note that technical
change is often accompanied by job mismatches,
hence changes in the natural or equilibrium level of
unemployment
Keynesians would rely on the efficiency wage
argument
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A negative productivity shock can reduce labor demand--at
a fixed efficiency wage, the pool of unemployed would
grow and would stay higher persistently
Also, changes in labor supply behavior could change the
natural rate of unemployment.
Nobel Prizes
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Both Milton Friedman and Edmund Phelps won
Nobel Prizes for work on the “expectational” Phillips
curve model (and other things)
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The model explains why an apparent statistical relation
between unemployment and inflation cannot be exploited
by policymakers.
If a policymaker tries to lower unemployment by way of a
higher inflation rate, the attempt might be initially
successful, but ultimately inflation stays higher while
unemployment returns to its natural rate.
Keeping unemployment low would require that inflation
always be higher than expected, implying accelerating
inflation (hence the term NAIRU: the non-accelerating
inflation rate of unemployment)
Another Nobel
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Frequently policymakers assume that historical behavioral
regularities observed in the past will prevail in the future (i.e. the
Phillips Curve).
However, changing policy rules will often change behavior. We
cannot assume that empirical relationships observed under one
set of policy behavior will persist under a different policy regime.
This simple point, known as the Lucas Critique, was, in part,
responsible for the Nobel awarded to Robert Lucas.
 One of its implications is that we should be wary of embedding
ad hoc empirical regularities into a theory. Theory should be
derived from basic assumptions about rational behavior.
Policy: What are the Costs of
Unemployment?
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Unemployment is apparently costly
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People who are not working could have produced output,
which has value, but that is lost.
On the other hand, when I don’t work, I have more
leisure, so it is not correct to infer that the loss to
society is equal to the value of the forgone output.
 Classical economists believe that much search is
voluntary, hence optimal
Keynesians see a much larger cost of unemployment.
 In the efficiency wage model, there is true involuntary
unemployment
Policy: What are the Costs of
Inflation?
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In a world with money neutrality there are no
real effects of inflation
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Even in the Keynesian model, money neutrality
prevails in the long run.
Sometimes individuals seem to believe that
inflation robs them of real purchasing power.
In fact, a steady inflation raises wages and prices
in proportion and inflation does not reduce
society’s overall real standard of living. So this is
not a cost of inflation.
More on the Costs of Inflation
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A steady inflation does produce what are
sometimes caused “shoe-leather” costs
Unanticipated inflation is redistributive, and
inflation volatility increases risk for borrowers
and lenders
In the presence of high inflation, relative prices
are more difficult to observe, leading to a less
effective functioning of prices in their role of
allocating goods and services
Inflation-Tax interactions
A Final Question
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So why do we sometimes see economic
policy produce high inflation rates?
The End