Transcript Inflation And Its Relationship To Unemployment And Growth

Inflation and Its
Relationship to
Unemployment and
Growth
Chapter 15
© 2003 McGraw-Hill Ryerson Limited.
15 - 2
Some Basics about Inflation
Inflation is a continuous rise in the
price level.
 It is measured using a price index.

© 2003 McGraw-Hill Ryerson Limited.
15 - 3
The Distributional Effects of
Inflation

There are winners and losers in an
inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 4
The Distributional Effects of
Inflation
The winners are those who can raise
their prices or wages and still keep their
jobs or sell their goods.
 The losers in an inflation are those who
cannot raise their wages or prices.

© 2003 McGraw-Hill Ryerson Limited.
15 - 5
The Distributional Effects of
Inflation
Because they often enter into fixed
nominal contracts, lenders and
borrowers are affected by inflation.
 Unexpected inflation redistributes
income from lenders to borrowers.

© 2003 McGraw-Hill Ryerson Limited.
15 - 6
The Distributional Effects of
Inflation

The composition of the winners and
losers from an inflation changes over
time.
© 2003 McGraw-Hill Ryerson Limited.
15 - 7
The Distributional Effects of
Inflation

People who do not expect inflation and
who are tied to fixed nominal contracts
are likely lose in an inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 8
The Distributional Effects of
Inflation
If they are rational, these people will not
allow it to happen again.
 They will be prepared for a subsequent
inflation.

© 2003 McGraw-Hill Ryerson Limited.
15 - 9
Expectations of Inflation
Rational expectations economists argue
that if expectations are rational, they will
always be based on the economic
model.
 Rational expectations are the
expectations that the economists' model
predicts.

© 2003 McGraw-Hill Ryerson Limited.
15 - 10
Expectations of Inflation

Other economists argue that rational
expectations cannot be defined in terms
of economists' models. These
economists focus on the process by
which people develop expectations.
© 2003 McGraw-Hill Ryerson Limited.
15 - 11
Expectations of Inflation
There are two ways people form
expectations.
 Adaptive expectations are those
based, in some way, on what has been
in the past.
 Extrapolative expectations are those
that assume a trend will continue.

© 2003 McGraw-Hill Ryerson Limited.
15 - 12
Productivity, Inflation, and
Wages

There are two key measures that policy
makers focus on to determine whether
inflation may be coming:
 Changes
in productivity.
 Changes in wages.
© 2003 McGraw-Hill Ryerson Limited.
15 - 13
Productivity, Inflation, and
Wages

The basic rule of thumb:
 Wages
can increase at the same rate as
productivity increases without generating
inflationary pressures.
Inflation = Nominal wage increases
- Productivity growth
© 2003 McGraw-Hill Ryerson Limited.
15 - 14
Theories of Inflation

The quantity theory and the institutional
theory are two slightly different theories
of inflation.
 The
quantity theory emphasizes the
connection between money and inflation.
 The institutional theory emphasizes market
structure and price-setting institutions and
inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 15
The Quantity Theory of
Money and Inflation

The quantity theory of money is
summarized by the sentence: Inflation is
always and everywhere a monetary
phenomenon.
© 2003 McGraw-Hill Ryerson Limited.
15 - 16
The Equation of Exchange
The logic of the quantity theory of
money goes back to the equation of
exchange.
 According to the equation of exchange,
the quantity of money times velocity of
money equals price level times the
quantity of real goods sold.

© 2003 McGraw-Hill Ryerson Limited.
15 - 17
The Equation of Exchange

The equation of exchange:
MV = PQ
M = quantity of money
V = velocity of money (is
constant and determined by
institutional forces)
P = price level
Q = real output (is relatively
constant and determined by
real, not monetary forces)
PQ = the economy’s nominal
output (nominal GDP—
the quantity of goods
valued at whatever price
level exists at the time
© 2003 McGraw-Hill Ryerson Limited.
15 - 18
Velocity Is Constant
The first assumption of the quantity
theory is that velocity is constant.
 Its rate is determined by the economy’s
institutional structure.

© 2003 McGraw-Hill Ryerson Limited.
15 - 19
Velocity Is Constant

The velocity of money is the number
of times per year on average, a dollar
goes around to generate a dollar's worth
of income.
© 2003 McGraw-Hill Ryerson Limited.
15 - 20
Velocity Is Constant

If velocity is constant, the quantity
theory can be used to predict how much
nominal GDP will grow if we know how
much the money supply grows.
© 2003 McGraw-Hill Ryerson Limited.
15 - 21
Real Output Is Independent of
the Money Supply

The second assumption of the quantity
theory is that real output (Q) is
independent of the money supply.
© 2003 McGraw-Hill Ryerson Limited.
15 - 22
Real Output Is Independent of
the Money Supply

Q is autonomous, meaning real output
is determined by forces outside the
quantity theory.
© 2003 McGraw-Hill Ryerson Limited.
15 - 23
Real Output Is Independent of
the Money Supply
If Q grows, it is because of incentives in
the real economy.
 These incentives are on the supply side,
not the demand side.

© 2003 McGraw-Hill Ryerson Limited.
15 - 24
Real Output Is Independent of
the Money Supply

The conclusion of the quantity theory
is M  P.
 With
both V and Q unaffected by changes
in M, the only thing that can change is P.
© 2003 McGraw-Hill Ryerson Limited.
15 - 25
Real Output Is Independent of
the Money Supply

The quantity theory of money says
that the price level varies in response to
changes in the quantity of money.
© 2003 McGraw-Hill Ryerson Limited.
15 - 26
Real Output Is Independent of
the Money Supply

The quantity theory holds that real
output is not influenced by changes in
the money supply.
© 2003 McGraw-Hill Ryerson Limited.
15 - 27
Examples of Money's Role in
Inflation
The quantity theory lost its appeal in the
late 1970s and early 1990s.
 The formerly stable relationships
between measurements of money and
inflation appeared to break down.

© 2003 McGraw-Hill Ryerson Limited.
15 - 28
Examples of Money's Role in
Inflation

In the 1990s it seemed that the random
elements in the relationship between
money and inflation overwhelmed the
connection.
© 2003 McGraw-Hill Ryerson Limited.
15 - 29
Examples of Money's Role in
Inflation
The relationships between money and
inflation broke down because of
technological changes and changing
regulations in financial institutions.
 Another reason was the increasing
global interdependence of financial
markets.

© 2003 McGraw-Hill Ryerson Limited.
15 - 30
Examples of Money's Role in
Inflation

The empirical evidence that supports
the quantity theory of money in
developing countries is most convincing
in Brazil and Chile.
© 2003 McGraw-Hill Ryerson Limited.
15 - 31
Price Level and Money in
Canada, 1953-2001, Fig. 15-1, p 365
© 2003 McGraw-Hill Ryerson Limited.
15 - 32
Price Level and Money in
Brazil and Chile, Fig. 15-2, p 366
© 2003 McGraw-Hill Ryerson Limited.
15 - 33
The Inflation Tax

Developing countries such as Brazil and
Chile sometimes increase the money
supply to keep the economy running.
© 2003 McGraw-Hill Ryerson Limited.
15 - 34
The Inflation Tax
When their governments run a budget
deficit and try to finance it domestically,
their central banks often must buy the
bonds to finance that deficit.
 In essence, the increase in money
supply is caused by the government
deficit.

© 2003 McGraw-Hill Ryerson Limited.
15 - 35
The Inflation Tax

Financing the deficit by expansionary
monetary policy causes inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 36
The Inflation Tax
The inflation works as a kind of tax on
individuals, and is often called an
inflation tax.
 It is an implicit tax on the holders of
cash and the holders of any obligations
specified in nominal terms.

© 2003 McGraw-Hill Ryerson Limited.
15 - 37
The Inflation Tax

Central banks have to make a monetary
policy choice:
 Ignite
inflation by bailing out their
governments with an expansionary
monetary policy.
 Do nothing and risk recession or even a
breakdown of the entire economy.
© 2003 McGraw-Hill Ryerson Limited.
15 - 38
Policy Implications of the
Quantity Theory
In terms of policy, the quantity theory
says that monetary policy is powerful,
but unpredictable in the short run.
 Because of its unpredictability,
monetary policy should not be used to
control the level of output in an
economy.

© 2003 McGraw-Hill Ryerson Limited.
15 - 39
Policy Implications of the
Quantity Theory
Supporters of the quantity theory
oppose an activist monetary policy.
 Instead, they favour a monetary policy
set by rules not by discretion.

© 2003 McGraw-Hill Ryerson Limited.
15 - 40
Policy Implications of the
Quantity Theory
A monetary rule takes monetary policy
out of the hands of politicians.
 Many central banks use monetary
regimes or feedback rules.

© 2003 McGraw-Hill Ryerson Limited.
15 - 41
Policy Implications of the
Quantity Theory

Many economists favor creating
independent central banks to separate
politicians from the control of money
supply.
 They
feel that politicians will not be able to
hold down the money supply because of
the expansionary tendencies in politics.
© 2003 McGraw-Hill Ryerson Limited.
15 - 42
Policy Implications of the
Quantity Theory
In Canada, in 1991 the Bank of Canada
announced targets for the inflation rate
based on the CPI.
 Canadian monetary policy is aimed at
maintaining a low and stable inflation of
between one and three percent.

© 2003 McGraw-Hill Ryerson Limited.
15 - 43
Policy Implications of the
Quantity Theory

The U.S. Federal Reserve Bank does
not have strict rules governing money
supply, but it works hard to establish
credibility that it is serious about fighting
inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 44
The Institutional Theory of
Inflation
Supporters of institutional theories of
inflation accept much of the quantity
theory.
 While they agree that money and
inflation move together, they have
different causes and effects.

© 2003 McGraw-Hill Ryerson Limited.
15 - 45
The Institutional Theory of
Inflation

According to the quantity theory, the
direction of causation moves from left to
right:
MV  PQ
© 2003 McGraw-Hill Ryerson Limited.
15 - 46
The Institutional Theory of
Inflation
Institutional theories see it the other way
round.
 An increase in prices forces government
into positions where it must increase
money supply or cause unemployment.

MV  PQ
© 2003 McGraw-Hill Ryerson Limited.
15 - 47
The Institutional Theory of
Inflation

According to these theorists, the source
of inflation is in the price-setting process
of firms.
 Firms
find it easier to raise prices than to
lower them.
 Firms do not take into account the effect of
their pricing decisions on the overall price
level.
© 2003 McGraw-Hill Ryerson Limited.
15 - 48
Focus on the Price-Setting
Decisions of Firms

Any increase in firms’ wages, rents,
taxes, and other costs are simply
passed on to consumers in the form of
higher prices.
© 2003 McGraw-Hill Ryerson Limited.
15 - 49
Focus on the Price-Setting
Decisions of Firms

This works so long as the government
increases the money supply so that
demand is sufficient to buy the goods at
the higher prices.
© 2003 McGraw-Hill Ryerson Limited.
15 - 50
Price-Setting Strategies
Depend on the Labour Market

Whether the firm selects this priceraising strategy depends on the state of
the labour market.
© 2003 McGraw-Hill Ryerson Limited.
15 - 51
Price-Setting Strategies
Depend on the Labour Market
The state of the labour market plays a
key role in firms’ decisions whether to
give in to workers’ demands for higher
wages.
 That is why economists look at
unemployment to measure inflationary
pressures.

© 2003 McGraw-Hill Ryerson Limited.
15 - 52
Changes in the Money Supply
Follow Price-Setting by Firms

Institutional theorists see the nominal
wage- and price-setting process as
generating inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 53
Changes in the Money Supply
Follow Price-Setting by Firms
One group pushes up its nominal wage
and/or price, another group responds by
doing the same.
 More groups follow.

© 2003 McGraw-Hill Ryerson Limited.
15 - 54
Changes in the Money Supply
Follow Price-Setting by Firms
The first group finds its relative wages
and/or prices have not increased, so
they raise them again.
 And the process begins anew.

© 2003 McGraw-Hill Ryerson Limited.
15 - 55
Changes in the Money Supply
Follow Price-Setting by Firms

At this point, government has two
options:
 Increase
money supply, thereby accepting
the inflation.
 Refuse to ratify the inflation, thereby
causing unemployment to rise.
© 2003 McGraw-Hill Ryerson Limited.
15 - 56
The Insider/Outsider Model
and Inflation

The insider-outsider model is an
institutionalist story of inflation where
insiders bid up wages and outsiders are
unemployed.
© 2003 McGraw-Hill Ryerson Limited.
15 - 57
The Insider/Outsider Model
and Inflation

Insiders are business owners and
workers with good jobs with excellent
long-run prospects; outsiders are
everyone else.
© 2003 McGraw-Hill Ryerson Limited.
15 - 58
The Insider/Outsider Model
and Inflation

If markets were purely competitive,
wages, profits, and rents would be
pushed down to equilibrium levels.
© 2003 McGraw-Hill Ryerson Limited.
15 - 59
The Insider/Outsider Model
and Inflation

Insiders don’t like this, so they develop
sociological and institutional barriers to
prevent outsiders from competing away
the wages, profits and rents.
 Barriers
include unions, laws restricting the
firing of workers, and brand recognition.
© 2003 McGraw-Hill Ryerson Limited.
15 - 60
The Insider/Outsider Model
and Inflation

Outsiders must take dead-end, lowpaying jobs or try to undertake marginal
businesses that pay little return per hour
worked.
© 2003 McGraw-Hill Ryerson Limited.
15 - 61
The Insider/Outsider Model
and Inflation

Outsiders are the first to be fired and
their businesses are the first to fail in a
recession.
© 2003 McGraw-Hill Ryerson Limited.
15 - 62
The Insider/Outsider Model
and Inflation
The economy is only partially
competitive – the invisible hand is
thwarted by social and political forces.
 Insiders push to raise their nominal
wages to protect their real wages while
outsiders suffer.

© 2003 McGraw-Hill Ryerson Limited.
15 - 63
Policy Implications of
Institutional Theories

The quantity theorists have a simple
solution for stopping inflation – just cut
the growth of the money supply.
© 2003 McGraw-Hill Ryerson Limited.
15 - 64
Policy Implications of
Institutional Theories
The institutional theorists agree with this
prescription, but they argue that is not
only inefficient but unfair.
 It causes unemployment among those
least able to handle it.

© 2003 McGraw-Hill Ryerson Limited.
15 - 65
Policy Implications of
Institutional Theories

They suggest that contractionary
monetary policies be used in
combination with additional policies that
directly slow down inflation at its source.
© 2003 McGraw-Hill Ryerson Limited.
15 - 66
Policy Implications of
Institutional Theories

This additional policy is often called an
incomes policy that places direct
pressure on individuals and businesses
to hold down their nominal wages and
prices.
© 2003 McGraw-Hill Ryerson Limited.
15 - 67
Policy Implications of
Institutional Theories
Formal policies have been out of favour
for a number of years.
 Informal incomes policies exist in many
European countries.

© 2003 McGraw-Hill Ryerson Limited.
15 - 68
Inflation and Unemployment:
The Phillips Curve

The AS/AD model expresses a tradeoff
between inflation and unemployment.
A
low unemployment rate is generally
accompanied by high inflation.
 A high unemployment rate is generally
accompanied by low inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 69
Inflation and Unemployment:
The Phillips Curve

The tradeoff can be represented
graphically in the short-run Phillips
Curve which represents the relationship
between inflation and unemployment
when expected inflation is constant.
© 2003 McGraw-Hill Ryerson Limited.
15 - 70
Inflation and Unemployment:
The Phillips Curve
The Phillips curve shows us what
combinations of unemployment and
inflation are possible.
 Unemployment is measured on the
horizontal axis, and inflation is
measured on the vertical axis.

© 2003 McGraw-Hill Ryerson Limited.
15 - 71
The Hypothesized Phillips
Curve, Fig. 15-3a, p 373
5
A
Inflation
4
3
2
B
1
0
4
5
6
7 Unemployment rate
© 2003 McGraw-Hill Ryerson Limited.
15 - 72
History of the Phillips Curve
In the 1950s and 1960s, whenever
unemployment was high, inflation was
low and vice versa.
 The tradeoff between unemployment
and inflation seemed relatively stable
during the 1960s.

© 2003 McGraw-Hill Ryerson Limited.
15 - 73
History of the Phillips Curve

In the 1960s, the short-run Phillips
Curve began to play an important role in
discussions of macroeconomic policy.
© 2003 McGraw-Hill Ryerson Limited.
15 - 74
History of the Phillips Curve

Conservatives generally favoured
contractionary monetary and fiscal
policy that meant high unemployment
and low inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 75
History of the Phillips Curve

Liberals generally favoured
expansionary monetary and fiscal policy
that meant low unemployment and high
inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 76
The Breakdown of the ShortRun Phillips Curve
In the late 1970s, the relationship
between inflation and unemployment
began breaking down.
 Unemployment was high, but so was
inflation.

© 2003 McGraw-Hill Ryerson Limited.
15 - 77
The Breakdown of the ShortRun Phillips Curve
This phenomenon was termed
stagflation.
 Stagflation is the combination of high
and accelerating inflation and high
unemployment.

© 2003 McGraw-Hill Ryerson Limited.
15 - 78
The Phillips Curve Trade-Off,
Fig. 15-3, p 373
© 2003 McGraw-Hill Ryerson Limited.
15 - 79
The Long-Run and Short-Run
Phillips Curves

The continually changing relationship
between inflation and unemployment
has economists somewhat perplexed.
© 2003 McGraw-Hill Ryerson Limited.
15 - 80
The Importance of Inflation
Expectations
Expectations of inflation have been
incorporated into the analysis by
distinguishing between short-run and
long-run Phillips curves.
 Expectations of inflation – the rise in
the price level that the average person
expects.

© 2003 McGraw-Hill Ryerson Limited.
15 - 81
The Importance of Inflation
Expectations

The short-run Phillips curve is one
showing the trade-off between inflation
and unemployment when expectations
of inflation are fixed.
© 2003 McGraw-Hill Ryerson Limited.
15 - 82
The Importance of Inflation
Expectations
The long-run Phillips curve is thought to
be a vertical curve at the unemployment
rate consistent with potential output.
 It shows the trade-off (or complete lack
thereof) when expectations of inflation
equal actual inflation.

© 2003 McGraw-Hill Ryerson Limited.
15 - 83
The Importance of Inflation
Expectations

When expectations of inflation are
higher, the same level of unemployment
will be associated with a higher level of
inflation.
© 2003 McGraw-Hill Ryerson Limited.
15 - 84
The Importance of Inflation
Expectations

It makes sense to assume that the
short-run Phillips curves moves up or
down as expectations of inflation
change.
© 2003 McGraw-Hill Ryerson Limited.
15 - 85
The Importance of Inflation
Expectations

The only sustainable combination of
inflation and unemployment rates on the
short-run Phillips curve is at points
where the curve intersects the long-run
Phillips curve.
© 2003 McGraw-Hill Ryerson Limited.
15 - 86
Moving Off the Long-Run
Phillips Curve
If government decides to increase
aggregate demand, this pushes output
above its potential.
 Demand for labour goes up pushing
wages higher than productivity
increases.

© 2003 McGraw-Hill Ryerson Limited.
15 - 87
Moving Off the Long-Run
Phillips Curve
Workers are initially satisfied that their
increased wages will raise their
standard of living with the expectation of
zero inflation.
 But if productivity does not go up,
inflation will wipe out their wage gains.

© 2003 McGraw-Hill Ryerson Limited.
15 - 88
Moving Back onto the LongRun Phillips Curve

When workers find their initial raise did
not keep up with unexpected inflation,
they ask for more money giving a boost
to a wage-price spiral.
© 2003 McGraw-Hill Ryerson Limited.
15 - 89
Moving Back onto the LongRun Phillips Curve
If unemployment is lower than the target
level of unemployment, inflation and the
expectation of inflation will increase.
 The short-run Phillips curve will shift up.

© 2003 McGraw-Hill Ryerson Limited.
15 - 90
Moving Back onto the LongRun Phillips Curve

The short-run Phillip curve will continue
to shift up until output is no longer
above potential.
© 2003 McGraw-Hill Ryerson Limited.
15 - 91
Moving Back onto the LongRun Phillips Curve

If the cause of inflation is expectations
of inflation, any level of unemployment
is consistent with the target level of
unemployment.
© 2003 McGraw-Hill Ryerson Limited.
15 - 92
Inflation Expectations and the
Phillips Curve, Fig. 15-4, p 375
Price
level
Inflation PC PC1 (expected inflation = 4)
0
rate
Long-run
SAS2
Phillips
SAS1 8
curve
SAS0 6
LAS
D
C
B
A
AD1
AD0
Real output
4
2
B C expected
inflation = 0
A
4.5 5.5 6.5
D
Unemployment
rate
© 2003 McGraw-Hill Ryerson Limited.
15 - 93
Stagflation and the Phillips
Curve

Economists theorized that the
stagflation of the late 1970s and early
1980s was caused when government
attempted to push down inflation
through contractionary aggregate
demand policy.
© 2003 McGraw-Hill Ryerson Limited.
15 - 94
Stagflation and the Phillips
Curve

The lower aggregate demand pushed
the economy to the point where
unemployment exceeded the target
rate.
© 2003 McGraw-Hill Ryerson Limited.
15 - 95
Stagflation and the Phillips
Curve

The higher unemployment put
downward pressure on wages and
prices, shifting the short-run Phillips
curve down.
© 2003 McGraw-Hill Ryerson Limited.
15 - 96
The New Economy
Output expanded significantly during the
late 1990s and early 2000s, and
unemployment rates were lower than
most economists predicted.
 The cause of the good times was a
combination of factors.

© 2003 McGraw-Hill Ryerson Limited.
15 - 97
The New Economy

The economy was experiencing a
temporary positive productivity shock
because Internet growth and investment
were shifting potential output out.
© 2003 McGraw-Hill Ryerson Limited.
15 - 98
The New Economy
Competition increased because of
globalization.
 Price comparisons were made possible
by e-commerce.

© 2003 McGraw-Hill Ryerson Limited.
15 - 99
The New Economy

Workers were less concerned with real
wages and more concerned with
protecting their jobs, so firms did not
raise wages even with extremely tight
labour markets.
© 2003 McGraw-Hill Ryerson Limited.
15 - 100
The New Economy
Some economists argued that these
conditions were permanent.
 Others argued that this combination of
effects were temporary and that the
economy would come out of its
“Goldilocks period.”

© 2003 McGraw-Hill Ryerson Limited.
15 - 101
The Relationship Between
Inflation and Growth
In the AS/AD model, as the economy
expands and output increases, at some
point input prices begin to rise, shifting
the SAS curve up.
 The problem is that no one knows
where the potential output is.

© 2003 McGraw-Hill Ryerson Limited.
15 - 102
The Relationship Between
Inflation and Growth

Institutional economists prefer a point
where the output level is as high as
possible while keeping inflation low and
not accelerating.
© 2003 McGraw-Hill Ryerson Limited.
15 - 103
The Price/Output Path, Fig. 15-5a, p 377
Price
level
Keynesian
range
Intermediate
range
Classical
range
Price/output path
Low estimate
of potential
output
Real output
High estimate
of potential
output
© 2003 McGraw-Hill Ryerson Limited.
15 - 104
Quantity Theory and the
Inflation/Growth Trade-Off
Quantity theorists are much more likely
to err on the side of preventing inflation.
 For them, erring on the low side pays off
by stopping any chance of inflation.
 It also builds credibility for the Bank of
Canada.

© 2003 McGraw-Hill Ryerson Limited.
15 - 105
Quantity Theory and the
Inflation/Growth Trade-Off
Quantity theorists justify erring on the
side of preventing inflation by arguing
that there is a high cost associated with
igniting inflation.
 Inflation undermines the economy’s
long-run growth and hence its future
potential income.

© 2003 McGraw-Hill Ryerson Limited.
15 - 106
Quantity Theory and the
Inflation/Growth Trade-Off

Quantity theorists argue that there is no
long-run tradeoff between inflation and
unemployment.
© 2003 McGraw-Hill Ryerson Limited.
15 - 107
Quantity Theory and the
Inflation/Growth Trade-Off

Quantity theorists believe low inflation
leads to higher growth:
 It
reduces price uncertainty, making it
easier for businesses to invest in future
production.
 It encourages businesses to enter into longterm contracts.
 It makes using money much easier.
© 2003 McGraw-Hill Ryerson Limited.
15 - 108
Quantity Theory and the
Inflation/Growth Trade-Off

There is no solid empirical evidence
showing who is correct, the quantity
theorists or the institutionalists.
© 2003 McGraw-Hill Ryerson Limited.
15 - 109
Growth/Inflation Tradeoff, Fig.
15-5b, p 377
Inflation
0
Growth
© 2003 McGraw-Hill Ryerson Limited.
15 - 110
Institutional Theory and the
Inflation/Growth Trade-Off

Supporters of the institutional theory of
inflation are less sure about a negative
relationship between inflation and
growth.
© 2003 McGraw-Hill Ryerson Limited.
15 - 111
Institutional Theory and the
Inflation/Growth Trade-Off
Institutional theorists agree that rises in
the price level have the potential of
generating inflation.
 They agree that high accelerating
inflation undermines growth.
 They do not agree that all price level
increases start an inflation.

© 2003 McGraw-Hill Ryerson Limited.
15 - 112
Institutional Theory and the
Inflation/Growth Trade-Off

If inflation does get started, the
government has some medicine to give
the economy that will get rid of inflation
relatively easily.
© 2003 McGraw-Hill Ryerson Limited.
15 - 113
Institutional Theory and the
Inflation/Growth Trade-Off

This was highlighted in the debate
about monetary policy in the early 2000.
© 2003 McGraw-Hill Ryerson Limited.
15 - 114
Institutional Theory and the
Inflation/Growth Trade-Off

Quantity theorist argued that inflation
was just around the corner, and unless
government instituted contractionary
aggregate demand policy, the seeds of
inflation would be sown.
© 2003 McGraw-Hill Ryerson Limited.
15 - 115
Institutional Theory and the
Inflation/Growth Trade-Off
Other economists argued that the
institutional changes in the labour
market had reduced the inflation threat
and that more expansionary policy was
needed.
 The Bank of Canada followed a path
between these two positions.

© 2003 McGraw-Hill Ryerson Limited.
Inflation and Its
Relationship to
Unemployment and
Growth
End of Chapter 15
© 2003 McGraw-Hill Ryerson Limited.