Inflation And Its Relationship To Unemployment And Growth
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Transcript Inflation And Its Relationship To Unemployment And Growth
Inflation and Its
Relationship to
Unemployment and
Growth
Chapter 15
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15 - 2
Some Basics about Inflation
Inflation is a continuous rise in the
price level.
It is measured using a price index.
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15 - 3
The Distributional Effects of
Inflation
There are winners and losers in an
inflation.
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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.
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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.
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The Distributional Effects of
Inflation
The composition of the winners and
losers from an inflation changes over
time.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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Real Output Is Independent of
the Money Supply
Q is autonomous, meaning real output
is determined by forces outside the
quantity theory.
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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.
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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.
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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.
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Real Output Is Independent of
the Money Supply
The quantity theory holds that real
output is not influenced by changes in
the money supply.
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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.
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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.
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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.
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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.
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Price Level and Money in
Canada, 1953-2001, Fig. 15-1, p 365
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Price Level and Money in
Brazil and Chile, Fig. 15-2, p 366
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The Inflation Tax
Developing countries such as Brazil and
Chile sometimes increase the money
supply to keep the economy running.
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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.
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The Inflation Tax
Financing the deficit by expansionary
monetary policy causes inflation.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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The Institutional Theory of
Inflation
According to the quantity theory, the
direction of causation moves from left to
right:
MV PQ
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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
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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.
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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.
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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.
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Price-Setting Strategies
Depend on the Labour Market
Whether the firm selects this priceraising strategy depends on the state of
the labour market.
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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.
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Changes in the Money Supply
Follow Price-Setting by Firms
Institutional theorists see the nominal
wage- and price-setting process as
generating inflation.
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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.
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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.
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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.
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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.
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The Insider/Outsider Model
and Inflation
Insiders are business owners and
workers with good jobs with excellent
long-run prospects; outsiders are
everyone else.
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The Insider/Outsider Model
and Inflation
If markets were purely competitive,
wages, profits, and rents would be
pushed down to equilibrium levels.
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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.
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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.
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The Insider/Outsider Model
and Inflation
Outsiders are the first to be fired and
their businesses are the first to fail in a
recession.
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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.
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Policy Implications of
Institutional Theories
The quantity theorists have a simple
solution for stopping inflation – just cut
the growth of the money supply.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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The Hypothesized Phillips
Curve, Fig. 15-3a, p 373
5
A
Inflation
4
3
2
B
1
0
4
5
6
7 Unemployment rate
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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.
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History of the Phillips Curve
In the 1960s, the short-run Phillips
Curve began to play an important role in
discussions of macroeconomic policy.
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History of the Phillips Curve
Conservatives generally favoured
contractionary monetary and fiscal
policy that meant high unemployment
and low inflation.
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History of the Phillips Curve
Liberals generally favoured
expansionary monetary and fiscal policy
that meant low unemployment and high
inflation.
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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.
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The Breakdown of the ShortRun Phillips Curve
This phenomenon was termed
stagflation.
Stagflation is the combination of high
and accelerating inflation and high
unemployment.
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The Phillips Curve Trade-Off,
Fig. 15-3, p 373
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The Long-Run and Short-Run
Phillips Curves
The continually changing relationship
between inflation and unemployment
has economists somewhat perplexed.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Moving Back onto the LongRun Phillips Curve
The short-run Phillip curve will continue
to shift up until output is no longer
above potential.
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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.
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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
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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.
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Stagflation and the Phillips
Curve
The lower aggregate demand pushed
the economy to the point where
unemployment exceeded the target
rate.
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Stagflation and the Phillips
Curve
The higher unemployment put
downward pressure on wages and
prices, shifting the short-run Phillips
curve down.
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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.
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The New Economy
The economy was experiencing a
temporary positive productivity shock
because Internet growth and investment
were shifting potential output out.
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The New Economy
Competition increased because of
globalization.
Price comparisons were made possible
by e-commerce.
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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.
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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.”
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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.
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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.
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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
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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.
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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.
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Quantity Theory and the
Inflation/Growth Trade-Off
Quantity theorists argue that there is no
long-run tradeoff between inflation and
unemployment.
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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.
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Quantity Theory and the
Inflation/Growth Trade-Off
There is no solid empirical evidence
showing who is correct, the quantity
theorists or the institutionalists.
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Growth/Inflation Tradeoff, Fig.
15-5b, p 377
Inflation
0
Growth
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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.
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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.
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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.
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Institutional Theory and the
Inflation/Growth Trade-Off
This was highlighted in the debate
about monetary policy in the early 2000.
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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.
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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.
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Inflation and Its
Relationship to
Unemployment and
Growth
End of Chapter 15
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