CHAPTER 15

1. CHAPTER 15 THE DYNAMICS OF INFLATION AND UNEMPLOYMENT

2. PRIME RATE Interest rate charged on short-term loans by banks to their best customers.

3. MONEY IS NEUTRAL • If the Federal Reserve increases the money supply by 5%, there will be a 5% inflation -- Prices in the economy will rise by 5% per year • Nominal dollar wages of workers rise by 5% a year • Since prices are rising at 5% a year, real wages -- wages adjusted for changes in purchasing power -- remain constant

4. MONEY ILLUSION A confusion of real and nominal magnitudes.

5. EXPECTATIONS OF INFLATION • After some period of time, everyone in the economy would expect the 5% inflation would continue • These expectations affect all aspects of economic life • Continued inflation becomes the normal state of affairs • Expectations of inflation become ingrained in decisions made in all aspects of economic life • When the public holds expectations of inflation, real an nominal interest rates will differ

6. EXPECTED REAL RATE OF INTEREST • The nominal rate of interest adjusted for inflation: expected real rate = nominal rate - expectations of inflation • If nominal interest is 10% and people expect 6% inflation • Expected real rate of interest is 10% - 6% = 4% • If $100 invested, you receive $110 at end of year • If you expect 6% inflation, you need $6 to maintain purchasing power • The real gain you anticipate is $4

7. MONEY IS NEUTRAL • The real rate of interest does not depend on monetary policy because money is neutral but, • Nominal rates of interest depend on the inflation rate, which in the long run is determined by growth in money supply • Monetary policy does affect the nominal interest rate in the long run • If two countries had the same real interest rate, but one had a higher inflation rate, it would also have a higher nominal interest rate

8. DEMAND FOR MONEY AND EXPECTED INFLATION • Money demand is affected by inflation rate • If prices rise by 6% per year, so does the value of transactions • The public needs 6% more money each year for these transactions • If Federal Reserve allows money to increase at 6%, the demand and supply of money will grow at the same rate • With both demand and supply of money growing at the same rate, real and nominal interest rates will remain constant

9. IN SHORT RUN, MONEY GROWTH RATE CHANGES AFFECT REAL INTEREST RATES • Initially, public expects 6% inflation and money supply and demand grow at 6% per year • If Federal Reserve suddenly decreases growth rate of money to 4%, while public still expects 6% • The growth in demand for money will exceed growth in supply of money • Both nominal and real interest rates will increase • Higher real interest rates reduce investment spending by firms and consumer durable spending by households • With reduced demand for goods and services, real GDP will fall and unemployment will rise

10. IN THE LONG RUN • The economy will adjust to lower money growth rates • Output will return to full employment through the adjustment process • Since money is neutral in the long run, the real rate of interest will return to its previous value • Inflation will fall to 4%, the rate of growth of the money supply • Nominal interest rates will also fall

11. EXPECTATIONS PHILLIPS CURVE • Inflation increases when economic activity booms and unemployment falls below its natural rate • The rate of inflation falls when the economy is in a recession and unemployment exceeds the natural rate • A refined version of the adjustment mechanism for the economy

12. CONSIDERING ONGOING INFLATION Wages and prices can change for two reasons 1. Wages and prices will tend to rise during booms and fall during recessions 2. Workers and firms will raise their nominal wages and prices to the extent they expect ongoing inflation, to maintain the same level of real wages and real prices

13. ECONOMY OPERATING AT FULL EMPLOYMENT • Wages and prices will rise at the rate of inflation expected by workers and firms • If unemployment exceeds the natural rate, the high level of unemployment will put downward pressure on wages and prices, and inflation will fall relative to what is expected • If unemployment were below the natural rate, employers would bid aggressively for workers, and wages and prices would rise faster than previously expected

14. IF EXPECTATIONS OF INFLATION RATE ARE BASED ON LAST YEAR’S INFLATION RATE The expectations Phillips curve becomes a relationship between the change in the inflation rate and the level of unemployment • If the actual unemployment rate exceeds the natural rate, inflation will fall below last year’s level • If the actual unemployment rate is below the natural rate, the inflation rate will rise above last year’s level

15. A Point A represents the natural rate of unemployment -- 6% with 0 inflation Source: Author’s calculations based on Economic Report of the President, Washington DC: U.S. Government Printing Office

16. HOW TO USE THE EXPECTATIONS PHILLIPS CURVE TO PREDICT INFLATION • Suppose the natural rate of unemployment is 6% and the current inflation rate is 8% • Unemployment rises suddenly to 9% and remains at that level for two years before returning to 6% • Inflation will fall 1/2% per year for each point by which the unemployment rate exceeds the natural rate • Since unemployment will exceed the natural rate by 3 percentage points for two years (for a total of 6 points), inflation will fall by 3 percentage points, from 8% to 5%

17. PHILLIPS CURVE • Differs from the expectations Phillips curve • Initial attempts to explain the relationship between inflation and unemployment • In 1950’s, an engineer named A. W. Phillips found lower unemployment to be associated with higher inflation • He noticed a negative relationship between the level of inflation and unemployment in British data

18. 1989 1990 1991 1988 1986 1987 1992 1993 Source Data from: Economic Report of the President, (Washington, DC: U.S. Government Printing Office, yearly

19. USING THE EXPECTATIONS PHILLIPS CURVE TO DESCRIBE ECONOMIC PATTERNS OF THE 1980S When President Carter took office in 1977: Inflation was nearly 6.5% and unemployment >7% By 1980 inflation had risen to 9.4% Reasons Unemployment had reduced to below 6% by 1979; since natural rate was approximately 6%, inflation increased Second oil shock in 1979 also contributed to inflation

20. USING THE EXPECTATIONS PHILLIPS CURVE TO DESCRIBE ECONOMIC PATTERNS OF THE 1980S • President Carter’s appointment of Paul Volker as Chairman of the Federal Reserve led to “tight money” policy, resulting in sharply rising interest rates by 1980 • With Volker’s policy supported by President Reagan, continued high real interest rates resulted in unemployment of over 10% by 1984 • As unemployment exceeded the natural rate, inflation rate fell to 2.7% by 1986, with unemployment at 7%

21. USING THE EXPECTATIONS PHILLIPS CURVE TO DESCRIBE ECONOMIC PATTERNS OF THE 1980S • After 1986, the unemployment rate began to fall again • As it fell below the natural rate, inflation began to rise, and had risen to 4.5% by 1989 • The Federal Reserve increased unemployment to bring down the inflation rate • By 1992, the unemployment rate had risen to 7.4%, and by 1993 inflation was below 3%

22. CHOICES FOR THE FED Price, p E AS0 AD0 Output, y yF

23. CHOICES FOR THE FED Price, p AS1 E AS0 AD1 AD0 Output, y yF If workers push up their normal wages, the aggregate supply curve will shift from AS0 to AS1.

24. CHOICES FOR THE FED Price, p A AS1 E AS0 AD0 Output, y yF If workers push up their normal wages, the aggregate supply curve will shift from AS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will occur at A and eventually the economy will return to full employment at E.

25. CHOICES FOR THE FED Price, p A F AS1 E AS0 AD1 AD0 Output, y yF If workers push up their normal wages, the aggregate supply curve will shift from AS0 to AS1. If the Fed keeps aggregate demand constant at AD0, a recession will occur at A and eventually the economy will return to full employment at E. If the Fed increases aggregate demand , the economy remains at full employment at F, but with a higher price level.

26. EXPECTATIONS OF THE UNION • The actions of the union will depend on what its leaders expect the Fed to do: -- If they expect the Fed will not increase aggregate demand, their actions will trigger a recession -- The union may be reluctant to negotiate a high wage, permitting the economy to remain at full employment and experience no increase in prices -- If the leaders believe the Fed will increase aggregate demand, the union will increase the nominal wage -- The result will be higher prices in the economy

27. EXPECTATIONS ABOUT THE FED • Expectations about the Fed’s determination to fight inflation will affect the behavior in the private sector • If the Fed is credible or believable in its desire to fight inflation, it can deter the private sector from taking aggressive actions that drive up prices • Some political scientists and economists have suggested that central banks which have true independence from the rest of government, and are less subject to political influence, will be more credible in their commitment to fight inflation

28. INFLATION VERSUS CENTRAL BANK INDEPENDENCE Spain New Zealand Italy The United Kingdom Australia Denmark France / Norway / Sweden Japan Canada The United States Belgium The Netherlands Switzerland Germany Source data from Alisena and Summers, Central Bank Independence and Macroeconomic Performance,” Journal of Money, Credit, and Banking, May 1993

29. RATIONAL EXPECTATIONS • Theory developed by Nobel laureate Robert E. Lucas, Jr. from the University of Chicago • Analyzes how firms and individuals may base their expectations on all the information they have available to them • According to the theory, individuals form expectations such that, on average, they anticipate the future correctly

30. EXPECTATIONS PLAY IMPORTANT ROLE IN ALMOST ALL AREAS OF ECONOMICS • Borrowers and lenders must form expectations about future inflation rates in setting nominal interest rates • Prices of stocks of firms will depend on investors’ expectations about future dividends • Your decision to buy or rent a home will depend on your expectation about the future prices of homes

31. VELOCITY OF MONEY The ratio of nominal GDP to money supply velocity of money = nominal GDP / money supply • The number of times the money supply has to turn over during a given year to purchase nominal GDP • Suppose nominal GDP were $5 trillion per year and the money supply were $1 trillion velocity = $5 trillion / $1 trillion = 5 per year

32. VELOCITY OF MONEY • If velocity is very high, individuals turn over money quickly • If velocity is low, they turn over money slowly and hold onto money for a longer period of time $$

33. QUANTITY EQUATION • Equation of exchange money supply x velocity = nominal GDP M x V = P x y • M is the money supply • V is the velocity of money • P is a measure of the average price level • y is the real GDP • P and y together equal nominal GDP • On the right side is nominal GDP, the product of the chain-type price index and the real GDP • This is the total value of spending

34. GROWTH VERSION OF THE QUANTITY EQUATION • The basic quantity equation can be used to derive a closely related formula that is useful for understanding inflation in the long run • Growth Rate + Growth Rate = Growth Rate + Growth Rate of money of velocity of prices of real output • Suppose money growth is 10% / year and growth of real output is 3% / year, with velocity at zero growth (constant), the rate of growth of prices (inflation ) is: • 10 + 0 = Growth of prices + 3 Growth of prices (inflation) = 7

35. MONEY GROWTH AND INFLATION FOR THE UNITED STATES Percent 10 9.5 Growth of M2 9 Inflation 8 7.1 6.9 6.8 7 6 5 4.5 3.8 4 3 2.5 3 2 1 0 1950s 1960s 1970s 1980s Average Yearly Percent Growth Per Year

36. HYPERINFLATION • Very high inflation rates, over 50% per month • Inflation rates observed in the United States in the last 40 years are insignificant in comparison to some experiences around the world throughout history

37. SOME CLASSIC HYPERINFLATIONS Country Greece Hungary Russia Dates 11/43 - 11/44 8/45 - 7/46 12/21 - 1/24 Monthly Rate 365 19,800 57 of inflation Monthly Rate of 220 12,200 49 money growth Approximate 14 333 3.70 increase in Velocity Source: Adapted from Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” Studies in the Quantity Theory of Money, edited by Milton Friedman, (Chicago: University of Chicago Press, 1956

38. HIGH INFLATIONS IN THE 1980s Country Bolivia Argentina Nicaragua Year 1985 1989 1988 Yearly Inflation 1,152, 200 975, 000 302, 200 Rate (%) Monthly Inflation 118 95 115 Rate (%) Monthly Money 91 93 66 Growth Rate (%) Source: International Financial Statistics Yearbook, 1992, (Washington DC: International Monetary Fund)

39. DURING HYPERINFLATIONS • Money no longer works very well in facilitating exchange • Since prices are changing so fast and unpredictably, there is typically massive confusion about the true value of commodities • Different stores may be raising prices at different rates • The same commodities may sell for radically different prices • Everyone spends all their time hunting for bargains and finding the lowest prices • Governments are forced to put an end to hyperinflation before it destroys their economies

40. THE CAUSE OF HYPERINFLATION Excessive money growth • If a government wants to spend a specified amount of money, but is collecting less in taxes, it must cover the difference in some way: • -- the government may borrow the difference from the public and issue bonds, for which it must pay back what it borrows and interest in the future • -- the government may print new money -- governments could mix borrowing and printing money to cover the deficit government deficit = new borrowing + new money created

41. HYPERINFLATION • occurs in countries that have large deficits, but cannot borrow and are forced to print new money • is only stopped by eliminating the deficit, which is the basic cause: -- increase taxes -- cut spending • Once the deficit has been cut and the government stops printing money, the hyperinflation will end

42. MONETARISTS • Economists who traditionally emphasize the important role that the supply of money plays in determining nominal income and inflation • Most famous -- Milton Friedman, Nobel laureate -- studied versions of quantity equation and role of money in economic life • Philip Cagan -- best known for work on hyperinflations • Monetarist economists did pioneering research on link between money, nominal income and inflation

43. COSTS OF UNEMPLOYMENT • Excess unemployment -- above the natural rate -- means the economy is no longer producing at potential • Resulting loss of resources can be very large • Reduced employment and income for individuals • To families with fixed obligations, the loss can bring immediate hardships

44. UNEMPLOYMENT INSURANCE • Payments received from the government upon becoming unemployed • Typically only temporary • Does not replace a workers full earnings

45. LONGER EFFECTS OF UNEMPLOYMENT • Workers who suffer from a prolonged period of unemployment are likely to lose some of their skills • Economists point to loss of both skills and good work habits • Losing a job can impose severe psychological costs, leading to increases in: -- crime -- divorce -- suicide

46. ANTICIPATED INFLATION Fully Anticipated Inflation • Inflation at 4% would mean workers would know that nominal wage increases of 4% were not real wage increases, and • Investors earning a 7% rate of interest on bonds would know that their real return would be 3% after adjusting for inflation • Menu costs -- the actual physical costs of changing prices • Shoe leather costs -- additional wear and tear necessary to hold less cash • Our tax system and financial system do not fully adjust even to fully anticipated inflation

47. USURY LAWS Ceilings on interest rates

48. COSTS OF INFLATION Anticipated Unanticipated Inflation Inflation Institutions do Distortions in the Unfair redistributions not adjust tax system, Problems in financial markets Institutions Cost of changing Institutional adjust prices , disintegration Shoe-leather costs

49. UNANTICIPATED INFLATION • Unexpected inflation • Cost includes arbitrary redistributions of income: -- borrowers gain; lenders lose -- Anyone making a nominal contract to sell a product will lose • Impose real costs to the economy -- individuals and institutions change behavior -- If unanticipated inflation becomes extreme, individuals will spend more time trying to profit from inflation than working at productive jobs -- The economy becomes less efficient when people take actions based on beating inflation

50. INDEXED • Describes something whose payments are adjusted for changes in prices, such as bonds or nominal contracts • In practice, countries find that indexing is not the perfect solution to problems caused by inflation: -- policymakers worry indexing lowers the resolve to fight inflation -- Price indices are far from perfect and are extremely difficult to construct when prices are increasing rapidly -- Some economists believe that indexing builds inflation into the economic system and makes it difficult to reduce inflation