Title: Ch. 12: U.S. Inflation, Unemployment and Business Cycles
1Ch. 12 U.S. Inflation, Unemployment and
Business Cycles
- Demand-pull and cost-push inflation.
- SR and LR tradeoff between inflation and
unemployment (Phillips Curve) - Business cycle theories.
2The Misery Index
- MI proposed by Arthur Okun in 1970s
- MI inflation rate plus the unemployment rate.
- We want both low inflation low unemployment
are there trade-offs between the two?
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4Real GDP and the Price Level 1947-2010
5The Evolving U.S. Economy
- Inflation
- The upward movement of the dots shows inflation.
- Recession
- Leftward movement of dots shows declining real
GDP - Economic Growth
- The rightward movement of the dots shows the
growth of real GDP.
6Inflation Cycles
- In the long run, according to equation of
exchange - inflation ch in M ch in V - ch in y
- inflation occurs if money grows faster than
potential GDP. - In the short run,
- Inflation can be initiated by
- Increases in AD (demand pull inflation)
- Decreases in SAS (cost push inflation)
7Inflation Cycles
- Demand-Pull Inflation
- starts because AD increases
- can begin with any factor that increases AD.
- Examples
- Monetary policy interest rates
- Fiscal policy government spending or taxes
- Exports (value of or foreign income levels)
- Investment (expected profits, technological
advances) - Consumer expectations
- Income
- Future inflation
8Inflation Cycles Demand Pull
- Starting from full employment, an increase in AD
- Increases P (spell of inflation)
- Increases RGDP
- Creates inflationary gap
9Inflation Cycles Demand Pull
- Since
- unempl lt natural rate
- money wage rate rises
- SAS shifts left
- P rises (another spell of inflation)
- RGDP falls until GDPpotential GDP
- Inflation is finished unless AD increases
again.
10Inflation Cycles Demand Pull
- Demand-Pull Inflation Process
- AD must continually increase so that the process
described above repeats itself - Although any of several factors can increase AD
to start a demand-pull inflation, only an ongoing
increase in the quantity of money can sustain it.
11Inflation Cycles Cost Push
- Cost-Push Inflation
- starts with an increase in costs
- Possible sources of increased costs
- An increase in the money wage rate
- An increase in the money price of raw materials
(e.g. oil) - Natural disasters
- Regulation (e.g. carbon taxes)
- Results in decrease in SAS
12Inflation Cycles Cost Push
- Initial Effect of a Decrease in AS
- A rise in the price of oil decreases SAS and
shifts the curve leftward. - Real GDP decreases and the price level rises.
- stagflation (higher prices, less output)
13Inflation Cycles Cost Push
- Aggregate Demand Response
- The initial increase in costs creates a one-time
rise in the price level, not continued inflation. - To create inflation, AD must increase after AS
decreases. - Although any of several factors can increase AD
to start a demand-pull inflation, only an ongoing
increase in the quantity of money can sustain it.
14Inflation Cycles Inflation Expectations
- Expected Inflation
- If inflation is expected,
- AD increases
- AS decreases as workers negotiate wage increases
to offset expected inflation. - Movement along LAS curve
- No change in real GDP, real wages, or
unemployment
15Inflation Cycles Inflation Expectations
- When the inflation forecast is correct, the
economy operates at full employment. - If AD grows faster than expected,
- Inflation gt expected
- Real wages decrease
- Real GDP increases above potential
- Unemployment rate falls below natural rate
- If AD grows slower than expected
- Inflation lt expected
- Real wages rise
- Unemployment rate rises above natural rate
16AD/AS representation of impact of inflation gt
expected inflation
17AD/AS representation of impact of inflation lt
expected inflation
18The Phillips Curve
- Phillips curve
- shows the relationship between the inflation rate
and the unemployment rate. - SR Phillips curve
- Shows tradeoff between inflation and unemployment
holding constant - The expected inflation rate
- The natural unemployment rate
- LR Phillips curve
- shows the relationship between inflation and
unemployment when the actual inflation rate
equals expected inflation - vertical at natural rate of unemployment
19The Phillips Curve
- A short-run Phillips curve (SRPC)
- As inflation increases, unemployment decreases
- AD/AS explanation.
- If inflationexpected, unempl natural rate.
- If inflationgtexpected, unemplltnatural rate
- If inflation lt expected, unemplgtnatural rate
20The Phillips Curve
- The long-run Phillips curve (LRPC)
- vertical at the natural unemployment rate.
- intersects SRPC at expected inflation rate.
- Shifts only if natural unemployment rates rises
or falls - Unemployment insurance
- Demographics of labor force
21The Phillips Curve
- SRPC shifts up/down as inflation expectations
rise/fall
22The Phillips Curve in U.S.
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24Business Cycles
- Two approaches to understanding business cycles
are - Mainstream business cycle theory
- Real business cycle theory
- Mainstream (Demand Side) Business Cycle Theory
- Because potential GDP grows at a steady pace
while aggregate demand grows at a fluctuating
rate, real GDP fluctuates around potential GDP.
25Business Cycles
- Real Business Cycle Theory
- Argues that random fluctuations in productivity
are the main source of economic fluctuations. - fluctuations in the pace of technological change.
- international disturbances, climate fluctuations,
or natural disasters. - rapid productivity growth generates expansion
slow productivity growth (or decreases in
productivity) cause contraction. - productivity growth affects
- Investment and interest rates
- Labor market and wages
26Real Business Cycles Investment
- negative productivity shock
- investment demand and loan demand falls
- Interest rates fall
- reverse happens for positive productivity shock
27Real Business Cycles Labor
- Negative productivity shock
- Labor demand decreases
- Labor supply decreases because of lower interest
rates (prior slide) and intertemporal subst - Employment and the real wage rate decrease
(assuming LD shift larger than LS). - Reverse happens when there is an expansion
caused by rapid productivity increase.
28Productivity and Wages over the Business Cycle
1970-2011