Ch. 12: U.S. Inflation, Unemployment and Business Cycles - PowerPoint PPT Presentation

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Ch. 12: U.S. Inflation, Unemployment and Business Cycles

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Title: Parkin-Bade Chapter 28 Author: Robin Bade and Michael Parkin Last modified by: Administrator Created Date: 6/9/2002 12:26:05 AM Document presentation format – PowerPoint PPT presentation

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Title: Ch. 12: U.S. Inflation, Unemployment and Business Cycles


1
Ch. 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.

2
The 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?

3
(No Transcript)
4
Real GDP and the Price Level 1947-2010
5
The 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.

6
Inflation 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)

7
Inflation 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

8
Inflation Cycles Demand Pull
  • Starting from full employment, an increase in AD
  • Increases P (spell of inflation)
  • Increases RGDP
  • Creates inflationary gap

9
Inflation 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.

10
Inflation 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.

11
Inflation 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

12
Inflation 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)

13
Inflation 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.

14
Inflation 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

15
Inflation 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

16
AD/AS representation of impact of inflation gt
expected inflation
17
AD/AS representation of impact of inflation lt
expected inflation
18
The 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

19
The 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

20
The 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

21
The Phillips Curve
  • SRPC shifts up/down as inflation expectations
    rise/fall

22
The Phillips Curve in U.S.
23
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24
Business 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.

25
Business 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

26
Real Business Cycles Investment
  • negative productivity shock
  • investment demand and loan demand falls
  • Interest rates fall
  • reverse happens for positive productivity shock

27
Real 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.

28
Productivity and Wages over the Business Cycle
1970-2011
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