Ch. 13: U.S. Inflation, Unemployment and Business Cycles

1
Ch. 13 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.
• MI peak 21 in 1981
• MI minimum 6 in 1964 and 1999.
• MI in 2007 4.5 unempl 4.0 inflation 8.5
• We want both low inflation low unemployment
  are there trade-offs between the two?

3
(No Transcript)
4
Inflation and Unemployment in U.S. 1950-2008
5
According to the U.S. experience, inflation tends
to ___ during a recession and unemployment tends
to ___ during a recession.

1. Rise rise
2. Rise fall
3. Fall fall
4. Fall rise

6
Real GDP and the Price Level 1948-2008
7
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.

8
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)

9
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

10
Inflation Cycles Demand Pull

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

11
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.

12
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.

13
If there is a decrease in AD, the short run
effect is to _____ prices, ____ real wages, and
cause unemployment to _____.

1. Decrease decrease increase
2. Decrease increase increase
3. Increase decrease decrease
4. None of the above

14
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

15
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)

16
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.

17
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

18
If there is exceptionally good weather in the
U.S., this should cause SAS to _____. The short
run effect of this is to _____ prices and _____
real GDP.

1. Decrease increase increase
2. Increase decrease increase
3. Increase increase increase
4. None of the above

19
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

20
AD/AS representation of impact of inflation gt
expected inflation
21
AD/AS representation of impact of inflation lt
expected inflation
22
If the Federal Reserve creates more money than
people expected, in the short run, this will
cause real wages to ____ and unemployment
to______.

1. Rise rise
2. Rise fall
3. Fall fall
4. Fall rise

23
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

24
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

25
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

26
The Phillips Curve

• SRPC shifts up/down as inflation expectations
  rise/fall

27
If the Federal Reserve cuts interest rates
unexpectedly, this should cause

1. A movement downward along the Phillips curve
2. A movement upward along the Phillips curve
3. An upward shift of the Phillips curve
4. A downward shift of the Phillips curve

28
If the general public begins to believe that the
Federal Reserve stimulus is going to lead to
higher inflation in the future, this should cause

1. A movement downward along the Phillips curve
2. A movement upward along the Phillips curve
3. An upward shift of the Phillips curve
4. A downward shift of the Phillips curve

29
The Phillips Curve in U.S.
30
(No Transcript)
31
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.

32
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

33
Real Business Cycles Investment

• negative productivity shock
• investment demand and loan demand falls
• Interest rates fall
• reverse happens for positive productivity shock

34
Real Business Cycles Labor

• Negative productivity shock
• Labor demand decreases
• Labor supply decreases because of lower interest
  rates (above) 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.

35
(No Transcript)