Chapter 13 Unemployment and Inflation Copyright © 2016 Pearson Canada Inc

Chapter 13

Unemployment and Inflation

Copyright © 2016 Pearson Canada Inc.

Main Questions

■ Is there a trade-off between unemployment and inflation?

■ What are the problems that stem from unemployment and inflation?

Copyright © 2016 Pearson Canada Inc. 13-2



■ The Phillips curve is a negative empirical relationship between unemployment and inflation.

■ In 1970-2009 there seemed to be no reliable relationship between unemployment and inflation.

13-3



13-4



13-5


The Expectations Augmented Phillips Curve

■A negative relationship should exist between unanticipated inflation and cyclical unemployment.

13-6


The Phillips Curve (continued)■ If increase in M is anticipated, and if there is

no misperception, the economy remains at , unemployment remains at , and cyclical unemployment is zero.

Y u

13-7


The Phillips Curve (continued)

■ If increase in M is unanticipated, unanticipated inflation is created, Y is above , and u is below .

■ h measures the strength of the relationship between unanticipated inflation and cyclical unemployment.

Y u)uh(uππ e

13-8



13-9



■ The expectation-augmented Phillips curve states that if π exceeds πe then u is less than .

h is related to the slope of the SRAS curve.

u

)uh(uππ e

13-10


Shifting of the Philips Curve

■ The Phillips curve depends on the expected rate of inflation and the natural rate of unemployment. If either factor changes the Phillips curve will shift.

huuhππ e

13-11


Changes in the Expected Rate of Inflation

■ If households anticipate a change in the price level they respond by their expectations of the price level (the rate of inflation) one-for-one.

13-12


Changes in the Expected Rate of Inflation■ The Phillips curve shifts up by the

amount of the increase in the expected rate of inflation.

13-13


Changes in the Natural Rate of Unemployment■ An increase in the natural

unemployment rate causes the Phillips curve to shift up and to the right.

13-14


Supply Shocks and the Phillips Curve

■ An adverse supply shock causes a burst of inflation and raises the natural rate of unemployment:■ by increasing the degree of mismatch

between workers and jobs (classical economists);

■ by reducing MPN and labour demanded at full employment (Keynesian economists).

13-15


Supply Shocks and the Phillips Curve

■ An adverse supply shock should shift the Phillips curve up and to the right.

■ The Phillips curve should be unstable particularly during periods of supply shocks.

13-16


The Shifting Phillips Curve in Practice

■ The Friedman-Phelps analysis shows that a negative relationship between the levels of inflation and unemployment holds as long as expected inflation and the natural unemployment rate are approximately constant.

13-17


The Shifting Phillips Curve in Practice (continued)

■ During 1970-2009 there was a number of productivity shocks as well as changes in government and macroeconomic policies.

■ A negative relationship between unanticipated inflation and cyclical unemployment does appear in the data.

13-18


The Shifting Phillips Curve in Practice (continued)

13-19


Macroeconomic Policy and the Phillips Curve

■ Keynesians believe that, in a recession, expansionary AD policy can increase inflation back to the anticipated levels that were used as a basis for nominal wage contracts and pricing.

13-20


The Lucas Critique

■ Because new policies change the economic “rules” and, thus, affect economic behaviour, no one can safely assume that historical relationships between variables will hold when policies change.

13-21


The Long-Run Phillips Curve

■ Economists agree that in the long run economy will adjust to the general equilibrium where π=πe and u= .

■ The long-run Phillips curve is vertical line at u= . It is related to the long-run neutrality of money.

u

u

13-22


The Cost of Unemployment

■ The output is lost because fewer people are productively employed.

■ Unemployed workers and their families face psychological cost.

■ The offsetting factors are acquiring new skills and more leisure time.

13-23


The Long-Term Behaviour of the Unemployment Rate

■ The long-term unemployment rate may be influenced by:■ changes in the composition of the

labour force by age and sex;■ structural changes in the economy

brought about by technological change.

13-24


The Long-Term Behaviour of the Unemployment Rate

13-25


Hysteresis in Unemployment■ Hysteresis in unemployment

means that the natural unemployment rate changes in response to the actual unemployment rate.

■ If workers are idle for long periods of time, their skills deteriorate and the mismatch increases.

13-26


Hysteresis in Unemployment (continued)■ Some regulations on firms may

cause them to be cautious about hiring workers, because the regulations make it difficult to fire them.

■ Insider-outsider theory suggests that unionized labour increases wages for insiders and leaves outsiders unemployed.

13-27


How to Reduce the Natural Rate of Unemployment■ Tax credits or subsidies for

training and relocating unemployed workers.

■ Minimize payroll taxes and the “tax wedge” by reforming the Employment Insurance program.

■ Use aggressive policy to keep actual unemployment rate low.

13-28


Perfectly Anticipated Inflation■ Because nominal wages are rising

together with prices, the purchasing power is not hurt by the perfectly anticipated inflation.

■ Perfectly anticipated inflation would not hurt the value of savings accounts.

13-29


The Cost of Perfectly Anticipated Inflation

■ Shoe leather costs of inflation is time and effort incurred by people and firms who are trying to minimize their holdings of cash.

■ Menu costs of inflation.■ Welfare costs of inflation-induced

tax distortions.

13-30


The Cost of Unanticipated Inflation

■ Creditors and those with incomes set in nominal terms are hurt, whereas debtors and those who make fixed nominal payments are helped by unanticipated inflation.

13-31


The Cost of Unanticipated Inflation (continued)

■ People are made worse off by increasing risk of gaining or losing wealth as a result of unanticipated inflation.

■ People must spend time and effort learning about different prices.

13-32


The Cost of Hyperinflation

■ Hyperinflation occurs when the inflation rate is extremely high for a sustained period of time.■ The shoe leather costs are enormous.■ The government’s ability to collect

taxes is undermined.■ The market efficiency is disrupted.

13-33


Fighting Inflation: The Role of Inflationary Expectations

■ The only factor that can create sustained rises in aggregate demand and ongoing inflation is a high rate of money growth.

■ Governments may print money to finance their spending or use monetary policy to fight recession.

13-34


Fighting Inflation (continued)■ The process of disinflation – the

reduction of money growth – can lead to a recession.

■ If inflation falls below the expected rate, unemployment will rise above the natural rate.

■ A recession can be avoided if the expected inflation rate can be made to fall.

13-35


Rapid versus Gradual Disinflation

■ A cold turkey strategy is a rapid and decisive reduction in the growth rate of the money supply.

■ It may lead to a significant increase in cyclical unemployment.

13-36


Rapid versus Gradual Disinflation (continued)

■ Inflation expectations may not lower if the government is expected to abandon the policy under political pressure.

■ A policy of gradualism is a policy of reducing the rate of money growth gradually over a period of time.

13-37


Rapid versus Gradual Disinflation (continued)

■ This policy will raise unemployment by less than the cold-turkey strategy, but the period of higher unemployment will be longer.

13-38


Wage and Price Controls

■ Wage and price controls (income policies) are legal limits on the ability of firms to raise wages or prices.

■ Price controls are likely to create shortages.

■ Wage-price controls are intended to affect the public’s expectations of inflation.

13-39


Credibility and Reputation

■ The expected inflation adjusts quickly if government’s announced disinflationary policy is credible.

■ Policymakers increase their credibility by developing a reputation for carrying through on promises.

13-40


Credibility and Reputation (continued)

■ A strong and independent central bank is more likely to be deemed a credible policymaker by the public.

13-41

Documents

Chapter 13 Unemployment and Inflation Copyright © 2016 Pearson Canada Inc