Macroeconomics

Lecture 12

Inflation and unemployment

Goods marketKeynesian Cross (IS)

Financial markets (LM)

IS-LM(R, Y)

AD

Labour market(AS)

AD-AS(R,P,Y)

Foreign exchange markets

AD*

(R*,Y,e, CA)

DAD-SAS(R,,u)

Outline

• Empirical facts

• The dynamic AD-AS model (the Phillips Curve Model).

• Using the Phillips Curve Model to make sense of the 80ies.

The Phillips curveProf. A W Phillips demonstrated a statistical relationshipbetween annual inflation and unemployment in the UK

Unemployment rate (%)

Infla

tion

rate

(%

)

The Phillips curve showsthat a higher inflation rateis accompanied by a lower unemployment rate.

Phillips curve

It suggests we can trade-off more inflation forless unemployment orvice versa.

024681012

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

Un

em

plo

ym

en

tUnemployment as a % of the labour force,

United Kingdom

OECD, Main indicators.

0

5

10

15

20

25

30

1950 1960 1970 1980 1990 2000

Infl

ati

on

Inflation, GDP deflator (annual, %) United Kingdom

OECD. Main indicators.

Inflation and unemploymentin the UK 1978-99

02468

101214161820

4 5 6 7 8 9 10 11 12

Unemployment

Infl

atio

n

1978

1980

1986

1990

1999 1993

Inflation and unemployment inthe short-run

Static model Dynamic model

Aggregate demand(AD)

Dynamic Aggregate demand (DAD)

Short-run aggregatesupply (SAS)

Short-run Phillips Curve (SPC)

P and Y Inflation and

unemployment

Long-run aggregatesupply (LAS)

Long-run Phillipscurve (LPC)

The Phillips Curve

)( ePPYY Aggregate supply:

)(1 YYPP e Rewrite:

Subtract P-1: )(111 YYPPPP e

)(1 YYe Inflation

Okun’s law

The deviation of output from its equilibrium level is inversely related to the deviation of

unemployment from its equilibrium level

)()( NuuYY 1 percentage point of unemployment gap = 2 percentage points of GDP gap.

SNe uu

)(

Expected inflation Cyclical

unemployment

Randomsupply shocks

Slopeof the Phillips

curve

U

UN

)( 0eSPC

)( 1eSPC

0e

1e

SNe uu

)(

01ee

Y

P

M up

AD0AD1

The static AD curve

Dynamic Aggregate demand (DAD)

)( SmYY

Growth in real money supply

)(1 YYmS

Dynamic multiplier

Use Okun’s Law

DNS uum

)(

Moneygrowth Cyclical

unemployment

Slopeof the DAD

curve

Demandshock

U

UN

0Sm

1Sm )( 0

SmDAD

)( 1SmDAD

dNS uum

)(

Long-run equilibrium

• Stable (constant) inflation.

• Expectations are fulfilled.

• No shocks.

Steady state equilibrium

Characterization of long-runequilibrium

Sm

)( 0eSPC

eNuu

The natural rate of unemployment

)( 0SmDAD

00eSm

u

• Disinflation in the 80ies.

Short-run analysis

The model in action

U

UN

)( 0eSPC

1

)( 1SmDAD

LPC

A)( 2

SmDAD

B

C

B

211 Se m

)( 1eSPC

UB

Dis-inflation in the beginning of the 1980s

0

1

u

uN

Time

Time

Fig

Inflation and unemployment in the UK is the early 1980s

05

1015

20

%

Inflation Unemployment

Sacrifice ratio (SR) = the percentage points loss in a year’s GDP as a consequence of a one percentage pointreduction in inflation.

Inflation reduced from 20 to 5 percent in 6 years

Suppose the natural rate is 3 percent.

The unemployment gap is: 2+5+7+7+7+7=35

Okun’s Law suggests that this translated intoa 70 percentage point accumulated loss over 6 years.

SR = 70/15=4.6.

Defeating inflation

• In the long run, inflation will be low if the rate of money growth is low.

• The transition from high to low inflation may be painful if expectations are slow to adjust

• Adaptive expectations and the sacrifice ratio.

• Rational expectations and painless disinflation.

• Wage contracts take time to adjust

• Policy credibility may speed the adjustment process

What is next?

• The open economy