Chapter 12 Unemployment and Inflation

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Chapter 12 Unemployment and Inflation
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Unemployment and inflation are the twin evils of
macroeconomics
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Three theories of the Phillips curve

• Tradeoff between percentage increases in wages
  and unemployment
• Expectations augmented Phillips curve or adaptive
  expectations model
• Rational expectations model

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A.W. Phillips

• A.W. Phillips looking at 97 years of data for
  Britain observed a tradeoff between unemployment
  and wage growth
• 1960s for the US seems to show a tradeoff,
• from 1970 to 2002 there appeared to be no
  necessary tradeoff
• 1975 was characterized by both high inflation and
  high unemployment
• 1960s the tradeoff between unemployment and
  inflation seemed to hold for the US
• Not so during the 1980s and 90s

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Original Phillips Curve

• Wao- hU
• Where Wpercentage change in nominal wages
• aoconstant
• h relates wage rate to unemployment

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Expectations Augmented Phillips Curve

• Milton Friedman and Edmund Phelps rejected that
  the Phillips curve should display a tradeoff
  between unemployment and unanticipated inflation
• Showed that a demand shock increases the price
  level, reducing the real wage and increasing
  employment and therefore output

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Two cases

• First, an economy at full employment with fully
  anticipated inflation
• Used the extended classical model
• Money supply has been growing at 10 a year, and
  this is expected to continue
• Money supply increases, which increases aggregate
  demand
• In this case, price level increases from E to F,
  leaving output unchanged
• SRAS shifts up as well because people expect an
  increase in the price level by 10, in this case
  there is no increase in unemployment

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Second, case aggregated demand increased
unexpectedly

• Now money supply increases by 15 instead of 10
  as it had in the recent past
• Aggregate demand rises, but because money is
  rising faster than anticipated aggregated demand
  increases more than anticipated. Unemployment
  falls
• Output rises for 2 reasons
• money supply increases by 15, price level
  increases by 13 percent, implying a real increase
  in the money supply, lowering interest rates and
  stimulating investment and consumption
• because price level rises by 13 percent,
  producers are fooled believing that the prices
  for their goods have increased
• in the long run, producers realize what has
  happened , and respond accordingly

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Expected inflation

• Assume individuals are rational, and learn from
  their mistakes
• An increase in the money supply increases
  aggregate demand (AD)
• This increase, however, is expected, hence,
  workers will respond by demanding higher nominal
  wages, shifting the short run aggregate supply
  curve (SRAS) to the left

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Shifting the Phillips Curve

• The short run Phillips curve rests on the
  assumption that the expected inflation rate
  equals the actual inflation rate.
• Reductions in unemployment result from actual
  inflation rate differing from the expected

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Shifting Phillips Curve

• Changes in the expected rate of inflation
• Changes in the natural rate of unemployment
• Supply shocks

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The natural rate of Unemployment

• The rate of unemployment at which the ? ?e
• Changes in natural rate result from cultural and
  institutional factors

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Macroeconomics and the Phillips curve

• Can policy makers reduce unemployment by
  increasing inflation
• The issue turns on whether inflation is
  anticipated or unanticipated.
• Classical economists assert that people form
  rational expectations, using available knowledge
  to forecast the effect of economic policy
• Keynesians assert that in the short run at least
  government can create unanticipated inflation

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Long run Phillips curve

• Underlying assumption ??e
• People on average are correct about their
  expectations
• Hence, monetary and fiscal policy are ineffective

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Problem of Unemployment

• Costs of unemployment
• Loss of output, measured by Okuns law
• -?Y 2 ?U
• Loss of tax revenue, and increased expense of
  supporting unemployed
• Psychological costs

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Long term behavior of unemployment

• Natural rate of unemployment seems to be changing
• In US, decline in the percentage of youth in the
  labor force

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Changing the natural rate of unemployment

• Reasons for the rise in the natural rate of
  unemployment before 1980
• Minorities often are channeled into marginal jobs
  owing to discrimination, lack of education, etc
• Women caring for children
• Since WWII to 1980, teens, minorities, and women
  increasingly formed a larger portion of the labor
  force, potentially increasing the unemployment
  rate

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Reasons for the decline in the natural rate of
unemployment after 1980

• Since 1980, teens have comprised a smaller
  portion of the labor force, possibly explaining
  the decline in the natural rate of unemployment
• Another reason labor market has become better at
  matching jobs to workers
• increased productivity

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Different Unemployment Rates in Europe and US

• Supply shock resulting from increase in
  unemployment in 1970s increased unemployment in
  industrialized world
• Europe unemployment increased and remained high
• US unemployment has come down

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Explanation institutional differences

• Europe
• existence of unions in Europe and social
  benefits have kept unemployment high
• Germany the problems associated with absorbing
  East Germany
• US
• Unions are much weaker, corporations much
  stronger than in Europe
• Wages are more flexible
• 1990s, US was a source of innovation and growth

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Hysteresis in Unemployment

• Issue rise of unemployment in Europe
• Natural rate changes in response to changes in
  the actual unemployment rate
• Government intervention keeps unemployment high,
  such as restrictions in firing workers
• Insider-outsider theory union negotiates the
  best wage without causing the firm to cut
  employment

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Policies to reduce the natural rate

• Government support for job training
• Increased labor flexibility, that is, remove
  barriers that keep wages from adjusting
• Reform of unemployment insurance
• Higher pressure economy, use monetary and fiscal
  policy to reduce unemployment in the long run,
  thinking this will reduce the natural rate of
  unemployment

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Problem of Inflation
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Costs of inflation

• Unanticipated inflation
• hurts creditors
• hurts those on fixed incomes
• Creditors versus debtors
• increases uncertainty
• Repricing costs

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Benefits of Inflation

• alleviates the burden of debt
• raises profits, and therefore may help the economy

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Fighting inflation

• Problem reducing inflationary expectations
• Disinflation reducing inflation
• Reducing inflation below what is expected
  required increasing the unemployment rate.
• Sacrifice ratio amount of lost output resulting
  from reducing inflation by 1