Chapter 9: Inflation, Activity, and Money Growth

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Chapter 9 Inflation, Activity, and Money Growth

• 9-1 Output, Unemployment, and Inflation
• 9-2 The Medium Run
• 9-3 Disinflation A First Pass
• 9-4 Expectations, Credibility, and Nominal
  Contracts
• 9-5 The U.S. Disinflation, 1979 to 1985

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9-1 Output, Unemployment, and Inflation

• Okuns Law Output Growth and Changes in
  Unemployment
• The Phillips Curve Unemployment and the Change
  in Inflation
• The Aggregate Demand Relation Money, Growth,
  Inflation, and Output Growth

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Okuns Law Output Growth and Changes in
Unemployment

• The unemployment rate and output move in opposite
  directions
• The tradeoff is about 3 of output for every 1
  of unemployment
• ?actual rate of u. -0.4(output growth 3)
• 3 is the rate required to maintain a fixed
  unemployment rate
• There is some labor hoarding
• There are discouraged workers

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The Phillips Curve Unemployment and the Change
in Inflation

• Blanchard uses a modified Phillips relation which
  he calls a Phillips Curve for convenience
• This assumes that expected inflation equals last
  periods inflation
• ?inflation (natural rate actual rate of u.)
• This is simplified from Blanchards form

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The Aggregate Demand Relation Money, Growth,
Inflation, and Output Growth

• Generally, aggregate demand is formed by
  combining (by substitution) the IS and LM
  functions
• To focus on inflation, Blanchard introduces a
  simplified AD
• Yt ?Mt/Pt, where g is positive
• So ln(Yt) ln(?) ln(Mt) ln(Pt)
• And ln(Yt-1) ln(?) ln(Mt-1) ln(Pt-1)
• Subtracting yields output growth money growth
  - inflation

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9-2 The Medium Run

• Putting these three relations together allows us
  to talk about dynamics
• ?actual rate of u. -0.4(output growth 3)
• ?inflation (natural rate actual rate of u.)
• output growth money growth - inflation
• For example
• Reducing money growth, reduces output growth,
  which pushes up
• Constant money growth, should lead to constant
  output growth, unemployment and inflation

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9-3 Disinflation A First Pass

• How Much Unemployment? And for How Long?
• Working Out the Required Path of Money Growth

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How Much Unemployment? And for How Long?

• Unemployment and inflation can be traded off
  across the years
• A 2 increase in unemployment for 3 years will
  reduce inflation by 6
• A 3 increase in unemployment for 2 years will
  reduce inflation by 6
• A 6 increase in unemployment for 1 years will
  reduce inflation by 6
• Blanchard calls this tradeoff or rate-years of
  unemployment the traditional approach

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Working Out the Required Path of Money Growth

• Suppose the F.R. in 1998 wanted to reduce
  inflation from 3 to 0 in 3 years.
• Assume output growth was 3, and unemployment was
  at its natural rate of 4
• Money must have been growing at 6 per year to
  support the output growth and inflation
• Inflation will go 3, 2, 1, 0 from 1998 to 2001
• So, the unemployment rate must be 1 above its
  natural rate for 3 years

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Working Out the Required Path of Money Growth
Continued

• To bump unemployment up by 1, output growth must
  go down by 2.5 (to 0.5) for one year
• It must go up to 3 again after the first year
• So, money growth must drop from 6 to 2.5 in
  1999 (0.5 output growth plus 2 inflation)
• In 2000, money growth must go up to 4, to cover
  the 3 output growth and 1 inflation
• In 2001, money growth must fall again to 3,
  since there is no more inflation

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Working Out the Required Path of Money Growth
Continued

• In 2002, the inflation is gone, but unemployment
  is still above its natural rate
• Unemployment needs to drop by 1, which means
  that output must grow by 5.5
• So, in 2002, money growth must be 5.5 to support
  that output growth with no inflation
• In 2003, and after, money growth can go back down
  to 3, to cover output growth

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9-4 Expectations, Credibility, and Nominal
Contracts

• Expectations and Credibility The Lucas Critique
• Nominal Rigidities and Contracts

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Expectations and Credibility The Lucas Critique

• Lucas Critique argues that presuming that
  equations (like those in used in the traditional
  approach) would remain constant when policy was
  changed was unlikely
• The equations are reduced forms
• Policy is part of the structure that led us to
  derive these particular specifications
• Change policy, and the reduced forms change too

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Expectations and Credibility The Lucas Critique
Contd.

• Sargent argued that many inflations end more
  quickly than the traditional view would indicate
• Perhaps the (reduced form) equations changed
• Credibility of the policy change has a lot to do
  with this
• What if expectations could be reset at a new
  level without being equal to last periods prices?

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Nominal Rigidities and Contracts

• Fischer argued that the traditional view was
  problematic because expectations of inflation
  were already embodied in contracts
• Taylor extended this by showing that the
  staggering of nominal contracts put a limit on
  how fast a deflation could occur

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9-5 The U.S. Disinflation, 1979 to 1985

• Inflation was brought down about 10 in the first
  3 years
• Unemployment went up during those years
• Unfortunately it stayed up for several more years
• Define the sacrifice ratio as a measure of how
  painful it is to disinflate
• Point-Years of unemployment above the natural
  rate, divided by cumulative drop in inflation
• Sacrifice ratio was around 0.5 during 1981-2, but
  rose to around 1 in 1985

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Digression Balls Evidence on Sacrifice Ratios

• Disinflation appears to need more unemployment
  than theory suggests
• Faster disinflations require less employment to
  be sacrificed
• Sacrifice ratios are lower when wage contracts
  are shorter