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

Patterns in output and inflation in the evolving U.S. economy

Demand-pull and cost-push inflation.

SR and LR tradeoff between inflation and unemployment (Phillips Curve)

Business cycle theories.

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?

Real GDP and the Price Level: 1948-2008

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.

Inflation Cycles

In the long run,

• 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 caused by–Increases in AD (demand pull inflation)–Decreases in SAS (cost push inflation)

Inflation Cycles

Demand-Pull Inflation

•An inflation that starts because aggregate demand increases•can begin with any factor that increases aggregate demand. • Examples

–cut in the interest rate–increase in the quantity of money–increase in government expenditure–tax cut–increase in exports–increase in investment

Inflation Cycles: Demand Pull

Starting from full employment, an increase in AD

•Increases P (inflation)•Increases RGDP•Creates inflationary gap•increase in AD

Inflation Cycles: Demand Pull

Since

unempl < natural rate

• money wage rate rises

• SAS shifts left

• P rises

•RGDP falls until GDP=potential GDP

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 aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

Inflation Cycles: Cost Push

Cost-Push Inflation

•starts with an increase in costs•Main 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

•Results in decrease in SAS

Inflation Cycles: Cost Push

Initial Effect of a Decrease in Aggregate SupplyA rise in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward.

Real GDP decreases and the price level rises.

“stagflation”

Inflation Cycles: Cost Push

Aggregate Demand ResponseThe initial increase in costs creates a one-time rise in the price level, not continued inflation.

To create inflation, aggregate demand must increase.

That is, the Fed must increase the quantity of money persistently.

Inflation Cycles: Cost Push

Suppose that the Fed stimulates AD to counter the higher unemployment rate and lower level of real GDP.

Real GDP increases and the price level rises again.

Inflation Cycles: Cost Push

A Cost-Push Inflation ProcessIf oil producers raise the price of oil & workers raise wages to try to offset price level increase, SAS shifts left again

if Fed responds by increasing M yet again,

cost-push inflation continues.

Inflation Cycles & Inflation Expectations

Expected InflationIf 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

Inflation Cycles & Inflation Expectations

Inflation and the Business CycleWhen the inflation forecast is correct, the economy operates at full employment.

If AD grows faster than expected,

•Inflation > expected•Real wages decrease

–Real GDP increases above potential–Unemployment rate falls below natural rate

If AD grows slower than expected

•Inflation < expected–Real wages rise–Unemployment rate rises above natural rate

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

The Phillips Curve

The Short-Run Phillips Curve The short-run Phillips curve shows the tradeoff between the inflation rate and unemployment rate, holding constant

1. The expected inflation rate

2. The natural unemployment rate

The Phillips Curve

A short-run Phillips curve (SRPC)

• As inflation increases, unemployment decreases

•AD/AS explanation.

If inflation=expected, unemployment = natural rate.

If inflation>expected, unemployment<natural rate

If inflation < expected, unemployment>natural rate

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

The Phillips Curve

SRPC shifts up/down as inflation expectations rise/fall

The Phillips Curve in U.S.

Business Cycles

Two approaches to understanding business cycles are: Mainstream business cycle theory Real business cycle theory

Mainstream 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.

Business Cycles

Initially, potential GDP is $9 trillion and the economy is at full employment at point A.

Potential GDP increases to $12 trillion and the LAS curve shifts rightward.

Business Cycles

Real Business Cycle TheoryArgues that random fluctuations in productivity are the main source of economic fluctuations.

•productivity fluctuations result mainly from fluctuations in the pace of technological change. •other sources might be 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»Labor

Business Cycles

Effect of a negative productivity shock on Investment & interest rates.

•Decreased investment demand decreases the demand for loanable funds. •real interest rate falls and the quantity of loanable funds decreases.•Reverse happens when there is an expansion caused by rapid productivity increase

Business Cycles

Effect of a negative productivity shock on real wages & employment

•Decreases demand for labor

•The lower real interest rate (above) causes labor supply to decrease (intertemporal substitution effect)

•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.