Problems in the Macroeconomy:Inflation and Unemployment

Chapter 11 and Chapter 12

Problems

•When the economy is overheated, inflation is the problem.

•When the economy is under performing, unemployment is the problem.

The Historical Record of U.S. Economic Growth

Source: U.S. Department of Commerce.

National Business Activity, 1880 to the Present

Sources: American Business Activity from 1790 to Today, 67th ed., AmeriTrust Co., January 1996, plus author’s estimates.

Revised

Revised

Why does growth matter?

Allows wages and incomes to rise.

Standard of living increases

Takes the pressure of scarce resources… (why?)

Macroeconomic ProblemsHigh inflation rateHigh unemployment rateHigh interest ratesLow economic growth or stagnation

Is there relationship between unemployment and inflation

•From 1940- to 1960’s – economists insisted yes.

•From 1960 forward, economists acknowledge short-run relationship majority of times.

•Theory was discredited in 1980’s, but some economists still use the relationship as a given.

The Phillips Curve

•Shows the short-run trade-off between unemployment and inflation.▫unemployment rate increases? inflation

rate falls.▫unemployment rate decreases? inflation

rate rises.

The Phillips Curve

•Its position is determined by the capability and the incentive of the economy to produce.

•PC relates annual rates of inflation and annual rates of unemployment (December figures.)

•There is an inverse relationship.

Figure 11-1. The Phillips Curve

unemployment

infl

ati

on

PC

Movement Along the Phillips Curve•In the short run, assume no change in the

capability or the incentive of the economy to produce.

•Increased total spending causes a movement upward and to the left on the Phillips Curve.▫inflation rate increases▫unemployment rate decreases

Figure 11-2. Movement Along the Phillips Curve

unemployment

infl

ati

on

movement due toincreased spending

inflation increasesand unemploymentdecreases

Reminders:

•When wages and prices are flexible, increase in prices (general level of prices – PL) will stimulate the economy – businesses hire, people leave unemployed, wages increase (nominally.)

•When prices decrease – businesses do not hire, income is not earned, unemployment rises.

Movement Along the Phillips Curve•In the short run, assume no change in the

capability or the incentive of the economy to produce.

•Increased total spending causes a movement upward and to the left on the Phillips Curve.▫inflation rate increases▫unemployment rate decreases

Figure 11-2. Movement Along the Phillips Curve

unemployment

infl

ati

on

movement due toincreased spending

inflation increasesand unemploymentdecreases

Movement Along the Phillips Curve•In the short run, assume no change in the

capability or the incentive of the economy to produce.

•Decreased total spending causes a movement downward and to the right on the Phillips Curve.▫inflation rate decreases▫unemployment rate increases

Figure 11-3. Movement Along the Phillips Curve

unemployment

infl

ati

on

movement due todecreased spending

inflation decreasesand unemploymentincreases

Shifting the Phillips Curve•The Phillips Curve shifts leftward and

downward toward the origin if:▫production costs are lowered▫productivity is increased▫the incentive to work more or harder is

increased•Both the unemployment rate and the

inflation rate will decrease.

Figure 11-4. Shifting the Phillips Curve Left

unemployment

infl

ati

on

lower costs orincreasedproductivity shifts the PC to the left.inflation and unemployment bothdecrease

PC1

PC2

Shifting the Phillips Curve•The Phillips Curve shifts rightward and

upward away from the origin if:▫production costs are increased▫productivity is decreased▫the incentive to work more or harder is

decreased•Both the unemployment rate and the

inflation rate will increase.

Figure 11-5. Shifting the Phillips Curve Right

unemployment

infl

ati

on

higher costs ordecreasedproductivity shifts the PC to the right.inflation and unemploymentboth increase

PC1

PC2

Source: U.S. Department of Labor, Bureau of Labor Statistics

More Than a Century of Unemployment

Inflation and Deflation in U.S. History

Source: U.S. Department of Labor, Bureau of Labor Statistics

The Macroeconomic Goal

•Full-employment▫operate on the institutional PPC▫zero cyclical unemployment

•Also called:▫the “Natural Rate” of unemployment▫the “Non-Accelerating Inflation Rate of

Unemployment”

Figure 11-13. Full-Employment and the Phillips Curve

unemployment

infl

ati

on

full-employment

left side:overheatedeconomy

right side:underperformingeconomy

PC

What’s Next?•We know that the economy will begin to

self-correct from either of the two economic problems: ▫high unemployment in an underperforming

economy▫high inflation in an overheated economy

•We know that self-correction takes a long time and we are impatient.

•Next: We study how the government can form a policy to “fix” the economy more rapidly.

Macroeconomic PoliciesGovernment uses to fix economy

•Three policy options are available:▫Fiscal policy – in which the President and

Congress manipulate Federal spending and tax laws.

▫Monetary policy – in which the Federal Reserve manipulates the money supply and interest rates.

▫Supply-side policy – in which the President and Congress manipulate government regulations, incentive programs, and tax laws.

Fiscal Policy

• Fiscal Policy = taxing and spending by government (federal = Congress.)

•The budget consists of government spending (G) and tax revenues (T).

•Fiscal policy can increase G or decrease T to cause an increase in total spending.

•Fiscal policy can decrease G or increase T to cause a decrease in total spending.

Budget Deficit

•A budget deficit occurs when G > T, that is, spending exceeds tax receipts.

•The government must borrow to pay the bills.▫Added borrowing increases the already

huge national debt.▫If the government increases borrowing,

there are fewer available funds for the private sector to borrow. This is “crowding out”.

Fiscal Policy for an Underperforming Economy

•Unemployment is one of the main problems.

•Solution: Jumpstart the economy by either increasing G or decreasing T, or both.

• AD shifts to the right.•It also triggers the multiplier effect.•This action will increase the budget

deficit.

Figure 12-1. Fiscal Policy for an Underperforming Economy

employment

infl

ati

on

full-employment

left side:underperformingeconomy

right side:overheatedeconomy

the economyis here to begin with.

“jump-start”

multipliereffect1

2

3

4unemploymentfalls but inflationincreases

AS

AD1

AD2

Fiscal Policy for an Overheated Economy

•Inflation is the other major problem.•Solution: Jumpstart the economy by either

decreasing G or increasing T, or both.• AD shifts to the left.•It also triggers the multiplier effect.•This action will decrease the budget

deficit.

Figure 12-2. Fiscal Policy for an Overheated Economy

employment

infl

ati

on

full-employment

left side:underperformingeconomy

right side:overheatedeconomy

1the economyis here at thestart

2“jump-start”

3multipliereffect

4inflation decreasesand unemploymentrises to full-employ-ment level

AD2

AD1

Problems with Fiscal Policy

•There are several time lags in devising and implementing the policy.

•Politics will cause arguments on how to implement.▫Those who favor big government will want

to increase G to fight unemployment and increase T to fight inflation.

▫Those who think government is already too big will want to decrease T to fight unemployment and decrease G to fight inflation.

Automatic Stabilizers•Fiscal action that does work right away

are the two automatic stabilizers:▫Income tax withholding law.▫Unemployment compensation law.

As a recession begins, layoffs reduce taxes withheld and

generate applicants for unemployment compensation.

So T decreases and G increases, counteracting the downturn. The opposite occurs in recovery.

Monetary Policy for an Underperforming Economy

•Unemployment is the main problem.•Solution: Jumpstart the economy by

implementing an “easy money” policy, most likely by buying government securities in the open market.

• AD shifts to the right.

•It also triggers the multiplier effect.

Monetary Policy in an Underperforming Economy•The Fed conducts an “easy money” policy.

▫lower the required reserve ratio▫lower the discount rate▫buy government securities in the open

market•All increase money supply, increase

lending, and lower interest rates•Total spending increases.

Figure 12-3. Monetary Policy for an Underperforming Economy

employment

infl

ati

on

full-employment

left side:underperformingeconomy

right side:overheatedeconomy

the economyis here to begin with.

Fed buyssecurities

multipliereffect1

2

3

4unemploymentfalls but inflationincreases

AS

AD1

AD2

Monetary Policy for an Overheated Economy

•Inflation is the main problem.•Solution: Jumpstart the economy by

implementing an “tight money” policy, most likely by selling government securities in the open market.

• AD shifts to the left.

•It also triggers the multiplier effect. (in reverse)

Monetary Policy in an Overheated Economy•The Fed conducts a “tight money” policy.

▫raise the required reserve ratio▫raise the discount rate▫sell government securities in the open

market•All decrease money supply, decrease

lending, and raise interest rates•Total spending decreases.

Figure 12-4. Monetary Policy for an Overheated Economy

employment

infl

ati

on

full-employment

left side:underperformingeconomy

right side:overheatedeconomy

1the economyis here at thestart

2Fed sellssecurities

3multipliereffect

4inflation decreasesand unemploymentrises to full-employ-ment level

AD2

AD1

Supply-Side Policy2 ways to interpret

1. (Production)This is more of a long-run policy, designed to increase the capability and incentive of the nation to produce. Our level of income affects our consumption which affects the supply.

2. (Tax rates) Term also used to describe marginal tax rates. Supply siders believe lower marginal rates induce work ethic, more productivity, and more efficient use of resources.

Favorable Supply-Side Policy

•Lowering production costs and other business costs and increasing productivity will initiate this policy.

•Unemployment will fall, inflation will decrease, and economic growth will increase, a “triple good”.

Figure 12-5. Supply-Side Policy

employment

infl

ati

on

lower costs orincreased productivity shifts AS to the right.inflation and unemployment bothdecrease.

full employment

AD

AS1

AS2

The Case For Lower Tax Rates

•Taxes are a punishment for earning, a disincentive to produce.▫Higher taxes lead to decreased production.▫Lower taxes lead to increased production.

•Lowering tax rates allows producers to keep more of their income which is an incentive to earn more by producing more. The opposite is true when tax rates are raised.

The Case For Lower Tax Rates

•Critics of lowering tax rates assert that doing so will cause huge budget deficits.▫True in the short run; false in the long run.▫Short-run: pay less tax on current income.▫Long-run: respond to the powerful

incentive to earn more and produce more. Pay more taxes on higher income.

▫This is the J-Curve effect.