MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 16

All rights reserved.The Dynamics of Inflation and Unemployment Brock Williams P R E P A R E D B Y As the financial crisis spread in 2008, central banks around the world increased the su

C H A P T E R 16

The Dynamics of Inflation

and Unemployment

Copyright © 2012 Pearson Prentice Hall All rights reserved.

The Dynamics of Inflation

and Unemployment

Brock Williams

P R E P A R E D B Y

As the financial crisis spread in 2008, central banks around the world

increased the supply of money and liquidity, and governments borrowed

extensively and incurred increasing amounts of government debt.

CHAPTER

16

Copyright © 2012 Pearson Prentice Hall All rights reserved.

How can data on vacancies and unemployment be used

to measure shifts in the natural rate?

Shifts in the Natural Rate of Unemployment

Can changes in the way central banks are governed affect inflation expectations?

Increased Political Independence for the Bank of England Lowered Inflation Expectations

What caused a severe hyperinflation to emerge recently

in Zimbabwe?

Hyperinflation in Zimbabwe

3

A P P L Y I N G T H E C O N C E P T S

Wages expressed in current dollars.

MONEY GROWTH, INFLATION, AND INTEREST RATES

C H A P T E R 16

The Dynamics of Inflation

and Unemployment

Inflation in a Steady State

INFLATION EXPECTATIONS AND INTEREST RATES

INFLATION EXPECTATIONS AND MONEY DEMAND

When the public expects inflation, real and nominal rates of interest will differ

because we need to account for inflation in calculating the real return from

lending and borrowing

MONEY GROWTH, INFLATION, AND INTEREST RATES (cont’d)

16.1

R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—its purchasing power—not its “face” value.

How Changes in the Growth Rate of Money Affect the Steady State

MONEY GROWTH, INFLATION, AND INTEREST RATES (cont’d)

16.1

● expectations Phillips curve

The relationship between unemployment and inflation when taking into account expectations of inflation

Are the Public’s Expectations About Inflation Rational?

UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d)

16.2

Inflation rose and the

unemployment rate fell below

the natural rate

Inflation later fell as

unemployment exceeded the

natural rate.

UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d)

16.2

Shifts in the Natural Rate of Unemployment in the 1990s

What factors can shift the natural rate of unemployment?

• Demographics

• Institutional changes

• The recent history of the economy

• Changes in growth of labor productivity

UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d)

16.2

C H A P T E R 16

The Dynamics of Inflation

and Unemployment

•The natural rate of unemployment changes over time

•Policy makers need to know what the natural rate is to avoid unnecessary

unemployment and inflation

•One way to estimate is to look at the Beveridge Curve, the relationship between job vacancies and the unemployment rate

•Economist William Dickens tracked the natural rate in recent decades:

Five percent in the mid 1960sPeaked near seven percent in the late 1970s and early 1980sFalling through the 1990s and reached five percent in 2000

SHIFTS IN THE NATURAL RATE OF UNEMPLOYMENT

APPLYING THE CONCEPTS #1: How can data on vacancies and unemployment be used to measure shifts in the natural rate?

A P P L I C A T I O N 1

If workers push up their nominal

wages, the aggregate supply curve

will shift from AS0 to AS1

If the Fed keeps aggregate demand

constant at AD0, a recession will

occur at point a, and the economy

will eventually return to full

employment at point c

If the Fed increases aggregate

demand, the economy remains at

full employment at b, but with a

higher price level

HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (cont’d)

16.3

In 1997, a major change in monetary policy allowed the Bank of England to be free

to pursue its policy goals without direct political control

An economist studied how the British bond market reacted to the policy change by

comparing the interest rates changes on two types of long-term bonds: bonds that

are automatically adjusted (or indexed) for inflation and bonds that are not

• The difference between the two interest rates primarily reflects expectations of inflation

• If the gap narrowed following the policy announcement, this would be evidence that the new policy reduced expectations of inflation

• If it did not, the announced policy would have had no effect on inflation expectations

Result: After the announcement, the gap narrowed

Conclusion: The announcement did cause expectations about inflation to fall by

about half a percentage

INCREASED POLITICAL INDEPENDENCE FOR THE BANK

OF ENGLAND LOWERED INFLATION EXPECTATIONS

APPLYING THE CONCEPTS #2: Can changes in the way central banks are governed affect inflation expectations?

A P P L I C A T I O N 2

C H A P T E R 16

The Dynamics of Inflation

● velocity of money

The rate at which money turns over during the year It is calculated as nominal GDP divided by the money supply

growth rate of money + growth rate of velocity

= growth rate of prices + growth rate of real output

● growth version of the quantity equation

An equation that links the growth rates of money, velocity, prices, and real output

INFLATION AND THE VELOCITY OF MONEY (cont’d)

16.4

C H A P T E R 16

The Dynamics of Inflation

● hyperinflation

An inflation rate exceeding 50 percent per month

Revenue raised from money creation.

How Budget Deficits Lead to Hyperinflation

government deficit = new borrowing from the public + new money created

● monetarists

Economists who emphasize the role that the supply of money plays in determining nominal income and inflation

HYPERINFLATION (cont’d)

16.5

C H A P T E R 16

The Dynamics of Inflation

and Unemployment

In June 2008, the consumer price index in Zimbabwe was 8 million percent higher

than it was a year before A $12 lunch in local currency cost 1.1 trillion Zimbabwe

dollars

What caused Zimbabwe to suffer from this crippling hyperinflation?

The simple answer is that the political and economic system began to self-destruct

HYPERINFLATION IN ZIMBABWE

APPLYING THE CONCEPTS #3: What caused a severe hyperinflation to emerge recently in

Zimbabwe?

Zimbabwe has been ruled since 1980 by the dictator Robert Mugabe, whose

policies to intervene militarily in African conflicts and expropriate white-owned

farms had the cumulative effect of crippling the economy

• As the economy deteriorated, tax revenues declined

• Mugabe and his central bank simply resorted to printing new banknotes

Result: Hyperinflation and further deterioration of the economy as the financial

A P P L I C A T I O N 3

monetarists money illusion nominal wages quantity equation rational expectations real wages

seignorage velocity of money

K E Y T E R M S