The big picture marcoeconomics 12e parkin chapter 12

The Business Cycle, Inflation and Deflation Explain how aggregate demand shocks and aggregate supply shocks create the business cycle  Explain how demand-pull and cost-push forces brin

T h e B i g P i c t u r e

Where we have been:

Chapter 12 uses the AS-AD model developed in Chapter 10 to explore business

cycles, inflation, and deflation The distinction between the short-run and long-run aggregate supply curves is useful for appreciating the difference between the short-run and long-run Phillips curves Chapter 12 also draws on the definition of inflation in Chapter 5

Where we are going:

Chapter 12 is the last of three chapters dealing with macroeconomic

fluctuations The explanation of the business cycle through the lens of the aggregate supply-aggregate demand model lays the foundation for the next two chapters, on fiscal policy and monetary policy respectively

N e w i n t h e Tw e l f t h E d i t i o n

Along with the new title for the chapter, there is now a new section on deflation

None of the other content was removed, but some sections were written more

concisely and the chapter was reorganized to move the business cycle section to the beginning The Economics In Action about the United States Phillips Curve was shortened by including only data for the 2000’s The end of chapter Economics In The News feature has a 2014 article about the ECB’s attempts to fight stagnation

in the Eurozone The Worked Problem covers demand-pull and cost-push inflation issues The Worked Problem gives aggregate demand and short-run aggregate

supply schedules and then asks the effect of changes in aggregate demand and

aggregate supply It also asks what type of output gap is created The answers use both the data in the aggregate demand and short-run aggregate supply functions

as well as an aggregate supply/aggregate supply figure To include the new

Worked Problem without lengthening the chapter, some problems have been

removed from the Study Plan Problem and Applications These problems are still in the MyEconLab and are called Extra Problems

1 2

THE BUSINESS CYCLE, INFLATION

C h a p t e r

T H E B U S I N E S S C YC L E , I N F L AT I O N , A N D D E F L AT I O N 1 9

The Business Cycle, Inflation and Deflation

 Explain how aggregate demand shocks and aggregate supply shocks create the business cycle

 Explain how demand-pull and cost-push forces bring cycles in inflation and output

 Explain the causes and consequences of deflation

 Explain the short-run and long-run tradeoff between inflation and unemployment

I The Business Cycle

Business Cycles Most principles of economics textbooks have a chapter that is similar

to this one However, many of them contain an extended discussion to the effect that, “This school of thought thinks this, but this other school of thought disagrees, and, by the way, here’s a third school of thought that thinks the first school is partially correct but partially wrong ” This material is (appropriately enough!) found to be exceptionally tedious by the students Fortunately, Parkin’s chapter is not at all like these other weak attempts Parkin shows the students how the schools relate to each other and presents an incredibly

exciting chapter

You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated about where their instructor fits into the scheme of controversies that they are learning about By discussing your place in the line-up of different schools, be it

“hard-line” monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students’ strong interest when you discuss this topic

You might also point out to the students that theories are not necessarily mutually

exclusive For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other

approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics

Mainstream Business Cycle Theory

The mainstream business cycle theory regardless fluctuations in aggregate demand around

a growing potential GDP (and hence constantly rightward shifting LAS and SAS curves) as

the cause of the business cycle Real GDP differs from potential GDP when money wage rates do not offset changes in the price level

 Keynesian Cycle Theory: The Keynesian cycle theory asserts that fluctuations in

investment driven by fluctuations in business confidence—summarized by the phrase “animal spirits”—are the main source of fluctuations in aggregate demand Money wage rates are assumed rigid

 Monetarist Cycle Theory: The monetarist cycle theory asserts that fluctuations in

both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main sources of fluctuations in aggregate demand Money wage rates are assumed rigid

 New Classical Cycle Theory: The new classical cycle theory asserts that the

money wage rate and hence the position of the SAS curve are determined by the

rational expectation of the price level, which depends on potential GDP and expected aggregate demand Because the money wage rate changes with expected changes

in aggregate demand, only unexpected fluctuations in aggregate demand lead to business cycle fluctuations

 New Keynesian Cycle Theory: The new Keynesian cycle theory asserts that

today’s money wage rates were negotiated at many past dates, which mean that

past rational expectations of the current price level influence the money wage rate and the position of the SAS curve Because the money wage rate does not change with newly expected changes in aggregate demand, both expected and unexpected

fluctuations in aggregate demand lead to business cycle fluctuations

Real Business Cycle Theory

The real business cycle theory (or RBC theory) regards random fluctuations in

productivity as the main source of economic fluctuations

 RBC Impulse: changes in the growth rate of productivity that results from

technological change A decrease in productivity growth brings a recession and an increase brings an expansion Productivity shocks are measured using growth accounting

 The RBC Mechanism: A change in productivity changes investment demand and the demand for labor

 If productivity falls, investment demand and hence the demand for loanabe fund decreases In addition, the demand for labor decreases The decrease in the demand for loanable funds means the real interest rate falls According to RBC theory, the fall in the real interest rate decreases the supply of labor because of intertemporal substitution Because both the supply of labor and the demand for labor decrease, employment decreases and the change in the real wage rate is small Real GDP decreases

 Money plays no role in generating business cycles in the RBC theory; it affects only the price level

I like to motivate RBC theory by suggesting that economists, such as Lucas and Prescott,

challenged our previous portrayal of the LAS curve as being a stable curve that the short run fluctuations revolve around You can use your arm to suggest that the LAS curve itself

might shift leftward and rightward because of technology continuously impacting

productivity in unstable ways

Criticisms and Defenses of Real Business Cycle Theory

 Critics assert that money wages are sticky and that intertemporal substitution is too weak to account for large fluctuations in the supply of labor, which are necessary for RBC theory to explain the empirical fact that there are large fluctuations in

employment with only small fluctuations in the real wage rate

 A second criticism of RBC theory has to do with the direction of causality between productivity and business cycle fluctuations RBC theory assumes changes in

productivity cause business cycle fluctuations Traditional aggregate demand

theories suggest that measures of productivity change as a result of business cycle fluctuations For instance, they assert that in expansions, capital and labor are used more intensely so that measured productivity increases, even with no change in technology

What does it mean to use capital and labor more intensely? It is easy to see with labor hours A firm could record the same number of labor hours in an expansion as in a

recession But, if the firm is trying to increase production to meet high demand in the expansion, workers will work harder and, therefore, be more productive in the expansion This change in productivity is not related to technology but growth accounting likely will (erroneously) attribute the increase in productivity to a technological advance

 RBC theory defenders point out that the theory is consistent with microeconomic evidence about labor supply decisions and labor demand and investment demand decisions

II Inflation Cycles

Inflation is a process in which the price level is rising and money is losing value Inflation is not a rise in one price—it is a broad increase in the price level Inflation also is not a one-time jump in the price level It is an ongoing process

There are many examples of one-time jumps in the price level that are not the same as inflation In Canada, when the federal sales tax was changed in the early 1990s, there was

a one-time increase in the CPI Likewise, when the euro was introduced in 2001, there were one-time increases in many prices in some countries Neither of these events led to a persistent rise in the rate at which the price level increased and measured inflation using the CPI fell to previous levels soon after the one-time events

Demand-Pull Inflation

An inflation that results from an initial increase in aggregate demand is called demand-pull inflation Any factor that increases aggregate demand, such as an increase in the

quantity of money, an increase in government expenditure, or an increase in exports, can start a demand-pull inflation

 In the short run, an increase in aggregate

demand raises the price level and increases

real GDP In the figure the aggregate demand

curve shifts from AD0 to AD1 so that the

economy moves from point a to point b and

the price level rises from 100 to 110

 Real GDP exceeds potential GDP and so in the

tight labor market the money wage rate

rises The rise in the money wage rate

decreases short-run aggregate supply In the

figure, the SAS curve shifts from SAS0 to

SAS1 As a result, the economy moves from

point b to point c and the price level rises

even more, in the figure to 120 Real GDP

returns to potential GDP

 Inflation occurs only if aggregate demand continues to increase And aggregate demand continues to increase only if the quantity of money persistently increases

Demand-Pull Inflation The potential difficulty with both demand-pull and cost-push

inflation stories is how the one-time increase translates into an inflationary process It is relatively easy to come up with stories as to why aggregate demand might shift to the right, for example because of persistent government budget deficits (However

immediately tell the students that if the budget deficit does not constantly increase in size relative to GDP, it will not lead to a constant increase in aggregate demand.) What is a little harder is to provide a plausible story as to why the monetary authorities would

continue to accommodate the budget deficit with continuous increases in the quantity of money Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment In other countries, particularly where the central bank is less independent than in the United States, it has been more common for the central bank to consistently monetize budget deficits

Cost-Push Inflation

An inflation that results from an initial increase in costs is called cost-push inflation The

two main sources of increases in costs are an increase in money wage rates or an increase

in the money prices of raw materials

 The cost hike decreases short-run

from SAS0 to SAS1 so that the

and a fall in real GDP is called

stagflation.

 One possible response to the

monetary policy to increase

aggregate demand If the Fed

increases aggregate demand, real GDP increases and the price level rises still

higher In the figure, this Fed policy shifts the aggregate demand curve from AD0 to

AD1 and the price level rises to 120

 Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase aggregate demand

Cost-Push Inflation The text gives a good description of the first oil price increase in the

1970s as a cost-push inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in 1979 An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority Such a process of repeated wage increases, inflation, and

monetary accommodation can give rise to continuing inflation Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period This is incorrect; inflation is the result of

monetary growth To explain inflation, economists are looking for an explanation that fits all cases not an explanation that focuses on specific prices of specific goods that differ from one inflation to another

Expected Inflation

 When inflation is anticipated, the money wage rate changes to keep up with the

anticipated inflation So when the AD curve shifts rightward, increasing the price level, the money wage rate increases and the SAS curve shifts leftward If the

increase in the price level is fully anticipated, then the money wage rate rises by the same percentage so that the real wage rate remains constant There are no

deviations from full employment The magnitude of the shift in A D equals that in SAS so that GDP remains equal to potential GDP and the economy moves up along the LAS curve, from point a to point c in the figures above.

 If inflation is not perfectly anticipated, the money wage rate changes but by a different percentage than the price level Some of the inflation is unanticipated, so

as a result the real wage rate changes and there are deviations from full

employment If aggregate demand grows faster than anticipated, real GDP exceeds potential GDP and the economy behaves as if it were in a demand-pull inflation If

aggregate demand grows slower than anticipated, real GDP is less than potential GDP and the economy behaves as if it were in a cost-push inflation

 Because of the costs of unanticipated inflation, there are benefits to forming

accurate forecasts of inflation The best available forecast is the one that is based on

all relevant information and is called a rational expectation.

III Deflation

An economy experiences deflation when it has a persistently falling price level.

What Causes Deflation?

 The starting point for understanding the cause of deflation is to distinguish between

a one-time fall in the price level and a persistently falling price level A onetime fall

in the price level is not deflation Deflation is a persistent and ongoing falling price

level

The Quantity Theory and Deflation

 The quantity theory of money explains the trends in inflation by focusing on the trend influences on aggregate supply and aggregate demand The foundation of the

quantity theory is the equation of exchange, which in its growth rate version and

solved for the inflation rate states:

Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate

 The quantity theory adds to the equation of exchange two propositions

 First, the trend rate of change in the velocity of circulation does not depend on the money growth rate and is determined by decisions about the quantity of money to hold and to spend

 Second, the trend growth rate of real GDP equals the growth rate of potential GDP and, again, is independent of the money growth rate

 With these two assumptions, the equation of exchange becomes the quantity theory

of money and predicts that a change in the money growth rate brings an equal change in the inflation rate

What are the Consequences of Deflation?

The effects of deflation (like those of inflation) depend on whether it is anticipated or

unanticipated But because inflation is normal and deflation is rare, when deflation occurs,

it is usually unanticipated

 Unanticipated deflation redistributes income and wealth, lowers real GDP and

employment, and diverts resources from production

 Workers with long-term wage contracts find their real wages rising But

employers respond to a higher and rising real wage by hiring fewer workers, so employment and output decrease

 With lower output and profits, firms re-evaluate their investment plans and cut back on projects that they now see as unprofitable This fall in investment slows the pace of capital accumulation and slows the growth rate of potential GDP

An Economics in Action explores the “Fifteen Years of Deflation in Japan.” The Economics in Action feature describes how the deflation was unexpected, which decreased Japan’s economic growth rate, and was the result of monetary growth that was kept too low

How Can Deflation be Ended?

 Deflation can be ended by removing its cause: The quantity of money is growing too slowly If the central bank ensures that the quantity of money grows at the target

inflation rate plus the growth rate of potential GDP minus the growth rate of the

velocity of circulation, then, on average,

Money Growth, Not the Quantity of Money

 It takes an increase in the growth rate of the money stock, not a one-time increase in the quantity of money, to end deflation

 Central banks sometimes increase the quantity of money and fail to increase its growth rate

IV Inflation and Unemployment: The Phillips Curve

A Phillips curve shows the relationship between inflation and unemployment There are

two time frames for a Phillips curve: the short run and the long run

HISTORY NOTE: The Phillips Curve As a description of how economics advances, I like

to give the students a stylized history of the Phillips curve The story I tell starts in 1958 when A W Phillips published his empirical work At that time the mainstream economic

model was quite different from the AS-AD model derived in the text Essentially, it was

similar to the simple aggregate expenditure model presented in Chapter 11 He had British data that covered a long period of time and so his results appeared to be a long run

phenomenon The model was based on the assumption that the price level was constant, making the inflation rate zero This assumption was not too unrealistic immediately after World War II By 1955, however, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959 Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve

In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure

This type of analysis reached its peak of popularity during the early and middle 1960s By

1967, however, it was under attack On a theoretical level, economist Milton Friedman— among others—pointed out the flimsy justification behind the simple, fixed Phillips curve assumption On an empirical level, the simple, fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve

At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed The concept that aggregate supply is an important component of

macroeconomics was taking hold, as was the idea that short-run Phillips curves shift

because of changes in people’s expectations Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient

The Short-Run Phillips Curve

 The short-run Phillips curve (SRPC)

shows the relationship between the

inflation rate and the unemployment rate

holding constant the expected inflation

rate and the natural unemployment rate

The figure shows a short-run Phillips

negative relationship in the short run, so

moving along a short-run Phillips curve, a

higher inflation rate (holding constant the

expected inflation rate) leads to lower a

unemployment rate

 The downward sloping short-run Phillips

curve is equivalent to the upward sloping

short-run aggregate supply curve When

aggregate demand unexpectedly

increases so that real GDP and the price level both unexpectedly rise, the increase in real GDP lowers the unemployment rate and the unexpectedly higher price level means there is unexpectedly high inflation The short-run Phillips curve captures the relationship between the lower unemployment rate and higher inflation rate

Use the board to create a scatter plot of observations that allow you to later “statistically fit” a line through the points as the Phillips curve As you make the points on the graph, you can call them out as different years from 1950-1969 Now discuss how policy-makers embraced this model as getting to choose where they want to be on the Phillips curve You can motivate this by picking two points and asking the students which one they thought would be preferred, high inflation and low unemployment or vice versa

As government started to think it could “fine-tune the economy,” we began to observe data points that had high inflation and high unemployment Was Phillips wrong? Ask the

students what might have happened and you may get someone to say it shifted! This answer is, of course, correct Economists started to explore the effect of expected inflation

as a factor that shifts the Phillips curve You can now discuss the distinction between the long-run and the sort-run Phillips curve

The Long-Run Phillips Curve

 The long-run Phillips curve (LRPC) shows

the relationship between the inflation rate

and the unemployment rate when the actual

inflation rate equals the expected inflation

rate As illustrated in the figure, the long-run

Phillips curve is vertical at the natural

unemployment rate

 The short-run Phillips curve intersects the

long-run Phillips at the expected inflation

rate In the figure the expected inflation rate

is equal to 4 percent

 In the long run, higher or lower inflation has

no effect on the unemployment rate This

result is analogous to the conclusion from

the AS-AD model that in long run, a higher or

lower price level has no effect on real GDP,

which equals potential GDP so that the

economy is at full employment

The Phillips curve and the AS-AD model: Students can become confused about the tie

between the Phillips curve and the aggregate supply/aggregate demand (AS-AD) model

Although this relationship is nicely developed in the text, some students will remain

baffled I do not think that a principles course is the appropriate place to derive the link between the two in much detail But I do think that my lectures are an appropriate place to convey the idea of the relationship Thus I point out that the vertical long-run aggregate supply curve is analogous to the vertical long-run Phillips curve If you graph the two side

by side, identify potential real GDP and the natural rate of unemployment on the two

graphs at the intersection of the long run curves and the horizontal axis The point that the long-run aggregate supply curve is vertical means that a higher price level has no effect

on real GDP and hence no effect on the unemployment rate Similarly, the fact that the long-run Phillips curve is vertical implies that a higher inflation rate has no effect on the unemployment rate and hence no effect on real GDP The analogy also carries over to the short-run curves: the positively sloped short-run aggregate supply curve shows that in the short-run an unexpected higher price level raises real GDP and thus lowers unemployment

In the same way, the negatively sloped short-run Phillips curve demonstrates that in the short-run an unexpected higher inflation rate lowers unemployment, thereby raising real GDP Students find that the two diagrams actually complement each other I think that this approach is preferable to having the two diagrams compete with each other!

Shifts of the Phillips Curves

 A change in the expected inflation rate shifts the SRPC vertically upward or

downward by the amount of the change but has no effect on the LRPC.

 A change in the natural unemployment rate shifts both the SRPC and the LRPC An increase in the natural rate shifts the SRPC and LRPC rightward by the amount of the

increase; a decrease shifts the curves leftward by the amount of the decrease

The U.S Phillips Curves

Because of changes in the expected inflation and the natural rate of unemployment, the short-run Phillips curve has shifted around a lot over time so that there is no single obvious negative relationship between inflation and unemployment

The Economics in the News section analyzes the EBC’s response to potential deflation in

2014

A d d i t i o n a l P r o b l e m s

recessions? Explain

the economy in Argentina Column A is the

year, Column B is real GDP in billions of 2000

pesos, and Column C is the price level

a In which years did Argentina experience

inflation? In which years did it experience

deflation (a falling price level)?

b In which years did recessions occur? In

which years did expansions occur?

c In which years do you expect the

unemployment rate was highest? Why?

d Do these data show a relationship between

unemployment and inflation in Argentina?

S o l u t i o n s t o A d d i t i o n a l P r o b l e m s

1, The United States has experienced inflation during recent recessions, though there have been instances when the inflation rate fell during recessions For instance in late

2008 the inflation rate fell as the economy moved into a recession Inflation, however, generally continued because aggregate demand continued to increase during the recessions, though at a slower rate

2 a Argentina experienced inflation in 2000 and from 2002 through 2008 Argentina

experienced deflation in 1998, 1999, and 2001

b Argentina had recessions in 1999, 2000, 2001, and 2002 Argentina had expansions

in 1998 and 2003 through 2008

c The unemployment rate was probably high in all of the recessionary years It was probably the highest in 2000 and 2002 when the recessions were at their worst

d There is not a strong relationship between unemployment and inflation in the data The unemployment rate would likely have been higher in the recession years of

1999, 2000, 2001, and 2002 In 2000 Argentina experienced low inflation and 2002 Argentina experienced high inflation In 1999 and 2001 Argentina experienced deflation But Argentina also experienced deflation 1998 So there is no consistent relationship between either inflation and high unemployment or deflation and high unemployment There also is a similar lack of relationship between inflation and low unemployment or deflation and low unemployment

A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s

11 Some economists claim that inflation is always a “monetary

phenomenon.” What do they mean by this claim and are they correct?

This claim points to the result that an on-going inflation requires the central bank to constantly increase the quantity of money In the absence of continual monetary growth, the price level might rise but it would eventually stabilize The price level will continue to rise, which means that on-going inflation will occur, only if the Federal Reserve constantly increases the quantity of money