macro233 - jafgac inflation and its relationship to unemployment and growth chapter 13
TRANSCRIPT
Macro233 - JAFGAC
Inflation and Its Inflation and Its Relationship to Relationship to
Unemployment and Unemployment and Growth Growth
Chapter 13
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Laugher CurveLaugher Curve
Economics is the only field in which two people can share a Nobel Prize for saying opposing things.
Specifically, Gunnar Myrdahl and Friedrich S. Hayek shared one.
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Some Basics about Some Basics about InflationInflation Inflation is a continuous rise in the price
level. It is measured using a price index.
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The Distributional Effects The Distributional Effects of Inflationof Inflation There are individual winners and losers in
an inflation. On average, winners and losers balance
out.
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The Distributional Effects The Distributional Effects of Inflationof Inflation The winners are those who can raise their
prices or wages and still keep their jobs or sell their goods.
The losers in an inflation are those who cannot raise their wages or prices.
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The Distributional Effects The Distributional Effects of Inflationof Inflation Unexpected inflation redistributes income
from lenders to borrowers. People who do not expect inflation and
who are tied to fixed nominal contracts are likely lose in an inflation.
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Expectations of InflationExpectations of Inflation
Expectations play a key role in the inflationary process. Rational expectations are the
expectations that the economists' model predicts.
Adaptive expectations are those based, in some way, on what has been in the past.
Extrapolative expectations are those that assume a trend will continue.
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Productivity, Inflation, Productivity, Inflation, and Wagesand Wages Changes in productivity and changes in
wages determine whether inflation may be coming.
There will be no inflationary pressures if wages and productivity increase at the same rate.
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Productivity, Inflation, Productivity, Inflation, and Wagesand Wages The basic rule of thumb:
Inflation = Nominal wage increases – Productivity growth
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DeflationDeflation
Deflation is the opposite of inflation and is associated with a number of problems in the economy.
Deflation – a sustained fall in the price level.
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DeflationDeflation
Deflation places a limit on how low the Fed can push the real interest rate.
Deflation is often associated with large falls in stock and real estate prices.
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Theories of InflationTheories of Inflation
The two theories of inflation are the quantity theory and the institutional theory. The quantity theory emphasizes the
connection between money and inflation.
The institutional theory emphasizes market structure and price-setting institutions and inflation.
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The Quantity Theory of The Quantity Theory of Money and InflationMoney and Inflation The quantity theory of money is
summarized by the sentence: Inflation is always and everywhere a
monetary phenomenon.
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The Equation of The Equation of ExchangeExchange Equation of exchange – the quantity of
money times velocity of money equals price level times the quantity of real goods sold.
MV = PQ M = Quantity of money V = velocity of money P = price level
Q = real output PQ = the economy’s
nominal output
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The Equation of The Equation of ExchangeExchange Velocity of money – the number of times
per year, on average, a dollar goes around to generate a dollar’s worth of income.
supply Money
GDP NominalVelocity
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Velocity Is ConstantVelocity Is Constant
The first assumption of the quantity theory is that velocity is constant.
Its rate is determined by the economy’s institutional structure.
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Velocity Is ConstantVelocity Is Constant
If velocity remains constant, the quantity theory can be used to predict how much nominal GDP will grow.
Nominal GDP will grow by the same percent as the money supply grows.
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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply The second assumption of the quantity
theory is that real output (Q) is independent of the money supply.
Q is autonomous – real output is determined by forces outside those in the quantity theory.
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Real Output Is Real Output Is Independent of the Independent of the Money SupplyMoney Supply The quantity theory of money says that
the price level varies in response to changes in the quantity of money.
With both V and Q unaffected by changes in M, the only thing that can change is P.
%M %P
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Examples of Money's Examples of Money's Role in InflationRole in Inflation The quantity theory lost favor in the late
1980s and early 1990s. The formerly stable relationships between
measurements of money and inflation appeared to break down.
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Examples of Money's Examples of Money's Role in InflationRole in Inflation The relationship between money and
inflation broke down because: Technological changes and changing
regulations in financial institutions. Increasing global interdependence of
financial markets.
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1965 1970 1975 1980 1985 1990 1995 2000 2005
6
5
4
3
2
1
01960
Pric
e le
vel a
nd m
oney
rel
ativ
e to
rea
l inc
ome
(196
0 =
1)
U.S. Price Level and U.S. Price Level and Money Relative to Real Money Relative to Real IncomeIncome
Money
Price level
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Inflation and Money Inflation and Money GrowthGrowth The empirical evidence that supports the
quantity theory of money is most convincing in Brazil and Chile.
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Inflation and Money Inflation and Money GrowthGrowth
10 20Annual percent change in the money supply (%)
30 40 50 60 70 80 90 1000
1009080706050403020100
Annu
al perc
ent
change
in inflati
on (
%)
Indonesia
Chile
Poland
Argentina
Nicaragua
Zaire
U.S.
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The Inflation TaxThe Inflation Tax
Central banks in nations such as Argentina and Chile are not a politically independent as in developed countries.
Their central banks sometimes increase the money supply to keep the economy running.
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The Inflation TaxThe Inflation Tax
The increase in money supply is caused by the government deficit.
The central bank must buy the government bonds or the government will default.
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The Inflation TaxThe Inflation Tax
Financing the deficit by expansionary monetary policy causes inflation.
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The Inflation TaxThe Inflation Tax
The inflation works as a kind of tax on individuals, and is often called an inflation tax.
It is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms.
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The Inflation TaxThe Inflation Tax
Central banks have to make a monetary policy choice: Ignite inflation by bailing out their
governments with an expansionary monetary policy.
Do nothing and risk recession or even a breakdown of the entire economy.
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Policy Implications of the Policy Implications of the Quantity TheoryQuantity Theory Supporters of the quantity theory oppose
an activist monetary policy. Monetary policy is powerful, but
unpredictable in the short run. Because of its unpredictability, monetary
policy should not be used to control the level of output in an economy.
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Policy Implications of the Policy Implications of the Quantity TheoryQuantity Theory Quantity theorists favor a monetary policy
set by rules not by discretionary monetary policy.
A monetary rule takes money supply decisions out of the hands of politicians.
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Policy Implications of the Policy Implications of the Quantity TheoryQuantity Theory Many central banks use monetary regimes
or feedback rules. New Zealand has a legally mandated
monetary rule based on inflation. The Fed does not have strict rules
governing money supply, but it works hard to establish credibility that it is serious about fighting inflation.
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Institutionalist Theories Institutionalist Theories of Inflation of Inflation Supporters of institutional theories of
inflation accept much of the quantity theory.
While they agree that money and inflation move together, they have different causes and effects.
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Institutionalist Theories Institutionalist Theories of Inflationof Inflation According to the quantity theory, the
direction of causation moves from left to right:
MV PQ
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Institutionalist Theories Institutionalist Theories of Inflationof Inflation Institutional theories see it the other way
round. Increases in prices forces government into
positions where it must increase money supply or cause unemployment.
MV PQ
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Institutionalist Theories Institutionalist Theories of Inflationof Inflation According to these theorists, the source of
inflation is in the price-setting process of firms. Firms find it easier to raise prices than to
lower them. Firms do not take into account the effect
of their pricing decisions on the overall price level.
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Focus on the Price-Focus on the Price-Setting Decisions of Setting Decisions of FirmsFirms Any increase in firms’ wages, rents, taxes,
and other costs are simply passed on to consumers in the form of higher prices.
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Focus on the Price-Focus on the Price-Setting Decisions of Setting Decisions of FirmsFirms This works so long as the government
increases the money supply so that demand is there to buy the goods at the higher prices.
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Focus on the Price-Focus on the Price-Setting Decisions of Setting Decisions of FirmsFirms Whether the firm selects this price-raising
strategy depends on the state of the labor market. If the labor market is tight, the firm
knows that it will lose workers if it doesn’t raise wages.
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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms Institutional theorists see the nominal
wage- and price-setting process as generating inflation.
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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms One group pushes up its nominal wage
and/or price, other groups responds by doing the same.
The first group finds its relative wages and/or prices have not increased, so they raise them again.
And the process begins anew.
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Changes in the Money Changes in the Money Supply Follow Price-Supply Follow Price-Setting by FirmsSetting by Firms At this point, government has two options:
Increase money supply, thereby ratifying the inflation.
Refuse to ratify the inflation, thereby causing unemployment to rise.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation The insider-outsider model is an
institutionalist story of inflation where insiders bid up wages and outsiders are unemployed.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation Insiders are business owners and workers
with good jobs with excellent long-run prospects; outsiders are everyone else.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation If markets were purely competitive, wages,
profits, and rents would be pushed down to equilibrium levels.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation Insiders don’t like this, so they develop
sociological and institutional barriers to prevent competition from outsiders.
Barriers include unions, laws restricting the firing of workers, and brand recognition.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation Outsiders must take dead-end, low-paying
jobs or try to undertake marginal businesses that pay little return per hour worked.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation Outsiders are the first to be fired and their
businesses are the first to fail in a recession.
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The Insider/Outsider The Insider/Outsider Model and InflationModel and Inflation The economy is only partially competitive –
the invisible hand is thwarted by social and political forces.
Insiders push to raise their nominal wages to protect their real wages while outsiders suffer.
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Policy Implications of Policy Implications of Institutionalist TheoriesInstitutionalist Theories The quantity theorists have a simple
solution for stopping inflation – just cut the growth of the money supply.
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Policy Implications of Policy Implications of Institutionalist TheoriesInstitutionalist Theories The institutional theorists agree with this
prescription, but they argue that is not only inefficient but unfair.
It causes unemployment among those least able to handle it.
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Policy Implications of Policy Implications of Institutionalist TheoriesInstitutionalist Theories They favor contractionary monetary
policies used in combination with incomes policy to directly slow down inflation.
Incomes policy – places direct pressure on individuals and businesses to hold down their nominal wages and prices.
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Policy Implications of Policy Implications of Institutionalist TheoriesInstitutionalist Theories Formal incomes policies have been out of
favor for a number of years. Informal incomes policies exist in many
European nations.
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Demand-Pull and Cost-Demand-Pull and Cost-Push InflationPush Inflation Demand-pull inflation – inflation that
occurs when the economy is at or above potential output.
It is generally characterized by shortages of goods and of workers.
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Demand-Pull and Cost-Demand-Pull and Cost-Push InflationPush Inflation Cost-push inflation – inflation that occurs
when the economy is below potential output.
Producers who raise their prices believe that they will sell their goods and workers who raise their wages believe they won’t lose their jobs.
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Inflation and Inflation and Unemployment: The Unemployment: The Phillips CurvePhillips Curve The AS/AD model expresses a tradeoff
between inflation and unemployment. A low unemployment rate is generally
accompanied by high inflation. A high unemployment rate is generally
accompanied by low inflation.
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Inflation and Inflation and Unemployment: The Unemployment: The Phillips CurvePhillips Curve The tradeoff can be represented
graphically in the short-run Phillips Curve. Short-run Phillips Curve – a downward-
sloping curve showing the relationship between inflation and unemployment when inflation expectations are constant.
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Infla
tion
Unemployment rate
5
4
3
2
1
0 4 5 6 7
A
B
The Hypothesized The Hypothesized Phillips CurvePhillips Curve
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History of the Phillips History of the Phillips CurveCurve In the 1950s and 1960s, whenever
unemployment was high, inflation was low and vice versa.
The tradeoff between unemployment and inflation seemed relatively stable during the 1960s.
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History of the Phillips History of the Phillips CurveCurve In the 1960s, the short-run Phillips Curve
began to play an important role in discussions of macroeconomic policy.
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History of the Phillips History of the Phillips CurveCurve Republicans generally favored
contractionary monetary and fiscal policy that meant high unemployment and low inflation.
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History of the Phillips History of the Phillips CurveCurve Democrats generally favored expansionary
monetary and fiscal policy that meant low unemployment and high inflation.
1968
1956
195719661967
19551964 1960 1958
19611963
1962195419591965
4
3
2
1
Unemploymentrate
0 4 5 6
Inflationrate
The Rise of the Phillips The Rise of the Phillips Curve (1954-1968)Curve (1954-1968)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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The Breakdown of the The Breakdown of the Short-Run Phillips CurveShort-Run Phillips Curve In the early 1970s, the relationship inflation
and unemployment began breaking down. Unemployment was high, but so was
inflation.
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The Breakdown of the The Breakdown of the Short-Run Phillips CurveShort-Run Phillips Curve This phenomenon was termed stagflation. Stagflation – the combination of high and
accelerating inflation and high unemployment.
The Fall of the Phillips The Fall of the Phillips Curve (1969-1981)Curve (1969-1981)
1969 1973
19701972
1971
1979
1974
1978
1976
1977
1980
1981 1975
8
6
4
2
Unemploymentrate
0 4 5 7
Inflationrate
6
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Questions About the Questions About the Phillips Curve (1981-Phillips Curve (1981-2002)2002) Inflation fell substantially in the 1980s. A Phillips-Curve-type relationship began to
reappear beginning in 1986. Both inflation and unemployment remained
relatively low in the mid- to late-1990s.
Questions About the Questions About the Phillips Curve (1981-Phillips Curve (1981-2002)2002)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
8
6
4
2
Unemploymentrate
0 4 5 7
Inflationrate
6
19901989
1980
1981
1982
1983
19841991
1985
1986 1992
1993
1987
19941995
19971998
1999
1996
20002001
2002
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The Long-Run and Short-The Long-Run and Short-Run Phillips CurvesRun Phillips Curves The continually changing relationship
between inflation and unemployment has economists somewhat perplexed.
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The Importance of The Importance of Inflation ExpectationsInflation Expectations Expectations of inflation have been
incorporated into the analysis by distinguishing between short-run and long-run Phillips curves.
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The Importance of The Importance of Inflation ExpectationsInflation Expectations Expectations of inflation – the rise in the
price level that the average person expects.
Expectations of inflation do not change along a short-run Phillips curve.
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The Importance of The Importance of Inflation ExpectationsInflation Expectations Long-run Phillips curve – a vertical curve
at the unemployment rate consistent with potential output.
It shows the trade-off between inflation and unemployment when expectations of inflation equal actual inflation.
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The Importance of The Importance of Inflation ExpectationsInflation Expectations When expectations of inflation are higher,
the same level of unemployment will be associated with a higher level of inflation.
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The Importance of The Importance of Inflation ExpectationsInflation Expectations It makes sense to assume that the short-
run Phillips curves moves up or down as expectations of inflation change.
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The Importance of The Importance of Inflation ExpectationsInflation Expectations The only sustainable combination of
inflation and unemployment rates on the short-run Phillips curve is at points where it intersects the long-run Phillips curve.
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Moving Off the Long-Run Moving Off the Long-Run Phillips CurvePhillips Curve If government decides to increase
aggregate demand, this pushes output above its potential.
Demand for labor goes up pushing wages higher than productivity increases.
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Moving Off the Long-Run Moving Off the Long-Run Phillips CurvePhillips Curve Workers are initially satisfied that their
increased wages will raise their standard of living with the expectation of zero inflation.
But if productivity does not go up, inflation will wipe out their wage gains.
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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-Run Phillips Curve Workers ask for more money when they
find their initial raise did not keep up with unexpected inflation.
This gives a boost to a wage-price spiral.
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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-Run Phillips Curve If unemployment is lower than the target
level of unemployment, inflation and the expectation of inflation will increase.
The short-run Phillips curve will shift up.
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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-Run Phillips Curve The short-run Phillips curve will continue to
shift up until output is no longer above potential.
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Moving Back onto the Moving Back onto the Long-Run Phillips CurveLong-Run Phillips Curve If the cause of inflation is expectations of
inflation, any level of unemployment is consistent with the target level of unemployment.
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Stagflation and the Stagflation and the Phillips CurvePhillips Curve Expectational inflation can be eliminated if
aggregate demand falls. Lower aggregate demand pushes the
economy to the point where unemployment exceeds the target rate.
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Stagflation and the Stagflation and the Phillips CurvePhillips Curve Higher unemployment puts downward
pressure on wages and prices, shifting the short-run Phillips curve down.
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Stagflation and the Stagflation and the Phillips CurvePhillips Curve Economists believe that the stagflation of
the late 1970s and early 1980s was caused by contractionary government aggregate demand policy.
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Potential output Long-run
Phillips curve
AD0
AD1
C
PC0PC1 (expected inflation = 4)
8
6
4
2
Unemployment rate
4.5 5.5 6.5
Inflation rate
Real output
Price level
Inflation Expectations Inflation Expectations and the Phillips Curveand the Phillips Curve
A
expected inflation = 0
BA
B
C
SAS0
SAS1
SAS2
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The Rise and Fall of the The Rise and Fall of the New EconomyNew Economy Output expanded significantly during the
late 1990s and early 2000s. The cause of the good times was a
combination of factors.
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The Rise and Fall of the The Rise and Fall of the New EconomyNew Economy The economy was experiencing a
temporary positive productivity shock because Internet growth and investment were shifting potential output out.
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The Rise and Fall of the The Rise and Fall of the New EconomyNew Economy Competition increased because of
globalization. Price comparisons were made possible by
e-commerce.
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The Rise and Fall of the The Rise and Fall of the New EconomyNew Economy Workers were less concerned with real
wages and more concerned with protecting their jobs, so firms did not raise wages even with extremely tight labor markets.
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The Rise and Fall of the The Rise and Fall of the New EconomyNew Economy Some economists argued that these
conditions were permanent. Others argued that this combination of
effects were temporary and that the U.S. economy would come out of its “Goldilocks period.”
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The Relationship The Relationship Between Inflation and Between Inflation and GrowthGrowth Economist generally agree that:
Below low potential output there is no inflationary, and possibly some deflationary pressures.
Above high potential output there will be significant inflationary pressures.
The degree of inflationary pressure between the extremes is ambiguous.
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The Inflation/Growth The Inflation/Growth Trade OffTrade Off
Inflationary pressures
Deflationarypressures
Inflationarypressures
Real output
Highpotential
output
Lowpotential
output
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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists are much more likely to
err on the side of preventing inflation. For them, erring on the low side pays off
by stopping any chance of inflation. It also builds credibility for the Fed.
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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists justify erring on the side
of preventing inflation by arguing that there is a high cost associated with igniting inflation.
Inflation undermines the economy’s long-run growth and hence its future potential income.
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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists argue that there is no
long-run tradeoff between inflation and unemployment.
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Quantity Theory and the Quantity Theory and the Inflation/Growth Trade-Inflation/Growth Trade-OffOff Quantity theorists believe low inflation
leads to higher growth: It reduces price uncertainty, making it
easier for businesses to invest in future production.
It encourages businesses to enter into long-term contracts.
It makes using money much easier.
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Growth/Inflation TradeoffGrowth/Inflation Tradeoff
Growth0
Inflation
0
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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Supporters of the institutional theory of
inflation are less sure about a negative relationship between inflation and growth.
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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Institutional theorists agree that rises in the
price level have the potential of generating inflation.
They agree that high accelerating inflation undermines growth.
They do not agree that all price level increases start an inflation.
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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off If inflation does get started, the
government has tools that will get rid of inflation relatively easily.
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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off This was highlighted in the debate about
monetary policy in early 2000.
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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Quantity theorist argued that inflation was
just around the corner. The seeds of inflation would be sown
unless government instituted contractionary aggregate demand policy.
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Institutional Theory and Institutional Theory and the Inflation/Growth the Inflation/Growth Trade-OffTrade-Off Other economists argued that the
institutional changes in the labor market had reduced the inflation threat and that more expansionary policy was needed.
The Fed deftly sailed between these two positions.
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Inflation and Its Inflation and Its Relationship to Relationship to
Unemployment and Unemployment and Growth Growth
End of Chapter 13