CHAPTER 12 : Unemployment and Inflation

What is Phillips Curve? Explain.

- The negative Empirical relationship between unemployment and inflation is known as the Philips
Curve,
What is Expectations-Augmented Phillips Curve? Explain.
– Friedman and Phelps: The cyclical unemployment rate (the difference between actual and
natural unemployment rates) depends only on unanticipated inflation (the difference
between actual and expected inflation)
• This theory was made before the Phillips curve began breaking down in the
1970s
• It suggests that the relationship between inflation and the unemployment rate
isn’t stable

What is the difference between Phillips Curve and Expectations-Augmented Phillips Curve?
-Phillips curve: Negative relationship with unemployment and inflation.
-Expectations- Augmented Phillips Curve: There should NOT be a negative relationship between
Unemployment and inflation but there is a negative relationship between unanticipated
inflation(difference between the actual and expected inflation rates) and cyclical unemployment.

What is unanticipated inflation? Know its formula.

-Unanticipated inflation is the (difference between the actual “r” and expected inflation rates
“r2”)
R-R2 = Unanticipated inflation.

What is cyclical unemployment? Know its formula.

- Cyclical Unemployment: the difference between actual “u” and natural unemployment rates
“U2”.

How does an expected or unexpected increase in money supply affect AD and SRAS curves?
Expected- rise AD and SRAS same level so output remains.
Unexpected- rise AD more than SRAS so, output increases.

– AD expected to shift up to AD2,old (money supply expected to rise 10%),

but unexpectedly money supply rises 15%, so AD shifts further up to
AD2,new
– SRAS shifts up based on expected 10% rise in money supply
– Result: P rises and Y rises as misperceptions occur
– So higher inflation occurs with lower unemployment
Long run: P rises further, Y declines to full-employment level Know the formula of Expectations-
Augmented Phillips Curve.

Know the formula of Expectations-Augmented Phillips Curve.

e hu
( u)

H= the slope of relationship between unanticipated inflation and cyclical unemployment.

Phillips curve will shift if expected rate of inflation and natural rate of unemployment changes.
How does a change in expected rate of inflation affect Phillips curve?
 -if expected rate increases Shift to the right of Phillips curve.

How does a change in natural rate of unemployment affect Phillips curve?

-If natural rate of unemployment increases shift to the right of Phillips curve.

How do supply shocks affect Phillips curve?

– An adverse supply shock increases both expected inflation and the natural rate of
unemployment
• A supply shock in the classical model increases the natural rate of
unemployment, because it increases the mismatch between firms and workers
• A supply shock in the Keynesian model reduces the marginal product of labor
and thus reduces labor demand at the fixed real wage, so the natural
unemployment rate rises
- adverse supply shock shifts the Phillips curve up and to the right

Can macroeconomic policy be used systematically to create unanticipated inflation? (Hint: think about
Classical Approach and Keynesian Approach )
• Classical model: NO

– The unemployment rate returns to its natural level quickly, as people’s expectations
adjust

– So unemployment can change from its natural level only for a very brief time
– Also, people catch on to policy games; they have rational expectations and try to
anticipate policy changes, so there is no way to fool people systematically

• Keynesian model: YES, temporarily

•
-The expected rate of inflation in the Phillips curve is the forecast of inflation at the time
the oldest sticky prices were set.
-It takes time for prices and expected prices to adjust, so unemployment may differ from
the natural rate for some time.

Know long-run Phillips Curve?

• -The long-run Phillips curve

– Long run: the u =

for both Keynesians and classicals
• The long-run Phillips curve is vertical, since when p = pe, u = ū

What is neutrality of money?

Long run prices are flexible are and money is neutral

– Changes in the level of money supply have no long-run real effects; changes in the
growth rate of money supply have no long-run real effects, either
 – Even though expansionary policy may reduce unemployment only temporarily,
policymakers may want to do so if, for example, timing economic booms right before
elections helps them (or their political allies) get reelected

What are the costs of unemployment?

– Loss in output from idle resources
• Workers lose income
• Society pays for unemployment benefits and makes up lost tax revenue
• Using Okun’s Law (each percentage point of cyclical unemployment is
associated with a loss equal to 2% of full-employment output), if full-
employment output is $10 trillion, each percentage point of unemployment
sustained for one year costs $200 billion
– Personal or psychological cost to workers and their families
• Especially important for those with long spells of unemployment
– There are some offsetting factors
• Unemployment leads to increased job search and acquiring new skills, which
may lead to increased future output
• Unemployed workers have increased leisure time, though most wouldn’t feel that
the increased leisure compensated them for being unemployed

What are the factors that make natural rate of unemployment lower?
• Some economists think the natural rate of unemployment is 4.5% or even lower
– The labor market has become more efficient at matching workers and
jobs, reducing frictional and structural unemployment
– Temporary help agencies have become prominent, helping the matching
process and reducing the natural rate of unemployment
• Increased labor productivity may increase the natural rate of unemployment
– If increases in real wages lag changes in productivity, firms hire more
workers and the natural rate of unemployment will decline temporarily
– Ball and Mankiw found evidence supporting this hypothesis in the 1990s

What are the costs of inflation?

DEPENDS ON WERE INFLATION IS ANTICIPATED OR NOT
– Perfectly anticipated inflation
• No effects if all prices and wages keep up with inflation
• Even returns on assets may rise exactly with inflation
• Shoe-leather costs: People spend resources to economize on currency holdings;
the estimated cost of 10% inflation is 0.3% of GNP
• Menu costs: the costs of changing prices (but technology may mitigate this
somewhat)
– Unanticipated inflation (p – pe)
• Realized real returns differ from expected real returns
– Expected r = i – pe
– Actual r = i – p
– Actual r differs from expected r by pe – p
– Numerical example: i = 6%, pe = 4%, so expected r = 2%; if p = 6%,
actual r = 0%;
if p = 2%, actual r = 4%
 – Unanticipated inflation (p – pe)
• Similar effect on wages and salaries
• Result: transfer of wealth
– From lenders to borrowers when p > pe
– From borrowers to lenders when p < pe
• So people want to avoid risk of unanticipated inflation
– They spend resources to forecast inflation
• Loss of valuable signals provided by prices
– Confusion over changes in aggregate prices vs. changes in relative prices
– People expend resources to extract correct signals from prices
– The costs of hyperinflation
• There are large shoe-leather costs, as people minimize cash balances
• People spend many resources getting rid of money as fast as possible
• Tax collections fall, as people pay taxes with money whose value has declined
sharply
• Prices become worthless as signals, so markets become inefficient

Know the followings:

- shoe leather cost: The cost in time and effort incurred by people and firms who are trying to minimize
their holdings of cash.

- menu cost: cost of changing nominal prices

- hyperinflation: occurs when the inflation rate is extremely high for a sustained period of time.

- disinflation: reduction of inflation rate.

- cold turkey: quickly implementation of disinflation by a rapid and decisive reduction in the growth rate
of the money supply.

- sacrifice ratio: When unanticipated tight monetary and fiscal policies are used to reduce inflation, they
reduce output and employment for a time, a cost that must be weighed against the benefits of lower
inflation. The sacrifice ratio is the number of percentage points of output lost in reducing inflation by one
percentage point.

Eje of sacrifice ratio: Ball’s study: U.S. inflation fell by 8.83 percentage points in the early 1980s,
with a loss in output of 16.18 percent of the nation’s potential output:

Sacrifice ratio = 16.18/8.83 = 1.832

- gradual disinflation: reducing the rate of money growth and inflation gradually over a period of years.

- credibility and reputation:

– Key determinant of the costs of disinflation: how quickly expected inflation adjusts
– This depends on credibility of disinflation policy; if people believe the government and if
the government carries through with its policy, expected inflation should drop rapidly
 – Credibility can be enhanced if the government gets a reputation for carrying out its
promises
– Also, having a strong and independent central bank that is committed to low inflation
provides credibility

Solve numerical problems 1 and 4. Their answers are as the followings:

1)
(a) Year 1: u 0.08. The unemployment rate is 0.02 higher than the natural rate. The percentage that
output falls short of full-employment output is 4%.
Year 2: u 0.06. The unemployment rate equals the natural rate, since inflation equals expected
inflation. Since unemployment is at its natural rate, output is at its full-employment level.
the sacrifice ratio is 0.5
(b) Use equations: u 0.06 0.5(e – ), output shortfall 2 (u – 0.06).
Year e u u – 0.06 Output Shortfall
1 0.08 0.10 0.07 0.01 0.02
2 0.04 0.08 0.08 0.02 0.04
3 0.04 0.06 0.07 0.01 0.02
4 0.04 0.04 0.06 0.0 0.0
The total output shortfall is 8 % of output lost. Inflation fell by 8 %. the sacrifice ratio is 1
4) (a) P 4 , e 0
(b) P 4.4 , Y 6040 , u .0467 , Cyclical unemployment is u – u –.0033. Unanticipated inflation
is 10%.
(c) h = 30. So the slope of the Phillips curve is –30