Output, Unemployment, and Inflation

Okuns Law

The actual relation between output growth

and the change in the unemployment rate
Chapter 9: Inflation, Activity, and Nominal Money Growth

is known as Okuns law.

Using thirty years of data, the line that best

fits the data is given by:

ut u t 1 0 .4 ( g yt 3% )

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 Output, Unemployment, and Inflation
Okuns Law

ut u t 1 0 .4 ( g yt 3% )

According to the equation above,

Chapter 9: Inflation, Activity, and Nominal Money Growth

If g yt 3 % , th e n u t u t1 0 .4 ( ) 0
If g yt 3 % , th e n u t u t1 0 .4 ( ) 0
If g yt 3 % , th e n u t u t1 0 .4 ( 0 ) 0

To maintain the unemployment rate constant, output growth

must be 3% per year. This growth rate of output is called
the normal growth rate.

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 Output, Unemployment, and Inflation
The Phillips Curve

t e
t (u t u n )
Chapter 9: Inflation, Activity, and Nominal Money Growth

Inflation depends on expected inflation and on the deviation of

unemployment from the natural rate of unemployment. When et is well
approximated by t-1, then:

t t1 (u t u n )

According to the Phillips curve,

ut un t t 1
ut un t t1

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 Output, Unemployment, and Inflation
The Aggregate Demand Relation

The aggregate demand relation:

Chapter 9: Inflation, Activity, and Nominal Money Growth

M t
A D R e la tio n Y t Y ,G t,Tt
Pt

Ignoring changes in output caused by other than changes in

the real money stock, then:

Mt
Yt Y
Pt

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 Output, Unemployment, and Inflation
The Aggregate Demand Relation

M t
Y t
Pt
Chapter 9: Inflation, Activity, and Nominal Money Growth

Keep in mind this simple relation hides the mechanism you

saw in the IS-LM model:
An increase in the real money stock leads to a
decrease in the interest rate.
The decrease in the interest rate leads to an increase
in the demand for goods and therefore, to an increase
in output.

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 The Effects of Money Growth

Okuns law relates the change in the unemployment rate

to the deviation of output growth from normal:

ut ut 1 g gt g y
Chapter 9: Inflation, Activity, and Nominal Money Growth

The Phillips curve relates the change in inflation to the

deviation of the unemployment rate from the natural rate:

t t 1 a ut un
The aggregate demand relation relates output growth to
the difference between nominal money growth and
inflation.

g yt g m t t

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 The Effects of Money Growth

Figure
Output Growth, Unemployment,
Inflation, and Nominal Money Growth
Chapter 9: Inflation, Activity, and Nominal Money Growth

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 The Effects of Money Growth
The Medium Run
Assume that the central bank maintains a constant
growth rate of nominal money,g call
m it . In this case, the
values of output growth, unemployment, and inflation in
the medium run:
Chapter 9: Inflation, Activity, and Nominal Money Growth

Output must grow at its normal rate of growth, g y .

If we define adjusted nominal money growth as

equal to nominal money growth minus normal output
growth, then inflation equals adjusted nominal money
growth.

The unemployment rate must be equal to the natural

rate of unemployment.

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 The Effects of Money Growth
The Short Run
Now suppose that the central bank decides to decrease
nominal money growth. What will happen in the short run?
Chapter 9: Inflation, Activity, and Nominal Money Growth

Given the initial rate of inflation, lower nominal money

growth leads to lower real nominal money growth , and
thus to a decrease in output growth.

Now, look at Okuns law, output growth below normal

leads to an increase in unemployment.

Now, look at the Phillips curve relation. Unemployment

above the natural rate leads to a decrease in inflation.

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 The Effects of Money Growth
The Short Run
In words: In the short run, monetary tightening leads to
a slowdown in growth and a temporary increase in
unemployment. In the medium run, output growth
Chapter 9: Inflation, Activity, and Nominal Money Growth

returns to normal, and the unemployment rate returns

to the natural rate.

Table The Effects of Monetary Tightening

Year 0 Year 1 Year 2 Year 3

1 Real money growth % (gm-) 3.0 0.5 5.5 3.0

2 Output growth % (gy) 3.0 0.5 5.5 3.0
3 Unemployment rate % (u) 6.0 7.0 6.0 6.0
4 Inflation gate % () 5.0 4.0 4.0 4.0
5 (Nominal money growth) % (gm) 8.0 4.5 9.5 7.0

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 The social costs of inflation
fall into two categories:
1. costs when inflation is expected
2. costs when inflation is different
than people had expected

CHAPTER 4 Money and Inflation

 The costs of expected inflation:
1. Shoeleather cost
def: the costs and inconveniences of
reducing money balances to avoid the
inflation tax.
i
real money balances
Remember: In long run, inflation does
not
affect real income or real spending.
So, same monthly spending but lower
average money holdings means more
frequent trips to the bank to withdraw
smaller
CHAPTER amounts
4 Money and Inflationof cash.
 The costs of expected inflation:
2. Menu costs

def: The costs of changing

prices.
Examples:
cost of printing new menus
cost of printing & mailing new
catalogs
The higher is inflation, the more
frequently firms must change
their prices and incur these costs.
CHAPTER 4 Money and Inflation
 The costs of expected inflation:
3. Relative price distortions
Firms facing menu costs change prices
infrequently.
Example:
A firm issues new catalog each January.
As the general price level rises throughout
the year, the firms relative price will fall.
Different firms change their prices at different
times, leading to relative price distortions
causing microeconomic inefficiencies
in the allocation of resources.

CHAPTER 4 Money and Inflation

 The costs of expected inflation:
4. Unfair tax treatment
Some taxes are not adjusted to account for
inflation, such as the capital gains tax.
Example:
Jan 1: you buy $10,000 worth of IBM
stock
Dec 31: you sell the stock for $11,000,

so your nominal capital gain is $1000

(10%).
Suppose = 10% during the year.
Your real capital gain is $0.
CHAPTER 4 Money and Inflation
 The costs of expected inflation:
5. General inconvenience

Inflation makes it harder to

compare nominal values from
different time periods.
This complicates long-range
financial planning.

CHAPTER 4 Money and Inflation

 Additional cost of unexpected inflation:
Arbitrary redistribution of purchasing power
Many long-term contracts not indexed,
but based on E .
If turns out different from E ,
then some gain at others expense.
Example: borrowers & lenders
If > E , then (i ) < (i E )
and purchasing power is transferred
from lenders to borrowers.
If < E , then purchasing power is
transferred from borrowers to lenders.

CHAPTER 4 Money and Inflation

 Additional cost of high inflation:
Increased uncertainty
When inflation is high, its more
variable and unpredictable:
turns out different from E more
often,
and the differences tend to be
larger
(though not systematically positive or
negative)

Arbitrary redistributions of wealth

become more likely.
CHAPTER 4 Money and Inflation
 One benefit of inflation
Nominal wages are rarely reduced,
even when the equilibrium real wage
falls.
This hinders labor market clearing.
Inflation allows the real wages to
reach equilibrium levels without
nominal wage cuts.
Therefore, moderate inflation
improves the functioning of labor
markets.
CHAPTER 4 Money and Inflation
 Hyperinflation
Common definition: 50% per month
All the costs of moderate inflation described
above become HUGE under hyperinflation.
Money ceases to function as a store of value,
and may not serve its other functions (unit of
account, medium of exchange).
People may conduct transactions with barter
or a stable foreign currency.

CHAPTER 4 Money and Inflation

 What causes hyperinflation?
Hyperinflation is caused by excessive
money supply growth:
When the central bank prints money,
the price level rises.
If it prints money rapidly enough, the
result is hyperinflation.

CHAPTER 4 Money and Inflation

 A few examples of hyperinflation
CPI
M2 Growth
country period Inflation
% per year
% per year
Israel 1983-85 338% 305%
Brazil 1987-94 1256% 1451%
Bolivia 1983-86 1818% 1727%
Ukraine 1992-94 2089% 1029%
Argentina 1988-90 2671% 1583%
Dem. Republic
1990-96 3039% 2373%
of Congo / Zaire
Angola 1995-96 4145% 4106%
Peru 1988-90 5050% 3517%
CHAPTER 4 Money and Inflation
Zimbabwe 2005-07 5316% 9914%
 Why governments create
hyperinflation

When a government cannot raise

taxes or sell bonds, it must finance
spending increases by printing
money.
In theory, the solution to
hyperinflation is simple: stop
printing money.
In the real world, this requires drastic
and painful fiscal restraint.
CHAPTER 4 Money and Inflation