INFLATION AND

UNEMPLOYMENT
 Lecture Outline

• Inflation and the Price Level

• Demand-Pull Inflation
• Cost-Push Inflation
• Effects of Inflation
• The Phillips Curve
 Inflation and the Price Level

• Inflation is a process in which the price

level rises and money loses value.
• Inflation is fundamentally a monetary
phenomenon.
• The average level of prices is rising.
• Inflation is not high prices and inflation is
not a jump in prices
 Inflation and the Price Level
• The figures
distinguishes
between a
one time
jump in
prices and
inflation.
• Part (b)
shows a one
time jump in
the price
level.
 Inflation and the Price Level
• Part (a)
shows the
process of
inflation.
• The inflation
rate is the
percentage
change in the
price level
during a
given period.
 Causes of Inflation
• There are three main causes of Inflation.

• The Monetarist theory of inflation.

• Demand Pull Inflation (Keynesian theory).

• Cost Push Inflation.

 MONETARISTS
• Economists who traditionally emphasize the
important role that the supply of money plays in
determining nominal income and inflation
• Most famous - Milton Friedman, Nobel laureate -
studied versions of quantity equation and role of
money in economic life
• Philip Cagan - best known for work on
hyperinflations
• Monetarist economists did pioneering research
on link between money, nominal income and
inflation
 MONETARISTS
1. The monetarist explanation of inflation:
• View inflation exclusively in terms of increases in
money supply

• The foundation is the quantity theory of money by

the classical school- review the Fisher equation
-MV=PQ…(1)

• Fisher concluded that given a constant V and Q, the

price level (P ) will vary directly with the quantity of
money (M)
 Monetarists
• The proportional relationship between the
money supply and prices can be shown as
follows:
– The elasticity of the price level with respect to the
money supply ( Epm) is:
• Epm= (dP/dM. M/P)….(2)
• Differentiate equation 1 totally to obtain
• MdV + VdM = PdQ + QdP…3
• Letting dQ and dV = 0
• VdM = QdP and thus, dP/dM = V/Q…. 4
• Substitute eq. 4 into eq. 2 to get:
• Epm = V/Q.M/P; Since V = PQ/M , therefore
• Epm = 1/Q. PQ/M . M/P = 1
 Monetarists
• This establishes the proportionality
between the money supply (M) and
prices (P) when V and Q are constants
and only money (M) and prices (P) are
left free to vary
• Milton Friedman is often associated with
the modern quantity theory of money-he
argues that the main determinant of
aggregate spending is increases in the
money supply.
 Demand-Pull Inflation

• Demand-pull inflation is inflation that

results from an initial increase in
aggregate demand.
• A demand pull inflation can result
from any influence that increases
aggregate demand.
 Demand-Pull Inflation

• In a demand-pull inflation, initially

– aggregate demand increases
– real GDP increases above potential
GDP and the price level rises
– money wages rise
– the price level rises further and real
GDP decreases toward potential GDP.
 Demand-Pull Inflation
• A one-time increase in aggregate
demand raises the price level but
does not always start a demand-pull
inflation.
• For demand pull inflation to occur,
aggregate demand must persistently
increase.
• The money supply must persistently
grow at a rate that exceeds the
growth rate of potential GDP.
 Demand-Pull Inflation
• The figures
show a
demand pull
inflation.
• Initially,
aggregate
demand
increases.
 Demand-Pull Inflation
• Real GDP
increases
and the price
level rises.
• Now real
GDP
exceeds
potential
GDP.
 Demand-Pull Inflation
• There is an
inflationary
gap.
• The money
wage rate
begins to rise.
• And the SAS
curve shifts
leftward.
 Demand-Pull Inflation
• Real GDP
decreases
toward
potential
GDP.
• The price
level rises
further.
 Demand-Pull Inflation
• This process
repeats in an
unending
price-wage
spiral.
 Cost-Push Inflation
• Cost-push inflation is an inflation
that results from an initial
increase in costs.
• The two main sources of cost-
push inflation are:
– an increase in the money wage rate
– an increase in the money prices of
raw materials
 Cost Push inflation
• Other sources of cost push inflation emphasizes the institutional
framework within which prices and wages are determined.

– Trade unions agitate for higher wages by putting pressures on their

employers especially governments through the threat of strikes.

– Rivalries may also exist between different unions to secure better pay
for their workers-this may lead to competitive bidding for better pay.

– The combination of all successful demands may be greater than the

increase in production that follows from the increase in wages.
– This may lead to increase in prices.
 Cost Push inflation
• Alternatively, the rise in wages is viewed as an increase in the
costs of production by the producers.

– This is passed on to the consumers in higher prices of goods

and services.

• This version of cost push theory is called wage push inflation

• Profit push occurs when firms (especially oligopolistic and

monopolistic firms) have a profit margin which they aim at.

• An increase in the profit margin or mark up to offset cost

increases could lead to inflation.
 Cost-Push Inflation
• In a cost-push inflation, initially
– short-run aggregate supply
decreases
– real GDP decreases below
potential GDP and the price level
rises
– the economy could become stuck
in this stagflation situation for
some time.
 Cost-Push Inflation

• A one-time decrease in aggregate

supply raises the price level but does
not always start a cost-push
inflation.
• For cost-push inflation to occur,
aggregate demand must increase in
response to the cost push.
 Cost-Push Inflation

• Just like the case of demand-

pull inflation, the money supply
must persistently grow at a rate
that exceeds the growth rate of
potential GDP if an inflation is to
become persistent.
 Cost-Push Inflation
• The
following
figures
show a
cost-push
inflation.
• Initially, a
factor price
rises.
 Cost-Push Inflation
• Short-run
aggregate
supply
decreases
and the
SAS curve
shifts
leftward
 Cost-Push Inflation
• Real GDP
decreases
and the
price level
rises in a
stagflation.
 Cost-Push Inflation
• With no
subsequet
change in
aggregate
demand,
the price
level
eventually
falls.
 Cost-Push Inflation
• There is no
inflation.
• For cost-
push
inflation to
take hold,
aggregate
demand
must
increase.
 Cost-Push Inflation
• An increase
in the money
supply
increases
aggregate
demand and
the AD curve
shifts
rightward.
 Cost-Push Inflation
• Real GDP
increases
and the
price level
rises.
 Cost-Push Inflation
• This
process
repeats to
create an
unending
cost-price
inflation
spiral.
 HYPERINFLATION
• Very high inflation rates, over 50% per
month
• Inflation rates observed in the US in
the last 40 years are insignificant in
comparison to some experiences
around the world throughout history
 HIGH INFLATIONS IN THE 1980s

Country Bolivia Argentina Nicaragua

Year 1985 1989 1988
Yearly Inflation 1,152, 200 975, 000 302, 200
Rate (%)
Monthly Inflation 118 95 115
Rate (%)
Monthly Money 91 93 66
Growth
Rate (%)
Source: International Financial Statistics Yearbook, 1992,
(Washington DC: International Monetary Fund)
 DURING HYPERINFLATIONS
• Money no longer works very well in facilitating
exchange
• Since prices are changing so fast and unpredictably,
there is typically massive confusion about the true
value of commodities
• Different stores may be raising prices at different rates
• The same commodities may sell for radically different
prices
• Everyone spends all their time hunting for bargains and
finding the lowest prices
• Governments are forced to put an end to hyperinflation
before it destroys their economies
 THE CAUSE OF HYPERINFLATION
Excessive money growth
• If a government wants to spend a specified
amount of money, but is collecting less in
taxes, it must cover the difference in some
way:
– the government may borrow the difference from the
public and issue bonds, for which it must pay back
what it borrows and interest in the future
– the government may print new money
– governments could mix borrowing and printing money
to cover the deficit

government deficit = new borrowing + new money created

 HYPERINFLATION
• occurs in countries that have large deficits,
but cannot borrow and are forced to print
new money
• is only stopped by eliminating the deficit,
which is the basic cause:
– increase taxes
– cut spending
• Once the deficit has been cut and the
government stops printing money, the
hyperinflation will end
 Effects of Inflation
• Regardless of whether its origin is
demand-pull or cost-push, inflation
imposes costs.
• The costs depend on whether the
inflation is anticipated or unanticipated.
 Effects of Inflation
• Regardless of whether its origin is
demand-pull or cost-push, inflation
imposes costs.
• The costs depend on whether the
inflation is anticipated or unanticipated.
 ANTICIPATED INFLATION
Fully Anticipated Inflation
• Inflation at 4% would mean workers would know that
nominal wage increases of 4% were not real wage
increases, and

• Investors earning a 7% rate of interest on bonds

would know that their real return would be 3% after
adjusting for 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 doesn’t
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 amounts of cash. slide 41
 The costs of expected inflation:
2. menu costs

• def: The costs of changing prices.

• Examples:
– print new menus
– print & mail new catalogs
• The higher is inflation, the more
frequently firms must change their
prices and incur these costs.

slide 42
 The costs of expected inflation:
3. relative price distortions
• Firms facing menu costs change prices
infrequently.
• Example:
Suppose a firm issues new catalog each
January. As the general price level rises
throughout the year, the firm’s relative price
will fall.
• Different firms change their prices at different
times, leading to relative price distortions…
• …which cause microeconomic inefficiencies
in the allocation of resources.
slide 43
 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 bought $10,000 worth of
Starbucks stock
 Dec 31: you sold the stock for $11,000,
so your nominal capital gain was $1000
(10%).
 Suppose  = 10% during the year.
Your real capital gain is $0.
 But the govt requires you to pay taxes on
slide 44
 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.

slide 45
 Effects of Inflation
• The costs of anticipated inflation are:
– other transactions costs
– decrease in potential GDP
– decrease in the long-term growth rate.
• These costs have been estimated to be
very high, even for a modest inflation.
• The main problem is that taxes on capital
income a seriously distorted by inflation.
 Effects of Inflation
• Unanticipated inflation can cause the
following problems:
– redistribute income between firms and
workers

– move real GDP away from potential GDP

– redistribute wealth between borrowers

and lenders.
 Effects of Inflation
– Borrowers gain in an inflation since at the time
the loan is to be repaid the real value of the
money used to repay the loan is less than the
real value when the money was borrowed.

– On the other hand, lenders lose because the

money paid back will buy less goods and
services than at the time the money was lent
out.(inflationary premium are often tied to the
lending rate to avoid this.

– This may result in too much or too little

savings and investment
 Effects of Inflation
• Because unanticipated inflation is costly,
people try to anticipate it.
• To make the best possible forecast of
inflation, people use all the information
they can about the source of inflation and
likely trends in those sources.
• Such a forecast is called a rational
expectation.
• An anticipated inflation avoids some of the
costs of inflation.
 COSTS OF INFLATION
Anticipated Unanticipated
Inflation Inflation
Institutions do Distortions in the Unfair redistributions
not adjust tax system,
Problems in
financial markets
Institutions Cost of changing Institutional
adjust prices, disintegration
Shoe-leather
costs
 THE PHILLIPS CURVE - 1
• The Phillips Curve is a graph depicting a
relationship between the unemployment
rate and the inflation rate. The figure below
shows a typical SHORT-RUN Phillips Curve.
 THE PHILLIPS CURVE - 2
• The implication of the negative slope is that the
unemployment rate and the inflation rate are
inversely related - in other words, there is a trade-
off between the two.

• At the beginning of the course, one things we said

was that society faces a short-run trade-off
between inflation and unemployment. This trade-
off is embodied in the short-run Phillips Curve.
 THE PHILLIPS CURVE - 3
• Since inflation and unemployment are BOTH
things we don't like, the relationship between the
AD-AS (short-run) macroeconomic model and the
Phillips Curve are important.

• Understanding the relationship between

economic policy and the inflation-unemployment
trade-off is key to your understanding of
macroeconomics.
 SHIFTS IN AD & THE PHILLIPS
CURVE - 1
Q: What happens in the Phillips Curve
diagram when there is a shift in AD?

A: There is a movement along the short-run

Phillips Curve and a trade-off between
inflation and unemployment.
SHIFTS IN AD & THE PHILLIPS
CURVE - 2
 SHIFTS IN AD & THE PHILLIPS
CURVE - 3
• In the previous slide, AD increases from AD1 to
AD2. As a result, the equilibrium in the economy
moves from point A to point B.
• There are two important things to notice about
the new equilibrium (relative to the old one):
– First, notice that the price level in the economy has
increased (from 102 to 106) - therefore, the rate of
inflation has risen.
– Second, the level of output produced in the economy
has risen (from Y1 to Y2). When the level of output
increases, the number of people employed also rises,
indicating that the unemployment rate MUST have
 SHIFTS IN AD & THE PHILLIPS
CURVE - 4
• Relative to point A in the figure on the right,
point B MUST be a point where there is higher
inflation and lower unemployment - but this just
represents a movement ALONG the short-run
Phillips Curve. Also, if AD were to shift in the
opposite direction, there would have been a
movement along the Phillips Curve in the
opposite direction.
 THE LONG-RUN PHILLIPS
CURVE - 1
The figure below depicts the long-run Phillips
Curve:
 THE LONG-RUN PHILLIPS
CURVE - 2
• Earlier in the course, we discussed the
natural rate of unemployment. This was
defined to be about 6% in the long-run,
and it was shown that the economy tends
to automatically return to this level on its
own.
• If this is true, then the long-run Phillips
Curve is quite easy to draw - it MUST be a
vertical line at 6% unemployment!
 THE LONG-RUN PHILLIPS
CURVE - 3
• If the long-run Phillips Curve is vertical at
6%, then policymakers must be able to
choose any inflation rate they desire along
this line.

Q: What is the cost of reducing inflation in the

long-run?

A: In the long-run, there is NO cost to

reducing inflation.
 THE LONG-RUN PHILLIPS
CURVE - 4
This is demonstrated in the figures below:
 THE LONG-RUN PHILLIPS
CURVE - 5
• On the left, if the Fed reduces the growth of the
money supply in the long-run, the AD curve will
shift to the left, causing the price level to fall
from P0 to P1.

• However, output is NOT affected by changes in

the money supply in the long-run (because of
monetary neutrality). Since output remains at the
natural rate of output, unemployment remains at
the natural rate of unemployment.
 THE LONG-RUN PHILLIPS
CURVE - 6
• On the right, the reduction in the growth of the
money supply has lowered the long-run rate of
inflation and has NOT affected the long-run
unemployment rate.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 1

• While there is not a trade-off between

inflation and unemployment in the long-
run, there IS a short-run trade-off.
• From the work of Milton Friedman and
Edmund Phelps, we know that
expectations of future inflation plays an
important role in the short-run trade-off.
• THE SHORT-RUN PHILLIPS CURVE &
EXPECTATIONS -
• The natural rate of unemployment is that rate of
unemployment that exists when workers and
employers correctly anticipate the rate of inflation
• In the long run, expected inflation adjusts to
changes in actual inflation
• Once people anticipate inflation, the only way to
get unemployment below the natural rate is for
actual inflation to be above the anticipated rate.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 2
The figure below demonstrates the relationship
between the short-run Phillips Curve and
inflationary expectations:
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 3
• Suppose the economy is initially at point
‘A’. Earlier we said that a shift in the AD
curve will cause a movement along the
short-run Phillips Curve.

• An increase in the money supply, an

increase in government spending or a tax
cut could all shift the AD curve to the right
- suppose one of these three occurs.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 4
• The rightward shift in AD is associated with
rising output and a rising price level.
• The rising price level IS an increase in the rate of
inflation.
• Rising output goes along with rising
employment (and falling unemployment).
• For these reasons, the rightward shift in AD will
cause a movement to point ‘B’ in this figure
(higher inflation and lower unemployment than
point ‘A’).
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 5

• Now, according to Friedman and Phelps,

the higher ACTUAL inflation will eventually
cause EXPECTED inflation to rise as well.

• The increase in EXPECTED inflation shifts

the short-run Phillips Curve to the right (to
SR-PC2), and the economy ends up at
point ‘C’.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 6
• We can describe SR-PC2 as a ‘short-run Phillips
Curve with high expected inflation’, while the
original curve, SR-PC1 can be described as a
‘short-run Phillips Curve with low expected
inflation’.

• The result you should take from the previous

figure is that government policies attempting to
EXPAND aggregate demand are likely to cause
permanently HIGHER rates of inflation, without
affecting the long-run unemployment rate.
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 7
• The relationship between the short-run Phillips
Curve and inflationary expectations described
by Friedman and Phelps is stated in the
following formula:
 THE SHORT-RUN PHILLIPS
CURVE & EXPECTATIONS - 8
• In the previous example, when ACTUAL inflation
exceed EXPECTED inflation (at point ‘B’),
unemployment was LESS THAN the natural rate.
In the long-run, actual and expected inflation will
be equal, and unemployment will equal the
natural rate (and the economy will be back on
the long-run Phillips Curve).
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 1
Q: What happens in the Phillips Curve
diagram when the AS curve shifts?

A: The short-run Phillips Curve shifts,

changing the attractiveness of the trade-
off between inflation and unemployment.
SUPPLY SHOCKS & THE
PHILLIPS CURVE - 2
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 3
• The figure on the left in the previous slide
depicts a typical supply shock in the
economy (like the OPEC shocks in the
1970s).

• As the AS curve shifts to the left, the

equilibrium in the marcoeconomy moves
from point A to point B.
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 4
• As with a shift in the AD curve, there are two
things you should watch for when AS shifts:

– First, notice that the equilibrium price level rises

(from P1 to P2), indicating that the level of inflation in
the economy has risen.

– Second, notice that the level of output produced has

FALLEN from Y1 to Y2. As output falls the number of
labourers required to produce this output also falls.
When these workers get laid off, the unemployment
rate RISES.
 SUPPLY SHOCKS & THE
PHILLIPS CURVE - 5
• In the figure on the right, point B MUST be a
point with a higher inflation rate AND a higher
unemployment rate.
• Point B MUST be up and to the right of point A.
Because of this, economists say that the short-
run Phillips Curve must have shifted to the right.
• This means that the trade-off between inflation
and unemployment is LESS attractive, because
BOTH rates have risen.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 1
• The figure below illustrates the cost of reducing
inflation in the short-run:
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 2
• To reduce inflation, the Fed will run a
contractionary monetary policy.
• The reduction in the money supply will shift AD
to the left.
• Recall that a leftward shift in AD will cause
falling output and a falling price level. The falling
price level means a falling rate of inflation, while
falling output means falling employment (which,
in turn, means rising unemployment).
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 3
• The contractionary monetary policy has the
effect of moving the economy from point ‘A’ to
point ‘B’ in the figure. You should think of SR-
PC1 as the ‘short-run Phillips Curve with HIGH
inflationary expectations’.
• At point ‘B’ inflation is lower and, in the long-run,
inflationary expectations will adjust downwards
to match the lower ACTUAL inflation. When this
occurs, the short-run Phillips Curve will shift
INWARD to SR-PC0 (think of SR-PC0 as the
‘short-run Phillips Curve with low inflationary
expectations’.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 4
Q: In this example, what WAS the short-run
cost of reducing inflation?

A: Temporarily higher unemployment.

However, as stated before, there is NO
long-run cost to reducing inflation,
because the economy returned to the
natural rate of unemployment as
inflationary expectations adjusted.
 COSTS OF REDUCING
INFLATION IN THE S/RUN - 5
Q: How big is the cost of reducing inflation in
reality?

A: There are two schools of thought:

– The Sacrifice Ratio.
– Rational Expectations.
 THE SACRIFICE RATIO
• The Sacrifice Ratio is the number of percentage points of
annual output lost in the process of reducing inflation by
1 percentage point. A typical sacrifice ratio is 5, meaning
that reducing inflation by 1% will reduce the output of the
economy by 5%.

• When Paul Volcker was the Chairman of the Federal

Reserve, he wanted to reduce inflation from about 10% to
about 4%, meaning that the output of the economy might
drop by as much as 30% (that's as large as the drop
during the Great Depression from 1929-1933). This
school of thought indicates that the short-run cost of
reducing inflation is rather large.
 RATIONAL EXPECTATIONS - 1
• Rational Expectations is a theory according to which
people optimally use all the information they have when
forecasting the future.

• Drawing on the analysis of Friedman and Phelps, rational

expectations (which is attributed to Lucas, Sargent and
Barro) claims that the short-run cost of reducing inflation
will be related to the speed with which inflationary
expectations adjust. Rational expectations implies that
the sacrifice ratio could be much lower than 5 if the
commitment to lower inflation by the Fed is seen as
‘CREDIBLE’. In other words, if people in the economy
immediately believe that the Fed WILL reduce inflation,
inflationary expectations could adjust downwards
immediately, and the sacrifice ratio could be 0.
 RATIONAL EXPECTATIONS - 2
• When Paul Volcker implemented his disinflation
policies in the early 1980s, there was neither a
30% drop in economic output, nor a 0% drop in
economic output.

• The fact that the drop was greater than 0%

caused many economists to refute the
conclusions of rational expectations, while the
much less than 30% drop in output caused
proponents of rational expectations to claim
success (stating that people reacted to the Fed’s
policy, but NOT immediately).