Macroeconomics 7. Chapter 26-27 ... i.e. the Fisher hypothesis says that real
interest rates .... David Begg, Stanley Fischer and Rudiger Dornbusch,
Economics,.
2012.03.27.
Inflation is ... Inflation is a rise in the price level. Pure inflation is when goods and input prices rise at the same rate. One of the first acts of the Labour government in 1997 was to make the Bank of England independent with a mandate to achieve low inflation.
Macroeconomics 7
Chapter 26-27 Inflation, Expectations and Unemployment
What are the causes of inflation?
What are the effects and hence costs of inflation?
What can be done about it?
These are the questions we seek to answer in what follows.
The quantity theory
Inflation in the UK, 1950-2007 30
%p.a.
25 20
The quantity theory of money says:
“Changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.”
We can state it algebraically as:
15 10 5 0 2000
1990
1980
1970
1960
1950
The change of consumer price index in Hungary (1985-2008) Source: KSH
40 35 30 25 20 15 10 5 0
MV = PY where V = velocity of circulation Y = potential level of real GDP P = the price level M = nominal money supply Given constant velocity, if prices adjust to maintain real income at the potential level an increase in nominal money supply leads to an equivalent increase in prices.
19 85 19 87 19 89 1 99 1 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07
Source: Economic Trends Annual Supplement, Labour Market Trends
Money, prices and inflation (1)
Milton Friedman famously claimed
“Inflation is always and everywhere a monetary phenomenon.”
i.e. it results when money supply grows more rapidly than real output.
Money, prices and causation (a)
But notice that the quantity theory equation does not tell us whether prices determine quantity or vice versa.
In money market equilibrium, the supply of real money equals the demand for money i.e. M/P = Y/V If the demand for real money is constant, M/P is constant. Monetary policy can fix M, in which case M P OR monetary policy can try and fix P over time, in which case P M This latter approach is known as inflation targeting in contrast to the former approach which indirectly targets the money supply.
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Hyperinflation
In 1958, Prof. A W Phillips demonstrated a statistical relationship between annual inflation (the rate of wages’ increase) and unemployment in the UK. The Phillips curve relates higher unemployment to lower inflation. It implies we can trade-off higher inflation for lower unemployment and vice versa.
persistent inflation must be accompanied by continuing money supply growth
The vertical long-run Phillips curve implies that sooner or later, the economy will return to U* whatever the inflation rate. The position of the short-run Phillips curve depends on expected inflation. The long-run and short-run curves intersect when actual and expected inflation are equalised. The long-run Phillips curve shows that in the long run there is no trade-off between unemployment and inflation.
Nominal interest rate minus inflation rate i.e. the Fisher hypothesis says that real interest rates do not change much but the nominal interest rate is the opportunity cost of holding money so a change in nominal interest rates affects real money demand.
The Phillips curve (1)
The long-run Phillips curve
a 1% increase in inflation will be accompanied by a 1% increase in interest rates
REAL INTEREST RATE
e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s.
Large government budget deficits help to explain such periods
FISHER HYPOTHESIS
Hyperinflations are periods when inflation rates are very large During such periods there tends to be a ‘flight from cash’, i.e. people hold as little cash as possible
In any case, in the long run, potential real GDP and interest rates will significantly alter real money demand Therefore, in the long run there may not be a perfect correspondence between excess monetary growth and inflation. Also, in the short run, the link between money and prices may be broken if: the velocity of circulation is variable prices are sluggish. For all the above reasons, we must therefore interpret the quantity theory with care.
Phillips curve
U* Unemployment rate (%)
The long-run Phillips curve and an increase in aggregate demand (1) Suppose the economy begins at E, with unemployment at the natural rate U*, and inflation at 1
Inflation
Inflation and interest rates
Inflation rate (%)
Money, prices and inflation (2)
2 1
A E U1 U*
Unemployment
PC1
An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment (U1) but inflation at 2. … but what happens next?
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If the nominal money supply continues to expand at the same rate thereafter, the economy will eventually move to B on PC2.
2 A
B
1
E
At B, inflation expectations coincide with actual inflation and nominal wages have been renegotiated so that the real wage and hence, employment are the same as before the monetary Expansion.
PC1 PC2
U1 U*
Unemployment
E A PC1
F
PC2 U*
1
B E PC1 PC2
U1 U*
Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*. The short-run Phillips curve shows just a short-run trade-off: its position may depend upon expectations about inflation.
Unemployment
Inflation and unemployment in the UK 1978-2003
Suppose the economy begins at E, with a newly-elected government pledged to reduce inflation. Monetary growth is cut to 2. In the short run, the economy moves to A along the shortrun Phillips curve. Unemployment rises to U1 As expectations adjust, the short-run Phillips curve shifts to PC2, and U* is restored at F.
LRPC
2
A
i.e. there is no trade-off between unemployment and inflation in the long-run
Expectations and credibility
1
LRPC
2
20
1980
15 Inflation
Inflation
LRPC
The long-run Phillips curve and an increase in aggregate demand (3) Inflation
The Long-run Phillips curve and an increase in aggregate demand (2)
1990
10
1978 5
2000
1986 1993
0 3
5
7
9
11
13
Unemployment
U1
Unemployment
Inflation illusion
Inflation and Unemployment in Hungary (1998-2008) Source: KSH
Inflation
20
15
People have inflation illusion when they confuse nominal and real changes. Welfare depends upon real variables, not nominal variables. If all nominal variables (prices and incomes) increase at the same rate, real income does not change.
The cost of inflation
10
5 0 5
5,5
6
6,5
7
Unemployment
7,5
8
Fully anticipated inflation: Institutions adapt to known inflation: nominal interest rates tax rates transfer payments (there is no inflation illusion) Some costs remain: shoe-leather (people economise on money holdings) menu costs (firms need to alter price lists etc.)
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The costs of inflation (2)
Even if inflation is fully anticipated, the economy may not fully adapt interest rates may not fully reflect inflation taxes may become distorted
fiscal drag may have unintended effects on tax liabilities capital and profits taxes may be distorted
The costs of unanticipated inflation
Unintended redistribution of income from lenders to borrowers from private to public sector from old to young Uncertainty firms find planning more difficult under inflation, which may discourage investment This has been seen as the most important cost of inflation
Defeating inflation
In the long run, inflation will be low if the rate of money growth is low.
The transition from high to low inflation may be painful if expectations are slow to adjust.
Policy credibility may speed the adjustment process.
The Monetary Policy Committee
Central Bank Independence may improve the credibility of anti-inflation policy.
Since 1997 UK monetary policy has been set by the Bank of England’s Monetary Policy Committee
which has the responsibility of meeting the (underlying) inflation target
via interest rates
which are set according to inflation forecasts.
Why inflation targeting?
Unpredictable changes in real money demand undermined attempts to use a nominal money target. Setting inflation targets involves an element of forward-looking. MPC performance so far has been creditable.
Chapter 27 Unemployment David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward
Some key terms Unemployment rate:
Labour force
those people holding a job or registered as being willing and available for work.
Participation rate
the percentage of the population of working age declaring themselves to be in the labour force.
% p.a.
the percentage of the labour force without a job but registered as being willing and available for work.
14 12 10 8 6 4 2 0 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 20 00
Unemployment in the UK 1950-2007
Source: Economic Trends Annual Supplement, Labour Market Trends
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Labour market flows
Unemployment (%) in selected countries
It is tempting to see the labour market in static terms
16
LABOUR FORCE
14 12 10
Working
% 8
Unemployed
6 4 2 0 1972 UK
1982 Ireland
1992 France
2001 EU
2004
USA
2006
Labour market flows
New hires Recalls
Unemployed
Job-losers Lay-offs Quits
Discouraged workers
Retiring Temporarily leaving
Non-participants
Frictional
Types of unemployment (2)
the irreducible minimum level of unemployment in a dynamic society
people between jobs
the ‘almost unemployable’
Structural
The size of these flows is surprisingly high. In 1999 unemployment in the UK began at 1.29 million. During the year: 3.14 million became unemployed but 3.3 million left the ranks of the unemployed.
Re-entrants New entrants
Types of unemployment
unemployment arising from a mismatch of skills and job opportunities when the pattern of demand and production changes
but...
More on labour market flows
LABOUR FORCE Working
Taking a job
Non-participants
Hungary
Demand-deficient unemployment
occurs when output is below full capacity
‘Keynesian’ unemployment occurs in the transitional period before wages and prices have fully adjusted
Classical unemployment
created when the wage is deliberately maintained above the level at which labour supply and labour demand schedules intersect
it takes time for ex-coal miners to retrain as international bankers
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The natural rate of unemployment The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium.
This is entirely voluntary.
Real wage
The natural rate of unemployment
It includes:
w*
frictional unemployment
structural unemployment
AJ
12
Number of workers
Real wage
8
A
E
w* w2
4
G
2 60-8 69-73 74-80 81-87 88-90 91-95 2002 Natural rate
Classical unemployment
A
B
LF
C
Equilibrium is at A
LD N2 N*
N1
Number of workers
and AB is involuntary. To the extent that this unemployment reflects a conscious decision by unions to restrict employment, it is voluntary unemployment.
labour demand falls to LD’. With sticky wages and prices in the short-run, the economy will move to equilibrium at A and there will be unemployment of AF. Of which EF will be voluntary and AE will be involuntary (i.e. Keynesian). If labour demand remains at LD’, the new equilibrium when wages and prices have fully adjusted will be at G.
A ‘modern’ view of unemployment
Suppose that union power succeeds in maintaining a real wage of w2.
of which BC is voluntary
F H
Number of workers
A similar categorisation is retained, but an important distinction is to be noted between: Voluntary unemployment
and unemployment is AC,
w*
LF
LD LD’
0 Actual rate
Equilibrium is at w*/ N*. The distance EF is the natural rate of unemployment.
LD: labur demand; LF: size of labour force AJ: the number of workers prepared to accept jobs Beginning at E, suppose
AJ
% 6
Real wage
N1
Keynesian unemployment
10
w2
AJ is to the left of LF because some members of the labour force are between jobs, others are waiting for better offers.
LD
The natural rate of unemployment in the UK, 1956-02
AJ
LF
F
E
N*
56-59
LD: labour demand LF: size of labour force AJ: the number of workers prepared to accept jobs
when a worker chooses not to accept a job at the going wage rate.
Involuntary unemployment
when a worker would be willing to accept a job at the going wage but cannot get an offer.
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Supply-side economics entails the use of microeconomic incentives to alter
Real wage
Tax cuts and unemployment
the level of full employment the level of potential output the natural rate of unemployment.
AJ
w1 w2 w3
In the long run the performance of the economy can only be changed by affecting the level of full employment and the corresponding level of potential output.
reducing the power of trade unions may limit distortions in the labour market
F B
C
LD
training and retraining measures
improving the efficiency of the labour market such measures may affect frictional and structural unemployment
Investment
Four channels: Insider-outsider distinction
firms and workers get used to low search
capital stock
Summary
people stop looking for jobs
Search and mismatch
only those in work take part in wage bargaining & they protect their own positions
Discouraged workers
The idea that a (short-run) fall in aggregate demand can lead to a persistence of unemployment even when the fall in aggregate demand has been reversed. This could help to explain high and persistent unemployment in Europe in the 1980s.
may be achieved via tax incentives or low interest rates
Hysteresis (continued)
higher investment may increase the demand for labour
Number of workers
AB is the amount of tax Unemployment is BC Without tax, equilibrium is at E. Unemployment is now EF. EF < BC i.e. unemployment is reduced.
Hysteresis
Other labour supply policies
Equilibrium is at N1
E
Trade union reform
LF
A
N1 N2
Other supply-side policies
Firms pay a gross wage of w1 w1 > w3 (the take-home net pay of workers).
Unemployment is a dynamic phenomenon. It impacts upon different groups differently. Modern view emphasises difference between voluntary and involuntary unemployment. Supply-side policies are a favoured way of dealing with the problem. Hysteresis may help to explain unemployment persistence.
low levels of investment in recession lead to permanently low capital stock levels
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