Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved Economics NINTH EDITION Chapter 16 The Dynamics of Inflation and Unemployment Insert Cover Picture

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved Learning Objectives 16.1 Describe how an economy at full unemployment with inflation differs from one without inflation Explain the relationship between inflation and unemployment in the short run and long run Discuss why increasing the credibility of a central bank can reduce inflation Define the velocity of money Identify the origins and causes of hyperinflation.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (1 of 3) Inflation in a Steady State ● Nominal wages Wages expressed in current dollars. ● Real wages Wage rates paid to employees adjusted for changes in the price level. ● Money illusion Confusion of real and nominal magnitudes. ● Expectations of inflation The beliefs held by the public about the likely path of inflation in the future.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (2 of 3) Inflation in a Steady State INFLATION EXPECTATIONS AND INTEREST RATES When the public expects inflation, real and nominal rates of interest will differ because we need to account for inflation in calculating the real return from lending and borrowing. INFLATION EXPECTATIONS AND MONEY DEMAND REAL – NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not its “face” value.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (1 of 4) ●Expectations Phillips curve The relationship between unemployment and inflation when taking into account expectations of inflation. TABLE 16.2 Expectations and Business Fluctuations When the economy experiences a …Unemployment is…Inflation is … boom Recession below the natural rate. above the natural rate. higher than expected. lower than expected.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (3 of 3) How Changes in the Growth Rate of Money Affect the Steady State TABLE 16.1 Money, Inflation, and Interest Rates in a Steady-State Economy Money Growth RateInflation Growth in Money Demand Real Interest Rate Nominal Interest 4% 5% 4% 5% 4% 5% 2% 6% 7%

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved APPLICATION 1 SHIFTS IN THE NATURAL RATE OF UNEMPLOYMENT APPLYING THE CONCEPTS #1: How can data on vacancies and unemployment be used to measure shifts in the natural rate? The natural rate of unemployment changes over time. Policy makers need to know what the natural rate is to avoid unnecessary unemployment and inflation. One way to estimate is to look at the Beveridge Curve, the relationship between job vacancies and the unemployment rate. Economist William Dickens tracked the natural rate in recent decades: Five percent in the mid 1960s Peaked near seven percent in the late 1970s and early 1980s Falling through the 1990s and reached five percent in 2000

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (2 of 4) Are the Public’s Expectations About Inflation Rational? ●Rational expectations The economic theory that analyzes how the public forms expectations in such a manner that, on average, they forecast the future correctly.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (3 of 4) U.S. Inflation and Unemployment in the 1980s Inflation rose and the unemployment rate fell below the natural rate. Inflation later fell as unemployment exceeded the natural rate. SOURCE: Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, yearly).

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (4 of 4) Shifts in the Natural Rate of Unemployment in the 1990s What factors can shift the natural rate of unemployment? Demographics Institutional changes The recent history of the economy Changes in growth of labor productivity

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (1 of 2) If workers push up their nominal wages, the aggregate supply curve will shift from AS 0 to AS 1. If the Fed keeps aggregate demand constant at AD 0, a recession will occur at point a, and the economy will eventually return to full employment at point c. If the Fed increases aggregate demand, the economy remains at full employment at b, but with a higher price level.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (2 of 2) Countries in which central banks are more independent from the rest of the government have, on average, lower inflation rates. SOURCE: Based on selected data in Table 5 of “Measuring the Independence of Central Banks and Its Effect on Policy Outcomes,” Alex Cukierman, Steven Webb, and Bilin Neyapti, The World Bank Economic Review, 6:3, 353–398.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved APPLICATION 2 ESTIMATING THE NATURAL REAL INTEREST RATE APPLYING THE CONCEPTS #2: How does the Fed use the concept of the natural interest rate to conduct monetary policy? In addition to being concerned about shifts in the natural rate of unemployment, the Fed also worries about shifts in the natural rate of interest. The natural rate of interest is defined as the real interest rate consistent with full employment after temporary demand and supply shocks have subsided.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.4 INFLATION AND THE VELOCITY OF MONEY (1 of 3) ●Velocity of money The rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.4 INFLATION AND THE VELOCITY OF MONEY (2 of 3) ● Quantity equation The equation that links money, velocity, prices, and real output. In symbols, we have M × V = P × y.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved ▼FIGURE 16.4 The Velocity of M2, 1959–2011

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.4 INFLATION AND THE VELOCITY OF MONEY (3 of 3) ●Growth version of the quantity equation An equation that links the growth rates of money, velocity, prices, and real output. growth rate of money + growth rate of velocity = growth rate of prices + growth rate of real output

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.5 HYPERINFLATION (1 of 2) ● Hyperinflation An inflation rate exceeding 50 percent per month. TABLE 16.3 Hyperinflations and Velocity CountryDatesMonthly Rate of Inflation Monthly Rate of Money Growth Approximate Increase in Velocity Greece Hungary Russia November 1943 to November 1944 August 1945 to July 1946 December 1921 to January % 19,800% 57% 220% 12,200% 49% SOURCE: Adapted from Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity Theory of Money, ed. Milton Friedman (Chicago: University of Chocago Press, 1956), 26 TABLE 16.4 Hyperinflation in the 1980s CountryYearYearly Rate of Inflation Monthly Rate of Inflation Monthly Money Growth Rate Bolivia Argentina Nicaragua ,152,200% 302, , % % SOURCE: International Financial Statistics, International Monetary Fund.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved 16.5 HYPERINFLATION (2 of 2) How Budget Deficits Lead to Hyperinflation ● Seignorage Revenue raised from money creation. Government deficit = new borrowing from the public + new money created ●Monetarists Economists who emphasize the role that the supply of money plays in determining nominal income and inflation.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved APPLICATION 3 THE END OF HYPERINFLATIONS APPLYING THE CONCEPTS #3: Why do hyperinflations end suddenly? In a classic study of four major hyperinflations, Nobel Laureate Thomas J. Sargent noticed that they ended rather quickly and the ends all followed similar patterns. He studied the hyperinflations after World War I in Germany, Austria, Hungary, and Poland, some of the most dramatic in world history. In each case, the hyperinflation ended with the creation of a central bank and change in the way that governments were financed. No longer would the country rely on its central bank to finance its debt. Instead, debt was sold to private parties who would value the debt based on the ability of the government to meet interest and principal payments from taxes. Once the governments made these reforms, there was an abrupt end to the hyperinflations and an actual increase in the demand for money in real terms by the private sector. Sargent said hyperinflations were ultimately caused by fiscal policy that was financed by money creation and not taxes. He also suggested that inflation could be tamed rather easily once fiscal reforms were made. While most economists agree with Sargent’s views on the ends of hyperinflation, there is less agreement that moderate inflations can be ended simply by changing fiscal regimes and not enduring a recession.

Copyright © 2015, 2012, 2009 Pearson Education, Inc. All Rights Reserved KEY TERMS Expectations of inflation Expectations Phillips curve Growth version of the quantity equation Hyperinflation Monetarists Money illusion Nominal wages Quantity equation Rational expectations Real wages Seignorage Velocity of money