2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 1 CHAPTER Grappling with Inflation, Unemployment, and Growth CHAPTER Grappling with Inflation, Unemployment, and Growth 3

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 2 Grappling with Inflation, Unemployment, and Growth Costs of Inflation –Redistribution of Income –Informational and Uncertainty Costs –Institutional and Constitutional Costs –Menu and Shoe Leather Costs Why Some Unemployment is Necessary –Flows In and Out of the Labor Market –Vacancies –Labor Market as a Matchmaker

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 3 Natural Rate of Unemployment Cyclical Unemployment The Phillips Curve

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 4 Policy Priorities Since low inflation and low unemployment may conflict in the short run, policy makers must give one top priority The Federal Reserve believes that –monetary policy does not affect the natural rate of unemployment –therefore, preventing inflation must be the primary goal of monetary policy

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 5 Legislative Basis of Policy Employment Act of 1946Employment Act of 1946 –Required the government to use all of its powers to promote “maximum employment, production, and purchasing power.” Full Employment and Balanced Growth Act of 1978Full Employment and Balanced Growth Act of 1978 –Requires the Fed chairman to present economic forecasts and targets for money supply growth to Congress twice a year

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 6 Effects of Inflation Inflation makes buyers poorer because they must pay higher prices Inflation makes sellers richer because they are paid higher prices Since most people are both buyers (as consumers) and sellers (as owners of factors of production), the average person’s income and wealth aren’t changed by inflation

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 7 Inflation Redistributes Income Inflation redistributes income from those who do not, or cannot, raise their prices to those who can, and do, raise their prices. People do not raise prices if inflation is unanticipated. People can not raise their prices if they are fixed by a contract.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 8 Inflation Redistributes Income from Lenders to Borrowers Suppose that you had planned to buy a pair of shoes for $100, but instead you lend the $100 to a friend for a year at 3% interest. At the end of the year your friend repays you $103. During the year, inflation was 5%, so now the shoes cost $105. Your real rate of return was -2%.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 9 Real and Nominal Interest Rates Nominal interest rate = Real interest rate + Anticipated inflation If lenders anticipate inflation, they add the amount of expected inflation to the real interest rate that they require to maintain their purchasing power.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 10 Costs of Inflation Informational Costs –Prices are used to make comparisons between goods, but inflation distorts that information. Uncertainty Costs –Inflation may distort and delay expenditures because it makes predicting future prices more difficult.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 11 Costs of Inflation Institutional Costs –Inflation undermines institutions and conventions, such as rules of thumb and contracts, which are based on relatively fixed prices. Constitutional Costs –Inflation undermines the convention of money that forms the basis of exchange in the economy.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 12 Costs of Inflation Menu Costs –Inflation requires firms to spend time and money posting current prices in catalogues, menus, and on ticketed merchandise. Shoe Leather Costs –Inflation increases the cost of managing cash balances.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 13 Shoe Leather Costs Shoe leather cost refers to the cost of time and effort (more specifically the opportunity cost of time and energy) that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank. The term comes from the fact that more walking is required (historically, although the rise of the Internet has reduced it) to go to the bank and get cash and spend it, thus wearing out shoes more quickly. The actual cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were no inflation.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 14 Inflation: Grease or Sand? Inflation (%) Growth Sand Grease Low inflation may stimulate growth, but inflation over 3% may reduce growth.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 15 Why Some Unemployment is Necessary Flows In and Out of the Labor Market –About 10 million people change their job status every month. Vacancies –Vacancies arise when workers leave their jobs and/or new jobs are created. Labor Market as a Matchmaker –The labor market is not an instant matchmaker between unemployed workers and job vacancies

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 16 Flows In and Out of the Labor Market Employed Million Unemployed 6.7 Million Not in Labor Market 66.8 Million 2 million1.7 million 1.2 million 3 million3.5 million

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 17 Supply and Demand for Labor Employment Real Wage  SMSM S D A B N1N1 WeWe N2N2 DMDM Point A represents labor market equilibrium with no search costs. Point B represents equilibrium with search costs. N 2 -N 1 is frictional unemployment.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 18 Supply and Demand for Labor with Above Equilibrium Wages Employment Real Wage  SMSM S D A B N1N1 WeWe N2N2 DMDM ND2ND2 ND1ND1 W1W1 Above equilibrium wages cause insider-outsider unemployment N S2 -N D1.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 19 Why are Wages Above Equilibrium? Unions may exert pressure for higher wages. The government may impose a minimum wage that is above the equilibrium wage. Efficiency wages are above equilibrium wages paid to attract and retain the best workers.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 20 Strategies to Lower European Unemployment Improve labor force skills with education and training Reform employment security laws Reduce regulation of work time and temporary jobs Reform the level and duration of unemployment benefits

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 21 The Natural Rate of Unemployment The natural rate of unemployment is the sum of frictional and insider- outsider unemployment. The natural rate of unemployment has decreased 0.6 to 1.1 percentage points from the mid 1980s to the late 1990s.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 22 Causes of the Decline in the Natural Rate

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 23 Cyclical Unemployment Cyclical unemployment occurs when real output is below potential output. Cyclical unemployment exists because of coordination failures. –Problems that develop in an economy because decisions by individuals feed back into the economy, augmenting the effect of the initial decision.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 24 The U.S. Unemployment Rate and Vacancy Rate

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 25 The Business Cycle in the Labor Market Employment Real Wage S D N1N1 WeWe N Recessions cause a decrease in the demand for labor from D to D 1 The wage rate remains the same in the short-run, and employment falls to N 1. D1D1

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 26 Cost of Cyclical Unemployment The cost of cyclical unemployment is the difference between actual output and potential output. Okun’s Rule of Thumb describes the relationship between unemployment and growth in GDP.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 27 Growth in GDP and Change in Unemployment

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 28 Okun’s Rule of Thumb %  Q =   U %  Q is the percent change in real GDP  U is the change in the unemployment rate

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 29 Equity Costs of Unemployment For individuals the costs of unemployment include lost income, a decline in skills, and loss of self-worth. Unemployment is not shared equally among demographic groups –Teenage unemployment is higher than the overall unemployment rate. –The unemployment rate for blacks and Hispanics is higher than for whites.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 30 U.S. Unemployment by Age, Gender, and Race

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 31 The Phillips Curve Unemployment Rate (%) Inflation Rate (%) A B 7% 3% 4%8% The Phillips curve represents a short-run trade off between inflation and unemployment. If policy makers choose to reduce unemployment from 8% (B) to 4% (A) the cost may be an increase in inflation from 3% to 7%.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 32 Inflation and Unemployment The Phillips curve which shows the historical relationship between inflation and unemployment has not remained stable over time. Between 1958 and 1969, an inverse relationship between unemployment and inflation did exist.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 33 Inflation and Unemployment

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 34 Inflation and Unemployment Between 1970 and 1984, the inverse relationship broke down. Both inflation and unemployment were high in those years. The inverse relationship between inflation and unemployment reappeared between 1985 and 1992, but disappeared again in 1992 when inflation and unemployment both decreased.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 35 Short-Run and Long-Run Phillips Curves Inflation Unemployment Long-Run Phillips Curve Short-Run Phillips Curve Natural rate of Unemployment There are two Phillips curves: A long-run Phillips curve which is vertical at the natural rate of unemployment. A short-run Phillips curve that shifts along the long-run curve.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 36 Short-Run and Long-Run Phillips Curves The long-run Phillips curve shows that policymakers cannot reduce unemployment below the natural rate by accepting more inflation. The short-run Phillips curve represents a tradeoff between inflation and unemployment that changes as the curve shifts.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 37 Sacrifice Ratio The sacrifice ratio is the annual percentage point loss of output for every percentage point decline in the annual inflation rate. The sacrifice ratio during the early 1980s was 2.3.

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 38 The Sacrifice Ratio for the United States,