Chapter 13 Unemployment and Inflation Copyright © 2016 Pearson Canada Inc.

Main Questions ■ Is there a trade-off between unemployment and inflation? ■ What are the problems that stem from unemployment and inflation? Copyright © 2016 Pearson Canada Inc.13-2

Copyright © 2016 Pearson Canada Inc. Unemployment and Inflation ■ The Phillips curve is a negative empirical relationship between unemployment and inflation. ■ In there seemed to be no reliable relationship between unemployment and inflation. 13-3

Copyright © 2016 Pearson Canada Inc. Unemployment and Inflation 13-4

Copyright © 2016 Pearson Canada Inc. Unemployment and Inflation 13-5

Copyright © 2016 Pearson Canada Inc. The Expectations Augmented Phillips Curve ■ A negative relationship should exist between unanticipated inflation and cyclical unemployment. 13-6

Copyright © 2016 Pearson Canada Inc. The Phillips Curve (continued) ■ If increase in M is anticipated, and if there is no misperception, the economy remains at, unemployment remains at, and cyclical unemployment is zero. 13-7

Copyright © 2016 Pearson Canada Inc. The Phillips Curve (continued) ■ If increase in M is unanticipated, unanticipated inflation is created, Y is above, and u is below. ■ h measures the strength of the relationship between unanticipated inflation and cyclical unemployment. 13-8

Copyright © 2016 Pearson Canada Inc. The Phillips Curve (continued) 13-9

Copyright © 2016 Pearson Canada Inc. The Phillips Curve (continued) ■ The expectation-augmented Phillips curve states that if π exceeds π e then u is less than. h is related to the slope of the SRAS curve

Copyright © 2016 Pearson Canada Inc. Shifting of the Philips Curve ■ The Phillips curve depends on the expected rate of inflation and the natural rate of unemployment. If either factor changes the Phillips curve will shift

Copyright © 2016 Pearson Canada Inc. Changes in the Expected Rate of Inflation ■ If households anticipate a change in the price level they respond by their expectations of the price level (the rate of inflation) one- for-one

Copyright © 2016 Pearson Canada Inc. Changes in the Expected Rate of Inflation ■ The Phillips curve shifts up by the amount of the increase in the expected rate of inflation

Copyright © 2016 Pearson Canada Inc. Changes in the Natural Rate of Unemployment ■ An increase in the natural unemployment rate causes the Phillips curve to shift up and to the right

Copyright © 2016 Pearson Canada Inc. Supply Shocks and the Phillips Curve ■ An adverse supply shock causes a burst of inflation and raises the natural rate of unemployment: ■ by increasing the degree of mismatch between workers and jobs (classical economists); ■ by reducing MPN and labour demanded at full employment (Keynesian economists)

Copyright © 2016 Pearson Canada Inc. Supply Shocks and the Phillips Curve ■ An adverse supply shock should shift the Phillips curve up and to the right. ■ The Phillips curve should be unstable particularly during periods of supply shocks

Copyright © 2016 Pearson Canada Inc. The Shifting Phillips Curve in Practice ■ The Friedman-Phelps analysis shows that a negative relationship between the levels of inflation and unemployment holds as long as expected inflation and the natural unemployment rate are approximately constant

Copyright © 2016 Pearson Canada Inc. The Shifting Phillips Curve in Practice (continued) ■ During there was a number of productivity shocks as well as changes in government and macroeconomic policies. ■ A negative relationship between unanticipated inflation and cyclical unemployment does appear in the data

Copyright © 2016 Pearson Canada Inc. The Shifting Phillips Curve in Practice (continued) 13-19

Copyright © 2016 Pearson Canada Inc. Macroeconomic Policy and the Phillips Curve ■ Keynesians believe that, in a recession, expansionary AD policy can increase inflation back to the anticipated levels that were used as a basis for nominal wage contracts and pricing

Copyright © 2016 Pearson Canada Inc. The Lucas Critique ■ Because new policies change the economic “rules” and, thus, affect economic behaviour, no one can safely assume that historical relationships between variables will hold when policies change

Copyright © 2016 Pearson Canada Inc. The Long-Run Phillips Curve ■ Economists agree that in the long run economy will adjust to the general equilibrium where π=π e and u=. ■ The long-run Phillips curve is vertical line at u=. It is related to the long-run neutrality of money

Copyright © 2016 Pearson Canada Inc. The Cost of Unemployment ■ The output is lost because fewer people are productively employed. ■ Unemployed workers and their families face psychological cost. ■ The offsetting factors are acquiring new skills and more leisure time

Copyright © 2016 Pearson Canada Inc. The Long-Term Behaviour of the Unemployment Rate ■ The long-term unemployment rate may be influenced by: ■ changes in the composition of the labour force by age and sex; ■ structural changes in the economy brought about by technological change

Copyright © 2016 Pearson Canada Inc. The Long-Term Behaviour of the Unemployment Rate 13-25

Copyright © 2016 Pearson Canada Inc. Hysteresis in Unemployment ■ Hysteresis in unemployment means that the natural unemployment rate changes in response to the actual unemployment rate. ■ If workers are idle for long periods of time, their skills deteriorate and the mismatch increases

Copyright © 2016 Pearson Canada Inc. Hysteresis in Unemployment (continued) ■ Some regulations on firms may cause them to be cautious about hiring workers, because the regulations make it difficult to fire them. ■ Insider-outsider theory suggests that unionized labour increases wages for insiders and leaves outsiders unemployed

Copyright © 2016 Pearson Canada Inc. How to Reduce the Natural Rate of Unemployment ■ Tax credits or subsidies for training and relocating unemployed workers. ■ Minimize payroll taxes and the “tax wedge” by reforming the Employment Insurance program. ■ Use aggressive policy to keep actual unemployment rate low

Copyright © 2016 Pearson Canada Inc. Perfectly Anticipated Inflation ■ Because nominal wages are rising together with prices, the purchasing power is not hurt by the perfectly anticipated inflation. ■ Perfectly anticipated inflation would not hurt the value of savings accounts

Copyright © 2016 Pearson Canada Inc. The Cost of Perfectly Anticipated Inflation ■ Shoe leather costs of inflation is time and effort incurred by people and firms who are trying to minimize their holdings of cash. ■ Menu costs of inflation. ■ Welfare costs of inflation-induced tax distortions

Copyright © 2016 Pearson Canada Inc. The Cost of Unanticipated Inflation ■ Creditors and those with incomes set in nominal terms are hurt, whereas debtors and those who make fixed nominal payments are helped by unanticipated inflation

Copyright © 2016 Pearson Canada Inc. The Cost of Unanticipated Inflation (continued) ■ People are made worse off by increasing risk of gaining or losing wealth as a result of unanticipated inflation. ■ People must spend time and effort learning about different prices

Copyright © 2016 Pearson Canada Inc. The Cost of Hyperinflation ■ Hyperinflation occurs when the inflation rate is extremely high for a sustained period of time. ■ The shoe leather costs are enormous. ■ The government’s ability to collect taxes is undermined. ■ The market efficiency is disrupted

Copyright © 2016 Pearson Canada Inc. Fighting Inflation: The Role of Inflationary Expectations ■ The only factor that can create sustained rises in aggregate demand and ongoing inflation is a high rate of money growth. ■ Governments may print money to finance their spending or use monetary policy to fight recession

Copyright © 2016 Pearson Canada Inc. Fighting Inflation (continued) ■ The process of disinflation – the reduction of money growth – can lead to a recession. ■ If inflation falls below the expected rate, unemployment will rise above the natural rate. ■ A recession can be avoided if the expected inflation rate can be made to fall

Copyright © 2016 Pearson Canada Inc. Rapid versus Gradual Disinflation ■ A cold turkey strategy is a rapid and decisive reduction in the growth rate of the money supply. ■ It may lead to a significant increase in cyclical unemployment

Copyright © 2016 Pearson Canada Inc. Rapid versus Gradual Disinflation (continued) ■ Inflation expectations may not lower if the government is expected to abandon the policy under political pressure. ■ A policy of gradualism is a policy of reducing the rate of money growth gradually over a period of time

Copyright © 2016 Pearson Canada Inc. Rapid versus Gradual Disinflation (continued) ■ This policy will raise unemployment by less than the cold-turkey strategy, but the period of higher unemployment will be longer

Copyright © 2016 Pearson Canada Inc. Wage and Price Controls ■ Wage and price controls (income policies) are legal limits on the ability of firms to raise wages or prices. ■ Price controls are likely to create shortages. ■ Wage-price controls are intended to affect the public’s expectations of inflation

Copyright © 2016 Pearson Canada Inc. Credibility and Reputation ■ The expected inflation adjusts quickly if government’s announced disinflationary policy is credible. ■ Policymakers increase their credibility by developing a reputation for carrying through on promises

Copyright © 2016 Pearson Canada Inc. Credibility and Reputation (continued) ■ A strong and independent central bank is more likely to be deemed a credible policymaker by the public