16-1 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment Copyright © 2012 Pearson Prentice Hall. All rights reserved.

The Dynamics of Inflation and Unemployment Brock Williams P R E P A R E D B Y As the financial crisis spread in 2008, central banks around the world increased the supply of money and liquidity, and governments borrowed extensively and incurred increasing amounts of government debt. CHAPTER 16 Copyright © 2012 Pearson Prentice Hall. All rights reserved.

16-3 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment 1 2 How can data on vacancies and unemployment be used to measure shifts in the natural rate? Shifts in the Natural Rate of Unemployment Can changes in the way central banks are governed affect inflation expectations? Increased Political Independence for the Bank of England Lowered Inflation Expectations What caused a severe hyperinflation to emerge recently in Zimbabwe? Hyperinflation in Zimbabwe 3 A P P L Y I N G T H E C O N C E P T S

16-4 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment ● nominal wages Wages expressed in current dollars. MONEY GROWTH, INFLATION, AND INTEREST RATES 16.1 Inflation in a Steady State ● 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.

16-5 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment Inflation in a Steady State INFLATION EXPECTATIONS AND INTEREST RATES INFLATION EXPECTATIONS AND MONEY DEMAND 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. MONEY GROWTH, INFLATION, AND INTEREST RATES (cont’d) 16.1 R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or income—its purchasing power—not its “face” value.

16-6 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment How Changes in the Growth Rate of Money Affect the Steady State MONEY GROWTH, INFLATION, AND INTEREST RATES (cont’d) 16.1

16-7 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION 16.2 ● expectations Phillips curve The relationship between unemployment and inflation when taking into account expectations of inflation.

16-8 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment ●rational expectations The economic theory that analyzes how the public forms expectations in such a manner that, on average, they forecast the future correctly. Are the Public’s Expectations About Inflation Rational? UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d) 16.2

16-9 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment U.S. Inflation and Unemployment in the 1980s  FIGURE 16.1 The Dynamics of Inflation and Unemployment, 1986–1993 Inflation rose and the unemployment rate fell below the natural rate. Inflation later fell as unemployment exceeded the natural rate. UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d) 16.2

16-10 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment 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 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d) 16.2

16-11 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment 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 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? A P P L I C A T I O N 1

16-12 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION 16.3  FIGURE 16.2 Choices of the Fed: Recession or Inflation 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.

16-13 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment  FIGURE 16.3 How Central Bank Independence Affects Inflation Countries in which central banks are more independent from the rest of the government have, on average, lower inflation rates. HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (cont’d) 16.3

16-14 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment In 1997, a major change in monetary policy allowed the Bank of England to be free to pursue its policy goals without direct political control. An economist studied how the British bond market reacted to the policy change by comparing the interest rates changes on two types of long-term bonds: bonds that are automatically adjusted (or indexed) for inflation and bonds that are not. The difference between the two interest rates primarily reflects expectations of inflation. If the gap narrowed following the policy announcement, this would be evidence that the new policy reduced expectations of inflation. If it did not, the announced policy would have had no effect on inflation expectations. Result: After the announcement, the gap narrowed. Conclusion: The announcement did cause expectations about inflation to fall by about half a percentage. INCREASED POLITICAL INDEPENDENCE FOR THE BANK OF ENGLAND LOWERED INFLATION EXPECTATIONS APPLYING THE CONCEPTS #2: Can changes in the way central banks are governed affect inflation expectations? A P P L I C A T I O N 2

16-15 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment INFLATION AND THE VELOCITY OF MONEY 16.4 ● velocity of money The rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

16-16 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment or ● quantity equation The equation that links money, velocity, prices, and real output. In symbols, we have M × V = P × y. INFLATION AND THE VELOCITY OF MONEY (cont’d) 16.4

16-17 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment  FIGURE 16.4 The Velocity of M2, 1959–2009 INFLATION AND THE VELOCITY OF MONEY (cont’d) 16.4

16-18 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment growth rate of money + growth rate of velocity = growth rate of prices + growth rate of real output ● growth version of the quantity equation An equation that links the growth rates of money, velocity, prices, and real output. INFLATION AND THE VELOCITY OF MONEY (cont’d) 16.4

16-19 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment HYPERINFLATION 16.5 ● hyperinflation An inflation rate exceeding 50 percent per month.

16-20 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment ● seignorage Revenue raised from money creation. How Budget Deficits Lead to Hyperinflation 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. HYPERINFLATION (cont’d) 16.5

16-21 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment In June 2008, the consumer price index in Zimbabwe was 8 million percent higher than it was a year before. A $12 lunch in local currency cost 1.1 trillion Zimbabwe dollars. What caused Zimbabwe to suffer from this crippling hyperinflation? The simple answer is that the political and economic system began to self-destruct. HYPERINFLATION IN ZIMBABWE APPLYING THE CONCEPTS #3: What caused a severe hyperinflation to emerge recently in Zimbabwe? Zimbabwe has been ruled since 1980 by the dictator Robert Mugabe, whose policies to intervene militarily in African conflicts and expropriate white-owned farms had the cumulative effect of crippling the economy. As the economy deteriorated, tax revenues declined. Mugabe and his central bank simply resorted to printing new banknotes. Result: Hyperinflation and further deterioration of the economy as the financial system collapsed. A P P L I C A T I O N 3

16-22 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 16 The Dynamics of Inflation and Unemployment 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 K E Y T E R M S