1. Inflation and Unemployment

2. Money and Inflation  Rise in money supply does not equal a rise in Real GDP in the long run, since price level rises as well by the same percentage  Classical Model of Price Level – Since money supply and price level rise together, the Real Quantity of Money (M/P) stays at the original level  Wages and prices are more responsive to money supply changes in periods of high inflation

3. The Inflation Tax  Printing money to cover debt drives up inflation  Inflation tax is the reduction in value of money held by public when the government prints money to cover deficits  The U.S. can and does raise revenue by printing money – This is what happens when the Fed buys bonds to increase money supply

4. Hyperinflation  During times of inflation, people hold as little money as possible  Printing money (seignorage) creates revenue: (∆M/M) ● (M/P) OR Rate of growth of MS ● Real MS  When govt needs to collect a certain amount but people are holding less money, must increase rate of growth… which can spiral out of control

5. Moderate Inflation and Disinflation  Two shifts can lead to an increase in aggregate price level, emphasizing the importance of:  Cost-push inflation  Demand-pull inflation – which can result from expansionary policies  Economic policies have political ramifications, which explains why inflation can get out of control

6. Output Gap & Unemployment  Output gap is the difference between current level of output and potential output  Because the unemployment rate is the natural rate + cyclical unemployment, there is a relationship between output gap and unemployment rate When aggregate output = Y P, unemployment = natural rate When output gap is positive, unemployment < natural rate When output gap is negative, unemployment > natural rate

7. The Short Run Phillips Curve  The SRPC depicts the negative short run relationship between the unemployment rate and inflation rate

8. Inflation Expectations and SRPC  Expected inflation rate is the 2 nd most important factor affecting inflation  Actual rate of inflation at any given unemployment rate is higher when expected inflation rate is higher

9. Long Run Phillips Curve  Persistent attempts to keep unemployment low result in accelerating inflation  To avoid this, unemployment must be high enough that actual rate of inflation = expected rate, resulting in nonaccelerating inflation rate of unemployment  NAIRU means there is no longterm tradeoff between unemployment and inflation

10. Long Run Phillips Curve  LRPC is vertical because it is at NAIRU (natural rate)  Economists estimate NAIRU by looking at relationship between inflation rate and unemployment over the course of the business cycle

11. Costs of Disinflation  To bring down inflation, contractionary policies raise unemployment above the natural rate for an extended period  As a result, the economy loses potential output

12. Deflation  Value of money rising over time  Debt deflation results from borrowers cutting back their spending because of the additional burden of repaying money that is worth more, reducing aggregate demand – which leads to more deflation, which can spiral out of control

13. Effects of Expected Inflation  Fisher Effect shows that interest rates are impacted by expected inflation one-to-one  In case of deflation, interest rates will fall – but they are zero bound – which creates a limit for monetary policy  Interest rate too low leaves no incentive to save and a credit freeze  Liquidity trap results from sharp reduction in demand for loanable funds, causing interest rates to fall so low that monetary policy is ineffective