1. Output, Unemployment, & Inflation
Three Relations:
Okun’s Law: growth and the change in unemployment
Phillips Curve: unemployment and the change in inflation
Aggregate Demand: Money, output, and prices

2. Output, Unemployment, & Inflation
Okun’s Law: The Data

3. Output, Unemployment, & Inflation
Okun’s Law: The Equation
ut-ut-1 = -0.4(gyt-3%)
gyt must be at least 3% to keep
unemployment from rising
WHY?
Two factors:
Growth in the labor force
Increases in the productivity of labor

4. Output, Unemployment, & Inflation
ut-ut-1 = - 0.4(gYT-3%)
Why is the coefficient only 0.4?
Firms hoard labor and there is a minimum number of workers
Changes in labor force participation
Okun’s Law Coefficients Across Countries
Country
United States United Kingdom Germany* Japan

5. Output, Unemployment, & Inflation
Okun’s Law
In general, the relation between changes in unem- ployment and output growth is:
: how growth in excess of normal growth impacts the unemployment rate
: normal growth rate

6. Output, Unemployment, & Inflation
The Phillips Curve: Unemployment and the Change in Inflation
Assuming: equals last year’s inflation, , then:

7. Output, Unemployment, & Inflation
The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth
How does a change in impact AD?

8. Output, Unemployment, & Inflation
The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth
Moving from output level (Y) to the growth rate (gyt)
nominal money growth rate
growth rate in prices

9. Output, Unemployment, & Inflation
A Scenario: The money growth rate falls (short-run)
According to:
The AD relation, given inflation, output will fall
From Okun’s Law, a decrease in growth will increase unemployment
From the Phillip’s Curve, higher unemployment implies lower inflation
Will the impact end here—what about the medium run?

10. Output, Unemployment, & Inflation
IN MEDIUM RUN: ut = un
Assume a constant growth in the nominal money supply
Medium Run: (Okun’s Law)
(Aggregate Demand)

11. Output, Unemployment, & Inflation: The Medium Run
Adjusting to a decrease in nominal money growth un
Natural
unemployment rate
If decreases to :
u remains at un &  falls
Adjusted
money growth A
Inflation Rate, 
Adjusted
money growth B
Unemployment Rate, u

12. Output, Unemployment, & Inflation
Disinflation: How much unemployment? And for how long?
Scenario: Reduce inflation from 14 to 4 percent &  = 1 =
Time period: 1 yr: yrs: Year 1, -5% = -5% Year 2, % = -5% yrs: yrs of unemployment % above un yrs: 10 yr of unemployment % above un
Conclusion: Point years of excess unemployment equals 10

13. Output, Unemployment, & Inflation
Disinflation: How much unemployment? And for how long?
The Sacrifice Ratio:
Excess point years of unemployment Decrease in Inflation
If  = 1, what is the sacrifice ratio?

14. Output, Unemployment, & Inflation
Working on the required path of money growth
A Scenario: Reduce inflation from 14% to 4% in 5 years
Inflation (%)
Unemployment rate (%)
Output growth (%)
Nominal money growth (%)
Year Before Disinflation After

15. Output, Unemployment, & Inflation
The disinflation path
Inflation Rate (percent)
Unemployment Rate (percent)
Year 0 A
Year 1
Year 2
Year 3
Year 4 B
Year 5 C
Year 6+

16. Output, Unemployment, & Inflation
The Disinflation Path
Conclusions:
The transition to lower money growth and inflation is associated with a period of higher unemployment
Regardless of the path, the number of point-years of excess unemployment is the same
In the medium run: output and unemployment return to normal

17. Output, Unemployment, & Inflation
This model indicates that policy can change the timing but not number of point-years of excess unemployment.
Two challenges to this model:
Expectations, credibility
Lucas – Rat-X
Sargent – Low sacrifice in history
Nominal rigidities and contracts
Fischer – sticky wages
Taylor – staggered contracts

18. Output, Unemployment, & Inflation
Expectations & Credibility: The Lucas Critique
The previous model assumed:  te =  t-1
What if  te is based on an expectation that Fed policy would reduce inflation from 14% to 4%. Then:
4% = 4% %
Inflation falls to 4% and unemployment remains at the natural rate
Reduction in money growth could be neutral

19. Output, Unemployment, & Inflation
Disinflation Without Unemployment in the Taylor Model

20. Output, Unemployment, & Inflation
The U.S. Disinflation,
1979
Unemployment = 5.8%
GDP growth = 2.5%
Inflation = 13.3%
The Fed shifted from targeting interest to targeting the growth rate of nominal money

21. Output, Unemployment, & Inflation
The U.S. Disinflation,

22. Output, Unemployment, & Inflation
The U.S. Disinflation,
Did Fed credibility reduce the sacrifice ratio?
GDP growth (%)
Unemployment rate (%)
CPI Inflation (%)
Cumulative unemployment
Cumulative disinflation
Sacrifice ratio
Cumulative unemployment is the sun of point-years of excess unemployment from 1980 on, assuming a natural rate of 6.5%.
Cumulative disinflation is the difference between inflation in a given year and inflation in The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation.

23. Output, Unemployment, & Inflation
The U.S. Disinflation,
Observations
Disinflation was associated with high unemployment
The sacrifice ratio was very close to 10% disinflation with 10 point-years of excess unemployment
Phillips Curve relation was very robust

24. Output, Unemployment, & Inflation
Disinflation Experiences in 19 OECD Countries
Disinflation leads to higher unemployment
Faster disinflations are associated with small sacrifice ratios (Lucas/Sargent)
Sacrifice ratios are smaller in countries that have shorter wage contracts (Fischer & Taylor)