1. CHAPTER 11: INFLATION, MONEY GROWTH AND THE REAL RATE OF INTEREST

2. 11.1 Output, Unemployment and Inflation
This chapter characterises the economy by three relations:
Okun’s Law, which relates the change in unemployment to output growth.
The Phillips curve, which relates the changes in inflation to unemployment.
The aggregate demand relation, which relates output growth to both nominal money growth and inflation.

3. 11.1 Output, Unemployment and Inflation (Continued)
Okun’s law
According to the above equation, the change in the unemployment rate should be equal to the negative of the growth rate of output. It is what we have assumed so far, in the AD-AS model.
For example, if output growth is 4%, then the unemployment rate should decline by 4% (ut-ut-1=4%).

4. 11.1 Output, Unemployment and Inflation (Continued)
Okun’s law
The actual relation between output growth and the change in the unemployment rate is known as Okun’s law.
Using 30 years of data for the US, the line that best fits the data is given by:

5. 11.1 Output, Unemployment and Inflation (Continued)
Okun’s law
Figure Changes in the unemployment rate versus output growth in the USA since 1970 High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate.

6. 11.1 Output, Unemployment and Inflation (Continued)
Okun’s law
According to the equation above,
To maintain the unemployment rate constant, output growth must be 3% per year. This growth rate of output is called the normal growth rate, i.e. it represents the level of output that guarantees constant unemployment

7. 11.1 Output, Unemployment and Inflation (Continued)
Okun’s law
According to the above equation, output growth 1% above normal leads only to a 0.4% reduction in unemployment, for two reasons:
Labour hoarding: firms prefer to keep workers rather than lay them off when output decreases. Another possible explanation concerns the fact that training workers is costly, and hence it might be preferable for firms in good times to ask overtime to current workers
When employment increases, not all new jobs are filled by the unemployed. They might be filled by inactives.

8. 11.1 Output, Unemployment and Inflation (Continued)
Okun’s law
Using letters rather than numbers:
Output growth above (below) normal leads to a decrease (increase) in the unemployment rate. This is Okun’s law:

9. 11.1 Output, Unemployment and Inflation (Continued)
The Phillips curve
Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. When is well approximated by t1, then:
According to the Phillips curve,

10. 11.1 Output, Unemployment and Inflation (Continued)
The aggregate demand relation
The aggregate demand relation, as stated in Chapter 7, adding the time indices:
Ignoring changes in output caused by factors other than the real money stock, then:

11. 11.1 Output, Unemployment and Inflation (Continued)
The aggregate demand relation
Keep in mind this simple relation hides the mechanism you saw in the IS–LM model:
An increase in the real money stock leads to a decrease in the interest rate.
The decrease in the interest rate leads to an increase in the demand for goods and, therefore, to an increase in output.

12. Okun’s Law across Countries
The coefficient β in Okun’s law gives the effect on the unemployment rate of deviations of output growth from normal. A value of β of 0.4 tells us that output growth 1% above the normal growth rate for one year decreases the unemployment rate by 0.4%. Where product and labour regulations are higher, the coefficient seems to be lower, like in the Italian case. The intuition is that rigidity in the labour market limits the transmission between output growth and unemployment.
Table Okun’s law coefficients across countries and time

13. 11.2 Nominal versus Real Interest Rates
Interest rates expressed in terms of dollars (or, more generally, in units of the national currency) are called nominal interest rates.
Interest rates expressed in terms of a basket of goods are called real interest rates.

14. Nominal al real interest rate
In the following it is useful to distinguish between nominal interest rate (i) and real interest rate (r).
Generally, it is possible to identify the following relation, including the expectation of inflation:
If expected inflation is equal to zero, r=i.
When expected inflation is positive, r<i.
Monetary policty affect the nominal interest rate.
While economic agents use the real interest rate is their decisions concerning consumption, investments etc.

15. 11.2 Nominal versus Real Interest Rates (Continued)
Nominal and real interest rates in the UK since 1980
Figure Nominal and real interest rates in the UK since 1980 Although the nominal interest rate has declined considerably since the early 1980s, the real interest rate was actually higher in 2008 than in 1980.

16. 11.3 Nominal and Real Interest Rates and the IS–LM Model
When deciding how much investment to undertake, firms care about real interest rates. Then, the IS relation must read:
The interest rate directly affected by monetary policy – the one that enters the LM relation – is the nominal interest rate, then:
The real interest rate is:

17. 11.3 Nominal and Real Interest Rates and the IS–LM Model (Continued)
Note an immediate implication of these three relations:
The interest rate directly affected by monetary policy is the nominal interest rate.
The interest rate that affects spending and output is the real interest rate.
So, the effects of monetary policy on output depend on how movements in the nominal interest rate translate into movements in the real interest rate.

18. 11.4 The Effects of Money Growth
Okun’s law relates the change in the unemployment rate to the deviation of output growth from normal:
The Phillips curve relates the change in inflation to the deviation of the unemployment rate from the natural rate:
The aggregate demand relation relates output growth to the difference between nominal money growth and inflation.

19. 11.4 The Effects of Money Growth (Continued)
Figure Output growth, unemployment, inflation and nominal money growth

20. 11.4 The Effects of Money Growth (Continued)
The medium run
Assume that the central bank maintains a constant positive growth rate of nominal money, call it In this case, the values of output growth, unemployment and inflation in the medium run:
Output must grow at its normal rate of growth,
If we define adjusted nominal money growth as equal to nominal money growth minus normal output growth, then inflation equals adjusted nominal money growth.
The unemployment rate must be equal to the natural rate of unemployment.
As in the AD-AS model, output and unemployment remain at the natural rate, while inflation (prices) increases

21. 11.4 The Effects of Money Growth (Continued)
The short run
Now suppose that the central bank decides to increase nominal money growth. What will happen in the short run?
Given the initial rate of inflation, higher nominal money growth leads to higher real nominal money growth and thus to an increase in output growth.
Now, look at Okun’s law, output growth above normal leads to a decrease in unemployment.
Now, look at the Phillips curve relation. Unemployment below the natural rate leads to an increase in inflation.

22. 11.4 The Effects of Money Growth (Continued)
The short run
In words: In the short run, monetary expansion leads to a higher growth in output and a temporary decrease in unemployment.
In the medium run, output growth returns to normal and the unemployment rate returns to the natural rate. Inflation remain higher.
Table The effects of a monetary expansion

23. 11.5 Money Growth, Inflation and Nominal and Real Interest Rates
This section focuses on the following assertions:
Higher money growth leads to lower nominal interest rates in the short run, but to higher nominal interest rates in the medium run.
Higher money growth leads to lower real interest rates in the short run, but has no effect on real interest rates in the medium run.

24. 11.5 Money Growth, Inflation and Nominal and Real Interest Rates (Continued)
Nominal and real interest rates in the medium run
In the medium run, output returns to the natural level of output,
In the medium run, the rate of inflation is equal to the rate of money growth minus the rate of growth of output.

25. 11.5 Money Growth, Inflation and Nominal and Real Interest Rates (Continued)
Nominal and real interest rates in the medium run
In the medium run, the nominal interest rate increases one-for-one with inflation. This result is known as the Fisher effect, or the Fisher Hypothesis. This is due to the fact that in the medium run the inflation rate is equal to the growth of money (assuming that the output does not growth, remaining at its medium term level).
For example, an increase in nominal money growth of 10% is eventually reflected by a 10% increase in the rate of inflation, a 10% increase in the nominal interest rate and no change in the real interest rate.
The relation between nominal interest rate and inflation rate is called Fischer effect.

26. Key Terms Okun’s law Normal growth rate Labour hoarding
Nominal interest rates
Real interest rates
Adjusted nominal money growth
Fisher effect, fisher hypothesis
Disinflation
Point-year of excess unemployment
Sacrifice ratio
Lucas critique
Credibility
Nominal rigidities
Staggering of wage decisions