1. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #1 Inflation, Activity, & Money Growth – The Medium Run The links between output, unemployment, and inflation The short and medium-run effects of money growth on inflation and activity U.S. disinflation of the late 1970s Chapter Tour

2. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #2 Output, Unemployment, & Inflation 1.Okun’s Law 2.Phillips Curve 3.Aggregate Demand Three Relations:

3. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #3 Output, Unemployment, & Inflation 1.The labor force is constant 2.Changes in output lead to equal changes in employment Okun’s Law: Output Growth & Changes in Unemployment Assuming: Then: g yt = growth rate of output a 4% g yt reduces the unemployment rate by 4%

4. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #4 Output, Unemployment, & Inflation Okun’s Law: The Data

5. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #5 Output, Unemployment, & Inflation Okun’s Law: The Equation u t -u t-1 = -0.4(g yt -3%) g yt must be at least 3% to keep unemployment from rising g yt must be at least 3% to keep unemployment from rising Two factors: 1.Growth in the labor force (1.7%) 2. Increases in the productivity of labor (1.3%)

6. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #6 Output, Unemployment, & Inflation Okun’s Law – An Example u t -u t-1 = - 0.4(g YT -3%) Why is the coefficient only 0.4? Firms hoard labor and there is a minimum number of workers required regardless of output Changes in labor force participation

7. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #7 Okun’s Law Across Countries Okun’s Law Coefficients Across Countries and Time Country1960-19801981-1998 United States0.390.42 United Kingdom0.150.51 Germany*0.200.32 Japan0.100.20 *For Germany, the second period is 1981-1989, rather than 1981-1998

8. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #8 Output, Unemployment, & Inflation The Phillips Curve: Unemployment and the Change in Inflation According to: Inflation depends on expected inflation and the deviation of unemployment from the natural rate

9. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #9 Output, Unemployment, & Inflation The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth How does a change in impact AD?

10. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #10 Output, Unemployment, & Inflation The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth Moving from output level (Y) to the growth rate (g yt ) nominal money growth rate growth rate in prices

11. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #11 Output, Unemployment, & Inflation The Aggregate Demand Relation: Money Growth, Inflation, and Output Growth According to the aggregate demand relation is:

12. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #12 Output, Unemployment, & Inflation How does money growth affect output, inflation, and unemployment in the medium run?

13. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #13 Output, Unemployment, & Inflation SR Scenario: The money growth rate falls According to: 1.The AD relation, given inflation, output will fall 2.From Okun’s Law, a decrease in growth will increase unemployment 3.From the Phillip’s Curve, higher unemployment implies lower inflation Will the impact end here—what about the medium run?

14. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #14 Output, Unemployment, & Inflation The Medium Run: Assume a constant growth in the nominal money supply Unemployment must be constant and output must grow at its normal rate. Therefore inflation must be constant: (Aggregate Demand)

15. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #15 Output, Unemployment, & Inflation The Medium Run: If inflation is constant, then:  t  t-1 and: (Phillips Curve)

16. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #16 The Medium Run Output, Unemployment, & Inflation An Observation: Changes in the nominal money growth have no effect on output or unemployment in the medium run.

17. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #17 Output, Unemployment, & Inflation Disinflation: A First Pass A Scenario: The economy is in medium run equilibrium Inflation is high and there is a consensus to reduce it

18. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #18 Output, Unemployment, & Inflation Disinflation: A First Pass What do you think… How can policy makers achieve disinflation? How will reducing money growth impact growth and unemployment? Answer: Reducing money growth Answer: Reduce growth and increase unemployment

19. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #19 Output, Unemployment, & Inflation Disinflation: How much unemployment? And for how long? Consider the Phillips Curve: = To achieve disinflation, unemployment must rise The total amount of unemployment does not vary with how quickly disinflation is achieved

20. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #20 Output, Unemployment, & Inflation Disinflation: How much unemployment? And for how long? Choosing between rapid or slow disinflation Point-year of excess unemployment: Difference between the actual and the natural unemployment of one percent point for one year Example:u n = 6.5 u = 9% for 4 years 4 x (9-6.5) = 10 point-years of excess unemployment

21. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #21 Output, Unemployment, & Inflation Disinflation: How much unemployment? And for how long? Scenario: Reduce inflation from 14 to 4 percent &  = 1 = Conclusion: Point years of excess unemployment equals 10 Time period: 1 yr: 2 yrs: Year 1, u t = 11.5% Year 2, u t = 11.5% 5 yrs: 5 yrs of unemployment 2% above u n 10 yrs: 10 yr of unemployment 1% above u n

22. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #22 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?

23. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #23 Output, Unemployment, & Inflation Disinflation: How much unemployment? And for how long? If the sacrifice ratio is constant, is the speed of disinflation irrelevant?

24. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #24 Output, Unemployment, & Inflation The Speed of Disinflation—An Example Time Frame: 1 year u t 10% > u n & u n = 6.5%: u t = 16.5% Okun’s Law: 16.5% - 6.5% = - 0.4%(g yt -3%) -15% in 1931—the greatest negative growth rate this century.

25. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #25 Output, Unemployment, & Inflation Working on the required path of money growth A Scenario: Reduce inflation from 14% to 4% in 5 years 012345678 Inflation (%)141210864444 Unemployment rate (%)6.58.58.58.58.58.56.56.56.5 Output growth (%)3-23333833 Nominal money growth (%)17101311971277 Year BeforeDisinflationAfter

26. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #26 Output, Unemployment, & Inflation The disinflation path Year 1 Year 2 Year 4 B Year 5 Year 0 A C Year 6+ Year 3 Inflation Rate (percent) Unemployment Rate (percent)

27. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #27 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

28. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #28 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 Critique Nominal rigidities and contracts Fischer and Taylor

29. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #29 Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1985 Unemployment = 5.8% GDP growth = 2.5% Inflation = 13.3% The Fed shifted from targeting interest to targeting the growth rate of nominal money 1979

30. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #30 Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1984

31. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #31 Output, Unemployment, & Inflation The U.S. Disinflation, 1979-1984 Did Fed credibility reduce the sacrifice ratio? 1979198019811982198319841985 1.GDP growth (%)2.5-0.51.8-2.23.96.23.2 2.Unemployment rate (%)5.87.17.69.79.67.57.2 3.CPI Inflation (%)13.312.58.93.83.83.93.8 4.Cumulative unemployment0.61.74.98.09.09.7 5.Cumulative disinflation0.84.49.59.59.49.5 6.Sacrifice ratio0.750.390.510.840.951.02 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 1979. The sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation.

32. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #32 Output, Unemployment, & Inflation 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 The U.S. Disinflation, 1979-1984 Observations

33. Chapter 9: Inflation, Activity, and Money GrowthBlanchard: Macroeconomics Slide #33 Output, Unemployment, & Inflation 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) Disinflation Experiences in 19 OECD Countries