Economics NINTH EDITION Chapter 16 Insert Cover Picture The Dynamics of Inflation and Unemployment Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved Learning Objectives 16.1 Describe how an economy at full unemployment with inflation differs from one without inflation 16.2 Explain the relationship between inflation and unemployment in the short run and long run 16.3 Discuss why increasing the credibility of a central bank can reduce inflation 16.4 Define the velocity of money 16.5 Identify the origins and causes of hyperinflation Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (1 of 3) Inflation in a Steady State ● Nominal wages Wages expressed in current dollars ● 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 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (2 of 3) Inflation in a Steady State INFLATION EXPECTATIONS AND INTEREST RATES 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 INFLATION EXPECTATIONS AND MONEY DEMAND REAL – NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not its “face” value Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (1 of 4) ● Expectations Phillips curve The relationship between unemployment and inflation when taking into account expectations of inflation TABLE 16.2 Expectations and Business Fluctuations When the economy experiences a … Unemployment is… Inflation is … boom below the natural rate higher than expected Recession above the natural rate lower than expected Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (3 of 3) How Changes in the Growth Rate of Money Affect the Steady State TABLE 16.1 Money, Inflation, and Interest Rates in a Steady-State Economy Money Growth in Real Interest Nominal Growth Rate Inflation Money Demand Rate Interest 4% 4% 4% 2% 6% 5% 5% 5% 2% 7% Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION • 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? • 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 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (2 of 4) Are the Public’s Expectations About Inflation Rational? ● Rational expectations The economic theory that analyzes how the public forms expectations in such a manner that, on correctly Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved average, they forecast the future 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (3 of 4) U.S Inflation and Unemployment in the 1980s Inflation rose and the unemployment rate fell below the natural rate Inflation later fell as unemployment exceeded the natural rate SOURCE: Economic Report of the President (Washington, D.C.: U.S Government Printing Office, yearly) Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (4 of 4) 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 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (1 of 2) If workers push up their nominal wages, the aggregate supply curve will shift from AS0 to AS1 If the Fed keeps aggregate demand constant at AD0, 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 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (2 of 2) Countries in which central banks are more independent from the rest of the government have, on average, lower inflation rates SOURCE: Based on selected data in Table of “Measuring the Independence of Central Banks and Its Effect on Policy Outcomes,” Alex Cukierman, Steven Webb, and Bilin Neyapti, The World Bank Economic Review, 6:3, 353–398 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION • ESTIMATING THE NATURAL REAL INTEREST RATE • APPLYING THE CONCEPTS #2: How does the Fed use the concept of the natural interest rate to conduct monetary policy? In addition to being concerned about shifts in the natural rate of unemployment, the Fed also worries about shifts in the natural rate of interest The natural rate of interest is defined as the real interest rate consistent with full employment after temporary demand and supply shocks have subsided Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.4 INFLATION AND THE VELOCITY OF MONEY (1 of 3) ● Velocity of money The rate at which money turns over during the year It is calculated as nominal GDP divided by the money supply Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.4 INFLATION AND THE VELOCITY OF MONEY (2 of 3) ● Quantity equation The equation that links money, velocity, prices, and real output In symbols, we have M × V = P × y Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved ▼FIGURE 16.4 The Velocity of M2, 1959–2011 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.4 INFLATION AND THE VELOCITY OF MONEY (3 of 3) ● Growth version of the quantity equation An equation that links the growth rates of money, velocity, prices, and real output • • growth rate of money + growth rate of velocity = growth rate of prices + growth rate of real output Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.5 HYPERINFLATION (1 of 2) ● Hyperinflation An inflation rate exceeding 50 percent per month TABLE 16.3 Hyperinflations and Velocity Country Dates Monthly Rate Monthly Rate of Money Growth of Inflation Greece November 1943 to Approximate Increase in Velocity 365% 220% 14.00 19,800% 12,200% 333.00 57% 49% 3.70 November 1944 Hungary August 1945 to July 1946 Russia December 1921 to January 1924 SOURCE: Adapted from Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity Theory of Money, ed Milton Friedman (Chicago: University of Chocago Press, 1956), 26 TABLE 16.4 Hyperinflation in the 1980s Country Year Yearly Rate of Inflation Monthly Rate of Inflation Monthly Money Growth Rate Bolivia 1985 1,152,200% 118% 91% Argentina 1989 302,200 95 93 Nicaragua 1988 975,500 115 66 SOURCE: International Financial Statistics, International Monetary Fund Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 16.5 HYPERINFLATION (2 of 2) How Budget Deficits Lead to Hyperinflation ● Seignorage Revenue raised from money creation 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 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION • THE END OF HYPERINFLATIONS • APPLYING THE CONCEPTS #3: Why hyperinflations end suddenly? • In a classic study of four major hyperinflations, Nobel Laureate Thomas J Sargent noticed that they ended rather quickly and the ends all followed similar patterns He studied the hyperinflations after World War I in Germany, Austria, Hungary, and Poland, some of the most dramatic in world history In each case, the hyperinflation ended with the creation of a central bank and change in the way that governments were financed No longer would the country rely on its central bank to finance its debt Instead, debt was sold to private parties who would value the debt based on the ability of the government to meet interest and principal payments from taxes Once the governments made these reforms, there was an abrupt end to the hyperinflations and an actual increase in the demand for money in real terms by the private sector • Sargent said hyperinflations were ultimately caused by fiscal policy that was financed by money creation and not taxes He also suggested that inflation could be tamed rather easily once fiscal reforms were made While most economists agree with Sargent’s views on the ends of hyperinflation, there is less agreement that moderate inflations can be ended simply by changing fiscal regimes and not enduring a recession Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved KEY TERMS 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 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved ... the future 16. 2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (3 of 4) U.S Inflation and Unemployment in the 1980s Inflation rose and the unemployment... the short run and long run 16. 3 Discuss why increasing the credibility of a central bank can reduce inflation 16. 4 Define the velocity of money 16. 5 Identify the origins and causes of hyperinflation... Rights Reserved 16. 1 MONEY GROWTH, INFLATION, AND INTEREST RATES (2 of 3) Inflation in a Steady State INFLATION EXPECTATIONS AND INTEREST RATES When the public expects inflation, real and nominal