C H A P T E R 16 The Dynamics of Inflation and Unemployment Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 16-1 CHAPTER The Dynamics of Inflation and Unemployment 16 As the financial crisis spread in 2008, central banks around the world increased the supply of money and liquidity, and governments borrowed extensively and incurred increasing amounts of government debt PREPARED BY Copyright © 2012 Pearson Prentice Hall All rights reserved Brock Williams C H A P T E R 16 The Dynamics of Inflation and Unemployment APPLYING THE CONCEPTS How can data on vacancies and unemployment be used to measure shifts in the natural rate? Shifts in the Natural Rate of Unemployment Can changes in the way central banks are governed affect inflation expectations? Increased Political Independence for the Bank of England Lowered Inflation Expectations What caused a severe hyperinflation to emerge recently in Zimbabwe? Hyperinflation in Zimbabwe Copyright © 2012 Pearson Prentice Hall All rights reserved 16-3 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES 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 © 2012 Pearson Prentice Hall All rights reserved 16-4 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (cont’d) 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 © 2012 Pearson Prentice Hall All rights reserved 16-5 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (cont’d) How Changes in the Growth Rate of Money Affect the Steady State Copyright © 2012 Pearson Prentice Hall All rights reserved 16-6 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION ● expectations Phillips curve The relationship between unemployment and inflation when taking into account expectations of inflation Copyright © 2012 Pearson Prentice Hall All rights reserved 16-7 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d) 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 average, they forecast the future correctly Copyright © 2012 Pearson Prentice Hall All rights reserved 16-8 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d) U.S Inflation and Unemployment in the 1980s FIGURE 16.1 The Dynamics of Inflation and Unemployment, 1986–1993 Inflation rose and the unemployment rate fell below the natural rate Inflation later fell as unemployment exceeded the natural rate Copyright © 2012 Pearson Prentice Hall All rights reserved 16-9 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d) 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 © 2012 Pearson Prentice Hall All rights reserved 16-10 C H A P T E R 16 The Dynamics of Inflation and Unemployment 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 © 2012 Pearson Prentice Hall All rights reserved 16-11 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION FIGURE 16.2 Choices of the Fed: Recession or Inflation 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 © 2012 Pearson Prentice Hall All rights reserved 16-12 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.3 HOW THE CREDIBILITY OF A NATION’S CENTRAL BANK AFFECTS INFLATION (cont’d) FIGURE 16.3 How Central Bank Independence Affects Inflation Countries in which central banks are more independent from the rest of the government have, on average, lower inflation rates Copyright © 2012 Pearson Prentice Hall All rights reserved 16-13 C H A P T E R 16 The Dynamics of Inflation and Unemployment APPLICATION INCREASED POLITICAL INDEPENDENCE FOR THE BANK OF ENGLAND LOWERED INFLATION EXPECTATIONS APPLYING THE CONCEPTS #2: Can changes in the way central banks are governed affect inflation expectations? In 1997, a major change in monetary policy allowed the Bank of England to be free to pursue its policy goals without direct political control An economist studied how the British bond market reacted to the policy change by comparing the interest rates changes on two types of long-term bonds: bonds that are automatically adjusted (or indexed) for inflation and bonds that are not • The difference between the two interest rates primarily reflects expectations of inflation • If the gap narrowed following the policy announcement, this would be evidence that the new policy reduced expectations of inflation • If it did not, the announced policy would have had no effect on inflation expectations Result: After the announcement, the gap narrowed Conclusion: The announcement did cause expectations about inflation to fall by about half a percentage Copyright © 2012 Pearson Prentice Hall All rights reserved 16-14 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.4 INFLATION AND THE VELOCITY OF MONEY ● 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 © 2012 Pearson Prentice Hall All rights reserved 16-15 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.4 INFLATION AND THE VELOCITY OF MONEY (cont’d) or ● quantity equation The equation that links money, velocity, prices, and real output In symbols, we have M × V = P × y Copyright © 2012 Pearson Prentice Hall All rights reserved 16-16 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.4 INFLATION AND THE VELOCITY OF MONEY (cont’d) FIGURE 16.4 The Velocity of M2, 1959–2009 Copyright © 2012 Pearson Prentice Hall All rights reserved 16-17 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.4 INFLATION AND THE VELOCITY OF MONEY (cont’d) growth rate of money + growth rate of velocity = growth rate of prices + growth rate of real output ● growth version of the quantity equation An equation that links the growth rates of money, velocity, prices, and real output Copyright © 2012 Pearson Prentice Hall All rights reserved 16-18 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.5 HYPERINFLATION ● hyperinflation An inflation rate exceeding 50 percent per month Copyright © 2012 Pearson Prentice Hall All rights reserved 16-19 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16.5 HYPERINFLATION (cont’d) 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 © 2012 Pearson Prentice Hall All rights reserved 16-20 C H A P T E R 16 The Dynamics of Inflation and Unemployment APPLICATION HYPERINFLATION IN ZIMBABWE APPLYING THE CONCEPTS #3: What caused a severe hyperinflation to emerge recently in Zimbabwe? In June 2008, the consumer price index in Zimbabwe was million percent higher than it was a year before A $12 lunch in local currency cost 1.1 trillion Zimbabwe dollars What caused Zimbabwe to suffer from this crippling hyperinflation? The simple answer is that the political and economic system began to self-destruct Zimbabwe has been ruled since 1980 by the dictator Robert Mugabe, whose policies to intervene militarily in African conflicts and expropriate white-owned farms had the cumulative effect of crippling the economy • As the economy deteriorated, tax revenues declined • Mugabe and his central bank simply resorted to printing new banknotes Result: Hyperinflation and further deterioration of the economy as the financial system collapsed Copyright © 2012 Pearson Prentice Hall All rights reserved 16-21 C H A P T E R 16 The Dynamics of Inflation and Unemployment 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 © 2012 Pearson Prentice Hall All rights reserved 16-22 ... and real output In symbols, we have M ì V = P ì y Copyright â 2012 Pearson Prentice Hall All rights reserved 16- 16 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16. 4 INFLATION AND. .. All rights reserved 16- 8 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16. 2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d)... All rights reserved 16- 9 C H A P T E R 16 The Dynamics of Inflation and Unemployment 16. 2 UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (cont’d)