The Dynamicsof Inflation andUnemployment F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA...

The Dynamics of Inflation and Unemployment FERNANDO QUIJANO, YVONN QUIJANO,

KYLE THIEL & APARNA SUBRAMANIAN

PREPARED BY:

© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

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2 of 20© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

1 Do regional differences in unemployment affect the natural rate of unemployment?

Regional Differences in Unemployment Increase the Natural Rate

2 Can changes in the way central banks are governed affect inflation expectations?

Increased Political Independence for the Bank of England Lowered Inflation

Expectations

3 Are there bonds that can protect your investments from inflation?

Inflation-Indexed Bonds in the United States

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• nominal wagesWages expressed in current dollars.

• real wagesNominal or dollar wages adjusted forchanges in purchasing power.

MONEY GROWTH, INFLATION,AND INTEREST RATES16.1

Inflation in a Steady State

• money illusionConfusion of real and nominalmagnitudes.

• expectations of inflationThe beliefs held by the public aboutthe likely path of inflation in the future.

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MONEY GROWTH, INFLATION,AND INTEREST RATES16.1

Inflation in a Steady State

INFLATION EXPECTATIONS AND INTEREST RATES

INFLATION EXPECTATIONS AND MONEY DEMAND

How Changes in the Growth Rate of Money Affect the Steady State

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• expectations Phillips curveThe relationship between unemployment and inflation when taking into account expectations of inflation.

UNDERSTANDING THE EXPECTATIONS PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION

16.2

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• rational expectationsThe economic theory that analyzeshow the public forms expectations insuch a manner that, on average, theyforecast the future correctly.


16.2

Are the Public’s Expectations About Inflation Rational?

U.S. Inflation and Unemployment in the 1980s

► FIGURE 16.1The Dynamics of Inflation and Unemployment, 1986–1993

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16.2

Shifts in the Natural Rate of Unemployment in the 1990s

What factors can shift the natural rate of unemployment?

• Demographics

• Institutional changes

• The state of the economy

• Changes in growth of labor productivity

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REGIONAL DIFFERENCES IN UNEMPLOYMENT INCREASE THE NATURAL RATE

APPLYING THE CONCEPTS #1: Do regional differences in unemployment affect the natural rate of unemployment?

Some regions of a country may experience difficulties while others prosper. Does this matter when it comes to understanding the behavior of inflation and unemployment?

• When unemployment is low, firms compete for workers and bid up wages sharply.

• When unemployment is high, it is more difficult for firms to cut wages because workers tend to resist wage cuts.

Result:

Even if the total unemployment rate in the country appears to be at the natural rate of unemployment, there could still be upwards inflation pressure if wages increase faster in the low-unemployment regions than they fall in the high-unemployment regions.

Economists studied how regional differences in unemployment have varied over time.

• Variations were relatively high during the 1980s but fell sharply in the 1990s.

• The U.S. labor market operated more like a national than a regional market in the 1990s.

• The natural rate of unemployment fell in the 1990s.

Economists estimated that the effect was large and that the natural rate fell by about 2%.

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THE MINIMUM WAGE: IT’S ALL LOCAL

• There will soon be 12 states with minimum wage laws that already exceed $7.00 per hour.

• Local governments have also gotten involved with 140 passing some form of minimum wage laws.

• While these laws are promoted by “living wage” advocates, they are also opposed by the National Restaurant Association.

The new Democrat-controlled Congress plans to push through an increase in minimum wage as one of its first agenda items. The current federal level of $5.15 per hour is the lowest inflation-adjusted minimum wage in 50 years. Congress’s current plan is to increase that amount to $7.25 per hour.

Increasing the federal minimum wage may have little or no impact in many areas where the market has already settled at equilibrium points above the expected new minimum wage. In other areas, local minimum wage laws already mandate wages higher than the proposed new federal minimum wage.

Extra Application 4

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HOW THE CREDIBILITY OF A NATION’SCENTRAL BANK AFFECTS INFLATION16.3

► FIGURE 16.2Choices of the Fed: Recession or Inflation

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HOW THE CREDIBILITY OF A NATION’SCENTRAL BANK AFFECTS INFLATION16.3

► FIGURE 16.3How Central Bank Independence Affects Inflation

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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?

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 point.

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INFLATION AND THE VELOCITY OF MONEY16.4

• velocity of moneyThe rate at which money turns overduring the year. It is calculated asnominal GDP divided by the moneysupply.

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INFLATION-INDEXED BONDS IN THE UNITED STATES

APPLYING THE CONCEPTS #3: Are there bonds that can protect your investments from inflation?

In 1997, the U.S. Department of the Treasury created a new financial instrument called the Treasury Inflation-Protected Security, or TIPS.

• TIPS make interest payments every six months and a payment of the original principal when the bond matures.

• Payments are automatically adjusted for changes in inflation.

• Because TIPS compensate for actual inflation, the interest rate on these bonds differs from conventional bonds by the expected inflation rate.

• By comparing the interest rates on TIPS to other government bonds of similar maturity, economists can estimate the public’s expectations of inflation.

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or

• quantity equationThe equation that links money,velocity, prices, and real output. Insymbols, we have M × V = P × y.

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INFLATION AND THE VELOCITY OF MONEY16.4 FIGURE 16.4The Velocity of M2, 1959–2005

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growth rate of money + growth rate of velocity

= growth rate of prices + growth rate of real output

• growth version of the quantity equationAn equation that links the growth rates of money, velocity, prices, and real output.

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HYPERINFLATION16.5• hyperinflation

An inflation rate exceeding

50 percent per month.

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HYPERINFLATION16.5

• seignorageRevenue raised from money creation.

How Budget Deficits Lead to Hyperinflation

government deficit = new borrowing from the public + new money created

• monetaristsEconomists who emphasize the role that the supply of money plays in determining nominal income and inflation.

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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

The Dynamicsof Inflation andUnemployment F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA...

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