Post on 12-Jan-2016
Unemployment, Inflation and
Growth
Unemployment, Inflation and
Growth
Money and PricesMoney and Prices
• The quantity theory of money
• The equation of exchange: MV = PY– M money supply
– V velocity of circulation
– P price level (number of times greater than in base year)
– Y real value of output at base-year prices
– MV = PQ
• The link between money and prices– quantity theory holds if V and Y are determined
independently of M
• The quantity theory of money
• The equation of exchange: MV = PY– M money supply
– V velocity of circulation
– P price level (number of times greater than in base year)
– Y real value of output at base-year prices
– MV = PQ
• The link between money and prices– quantity theory holds if V and Y are determined
independently of M
Money and PricesMoney and Prices
• Assumptions about the velocity of circulation
– the short run
• uncertain relationship between money and prices
• the monetary transmission mechanism
– the money–interest rate link
– the interest rate–spending link
– the long run
• the theory of portfolio balance
• Assumptions about the velocity of circulation
– the short run
• uncertain relationship between money and prices
• the monetary transmission mechanism
– the money–interest rate link
– the interest rate–spending link
– the long run
• the theory of portfolio balance
Money and PricesMoney and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
O
Pric
e le
vel
National output
AS
Different aggregate supply curvesDifferent aggregate supply curves
O
AS
Pric
e le
vel
National output
Y1
P1
AD1
Different aggregate supply curvesDifferent aggregate supply curves
P2
O
AS
Y1
Pric
e le
vel
National output
Y2
P1
AD2
AD1
Different aggregate supply curvesDifferent aggregate supply curves
Q1
Short-run response of a profit-maximisingfirm to a rise in demand
Short-run response of a profit-maximisingfirm to a rise in demand
MC
AR1
MR1
£
Q
P1
AR1
MR1
P1
Q1
AR2
MR2
£
Q
MC
Short-run response of a profit-maximisingfirm to a rise in demand
Short-run response of a profit-maximisingfirm to a rise in demand
AR1
MR1
P1
Q1
AR2
MR2Q2
P2
£
Q
MC
Short-run response of a profit-maximisingfirm to a rise in demand
Short-run response of a profit-maximisingfirm to a rise in demand
Money and PricesMoney and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
Money and PricesMoney and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
O
AS
Pric
e le
vel
National output
Y
Different aggregate supply curvesDifferent aggregate supply curves
P1
O
Pric
e le
vel
National output
AD1
Y
AS
Different aggregate supply curvesDifferent aggregate supply curves
O
P1
Pric
e le
vel
National output
AD2
P2
Y
AS
AD1
Different aggregate supply curvesDifferent aggregate supply curves
Money and PricesMoney and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
– the interdependence of markets
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
– the interdependence of markets
Money and PricesMoney and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
– the interdependence of markets
– the flexibility of prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
– the interdependence of markets
– the flexibility of prices
O
Pri
ce le
vel
National output
AD1
SRAS1
(expected price level = P1)
P1
Q1
a
The long-run aggregate supply curvewhen firms are interdependent
The long-run aggregate supply curvewhen firms are interdependent
O
Pri
ce le
vel
National output
AD1
SRAS1
(expected price level = P1)
P1
AD2
a
bP2
Q2
SRAS2
(expected price level = P3 )
P3
c
Q1
The long-run aggregate supply curvewhen firms are interdependent
The long-run aggregate supply curvewhen firms are interdependent
O
Pri
ce le
vel
National output
AD1
SRAS1
(expected price level = P1)
P1
Qn
AD2
a
bP2
Q2
SRAS2
(expected price level = P3 )
cP3
LRAS
The long-run aggregate supply curvewhen firms are interdependent
The long-run aggregate supply curvewhen firms are interdependent
Money and PricesMoney and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
– the interdependence of markets
– the flexibility of prices
• the effects of investment on aggregate supply
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
– the long run aggregate supply curve
• relatively inelastic
– the interdependence of markets
– the flexibility of prices
• the effects of investment on aggregate supply
Effect of investment on the long-run AS curveEffect of investment on the long-run AS curve
AD1
Pri
ce le
vel
National output
a
AS1 (short run)
AS (long run)
AS2 (short run)
AD1
Pri
ce le
vel
National output
a
AD2
b
d
AS1 (short run)
Effect of investment on the long-run AS curveEffect of investment on the long-run AS curve
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
• Expectations augmented Phillips curve– adaptive expectations
• Expectations augmented Phillips curve– adaptive expectations
O
P (%).
U (%)
aP1
.
U1
P2
.
U2
A Phillips curveA Phillips curve
b
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
0
4
8
12
16
20
0
P (%).
U (%)6 8I (Pe = 0)
.
b
The accelerationist theory of inflationThe accelerationist theory of inflation
a
IV (Pe = 12%).
III (Pe = 8%).
II (Pe = 4%)
P (%).
U (%)6
a
b c
d
8I (Pe = 0)
.
.
e
The accelerationist theory of inflationThe accelerationist theory of inflation
f
0
4
8
12
16
20
0
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
Un
0
4
8
12
16
20
0
P (%).
U (%)6 8
The long-run Phillips curveThe long-run Phillips curve
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
0
2
4
6
8
10
12
14
16
18
20
22
24
0
P (%).
U (%)8 13
J
X (Pe = 20%).
k
The effects of deflationThe effects of deflation
0
2
4
6
8
10
12
14
16
18
20
22
24
0
P (%).
U (%)8 13
k
X (Pe = 20%).
XI (Pe = 18%).
XII (Pe = 16%).
l
J
m
The effects of deflationThe effects of deflation
0
2
4
6
8
10
12
14
16
18
20
22
24
0
P (%).
U (%)8 13
k
l
m
a
J
The effects of deflationThe effects of deflation
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
• Phillips loops
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
• Phillips loops
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
Year 20
20
0
P (%).
U (%)Un
ab
c
Year 0, 1
Clockwise Phillips loopsClockwise Phillips loops
Year 5
Year 4
0
20
0
P (%).
U (%)Un
ab
c
d
ef
Year 0, 1
Year 2
Year 3
Clockwise Phillips loopsClockwise Phillips loops
0
20
0
P (%).
U (%)Un
ab
c
d
ef
h
i
J
Year 0, 1, 10
Year 2, 9
Year 3, 8
Year 4, 7
Year 5, 8
Clockwise Phillips loopsClockwise Phillips loops
g
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
• Phillips loops
• Policy implications
• Expectations augmented Phillips curve– adaptive expectations
• The accelerationist theory– accelerating inflation
• when unemployment is kept below the ‘natural’ level
– the long-run Phillips curve
– effects of deflationary policies
• Phillips loops
• Policy implications
Inflation and Unemployment: Introducing ExpectationsInflation and Unemployment: Introducing Expectations
Inflation and Unemployment: New Classical ViewsInflation and Unemployment: New Classical Views
• Assumption of flexible wages and prices
• Rational expectations– meaning of rational expectations
– imperfect information
– implications for AS and the Phillips curve
– policy implications
• Real business cycles– fluctuations in aggregate supply
– causes of changes in aggregate supply
– policy implications
• Assumption of flexible wages and prices
• Rational expectations– meaning of rational expectations
– imperfect information
– implications for AS and the Phillips curve
– policy implications
• Real business cycles– fluctuations in aggregate supply
– causes of changes in aggregate supply
– policy implications
Inflation and Unemployment: Keynesian ViewsInflation and Unemployment: Keynesian Views
• Changes in equilibrium unemployment– structural unemployment– hysteresis
• The persistence of demand-deficient unemployment– payment of efficiency wages– insider power
• Incorporation of expectations– expansion of aggregate demand– contraction of aggregate demand
• Keynesian criticism of non-intervention
• Changes in equilibrium unemployment– structural unemployment– hysteresis
• The persistence of demand-deficient unemployment– payment of efficiency wages– insider power
• Incorporation of expectations– expansion of aggregate demand– contraction of aggregate demand
• Keynesian criticism of non-intervention
Common ground between economists?Common ground between economists?
• Short-run effect of changes in AD– major effect on output and employment
– relatively small effect on prices
• Long-run effect of changes in AD– relatively small effect on output and jobs
– relatively large effect on prices
– some Keynesians disagree• stress long-run effects of changes in AD on
investment
• Importance of expectations
• Short-run effect of changes in AD– major effect on output and employment
– relatively small effect on prices
• Long-run effect of changes in AD– relatively small effect on output and jobs
– relatively large effect on prices
– some Keynesians disagree• stress long-run effects of changes in AD on
investment
• Importance of expectations
Demand-side PolicyDemand-side Policy
• Attitudes towards demand management
• Case against discretion– time lags
– problem of over-correction
– government may ignore long-term consequences
• Case for rules– help to reduce inflationary expectations
– create a stable environment for investment and growth
• Attitudes towards demand management
• Case against discretion– time lags
– problem of over-correction
– government may ignore long-term consequences
• Case for rules– help to reduce inflationary expectations
– create a stable environment for investment and growth
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Demand-side PolicyDemand-side Policy
• Case against rules– can cause severe fluctuations in interest
rates and can cause greater instability
– which rule to choose?
– rules may conflict
– rules may become unsuitable
• Case for discretion– fine tuning can be improved by better
forecasting and quick-acting policies
– allows governments to respond to changing circumstances
• Case against rules– can cause severe fluctuations in interest
rates and can cause greater instability
– which rule to choose?
– rules may conflict
– rules may become unsuitable
• Case for discretion– fine tuning can be improved by better
forecasting and quick-acting policies
– allows governments to respond to changing circumstances
Demand-side PolicyDemand-side Policy
• Demand-side policy in the UK– increasingly rules-based
– fiscal policy• 'golden rule'
• but some flexibility
– monetary policy• target of 2% inflation set by government
• Monetary Policy Committee adjusts interest rates to meet this 2% target
• benefits of transparency
• benefits for expectations
• Demand-side policy in the UK– increasingly rules-based
– fiscal policy• 'golden rule'
• but some flexibility
– monetary policy• target of 2% inflation set by government
• Monetary Policy Committee adjusts interest rates to meet this 2% target
• benefits of transparency
• benefits for expectations
Long-term Economic GrowthLong-term Economic Growth
• Growth over the decades• Growth over the decades
30
40
50
60
70
80
90
100
110
120
1950 1960 1970 1980 1990 2000
Re
al
GD
P (
19
95
= 1
00
)UK GDP at market prices (1995=100)UK GDP at market prices (1995=100)
30
40
50
60
70
80
90
100
110
120
1950 1960 1970 1980 1990 2000
Re
al
GD
P (
19
95
= 1
00
)UK GDP at market prices (1995=100)UK GDP at market prices (1995=100)
Long-term Economic GrowthLong-term Economic Growth
• The causes of economic growth
– increase in quantity of factors
– increase in productivity of factors
• Capital accumulation
– a simple model of economic growth
• effect of an increase in capital
• diminishing returns
• steady-state national income
• The causes of economic growth
– increase in quantity of factors
– increase in productivity of factors
• Capital accumulation
– a simple model of economic growth
• effect of an increase in capital
• diminishing returns
• steady-state national income
K0
Depreciation (D)
Investment (I)
Steady-state outputSteady-state output
Capital stock (K)
Ou
tpu
t (Y
), In
vest
me
nt (
I), D
epre
cia
tion
(D
)
K1
Y1
Output (Y)
g
Y0
bI0
D0
O
c
f
a
Long-term Economic GrowthLong-term Economic Growth
• The causes of economic growth
– increase in quantity of factors
– increase in productivity of factors
• Capital accumulation
– a simple model of economic growth
• effect of an increase in capital
• diminishing returns
• steady-state national income
– effect of an increase in the saving rate
• The causes of economic growth
– increase in quantity of factors
– increase in productivity of factors
• Capital accumulation
– a simple model of economic growth
• effect of an increase in capital
• diminishing returns
• steady-state national income
– effect of an increase in the saving rate
Capital stock (K)
K1 K2
Y2
Y1
Y
D
I2
I1g
m
nh
Ou
tpu
t (Y
), In
vest
me
nt (
I), D
epre
cia
tion
(D
)
f
Effect of an increase in the rate of saving and investmentEffect of an increase in the rate of saving and investment
Long-term Economic GrowthLong-term Economic Growth
• Technological progress– effect on steady-state output
• Technological progress– effect on steady-state output
Capital stock (K)
K1 K2
Y2
Y2
D
I2
I1g
p
nh
Ou
tpu
t (Y
), In
vest
me
nt (
I), D
epre
cia
tion
(D
)Effect of a technological advanceEffect of a technological advance
Y1
Y1
f
Long-term Economic GrowthLong-term Economic Growth
• Technological progress– effect on steady-state output– endogenous growth theory
• Technological progress– effect on steady-state output– endogenous growth theory
Long-term Economic GrowthLong-term Economic Growth
• Productivity and economic growth
– importance of productivity
– determinants of productivity
• private investment
• public investment in infrastructure and education
• innovation
• business environment
• management and entrepreneurial activity
• Productivity and economic growth
– importance of productivity
– determinants of productivity
• private investment
• public investment in infrastructure and education
• innovation
• business environment
• management and entrepreneurial activity
Supply-side PolicySupply-side Policy
• The use of supply-side policies
– to reduce unemployment
– to reduce inflation
– to increase economic growth
• Market-orientated supply-side policies
– reducing government expenditure
• The use of supply-side policies
– to reduce unemployment
– to reduce inflation
– to increase economic growth
• Market-orientated supply-side policies
– reducing government expenditure
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Government expenditure (central plus local) as a percentage of GDP
Supply-side PolicySupply-side Policy
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
Supply-side PolicySupply-side Policy
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
Supply-side PolicySupply-side Policy
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• importance of incentives
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• importance of incentives
Supply-side PolicySupply-side Policy
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• importance of incentives
• effects on imports
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• importance of incentives
• effects on imports
Supply-side PolicySupply-side Policy
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• importance of incentives
• effects on imports
• tax cuts for business
• Market-orientated supply-side policies
– reducing government expenditure
– tax cuts
• effects on labour supply and employment
• importance of incentives
• effects on imports
• tax cuts for business
Supply-side PolicySupply-side Policy
• Market-orientated supply-side policies (cont.)
– reducing the power of labour
– reducing welfare
– policies to encourage competition
• privatisation
• deregulation
• introducing market relationships into the public sector
• the Private Finance Initiative
• free trade and capital movements
• Market-orientated supply-side policies (cont.)
– reducing the power of labour
– reducing welfare
– policies to encourage competition
• privatisation
• deregulation
• introducing market relationships into the public sector
• the Private Finance Initiative
• free trade and capital movements
Supply-side PolicySupply-side Policy
• Background to interventionist policy
– the UK's poor productivity record
• Background to interventionist policy
– the UK's poor productivity record
Productivity in selected countries, 2001 (UK = 100)Productivity in selected countries, 2001 (UK = 100)
Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
Productivity in selected countries, 2001 (UK = 100)Productivity in selected countries, 2001 (UK = 100)
Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
Productivity in selected countries, 2001 (UK = 100)Productivity in selected countries, 2001 (UK = 100)
Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
Productivity in selected countries, 2001 (UK = 100)Productivity in selected countries, 2001 (UK = 100)
Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
Supply-side PolicySupply-side Policy
• Background to interventionist policy
– the UK's poor productivity record
– the UK's poor investment record
• Background to interventionist policy
– the UK's poor productivity record
– the UK's poor investment record
Gross fixed capital formation as % of GDPGross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDPGross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDPGross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDPGross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDPGross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDPGross fixed capital formation as % of GDP
Supply-side PolicySupply-side Policy
• Interventionist supply-side policy– failure of the market to provide adequate
training, R&D and investment
– help to firms• direct provision
• finance for research and development
• assistance to small firms
• advice and persuasion
• information
– infrastructure development
– training and education
• Interventionist supply-side policy– failure of the market to provide adequate
training, R&D and investment
– help to firms• direct provision
• finance for research and development
• assistance to small firms
• advice and persuasion
• information
– infrastructure development
– training and education