Output, Unemployment, & Inflation

Chapter 9: Inflation, Activity, and Money Growth Slide #1Blanchard: Macroeconomics

Output, Unemployment, & InflationOutput, Unemployment, & Inflation

1. Phillips Curve: unemployment and the change in inflation

2. Okun’s Law: growth and the change in unemployment

3. Aggregate Demand: Money, output, and prices

Three Relations:Three Relations:



The Phillips Curve: Unemployment and the Change in InflationThe Phillips Curve: Unemployment and the Change in Inflation

)( nte

tt uu

etAssuming: equals last year’s inflation,

, then:1t

)( nte

tt uu



Okun’s Law: The DataOkun’s Law: The Data



Okun’s Law: The EquationOkun’s Law: The Equation

ut-ut-1 = -0.4(gyt-3%)

gyt must be at least 3% to keepunemployment from rising

WHY?

Two factors:

1. Growth in the labor force

2. Increases in the productivity of labor

gyt must be at least 3% to keepunemployment from rising

WHY?

Two factors:

1. Growth in the labor force

2. Increases in the productivity of labor



Δu = ut - ut-1 = - 0.4(gyt - 3%)

Why is the coefficient only 0.4?• Firms hoard labor and there is a minimum

number of workers •Changes in labor force participation

Okun’s Law Coefficients Across Countries

Country 1960-1980 1981-1998

United States 0.39 0.42United Kingdom 0.15 0.51Germany* 0.20 0.32Japan 0.10 0.20



Okun’s LawOkun’s Law

)(1 yyttt gguu

In general, the relation between changes in unem-ployment and output growth is:

yg : normal growth rate

: how growth in excess of normal growth impacts the unemployment rate



The Aggregate Demand Relation: Money Growth, Inflation, and Output GrowthThe Aggregate Demand Relation: Money Growth, Inflation, and Output Growth

t

t

t

tt

P

M

ADP

MYY

to

toalproportionisthen:If

How does a change in impact AD?t

t

P

M

Yr)(multiplie ADiP

M

t

t


Or going straight to the equation of exchange:

MV = PY

VdM + MdV = YdP + PdY

dM/M + dV/V = dP/P + dY/Y

gmt + dV/V = πt + gyt



The Aggregate Demand Relation: Money Growth, Inflation, and Output GrowthThe Aggregate Demand Relation: Money Growth, Inflation, and Output Growth

When velocity is constant, dV/V = 0

tmtyt gg mtg nominal money growth rate

t growth rate in prices


Our Three RelationsOur Three Relations Phillips Curve (AS):

Δt = - α (ut – ut)

Okun’s Law:

Δ ut = - β (gyt - gn)

Equation of exchange (AD):

gyt = gmt - πt



A Scenario: The money growth rate falls (short-run)A Scenario: The money growth rate falls (short-run)

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?Will the impact end here—what about the medium run?



IN MEDIUM RUN: ut = un

Assume a constant growth in the nominal money supply

)( mg

Medium Run: (Okun’s Law)yy gg

ym gg (Aggregate Demand)


Output, Unemployment, & Inflation:Output, Unemployment, & Inflation:The Medium RunThe Medium Run

Unemployment Rate, u

Infl

atio

n R

ate,

un

Naturalunemployment rate

)g-g( ym

Adjustedmoney growth

)gg (for mm

B

If decreases to :u remains at un & falls

mg mg

Adjustedmoney growth

A)gg( ym

)g (for m

Adjusting to a decrease in nominal money growth



Disinflation: How much unemployment? And for how long?Disinflation: How much unemployment? And for how long?

Scenario: Reduce inflation from 14 to 4 percent & = 1

1 tt )( nt uu =

Conclusion: Point years of excess unemployment equals 10Conclusion: Point years of excess unemployment equals 10

Time period: 1 yr: 2 yrs: Year 1, -5% = -5% Year 2,

-5% = -5% 5 yrs: 5 yrs of unemployment

2% above un

10 yrs: 10 yr of unemployment 1% above un

%10%10)(1144 nt uu



Disinflation: How much unemployment? And for how long?Disinflation: How much unemployment? And for how long?

The Sacrifice Ratio: Excess point years of unemploymentDecrease in Inflation

If = 1, what is the sacrifice ratio?If = 1, what is the sacrifice ratio?



Working on the required path of money growthWorking on the required path of money growth

A Scenario: Reduce inflation from 14% to 4% in 5 years4.0,1%,5.6%,3 nu ug

0 1 2 3 4 5 6 7 8

Inflation (%) 14 12 10 8 6 4 4 4 4

Unemployment rate (%) 6.5 8.5 8.5 8.5 8.5 8.5 6.5 6.5 6.5

Output growth (%) 3 -2 3 3 3 3 8 3 3

Nominal money growth (%) 17 10 13 11 9 7 12 7 7

YearBefore Disinflation After



The disinflation pathThe disinflation path

Year 1

Year 2

Year 4

B

Year 5

Year 0

A

CYear 6+

Year 3

10.5

16

14

2

4

6

8

10

12

2.5 4.5 6.5 8.5

Infl

atio

n R

ate

(p

erce

nt)

Unemployment Rate (percent)



The Disinflation PathThe 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



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 – Rat-X

•Sargent – Low sacrifice in history

• Nominal rigidities and contracts

•Fischer – sticky wages

•Taylor – staggered contracts



Expectations & Credibility: The Lucas CritiqueExpectations & Credibility: The Lucas Critique

• The previous model assumed: te = t-1

• What if te is based on an expectation that Fed

policy would reduce inflation from 14% to 4%. Then: )( nt

ett uu

4% = 4% - 0%

• Inflation falls to 4% and unemployment remains at the natural rate

• Reduction in money growth could be neutral



Disinflation Without Unemployment in the Taylor ModelDisinflation Without Unemployment in the Taylor Model



The U.S. Disinflation, 1979-1985The 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




Did Fed credibility reduce the sacrifice ratio?1979 1980 1981 1982 1983 1984 1985

1. GDP growth (%) 2.5 -0.5 1.8 -2.2 3.9 6.2 3.2

2. Unemployment rate(%) 5.8 7.1 7.6 9.7 9.6 7.5 7.2

3. CPI Inflation (%) 13.3 12.5 8.9 3.8 3.8 3.9 3.8

4. Cumulative unemployment 0.6 1.7 4.9 8.0 9.0 9.7

5. Cumulative disinflation 0.8 4.4 9.5 9.5 9.4 9.5

6. Sacrifice ratio 0.75 0.39 0.51 0.84 0.95 1.02

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.



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


Observations



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 CountriesDisinflation Experiences in 19 OECD Countries

Output, Unemployment, & Inflation

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