Inflation, Activity, and Nominal Money Growth

1. Inflation, Activity,and Nominal MoneyGrowth

2. The Volcker Disinflation • In October 1979, the Fed, under Paul Volcker, decided to reduce nominal money growth and decrease inflation, then close to 14% per year. • Five years later, after a deep recession, inflation was down to 4% per year.

4. The Volcker Disinflation • How did the Fed reduce inflation? • It did it by changing the relationship between inflation and unemployment • It caused a recession to prove it was serious about inflation. This changed expectations of inflation.

5. Output, Unemployment,and Inflation 9-1 • This chapter builds on three relations: • Okun’s Law, which relates the change in unemployment to output growth. • The Phillips curve, which relates the changes in inflation to unemployment. • The aggregate demand relation, which relates output growth to both nominal money growth and inflation.

6. Output Growth, Unemployment, Inflation, and Nominal Money Growth

7. Output Growth, Unemployment, Inflation, and Nominal Money Growth • We are used to thinking in terms of AS-AD • AS, which shows the effect of output on prices, is split in this chapter into two parts: • Output affects unemployment through Okun’s Law. • A higher growth rate of output reduces unemployment. • Previously, we assumed Y = N = L(1-u), but life is richer and more complicated. • Unemployment affects inflation through the Phillips Curve. • A lower unemployment rate causes inflation to rise.

8. Output Growth, Unemployment, Inflation, and Nominal Money Growth • We are still using AD. • Higher prices lower output demanded. • Suppose the Central Bank increases the nominal money supply at a constant, positive rate = 5%. • Inflation = 3%, so the rate of growth of real money supply is 2% = 5% – 3%. • Suppose inflation rises unexpectedly to 4%. • Then the real money supply will rise more slowly, at 1% per year. • Higher inflation reduces the rate of growth of real money, which reduces the output growth rate.

9. Okun’s Law:FromOutput Growth to Unemployment

10. Okun’s Law: FromOutput Growth to Unemployment • If output grows, unemployment should fall, right? • Assume Y = N Y = L – U. Yt – Yt-1 = (Lt – Lt-1) – (Ut – Ut-1) • Assume the labor force doesn’t grow (Lt – Lt-1=0). Then Yt – Yt-1 = – (Ut – Ut-1)

11. Okun’s Law: FromOutput Growth to Unemployment • Yt – Yt-1 = – (Ut – Ut-1) • This also implies that the unemployment rate (u) is negatively related to the output growth rate (g): • We’ve made a lot of assumptions: no inputs besides labor, no diminishing returns • Particularly, we assumed no changes in labor productivity, constant labor force, etc.

12. Okun’s Law: FromOutput Growth to Unemployment • The change in the unemployment rate could be equal to the negative of the growth rate of output. • For example, if output growth is 4%, then the unemployment rate should decline by 4%. • Now, let’s be more realistic.

13. Okun’s Law: FromOutput Growth to Unemployment • The actual relation between output growth and the change in the unemployment rate is known as Okun’s law. • This relation allows for more realistic production functions, labor market behavior, etc. • Particularly, it allows for changes in labor productivity, and a growing labor force, etc, so the economy can be expected to be growing constantly.

14. Okun’s Law: FromOutput Growth to Unemployment High output growth is associated with a reduction in the unemployment rate; low output growth is associated with an increase in the unemployment rate. Changes in the Unemployment Rate Versus Output Growth in the United States, 1970-2000 • Using thirty years of data, the line that best fits the data is given by:

15. Okun’s Law Across Countries The coefficient β in Okun’s law gives the effect on the unemployment rate of deviations of output growth from normal. A value of β of 0.4 tells us that output growth 1% above the normal growth rate for 1 year decreases the unemployment rate by 0.4%.

16. Okun’s Law: FromOutput Growth to Unemployment • According to the equation above,

17. Okun’s Law: FromOutput Growth to Unemployment • To maintain the unemployment rate constant, output growth must be 3% per year. This growth rate of output is called the normal growth rate. • Output growth 1% above normal leads only to a b%<1 reduction in unemployment.

18. Okun’s Law: FromOutput Growth to Unemployment • Output growth above normal leads to a decrease in the unemployment rate. • If output grows below normal, the unemployment rate. Increases. • This is Okun’s law:

19. Okun’s Law: FromOutput Growth to Unemployment Assume ut-1 = 6%

20. The Phillips’s Curve:FromUnemployment to Inflation

21. The Phillips Curve: From Unemployment to Inflation • Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment. Suppose et is well approximated by t-1. Then: • The Phillips curve implies that

22. The Aggregate Demand RelationFromNominal Money Growth and InflationToOutput Growth

23. The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output Growth • If the IS curve is • And the LM curve is • Then the AD curve is • Aggregate Expenditure depends on all sorts of parameters (the c’s, the b’s, the d’s, t, and G), positively on M and negatively on P.

24. The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output Growth • More simply, we can say that • Even more simply, suppose that changes in output are caused only changes in the real money stock, then:

25. The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output Growth • Let’s put this in terms of growth rates: • gyt = (Yt-Yt-1)/Yt-1 • gmt = (Mt-Mt-1)/Mt-1 • p = (Pt-Pt-1)/Pt-1 • And since g is a parameter (gt-gt-1)/gt-1=0. • From this we can derive

26. The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output Growth • How do we go from to ? • The easiest way is to use logarithms and calculus: Log Y = log (gM/P) Log Y = log g + log M - log P Taking a total derivative

27. The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output Growth • In terms of the growth rates of output, money, and the price level: • According to the aggregate demand relation: • Given inflation, expansionary monetary policy leads to high output growth.

28. The Aggregate Demand Relation:From Nominal Money Growth and Inflation to Output Growth Assume pt = 3% Assume gmt = 6%

29. The Three Relations • Okun’s Law • Phillips Curve • AD Relation

30. Output Growth, Unemployment, Inflation, and Nominal Money Growth

31. 9-2 The Medium Run

32. The Medium Run • In chapter 6 we defined the medium run as the time when Pe=Pt-1=Pt. • This meant that there was no reason for Pe to change. • No changes in Pe meant that the WS would stay put, yielding a “steady-state”, medium-run level of unemployment, the natural rate of unemployment.

33. The Medium Run • The medium run: Pe=Pt-1=Pt. • In growth rates rather than levels, t = e. • Then, by the Phillips curve, u = un. • So inflation is constant. • Because un is constant, so is unemployment.

34. The Medium Run • Inflation is constant. • Because nominal money growth is a policy variable, it changes exogenously and it is more natural to imagine that its constant. • Then, by the aggregate demand curve,output growth must be constant.

35. The Medium Run • Is this constant equal towhich is normal output growth? • It has to be. If it weren’t, u would have to be changing, which is inconsistent withu = un.

36. The Medium Run • t = t-1. • t = e. • ut = ut-1. • ut = un . • For any level of gm.

37. The Medium Run • Alternatively, • Start by assuming that • This makes sense as a definition of the medium run because we want the MR to be a time of rest, stability, constancy.

38. The Medium Run • So Okun’s Law implies that output grows at its normal rate.

39. The Medium Run • Assume nominal money growth is • We know output growth is equal to its normal rate • Then the aggregate demand relation ( ) • implies that inflation is constant:

40. The Medium Run • According to the equation above, in the medium run, inflation equals the difference between nominal money growth and normal output growth. • Call adjusted nominal money growth.

41. The Medium Run • If inflation is constant, then t = t-1, if this is true, the Phillips curve implies that ut = un. Therefore, in the medium run, the unemployment rate must equal the natural rate of unemployment.

42. The Medium Run • Changes in nominal money growth have no effect on output or unemployment in the medium run, because in the medium runut = un and , and neither un nor normal output growth depend on the money supply. • So changes in nominal money growth must be reflected one for one in changes in the rate of inflation.

43. The Medium Run In the medium run, unemployment is equal to the natural rate of unemployment, at any level of inflation. Inflation and Unemploymentin the Medium Run

44. The Medium Run In the medium run, inflation is equal to adjusted nominal money growth. Inflation and Unemploymentin the Medium Run

45. The Medium Run In the medium run, a decrease in adjusted nominal money growth reduces inflation at the same level of unemployment. Inflation and Unemploymentin the Medium Run

46. The Medium Run • Suppose • In the medium run, gyt = • ut = • pt = • Adjusted money growth =

47. From the Short Run to the Medium Run

48. From the Short Run to the Medium Run • Above we defined Okun’s Law as • “Unemployment falls if output grows above the normal growth rate of output.” • But other authors define it as • “Cyclical unemployment arises if if output grows below the normal growth rate of output.”

49. From the Short Run to the Medium Run • If we use this definition of Okun’s Law • And we remember that the Phillips curve is • Then we can write an “Inflation Adjustment” curve. • It will say that inflation rises when output is above normal.

50. From the Short Run to the Medium Run Okun’s Law Phillips’ Curve Inflation-Adjustment curve • An “Inflation Adjustment” curve. • It says that inflation rises when output is above normal.