Inflation and Unemployment

1. Inflation and Unemployment

2. Money and Inflation • Rise in money supply does not equal a rise in Real GDP in the long run, since price level rises as well by the same percentage • Classical Model of Price Level – Since money supply and price level rise together, the Real Quantity of Money (M/P) stays at the original level • Wages and prices are more responsive to money supply changes in periods of high inflation

3. The Inflation Tax • Printing money to cover debt drives up inflation • Inflation tax is the reduction in value of money held by public when the government prints money to cover deficits • The U.S. can and does raise revenue by printing money – This is what happens when the Fed buys bonds to increase money supply

4. Hyperinflation • During times of inflation, people hold as little money as possible • Printing money (seignorage) creates revenue: (∆M/M) ● (M/P) OR Rate of growth of MS ● Real MS • When govt needs to collect a certain amount but people are holding less money, must increase rate of growth… which can spiral out of control

5. Moderate Inflation and Disinflation • Two shifts can lead to an increase in aggregate price level, emphasizing the importance of: • Cost-push inflation • Demand-pull inflation– which can result from expansionary policies • Economic policies have political ramifications, which explains why inflation can get out of control

6. Output Gap & Unemployment • Output gap is the difference between current level of output and potential output • Because the unemployment rateis the natural rate + cyclical unemployment, there is a relationship between output gap and unemployment rate When aggregate output = YP, unemployment = natural rate When output gap is positive, unemployment < natural rate When output gap is negative, unemployment > natural rate

7. The Short Run Phillips Curve • The SRPC depicts the negative short run relationship between the unemployment rate and inflation rate

8. Inflation Expectations and SRPC • Expected inflation rate is the 2nd most important factor affecting inflation • Actual rate of inflation at any given unemployment rate is higher when expected inflation rate is higher

9. Long Run Phillips Curve • Persistent attempts to keep unemployment low result in accelerating inflation • To avoid this, unemployment must be high enough that actual rate of inflation = expected rate, resulting in nonaccelerating inflation rate of unemployment • NAIRU means there is no longterm tradeoff between unemployment and inflation

10. Long Run Phillips Curve • LRPC is vertical because it is at NAIRU (natural rate) • Economists estimate NAIRU by looking at relationship between inflation rate and unemploymentover the course of the business cycle

11. Costs of Disinflation • To bring down inflation, contractionary policies raise unemployment above the natural rate for an extended period • As a result, the economy loses potential output

12. Deflation • Value of money rising over time • Debt deflation results from borrowers cutting back their spending because of the additional burden of repaying money that is worth more, reducing aggregate demand – which leads to more deflation, which can spiral out of control

13. Effects of Expected Inflation • Fisher Effect shows that interest rates are impacted by expected inflation one-to-one • In case of deflation, interest rates will fall – but they are zero bound – which creates a limit for monetary policy • Interest rate too low leaves no incentive to save and a credit freeze • Liquidity trap results from sharp reduction in demand for loanable funds, causing interest rates to fall so low that monetary policy is ineffective