Ch. 13: U.S. Inflation, Unemployment and Business CyclesThe Misery IndexSlide 3Slide 4According to the U.S. experience, inflation tends to ___ during a recession and unemployment tends to ___ during a recession.Slide 6The Evolving U.S. EconomyInflation CyclesSlide 9Inflation Cycles: Demand PullSlide 11Slide 12If there is a decrease in AD, the short run effect is to _____ prices, ____ real wages, and cause unemployment to _____.Inflation Cycles: Cost PushSlide 15Inflation Cycles: Cost PushInflation Cycles & Inflation ExpectationsIf there is exceptionally good weather in the U.S., this should cause SAS to _____. The short run effect of this is to _____ prices and _____ real GDP.Slide 19AD/AS representation of impact of inflation > expected inflationAD/AS representation of impact of inflation < expected inflationIf the Federal Reserve creates more money than people expected, in the short run, this will cause real wages to ____ and unemployment to______.The Phillips CurveSlide 24Slide 25Slide 26If the Federal Reserve cuts interest rates unexpectedly, this should causeIf the general public begins to believe that the Federal Reserve stimulus is going to lead to higher inflation in the future, this should cause:The Phillips Curve in U.S.Business CyclesSlide 32Real Business Cycles: InvestmentReal Business Cycles: LaborSlide 35Ch. 13: U.S. Inflation, Unemployment and Business CyclesDemand-pull and cost-push inflation.SR and LR tradeoff between inflation and unemployment (Phillips Curve)Business cycle theories.The Misery IndexMI proposed by Arthur Okun in 1970sMI = inflation rate plus the unemployment rate.MI peak: 21 in 1981MI minimum: 6 in 1964 and 1999.MI in 2007: 4.5% unempl + 4.0% inflation = 8.5%We want both low inflation & low unemployment – are there trade-offs between the two?0 20misery index01jan1950 01jan1960 01jan1970 01jan1980 01jan1990 01jan2000 01jan2010date5The Misery IndexInflation and Unemployment in U.S. 1950-2008According to the U.S. experience, inflation tends to ___ during a recession and unemployment tends to ___ during a recession.201. Rise; rise2. Rise; fall3. Fall; fall4. Fall; riseReal GDP and the Price Level: 1948-2008The Evolving U.S. EconomyInflationThe upward movement of the dots shows inflation.Recession Leftward movement of dots shows declining real GDPEconomic GrowthThe rightward movement of the dots shows the growth of real GDP.Inflation CyclesIn the long run, according to equation of exchange:• inflation = %ch in M + % ch in V - %ch in y• inflation occurs if money grows faster than potential GDP.In the short run, •Inflation can be initiated by–Increases in AD (demand pull inflation)–Decreases in SAS (cost push inflation)Inflation CyclesDemand-Pull Inflation•starts because AD increases•can begin with any factor that increases AD. • Examples–Monetary policy & interest rates–Fiscal policy: government spending or taxes–Exports (value of $ or foreign income levels)–Investment (expected profits, technological advances)–Consumer expectationsInflation Cycles: Demand PullStarting from full employment, an increase in AD•Increases P (spell of inflation)•Increases RGDP•Creates inflationary gapInflation Cycles: Demand PullSince unempl < natural rate • money wage rate rises• SAS shifts left• P rises (another spell of inflation) •RGDP falls until GDP=potential GDP• Inflation is finished unless AD increases again.Inflation Cycles: Demand PullDemand-Pull Inflation Process•AD must continually increase so that the process described above repeats itself•Although any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.If there is a decrease in AD, the short run effect is to _____ prices, ____ real wages, and cause unemployment to _____.201. Decrease; decrease; increase2. Decrease; increase; increase3. Increase; decrease; decrease4. None of the aboveInflation Cycles: Cost PushCost-Push Inflation•starts with an increase in costs•Possible sources of increased costs:– An increase in the money wage rate–An increase in the money price of raw materials (e.g. oil)–Natural disasters–Regulation (e.g. carbon taxes)•Results in decrease in SASInflation Cycles: Cost PushInitial Effect of a Decrease in ASA rise in the price of oil decreases SAS and shifts the curve leftward.Real GDP decreases and the price level rises.“stagflation” (higher prices, less output)Inflation Cycles: Cost Push Aggregate Demand ResponseThe initial increase in costs creates a one-time rise in the price level, not continued inflation.To create inflation, AD must increase after AS decreases. Although any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.Inflation Cycles & Inflation ExpectationsExpected InflationIf inflation is expected,• AD increases • AS decreases as workers negotiate wage increases to offset expected inflation.Movement along LAS curve • No change in real GDP, real wages, or unemploymentIf there is exceptionally good weather in the U.S., this should cause SAS to _____. The short run effect of this is to _____ prices and _____ real GDP.201. Decrease; increase; increase2. Increase; decrease; increase3. Increase; increase; increase4. None of the aboveInflation Cycles & Inflation ExpectationsWhen the inflation forecast is correct, the economy operates at full employment. If AD grows faster than expected,•Inflation > expected•Real wages decrease–Real GDP increases above potential–Unemployment rate falls below natural rate If AD grows slower than expected•Inflation < expected–Real wages rise–Unemployment rate rises above natural rateAD/AS representation of impact of inflation > expected inflationAD/AS representation of impact of inflation < expected inflationIf the Federal Reserve creates more money than people expected, in the short run, this will cause real wages to ____ and unemployment to______.201. Rise; rise2. Rise; fall3. Fall; fall4. Fall; riseThe Phillips CurvePhillips curve•shows the relationship between the inflation rate and the unemployment rate.SR Phillips curve–Shows tradeoff between inflation and unemployment holding constant»The expected inflation rate» The natural unemployment rateLR Phillips curve•shows the relationship between