CHAPTER 9 Inflation Activity and Nominal Money Growth Prepared by Fernando Quijano and Yvonn Quijano And modified by Gabriel Martinez 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard 9 1 Output Unemployment and Inflation This chapter builds on three relations 1 Okun s Law which relates the change in unemployment to output growth 2 The Phillips curve which relates the changes in inflation to unemployment 3 The aggregate demand relation which relates output growth to both nominal money growth and inflation 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Output Growth Unemployment Inflation and Nominal Money Growth 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output Growth to Unemployment 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output 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 Yt Yt 1 ut u t 1 g Yt 1 g yt Ut ut Lt yt 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output Growth to Unemployment ut u t 1 g yt 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output 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 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output Growth to Unemployment Changes in the Unemployment Rate Versus Output Growth in the United States 1970 2000 High output growth is associated with a reduction in the unemployment rate low output growth is associated with an increase in the unemployment rate Using thirty years of data the line that best fits the data is given by u t u t 1 0 4 g y t 3 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law Across Countries The coefficient in Okun s law gives the effect on the unemployment rate of deviations of output growth from normal A value of of 0 4 tells us that output growth 1 above the normal growth rate for 1 year decreases the unemployment rate by 0 4 Table 1 Country Okun s Law Coefficients Across Countries and Time 1960 1980 1981 2003 United States United Kingdom 0 39 0 15 0 39 0 54 Germany Japan 0 20 0 02 0 32 0 12 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output Growth to Unemployment ut u t 1 0 4 g yt 3 According to the equation above If g yt 3 th e n u t u t 1 0 4 0 If g yt 3 th e n u t u t 1 0 4 0 If g yt 3 th e n u t u t 1 0 4 0 0 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output 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 gy Output growth 1 above normal leads only to a 1 reduction in unemployment 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard Okun s Law From Output Growth to Unemployment ut ut 1 g yt g y 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 2003 Prentice Hall Business Publishing g yt g y ut u t 1 g yt g y ut u t 1 Macroeconomics 3 e Olivier Blanchard Okun s Law From Output Growth to Unemployment ut ut 1 0 4 g yt 3 Assume u 6 t 1 gyt 4 5 6 2 1 0 gyt 3 ut gyt ut ut 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard The Phillips s Curve From Unemployment to Inflation 2003 Prentice Hall Business Publishing Macroeconomics 3 e Olivier Blanchard The Phillips Curve From Unemployment to Inflation e t t ut un Inflation depends on expected inflation and on the deviation of unemployment from the natural rate of unemployment Suppose