Ch. 13: U.S. Inflation, Unemployment and Business CyclesThe Misery IndexSlide 3Slide 4The Evolving U.S. EconomyInflation CyclesSlide 7Inflation Cycles: Demand PullSlide 9Slide 10Inflation Cycles: Cost PushSlide 12Inflation Cycles: Cost PushInflation Cycles: Cost PushSlide 15Inflation Cycles & Inflation ExpectationsSlide 17The Phillips CurveSlide 19Slide 20Slide 21Slide 22The Phillips Curve in U.S.Business CyclesSlide 26Slide 27Slide 28Slide 29Slide 30Ch. 13: U.S. Inflation, Unemployment and Business CyclesPatterns in output and inflation in the evolving U.S. economy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?Real 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, • 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 caused by–Increases in AD (demand pull inflation)–Decreases in SAS (cost push inflation)Inflation CyclesDemand-Pull Inflation•An inflation that starts because aggregate demand increases•can begin with any factor that increases aggregate demand. • Examples–cut in the interest rate–increase in the quantity of money–increase in government expenditure–tax cut–increase in exports–increase in investmentInflation Cycles: Demand PullStarting from full employment, an increase in AD•Increases P (inflation)•Increases RGDP•Creates inflationary gap•increase in ADInflation Cycles: Demand PullSince unempl < natural rate • money wage rate rises• SAS shifts left• P rises •RGDP falls until GDP=potential GDPInflation 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 aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.Inflation Cycles: Cost PushCost-Push Inflation•starts with an increase in costs•Main 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 •Results in decrease in SASInflation Cycles: Cost PushInitial Effect of a Decrease in Aggregate SupplyA rise in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward.Real GDP decreases and the price level rises.“stagflation”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, aggregate demand must increase. That is, the Fed must increase the quantity of money persistently.Inflation Cycles: Cost PushSuppose that the Fed stimulates AD to counter the higher unemployment rate and lower level of real GDP.Real GDP increases and the price level rises again.Inflation Cycles: Cost PushA Cost-Push Inflation ProcessIf oil producers raise the price of oil & workers raise wages to try to offset price level increase, SAS shifts left againif Fed responds by increasing M yet again, cost-push inflation continues.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 unemploymentInflation Cycles & Inflation ExpectationsInflation and the Business Cycle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 rateThe 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 inflation and unemployment when the actual inflation rate equals expected inflation • vertical at natural rate of unemploymentThe Phillips CurveThe Short-Run Phillips Curve The short-run Phillips curve shows the tradeoff between the inflation rate and unemployment rate, holding constant1. The expected inflation rate2. The natural unemployment rateThe Phillips CurveA short-run Phillips curve (SRPC)• As inflation increases, unemployment decreases•AD/AS explanation.If inflation=expected, unemployment = natural rate. If inflation>expected, unemployment<natural rateIf inflation < expected, unemployment>natural rateThe Phillips CurveThe long-run Phillips curve (LRPC)•vertical at the natural unemployment rate.• intersects SRPC at expected inflation rate.• Shifts only if natural unemployment rates rises or falls–Unemployment insurance–Demographics of labor forceThe Phillips CurveSRPC shifts up/down as inflation expectations rise/fallThe Phillips Curve in U.S.Business CyclesTwo approaches to understanding business cycles are: Mainstream business cycle theory Real business cycle theoryMainstream Business Cycle TheoryBecause potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.Business CyclesInitially, potential GDP is $9 trillion and the economy is at full employment at point A.Potential GDP increases to $12 trillion and the LAS curve shifts rightward.Business CyclesReal Business Cycle TheoryArgues that random fluctuations in productivity are the main source of economic fluctuations.•productivity fluctuations result mainly from fluctuations in the pace of