Intermediate Macro:
Unemployment & Inflation
(the twin evils of Macro)
Jeffrey H. Nilsen
Inflation and Unemployment Ch. 12
Intro, Measuring
(ch. 1, 2)
Monetary Policy
(ch. 14)
Fiscal Policy
(ch. 15)
Business Cycles (ch. 8)
IS-LM, AD-AS
Classics (RBC)
Keynesians
Labor Market
Ch. 3
Ch. 9
Ch. 10
Ch. 11
Goods Market
Ch. 4,5
Open
(ch. 5, 13)
Growth (ch. 6)
Asset Market
Ch. 7
FT: Inflation in Emerging Markets
 http://video.ft.com/942829481001/Inflation-hitsemerging-markets/Markets
Phillips (1958)
 Using 97 years of UK (U, W growth) data, Phillips
found that :
 U was low when W rising
 U was high when W falling
  h  U
(h constant > 0)
Figure 12.1 The Phillips curve in the
1960s U.S.
Data in 60s seemed to confirm
Keynesians: There’s policy trade-off: if take higher π I’ll get
lower U !!
Friedman, Phelps
(in the 60s, at the time when data supported Phillips)
 NO, there can NEVER be a causal relation between a
nominal & a real variable !!
 However there’s a stable surprise inflation to cyclical
U relation
 The Expectations Augmented Phillips Curve (EAPC)



 h  U  U N


surprise 
cyclical U
e
US data: π vs. U (1970–2011)
New data supports Friedman & Phelps:
Negative U vs. π relation vanished !!
Due to greater πe & UN
volatility (from e.g. oil shocks)

US EAPC (1970 – 2011)
(surprise π) vs. (cyclical U) relation
is STABLE (supports EAPC)
EAPC is where
the Public & Central Bank Interact


 


 EAPC is anchored by:


 h  U  U N


surprise 
cyclical U
e
 πe value (set by public)
 UN value (set by FE employment)
 (Original Philips’ curve if constant UN & πe)
 E.g. π = πe = 3% then Y = YFE => U = UN at (point A)
Effect of π on U (≠ UN) depends on public’s πe
The BNB waits for the public to move and, seeing πe, UN , sets π
Eurozone inflation; is it too low ?
http://video.ft.com/3417006306001/Draghis-deflation-dilemma/editorschoice
Misperceptions’ Intuition for EAPC
 If surprise M rise, then π > πe
 Y > YFE (firms raise output thinking own P rose)
 AD shifts more than AS (G where U < UN)
 Result:
(π – πe) > 0 => (U - UN) < 0
 (inflation surprise > 0 => cyclical U < 0)
 Logic on short-run EAPC (unchanged UN & πe)
 π > πe = 3% => U < UN (move up & to left along
fixed EAPC from A)






 h  U  U N


surprise 
cyclical U
e
No Surprise
 Fed increases M (hence π) = public
expects: (π – πe = 0) no change in Y:
Y = YFE
 AS, AD shift up equal amounts to H
 EAPC: cyclical U or (U - UN) = 0,
Economy stays at A
Shifts In EAPC
 Public increases πe to 6% EAPC shifts up
 Fed choose to set either:
 π = 6%
to get U = UN (at F)
 π = 3%
to get U > UN (at Z)
 Public expects higher inflation, if Fed doesn’t
give it to them, recession !!
 E.g. AS shock increases UN to 7%:
 U = UN shifts out
 EAPC also shifts out so π = πe = 3% gives UN
(at J)
Z
Figure 12.9 Actual and natural unemployment
rates in the United States, 1960–2011
Sources: Actual unemployment rate, Federal Reserve Bank of St. Louis FRED database at
research.stlouisfed.org/fred2, series UNRATE; natural rate of unemployment: Congressional Budget Office,
www.cbo.gov/ftpdocs/100xx/doc10014/Mar09Web_Tbl_potential.xls.
Keynes vs. Neoclassics
How πe Changes Affect EAPC
 Neoclassics: rational expectations => M policy affects
π & πe at same time
 So can’t deviate from UN except in the very short run
 Keynesian: public partly bases πe on past info so M
rise => π > πe => U < UN
 In long run, everyone agrees: U returns to UN
whatever the π (neutral M)
Problem of Unemployment
 Costs of U: Both N & Y drop => U benefits and lost output
are cost to society. Estimate costs by Okun’s Law (each 1%
U > UN cuts GDP 2%)
 Psychological cost to families affected by joblessness,
especially if long spell
 But frictional U (matching workers and jobs) raises future
productivity
 But workers enjoy more “leisure” (but “enjoyment” drops
with greater leisure). The jobless are unlikely to enjoy it
much without feel job
U
 UN Causes important since determines long run U. Estimate 5 – 5.5%. Falling
since 6% in 80s due to fewer (U-prone) teens in LF
 Some say UN < 5% (citing 90s U 4% without π) due to better labor matching
 Or workers’ (rising productivity driven) W demands lag MPN rises => firms
increase N to temporarily cut UN
 European hysteresis (UN changes follow U changes) explain sticky high U
 When U high, workers lose skills, worsening worker-job mismatch
 European market bureaucratic: firms hesitate to hire difficult-to-fire workers
 Insider-outsider: unions seek highest W/P maintaining current N (insiders
gain) => but W set too high to hire new workers
 Policies to Cut UN:
 Help job training (firms lack incentive to train due to turnover)
 Increase flexibility: cut regulations to cut costs of hiring workers
 Reform U insurance since insurance increases time spent looking for work
Costs of Inflation
 Perfectly anticipated: all relative P unchanged (W & P rises equal) =>
purchasing power unchanged
 Savings also not hurt since nominal interest rate compensates for π
 Hold less M (suffer shoe leather costs of avoiding π costs, e.g. extra trips to
bank)
 Expend resources to change nominal P (menu costs, believed small)
 Unanticipated:
 Transfers wealth savers vs. borrowers (no aggregate loss, but people
“waste” resources to forecast and protect against it)
 Distorts relative P: farmers need PWH/PCO to know correct crop for max
profits: in erratic π, farmers confuse P rise with goods’ supply/demand shifts
 Hyperinflation drastically raises π’s cost. High shoe leather costs to avoid
holding M
 Destroys tax-collecting ability since any delay cuts value to government
 Economy reverts to barter, P no longer signal supply and demand changes
Disinflation
The only factor that can bring sustained AD increases is high M growth
If π excessive, the Fed sets contractionary policy to slow M growth, cut π
(recall Romer dates in discussion of empirical evidence on pro-cyclical M)
 Disinflation: when Fed slows M
growth to cut π
 EAPC predicts a recession until public
cuts πe
Disinflation Strategies
Neoclassic vs. Keynesian
https://www.youtube.com/watch?v=L832Jj7C0DA
 Neoclassic (“Cold Turkey”): cut M growth
quickly to go immediately from F to A
 Public cuts πe to 3% believing Fed’s promise to cut
π to 3%
 Keynesians: bad idea: cold turkey brings high U
since slow P adjustment
 Need “Gradualism” (slow M growth cut): let
firms cut P: move from F to B
 Since gradualism more sustainable, public likelier
to cut πe
 For both strategies, public needs to believe Fed
will continue disinflation and not get cold feet

B
Figure 12.10 Expected inflation rate 1971–2012
Sources: Survey of Professional Forecasters, Federal Reserve Bank of Philadelphia, available at www.philadelphiafed.org.
The Role of Credibility in Disinflation
 If the Fed’s announced disinflation widely believed
(i.e. credible): lower cost to disinflate (less U while
reducing inflation)
 An unyielding gov’t is more credible
 Independent central bank more credible than one
controlled by the finance ministry
 Volcker disinflation in 1979-82 caused high U
Other Policies to Disinflate?
Wage & Price Controls
 May cause shortages since mask relative price
changes
 If money continues expansionary with price controls
in place, public has greater πe when controls removed
 If the expected inflation rate is unchanged, a fall in
the natural rate of unemployment would
 (a) shift the Phillips curve to the right.
 (b) not shift the Phillips curve.
 (c) shift the Phillips curve to the left.
 (d) shift the Phillips curve to the left and shift the
long-run Phillips curve to the right.
 Historically, Brazil has suffered higher and more
variable rates of inflation than Venezuela. You would
expect the short-run aggregate supply curve of Brazil
to be _____ than that of Venezuela, and the Phillips
curve of Brazil to be _____ than that of Venezuela.
 (a) flatter; flatter
 (b) flatter; steeper
 (c) steeper; flatter
 (d) steeper; steeper
 The relationship between inflation & unemployment is given by
π = πe – 5(u – 0.06).
 (a) What is the value of the natural rate of unemployment?
 (b) Graph the short-run and long-run Phillips curves. Be precise
about their intercepts. Assume expected inflation = 0.10.
 (c) If actual inflation is 0.05 and expected inflation = 0.10, what
is the unemployment rate?
 (d) If actual inflation is 0.15 and expected inflation = 0.10, what
is the unemployment rate?
 (e) If the natural rate increased to 7% for the same expected
inflation rate, what would happen to the various Philips curves?