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Economics principles tools and applications 9th by sullivan sheffrin perez chapter 16

Economics

NINTH EDITION

Chapter 16
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The Dynamics of
Inflation and
Unemployment

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Learning Objectives

16.1 Describe how an economy at full unemployment with inflation differs from one without inflation.
16.2 Explain the relationship between inflation and unemployment in the short run and long run.
16.3 Discuss why increasing the credibility of a central bank can reduce inflation.
16.4 Define the velocity of money.
16.5 Identify the origins and causes of hyperinflation.


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16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (1 of 3)

Inflation in a Steady State


Nominal wages
Wages expressed in current dollars.



Real wages
Wage rates paid to employees adjusted for changes in the price level.



Money illusion
Confusion of real and nominal magnitudes.



Expectations of inflation
The beliefs held by the public about the likely path of inflation in the future.

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16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (2 of 3)

Inflation in a Steady State
INFLATION EXPECTATIONS AND INTEREST RATES
When the public expects inflation, real and nominal rates of interest will differ because we need to account for inflation in calculating the real return from lending and borrowing.

INFLATION EXPECTATIONS AND MONEY DEMAND

REAL – NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing power—not its “face” value.


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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (1 of 4)



Expectations Phillips curve
The relationship between unemployment and inflation when taking into account expectations of inflation.

TABLE 16.2 Expectations and Business Fluctuations

When the economy experiences a …

Unemployment is…

Inflation is …

boom

below the natural rate.

higher than expected.

Recession

above the natural rate.

lower than expected.

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16.1 MONEY GROWTH, INFLATION, AND INTEREST RATES (3 of 3)

How Changes in the Growth Rate of Money Affect the Steady State

TABLE 16.1 Money, Inflation, and Interest Rates in a Steady-State Economy

Money

Growth in

Real Interest

Nominal

Growth Rate

Inflation

Money Demand

Rate

Interest

4%

4%

4%

2%

6%

5%

5%

5%

2%

7%

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APPLICATION 1



SHIFTS IN THE NATURAL RATE OF UNEMPLOYMENT



APPLYING THE CONCEPTS #1: How can data on vacancies and unemployment be used to measure shifts in the natural rate?



The natural rate of unemployment changes over time.



Policy makers need to know what the natural rate is to avoid unnecessary unemployment and inflation.



One way to estimate is to look at the Beveridge Curve, the relationship between job vacancies and the unemployment rate.



Economist William Dickens tracked the natural rate in recent decades:
Five percent in the mid 1960s
Peaked near seven percent in the late 1970s and early 1980s
Falling through the 1990s and reached five percent in 2000

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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (2 of 4)

Are the Public’s Expectations About Inflation Rational?


Rational expectations
The economic theory that analyzes how the public forms expectations in such a manner that, on
correctly.

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average, they forecast the future


16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (3 of 4)

U.S. Inflation and Unemployment in the 1980s
Inflation rose and the unemployment rate fell below the natural rate.

Inflation later fell as unemployment exceeded the natural rate.

SOURCE: Economic Report of the President (Washington, D.C.: U.S.
Government Printing Office, yearly).

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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (4 of 4)

Shifts in the Natural Rate of Unemployment in the 1990s



What factors can shift the natural rate of unemployment?



Demographics



Institutional changes



The recent history of the economy



Changes in growth of labor productivity

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16.3 HOW THE CREDIBILITY OF A NATION’S
CENTRAL BANK AFFECTS INFLATION (1 of 2)

If workers push up their nominal wages, the aggregate supply curve will
shift from AS0 to AS1.

If the Fed keeps aggregate demand constant at AD0, a recession will
occur at point a, and the economy will eventually return to full
employment at point c.

If the Fed increases aggregate demand, the economy remains at full
employment at b, but with a higher price level.

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16.3 HOW THE CREDIBILITY OF A NATION’S
CENTRAL BANK AFFECTS INFLATION (2 of 2)

Countries in which central banks are more independent from the rest of the
government have, on average, lower inflation rates.

SOURCE: Based on selected data in Table 5 of “Measuring the Independence
of Central Banks and Its Effect on Policy Outcomes,” Alex Cukierman, Steven
Webb, and Bilin Neyapti, The World Bank Economic Review, 6:3, 353–398.

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APPLICATION 2



ESTIMATING THE NATURAL REAL INTEREST RATE



APPLYING THE CONCEPTS #2: How does the Fed use the concept of the natural interest rate to conduct monetary policy?

In addition to being concerned about shifts in the natural rate of unemployment, the Fed also worries about shifts in the natural rate of interest.

The natural rate of interest is defined as the real interest rate consistent with full employment after temporary demand and supply shocks have subsided.

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16.4 INFLATION AND THE VELOCITY OF MONEY (1 of 3)


Velocity of money
The rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

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16.4 INFLATION AND THE VELOCITY OF MONEY (2 of 3)


Quantity equation
The equation that links money, velocity, prices, and real output. In symbols, we have M × V = P × y.

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▼FIGURE 16.4
The Velocity of M2, 1959–2011

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16.4 INFLATION AND THE VELOCITY OF MONEY (3 of 3)


Growth version of the quantity equation
An equation that links the growth rates of money, velocity, prices, and real output.





growth rate of money + growth rate of velocity
= growth rate of prices + growth rate of real output

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16.5 HYPERINFLATION (1 of 2)



Hyperinflation
An inflation rate exceeding 50 percent per month.
TABLE 16.3 Hyperinflations and Velocity
Country

Dates

Monthly Rate

Monthly Rate of Money Growth

of Inflation
Greece

November 1943 to

Approximate
Increase in Velocity

365%

220%

14.00

19,800%

12,200%

333.00

57%

49%

3.70

November 1944
Hungary

August 1945 to July 1946

Russia

December 1921 to January 1924

SOURCE: Adapted from Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity Theory of Money, ed. Milton Friedman (Chicago: University of Chocago Press, 1956), 26

TABLE 16.4 Hyperinflation in the 1980s

Country

Year

Yearly Rate of Inflation

Monthly Rate of Inflation

Monthly Money
Growth Rate

Bolivia

1985

1,152,200%

118%

91%

Argentina

1989

302,200

95

93

Nicaragua

1988

975,500

115

66

SOURCE: International Financial Statistics, International Monetary Fund.

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16.5 HYPERINFLATION (2 of 2)

How Budget Deficits Lead to Hyperinflation


Seignorage
Revenue raised from money creation.

Government deficit = new borrowing from the public + new money created



Monetarists
Economists who emphasize the role that the supply of money plays in determining nominal income and inflation.

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APPLICATION 3



THE END OF HYPERINFLATIONS



APPLYING THE CONCEPTS #3: Why do hyperinflations end suddenly?



In a classic study of four major hyperinflations, Nobel Laureate Thomas J. Sargent noticed that they ended rather quickly and the ends all followed similar
patterns. He studied the hyperinflations after World War I in Germany, Austria, Hungary, and Poland, some of the most dramatic in world history. In each case, the
hyperinflation ended with the creation of a central bank and change in the way that governments were financed. No longer would the country rely on its central
bank to finance its debt. Instead, debt was sold to private parties who would value the debt based on the ability of the government to meet interest and principal
payments from taxes. Once the governments made these reforms, there was an abrupt end to the hyperinflations and an actual increase in the demand for
money in real terms by the private sector.



Sargent said hyperinflations were ultimately caused by fiscal policy that was financed by money creation and not taxes. He also suggested that inflation could be
tamed rather easily once fiscal reforms were made. While most economists agree with Sargent’s views on the ends of hyperinflation, there is less agreement that
moderate inflations can be ended simply by changing fiscal regimes and not enduring a recession.

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KEY TERMS

Expectations of inflation
Expectations Phillips curve
Growth version of the quantity equation
Hyperinflation
Monetarists
Money illusion
Nominal wages
Quantity equation
Rational expectations
Real wages
Seignorage
Velocity of money

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