Unemployment and Inflation
U6301 Macroeconomics for International and Public Affairs
ABC Chapter 12
1
Outline
1. Costs of Unemployment
2. Costs of Inflation
3. Trade-Off between Unemployment and Inflation
4. Unemployment, Inflation, and Monetary Policy
2
Outline
1. Costs of Unemployment
2. Costs of Inflation
3. Trade-Off between Unemployment and Inflation
4. Unemployment, Inflation, and Monetary Policy
3
Costs of Unemployment
At the aggregate level, when u increases
• loss of income in the nation (one can use Okun’s Law to estimate this loss)
• unemployment benefits ↑ (and ↓tax revenue due to ↓GDP) ⇒ ↑ government deficit.
At the individual level,
• unemployed people endure economic, personal and psychological costs that have long-
run consequences (human capital depreciation, etc.)
4
Outline
1. Costs of Unemployment
2. Costs of Inflation
3. Trade-Off between Unemployment and Inflation
4. Unemployment, Inflation, and Monetary Policy
5
Costs of Anticipated Inflation
• Actual inflation is equal to expected inflation, 𝜋 = 𝜋 𝑒
• In this case, the actual (ex-post) value of real variables is consistent with their real value that was
expected in advance (ex-ante).
• Actual real wage conforms with what was expected (an negotiated)
ഥ
𝑊 𝑊ഥ
𝑒 𝑒
𝜋=𝜋 ⟹𝑃=𝑃 ⟹ =
ณ
𝑃 ด𝑒
𝑃
𝐸𝑥−𝑝𝑜𝑠𝑡 𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 𝐸𝑥−𝑎𝑛𝑡𝑒 𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒
• Ex-post interest is equal to the ex-ante real interest rate
𝜋 = 𝜋𝑒 ⟹ 𝑖 − 𝜋 = 𝑖 − 𝜋𝑒
𝐸𝑥−𝑝𝑜𝑠𝑡 𝑟 𝐸𝑥−𝑎𝑛𝑡𝑒 𝑟
• Costs
• menu costs – cost of changing prices
• shoe leather costs –costs that are spent to reduce real money holdings
6
Costs of Unanticipated Inflation
• Actual inflation is different from expected inflation: 𝜋 ≠ 𝜋 𝑒
• When actual inflation is greater than expected inflation, firms and borrowers gain at the expense of workers and lender.
𝑊ഥ ഥ
𝑊
• 𝜋 > 𝜋 𝑒 ⟹ 𝑃 > 𝑃𝑒 ⟹ ณ < 𝑎𝑛𝑑 𝑖 − 𝜋 < 𝑖 − 𝜋𝑒
𝑃 𝑃ณ𝑒
𝐸𝑥−𝑝𝑜𝑠𝑡 𝑟 𝐸𝑥−𝑎𝑛𝑡𝑒 𝑟
𝐸𝑥−𝑝𝑜𝑠𝑡 𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 𝐸𝑥−𝑎𝑛𝑡𝑒 𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒
• The biggest cost of unanticipated inflation is redistribution
• Inflation does not have the same effect on the different income groups.
• When the very poor engage in subsistence activities and not earn a monetary income may not be affected much by an
increase in inflation.
• Those who earns income from wages or government transfers (low and middle income) are hit the most. This group also
spends a greater share of their income on food. They are also more vulnerable because they do not access to more
sophisticated financial assets that can protect from inflation.
• High income people may be less vulnerable because they spend less on food, are more likely to be self-employed or have
greater access to inflation-protected assets.
7
Outline
1. Costs of Unemployment
2. Costs of Inflation
3. Trade-Off between Unemployment and Inflation
4. Unemployment, Inflation, and Monetary Policy
8
Trade-Off between Unemployment and Inflation
• Using UK data from the previous century, William Phillips in the
late 1950s showed that there appeared to be a negative
statistical relationship between the inflation rate (computed, at
that time, on the percentage change in nominal wages) and the
unemployment rate.
• The data implied that policymakers could not eliminate both
unemployment and inflation.
• The apparent trade-off between inflation and unemployment was
taken as a menu of choice for policymakers.
9
Expectations-Augmented Phillips Curve
• During 70s, many countries in the world experienced both high inflation and high
unemployment rates. It seemed that there was no trade-off any longer.
• This result was predicted by Milton Friedman and Ned Phelps who, in the 1960s, argued
that the actual trade-off should be modified to relationship between
• actual inflation and expected inflation (unanticipated inflation): 𝜋 − 𝜋 𝑒
• gap between the actual unemployment rate and the natural rate of unemployment
(cyclical unemployment): 𝑢 − 𝑢ത
• Expectations-Augmented Phillips Curve
𝜋 − 𝜋𝑒 = −ℎ 𝑢 − 𝑢ത
𝑈𝑛𝑎𝑛𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑒𝑑 𝜋 𝐶𝑦𝑐𝑙𝑖𝑐𝑎𝑙 𝑢 10
Phillips Curve
𝜋 − 𝜋𝑒 = −ℎ 𝑢 − 𝑢ത
𝑈𝑛𝑎𝑛𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑒𝑑 𝜋 𝐶𝑦𝑐𝑙𝑖𝑐𝑎𝑙 𝑢
• The equation indicates that the expectations-augmented Phillips
curve will always go through the pair: 𝑢 = 𝑢ത , 𝜋 = 𝜋 𝑒
• The unemployment rate is at the natural rate ⇔ inflation is equal
to its expected value (point A)
𝜋 = 𝜋 𝑒 + ℎ𝑢ത −ℎ
ด𝑢
𝐼𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡 𝑆𝑙𝑜𝑝𝑒
• As a result, a change in either expected inflation or the natural rate of
unemployment would cause the Phillips curve to shift
• Adverse supply shocks also shift Phillips curve
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Outline
1. Costs of Unemployment
2. Costs of Inflation
3. Trade-Off between Unemployment and Inflation
4. Unemployment, Inflation, and Monetary Policy
12
Deriving Phillips Curve
ഥ ⟺ 𝑌 = 𝑌ത ⟺ 𝑢 = 𝑢ത ⟺ 𝜋 = 𝜋 𝑒
Point C: 𝑁 = 𝑁
ഥ ⟺ 𝑌 > 𝑌ത ⟺ 𝑢 < 𝑢ത ⟺ 𝜋 > 𝜋 𝑒
Point B: 𝑁 > 𝑁
ഥ ⟺ 𝑌 < 𝑌ത ⟺ 𝑢 > 𝑢ത ⟺ 𝜋 < 𝜋 𝑒
Point D: 𝑁 < 𝑁
• We will graphically derive the expectations-augmented
Phillips curve using an AD-AS model
• Look at 3 cases (corresponding to C, B, D):
1. anticipated change in money supply
2. money grows more than anticipated
3. money grows less than anticipated
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Anticipated Change in 𝑀𝑆
• Assume that nominal money supply between
2019 and 2020 grows by 5%, holding other
factors that affect the aggregate demand
constant.
• Assume that this policy was anticipated by
market participants.
• The anticipated change in money supply is
neutral
• Inflation rate at C is equal to the expected
𝑒 ) and unemployment is
inflation rate (𝜋20 = 𝜋20
equal to the natural rate (𝑢20 = ഥ
𝑢20 ) ⇒ point C
is consistent with the Phillips curve
14
𝑀𝑆 grows more than expected
• Suppose that between 2019 and 2020 the Central
Bank increases nominal money supply by 10% when
market participants were expecting 𝑀𝑆 to only grow
by 5%.
• Inflation at B is greater than the expected inflation
𝑒
rate (𝜋20 > 𝜋20 ). Also, the actual inflation rate is
greater than 5% but is smaller than 10%
• Because the economy’s GDP is greater than full-
employment GDP, unemployment is lower than the
natural rate (𝑢20 < 𝑢ത 20 )
• Point B is consistent with the Phillips curve and is
located to the North-West of point C 15
𝑀𝑆 grows less than expected
• Suppose that between 2019 and 2020 the Central
Bank increases nominal money supply by only 2%
when market participants were expecting MS to
only grow by 5%.
• Inflation rate at D is lower than the expected
𝑒
inflation rate (𝜋20 < 𝜋20 ).
• Because the economy’s GDP is lower than full-
employment GDP, unemployment is higher than
the natural rate (𝑢20 > 𝑢ത 20 ).
• Point D is consistent with the Phillips curve and is
located to the South-East of point C.
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From SR to LR Equilibrium
• Go back to the case where a growth rate in money supply that exceeds expectations
• To discuss the dynamics the economy from point B on, we need to think about the behavior of expected inflation
• If the 10% growth rate in nominal money supply persists, expected inflation will increase and the long-run
equilibrium on the Phillips curve will be given by point E
• Long-run Phillips curve is vertical. In the long-run, 𝒖 = 𝑢,
ത and inflation is equal to the expected inflation, no
matter what expected inflation is 𝝅 = 𝝅𝒆
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Policy Implications
• Anticipated changes in nominal money supply have no real effects (GDP remains at FE)
• Only unanticipated changes in money supply have real effects. These effects are, however, transitory
• But, why produce a surprise inflation then?
1. Seigniorage Revenue
2. An unanticipated change in money supply causes ex-post inflation to be greater than anticipated. Hence, the
real value of government debt falls. Further, because this policy benefits borrowers, governments pay a lower r
on their debt
3. In the proximity of the election, a politicized Central Bank may be pressured to increase money supply and
reduce unemployment (political-business cycle)
• Important policy implication: if the economy is clearly at FE, a countercyclical macroeconomic policies should not try to
move along PC because these movements will most likely destabilize expected inflation. On the other hand,
countercyclical macroeconomic policies should be used to bring the economy more quickly to FE
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Anchoring Inflation Expectations (Time Permitting)
• If LRPC is vertical, CBs should target the bottom portion of LRPC
• The policy of setting a certain level of 𝜋 𝑒 is known as “anchoring”
• Consider the case of a country where 𝜋 = 𝜋 𝑒 = 30%
• Suppose that CB would like to dis-inflate from 30% to 2%
• Simple solution to “move down” LRPC is to reduce the growth rate in 𝑀𝑆
• If policy is credible, individuals will revise 𝜋 𝑒 accordingly and the economy
would move from point E to point F
• If policy is not credible, workers and firms will maintain 𝜋 𝑒 =30% and the
economy would to point G, which lies on the Phillips curve where 𝜋 𝑒 =30%
• If the unemployment costs of point G are too high, CB may prefer
remaining in E and keep 𝜋 =30%
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Strategies to Anchor Inflation Expectations
1. Money Supply Target
• CB regulates the growth rate in nominal money supply to the expected growth rate in real GDP
2. Exchange Rate Target
• CB maintains the nominal exchange rate constant or under tight control to “import” the inflation
from abroad
3. Inflation Target
• CB announces a specific quantitative inflation goal, say π = 2% that needs to be achieved with
some degree of flexibility over a certain period of time
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