CHAPTER 14
INFLATION AND UNEMPLOYMENT
After reading Chapter 14, INFLATION AND UNEMPLOYMENT, you should be able to:
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Discuss the difference between DEMAND-SIDE and SUPPLY-SIDE INFLATION.
Explain why persistent monetary growth can cause persistent inflation.
Discuss the role played by VELOCITY and its determinants in causing inflation.
Tell how expected inflation affects nominal interest rates.
Understand the EQUATION OF EXCHANGE and how it can be used as a theory of inflation.
Discuss the theoretical and empirical relationship between government deficits and inflation.
Tell how inflation can affect people's job searches.
Understand the MISERY INDEX as the sum of the inflation rate and unemployment rate.
Describe the PHILLIPS CURVE and explain why economists no longer believe in it.
Define STAGFLATION.
Discuss the SHORT-RUN PHILLIPS CURVE and tell why it is consistent with stagflation.
Explain why inflation fell in the 1990s in the “new era” of stable prices and full employment?
CHAPTER OUTLINE
I. TYPES OF INFLATION
A.
There are two basic types of inflation:
1. DEMAND-SIDE INFLATION is when aggregate demand increases and causes inflation.
2. SUPPLY-SIDE INFLATION is when aggregate supply falls and causes inflation.
II. VELOCITY, INFLATION, AND INTEREST RATES
A.
B.
C.
Persisting inflation requires persisting increases in aggregate demand. Constant money growth in
excess of the growth in real GDP causes continuing inflation. Increases in government spending
may be a second source of inflation.
The VELOCITY OF CIRCULATION measures the average number of times a dollar changes
hands during the year, that is, it measures the speed with which money is spent. Velocity equals
(GDP) / (M).
1. Increases in velocity magnify the inflationary effect of monetary growth.
2. Since 1929, velocity has doubled. This increase in velocity together with steady growth in the
money supply is a cause of on-going inflation.
3. Velocity rises when interest rates increase because higher interest rates increase the opportunity
cost of holding money.
4. The EQUATION OF EXCHANGE states that MV = PY.
5. The equation of exchange can be used to state inflation as equaling the growth of the money
supply plus the growth of velocity minus the growth of real GDP.
The REAL INTEREST RATE is the percentage cost of borrowing, given in terms of purchasing
power; it is adjusted for inflation.
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1.
2.
ADAPTIVE EXPECTATIONS are when people form their inflationary anticipations about
the future from past experiences and only gradually alter their expectations as time passes.
RATIONAL EXPECTATIONS are when people use all available information (past
experiences plus predictions about the future) to form their inflation anticipations.
III. GOVERNMENT SPENDING DEFICITS AND INFLATION
A.
B.
C.
IV.
Government spending and the FEDERAL DEFICIT (the excess of government spending over
government revenues) are potential causes of inflation.
Higher deficits may cause higher inflation if the Federal Reserve buys more government securities,
thereby raising the supply of base money and banks' excess reserves.
Empirical evidence shows a positive relationship between deficits and inflation.
UNEMPLOYMENT
A.
Cyclical unemployment can occur when a reduction in aggregate demand reduces output below the
natural level of real GDP and thereby raises unemployment above the natural rate.
B.
Unemployed workers, searching for jobs, have a RESERVATION WAGE, the minimum wage
offer they must receive in order to accept a job.
1. Unanticipated inflation raises all wages and hence increases the likelihood that unemployed
workers receive a wage offer that exceeds their reservation wage. Hence unanticipated
inflation lowers unemployment.
2. Higher unemployment benefits increase the time workers search, and so raise unemployment.
V. PHILLIPS CURVE
A.
B.
C.
D.
E.
F.
G.
STAGFLATION is the combination of high inflation and high unemployment. Stagflation first
occurred in the 1970s.
The PHILLIPS CURVE shows an inverse relationship between the rate of inflation and the
unemployment rate.
The negative trade-off between inflation and unemployment suggested society faced a hard
decision: to reduce inflation, unemployment had to be raised, or to reduce unemployment, inflation
had to be increased.
The combination of high inflation and high unemployment of the 1970s and 1980s disagreed with
the predictions of the Phillips curve.
The SHORT-RUN PHILLIPS CURVE emphasizes the distinction between anticipated and
unanticipated inflation.
ANTICIPATED INFLATION causes no change in the unemployment rate. The economy remains
at the natural rate of unemployment.
UNANTICIPATED INFLATION gives a negative trade-off between inflation and unemployment
along a short-run Phillips curve.
1. Unanticipated inflation temporarily lowers unemployment.
2. As people and firms revise upward their inflation expectations, unemployment increases and
the short-run Phillips curve shifts up.
3. In the long run, after people and firms have revised their inflation expectations so that they
equal the actual rate of inflation (there is no unanticipated inflation), unemployment returns to
its natural rate.
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REVIEW QUESTIONS
True or False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question
give a short statement that supports your answer.
____ 1.
A one-shot rise in aggregate demand caused by a one-time only increase in the money supply
causes persistent inflation.
____ 2.
Supply-side inflation is when there is an increase in aggregate supply.
____ 3.
Reductions in aggregate supply seem to be the main cause of the inflation experienced in the
United States since 1965.
____ 4.
An increase in velocity magnifies the inflationary effects of growth in the money supply.
____ 5.
The higher are the interest rates, the lower is the velocity.
____ 6.
Adaptive expectations can be rapidly changed if people perceive a change in government
policies.
____ 7.
If an unemployed worker receives a job offer and the offered wage is below the worker's
reservation wage, the worker will not accept the job.
____ 8.
Data from the 1970s and 1980s support the Phillips curve, but data from earlier periods tend to
disagree with it.
____ 9.
The Phillips curve shows that unemployment can be lowered if inflation is raised.
____ 10. The short-run Phillips curve suggests that an unexpected increase in the inflation rate
permanently lowers the unemployment rate.
____ 11. The short-run Phillips curve shifts up as inflation expectations rise.
____ 12. The short-run Phillips curve claims the economy can never move away from the natural rate of
unemployment.
____ 13. The short-run Phillips curve shows that an anticipated increase in the inflation rate lowers the
unemployment rate.
____ 14. In the long run, the unemployment rate reached is the natural rate of unemployment.
____ 15. It is easy to explain stagflation using the Phillips curve.
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Multiple Choice
Circle the letter corresponding to the correct answer.
1.
The short-run Phillips curve suggests unemployment rises when there is
a. an anticipated increase in inflation.
b. an anticipated decrease in inflation.
c. an unanticipated increase in inflation.
d. an unanticipated decrease in inflation.
e. None of the above, because unemployment is not changed by inflation
2.
An adverse supply shock
a. does not cause a lasting inflation.
b. causes persistent inflation.
c. causes wages to rise more rapidly than prices.
d. can cause persisting inflation only if it raises velocity.
e. causes wages and prices to rise by the same amount.
3.
The Phillips curve
a. claims that only unanticipated inflation changes the unemployment rate.
b. suggested that higher inflation caused higher unemployment.
c. has been well supported by the data.
d. claimed that policymakers could achieve both lower inflation and unemployment.
e. was discredited by economic experiences of the 1970s and 1980s.
4.
Which Phillips curve claims unemployment can be permanently reduced by an increase in the inflation
rate?
a. The Phillips curve.
b. The short-run Phillips curve.
c. The natural-rate, long-run trade-off between inflation and unemployment
d. All the Phillips curves make this claim.
e. None of the Phillips curves make this claim.
5.
Suppose the anticipated inflation rate is 12 percent and the actual inflation rate is 7 percent. The shortrun Phillips curve suggests unemployment
a. falls.
b. does not change.
c. rises.
d. The short-run Phillips curve makes no prediction about this.
e. The short-run Phillips curve points out that the effect on unemployment depends on what is causing
the inflation.
6. The misery index:
a. was a term used by Marx.
b. is the sum of inflation and economic growth.
c. refers to a period of declining real GDP.
d. is the sum of inflation and unemployment rates.
e. does not exist.
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7. If real GDP is growing 3%, velocity is stable, and M 5%, the inflation rate is
a. 2%.
b. 3%
c. 4%
d. None of the above.
e. not able to be determined form this information.
Essay Questions
Write a short essay or otherwise answer each question.
1. Using the short-run Phillips curve, complete the following table by telling whether unemployment rises,
falls, or does not change.
Actual Inflation
8%
8%
8%
3%
Anticipated Inflation
12%
8%
5%
5%
Effect on Unemployment
2. The Phillips curve often was said to confront policymakers with a "cruel dilemma" between inflation
and unemployment. What was this "cruel choice"? Does the short run Phillips curve have the same
difficult choice?
3. If a worker is offered a wage of $12/hour, and if the average price of goods is $4/good, how many goods
can be purchased for an hour's work? Suppose the worker has underestimated the inflation rate so that
the worker believes the average price is $3/good. How many goods does the worker believe an hour's
work will buy? Is the worker more likely to accept the job if he or she believes the prices of goods are
$3/good or $4/good?
4. Suppose people's inflationary expectations are formed adaptively. What would be the immediate effect
on inflationary expectations if the government announced that it was going to lower the growth rate of
the money supply?
5. If people's inflationary expectations are formed rationally, what would be the immediate effect on
inflationary expectations if the government announced that it was going to lower the growth rate of the
money supply? Does your answer depend on whether the public believes the government's
announcement?
6. Explain using the evidence at the end of this chapter why some experts think we have entered a new era
of low inflation and low unemployment in the 1990s?
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ANSWERS TO REVIEW QUESTIONS
True or False
False
1.
The one-shot boost in the money supply creates a one-time-only increase in the price level but
does not cause continuing, persistent inflation.
False
2.
Supply-side inflation occurs as a result of a decrease in aggregate supply.
False
3.
Reductions in aggregate supply could be the cause of inflation, but the data show this is not the
case.
True
4.
If velocity increases, money is spent more rapidly, so the inflationary effect of any growth in
the money supply increases.
False
5.
The increase in interest rates lowers people's demand for money. People hold (demand) less
money by spending their money more rapidly, so velocity rises.
False
6.
Adaptive expectations depend on only past events. They do not respond quickly if the
government changes its policies.
True
7.
The reservation wage is the lowest acceptable wage; any job offering to pay a wage more than
or equal to this wage will be accepted, while jobs paying less will be rejected.
False
8.
Precisely the opposite is correct: earlier data tend to support the Phillips curve while the more
recent data have refuted it.
True
9.
The Phillips curve claimed that any time inflation was raised, unemployment would fall.
False
10. The increase in the inflation rate temporarily lowers unemployment.
True
11. As people revise upward their inflation expectations, the short-run Phillips curve shifts up.
False
12. Unanticipated inflation can temporarily lower unemployment below its natural rate;
unexpected deflation can temporarily raise unemployment above the natural rate.
False
13. The short-run Phillips curve shows that increases in unexpected inflation lower the
unemployment rate.
True
14. In the long run, unemployment is independent of the inflation rate.
False
15. Stagflation is when unemployment and inflation are both high. The Phillips curve claimed that
this could not happen because high inflation was said to result in low unemployment.
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Multiple Choice
1. d.
Unanticipated changes in inflation alter unemployment. An unanticipated decrease in inflation
raises unemployment.
2. a.
Like a single expansionary aggregate demand shock, a single adverse supply shock raises the price
level but does not cause a persistent, on-going inflation.
3. e.
The 1970s and 1980s brought stagflation, an experience that could not be explained by the Phillips
curve.
4. a.
The Phillips curve concluded that an increase in the inflation rate permanently lowers the
unemployment rate.
5. c.
If actual inflation is less than what people anticipated, unemployment rises.
6. d.
The misery index is the sum of inflation and unemployment rates.
7. a.
With velocity fixed, inflation equals money growth minus real GDP growth.
Essay Questions
1.
Actual Inflation Anticipated Inflation
8%
12%
8%
8%
8%
5%
3%
5%
Effect on Unemployment
Rise
Not Change
Fall
Rise
Whenever the actual inflation exceeds the expected inflation, unexpected inflation is positive so
unemployment falls. If actual inflation is less than expected inflation, unemployment rises. If the two
are equal, there is no change in unemployment. It is important to notice that the first three parts of this
question demonstrate how a given amount of actual inflation (8%) can be consistent with a rise, fall, or
no change in unemployment, depending on the level of expected inflation.
2.
The "cruel choice" forced on policymakers was that to lower either unemployment or inflation, the
other must be raised. Thus, if the public disliked both unemployment and inflation, to have less of one
meant that it must suffer more of the other. The short-run Phillips curve does not confront policymakers
with this problem. According to the short-run Phillips curve, in the long run, unemployment does not
depend on the inflation rate. So policymakers can lower the inflation rate confident that in the long run
they are not causing the unemployment rate to rise.
3.
An hour's work actually purchases 3 goods. The worker expects that an hour's work buys 4 goods.
Clearly the worker is more likely to accept the job if he or she thinks an hour's work is worth 4 goods.
This example shows how unexpected inflation can cause workers to more readily accept jobs. If the
worker were aware of how much the actual inflation rate had increased the price of goods, the worker
would be less inclined to accept the job offer.
4.
Adaptive expectations depend on only past experiences. Thus, there would be no immediate effect on
people's expectations.
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5. Rational expectations depend on all available information. So, if people believe the government's
announcement, they would promptly lower their inflationary expectations. If they did not believe the
government, they would not alter their inflationary expectations.
6. The new era of low inflation and low unemployment of the 1990s has supposedly been caused by
increased foreign competition, low energy prices, and the deflationary effects of the crisis in Asia.
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