Output, Unemployment, & Inflation
Three Relations:
1. Phillips Curve: unemployment and the change
in inflation
2. Okun’s Law: growth and the change in
unemployment
3. Aggregate Demand: Money, output, and
prices
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #1
Output, Unemployment, & Inflation
The Phillips Curve: Unemployment and
the Change in Inflation
Assuming:
t
e
equals last year’s inflation,
 t 1 , then:
 t   t   (ut  un )
e
 t   t   (ut  un )
e
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #2
Output, Unemployment, & Inflation
Okun’s Law: The Data
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #3
Output, Unemployment, & Inflation
Okun’s Law: The Equation
ut-ut-1 = -0.4(gyt-3%)
gyt must be at least 3% to keep
unemployment from rising
WHY?
Two factors:
1. Growth in the labor force
2. Increases in the productivity of labor
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #4
Output, Unemployment, & Inflation
Δu = ut - ut-1 = - 0.4(gyt - 3%)
Why is the coefficient only 0.4?
• Firms hoard labor and there is a minimum
number of workers
•Changes in labor force participation
Okun’s Law Coefficients Across Countries
Country
1960-1980
United States
United Kingdom
Germany*
Japan
Blanchard: Macroeconomics
0.39
0.15
0.20
0.10
1981-1998
0.42
0.51
0.32
0.20
Chapter 9: Inflation, Activity, and Money Growth
Slide #5
Output, Unemployment, & Inflation
Okun’s Law
In general, the relation between changes in unemployment and output growth is:
ut  ut 1    (g yt  g y )

gy
: how growth in excess of normal growth
impacts the unemployment rate
: normal growth rate
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #6
Output, Unemployment, & Inflation
The Aggregate Demand Relation: Money
Growth, Inflation, and Output Growth
 Mt
If : Yt  Y 
 Pt
Mt
to
Pt

 then AD is proportion al to

Mt
How does a change in
impact AD?
Pt
Mt

 i  AD (multiplie r)  Y
Pt
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #7

Or going straight to the equation of
exchange:

MV = PY

VdM + MdV = YdP + PdY

dM/M + dV/V = dP/P + dY/Y

gmt + dV/V = πt + gyt
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #8
Output, Unemployment, & Inflation
The Aggregate Demand Relation: Money
Growth, Inflation, and Output Growth
When velocity is constant, dV/V = 0
g yt  g mt   t
g mt  nominal money growth rate
 t  growth rate in prices
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #9
Our Three Relations

Phillips Curve (AS):
Δt = - α (ut – ut)


Okun’s Law:


Δ ut = - β (gyt - gn)
Equation of exchange (AD):

Blanchard: Macroeconomics
gyt = gmt - πt
Chapter 9: Inflation, Activity, and Money Growth
Slide #10
Output, Unemployment, & Inflation
A Scenario: The money growth rate falls
(short-run)
According to:
1. The AD relation, given inflation, output will fall
2. From Okun’s Law, a decrease in growth will
increase unemployment
3. From the Phillip’s Curve, higher unemployment
implies lower inflation
Will the impact end here—what about the medium
run?
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #11
Output, Unemployment, & Inflation
IN MEDIUM RUN: ut = un
(g m )
Assume a constant growth in the nominal money
supply
Medium Run:
gy  gy
  gm  g y
Blanchard: Macroeconomics
(Okun’s Law)
(Aggregate
Demand)
Chapter 9: Inflation, Activity, and Money Growth
Slide #12
Output, Unemployment, & Inflation:
The Medium Run
Inflation Rate, 
Adjusting to a decrease in nominal money growth
If gm decreases to g´m :
u remains at un &  falls
( gm  gy )
A
Adjusted
money growth
(for gm )
( g´m -gy )
B
Adjusted
money growth
Natural
unemployment rate
(for g´m  gm )
un
Unemployment Rate, u
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #13
Output, Unemployment, & Inflation
Disinflation: How much unemployment? And for how long?
Scenario: Reduce inflation from 14 to 4 percent &  = 1
 t   t 1
=   (ut  un )
Time period: 1 yr: 4  14  1(ut  un )  10%  10%
2 yrs: Year 1, -5% = -5% Year 2,
-5% = -5%
5 yrs: 5 yrs of unemployment
2% above un
10 yrs: 10 yr of unemployment
1% above un
Conclusion: Point years of excess unemployment equals 10
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #14
Output, Unemployment, & Inflation
Disinflation: How much unemployment?
And for how long?
The Sacrifice Ratio:
Excess point years of
unemployment
Decrease in Inflation
If  = 1, what is the sacrifice ratio?
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #15
Output, Unemployment, & Inflation
Working on the required path of money growth
A Scenario: Reduce inflation from 14% to 4% in 5 years
gu  3%, un  6.5%,  1,   0.4
Before
0
1
Inflation (%)
Year
Disinflation
2
3
4
5
6
After
7
8
14
12
10
8
6
4
4
4
4
Unemployment rate
(%)
6.5
8.5
8.5
8.5
8.5
8.5
6.5
6.5
6.5
Output growth (%)
3
-2
3
3
3
3
8
3
3
Nominal money
growth (%)
17
10
13
11
9
7
12
7
7
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #16
Output, Unemployment, & Inflation
The disinflation path
16
Inflation Rate (percent)
Year 0
14
A
12
Year 1
10
Year 2
Year 3
8
Year 4
6
Year 5
4
C
Year 6+
B
2
2.5
4.5
6.5
8.5
10.5
Unemployment Rate (percent)
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #17
Output, Unemployment, & Inflation
The Disinflation Path
Conclusions:
•
The transition to lower money growth and
inflation is associated with a period of higher
unemployment
•
Regardless of the path, the number of pointyears of excess unemployment is the same
•
In the medium run: output and unemployment
return to normal
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #18
Output, Unemployment, & Inflation
This model indicates that policy can change the
timing but not number of point-years of excess
unemployment.
Two challenges to this model:
•
Expectations, credibility
•Lucas – Rat-X
•Sargent – Low sacrifice in history
•
Nominal rigidities and contracts
•Fischer – sticky wages
•Taylor – staggered contracts
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #19
Output, Unemployment, & Inflation
Expectations & Credibility: The Lucas Critique
•
•
The previous model assumed:  te =  t-1
What if  te is based on an expectation that Fed
policy would reduce inflation from 14% to 4%.
Then:    e   (u  u )
t
t
4% = 4%
t
-
n
0%
•
Inflation falls to 4% and unemployment
remains at the natural rate
•
Reduction in money growth could be neutral
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #20
Output, Unemployment, & Inflation
Disinflation Without Unemployment in the Taylor
Model
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #21
Output, Unemployment, & Inflation
The U.S. Disinflation, 1979-1985
1979

Unemployment = 5.8%

GDP growth = 2.5%

Inflation = 13.3%

The Fed shifted from targeting interest to
targeting the growth rate of nominal money
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #22
Output, Unemployment, & Inflation
The U.S. Disinflation, 1979-1984
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #23
Output, Unemployment, & Inflation
The U.S. Disinflation, 1979-1984
Did Fed credibility reduce the sacrifice ratio?
1979 1980 1981 1982 1983 1984 1985
1. GDP growth (%)
2.5
2. Unemployment rate
(%)
5.8
3. CPI Inflation (%)
13.3
4. Cumulative
unemployment
5. Cumulative disinflation
6. Sacrifice ratio
-0.5
1.8
-2.2
3.9
6.2
3.2
7.1
12.5
7.6
8.9
9.7
3.8
9.6
3.8
7.5
3.9
7.2
3.8
1.7
4.4
0.39
4.9
9.5
0.51
8.0
9.5
0.84
9.0
9.4
0.95
9.7
9.5
1.02
0.6
0.8
0.75
Cumulative unemployment is the sun of point-years of excess unemployment from 1980 on, assuming
a natural rate of 6.5%.
Cumulative disinflation is the difference between inflation in a given year and inflation in 1979. The
sacrifice ratio is the ratio of cumulative unemployment to cumulative disinflation.
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #24
Output, Unemployment, & Inflation
The U.S. Disinflation, 1979-1984
Observations

Disinflation was associated with high
unemployment

The sacrifice ratio was very close to 10%
disinflation with 10 point-years of excess
unemployment

Phillips Curve relation was very robust
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #25
Output, Unemployment, & Inflation
Disinflation Experiences in 19 OECD Countries

Disinflation leads to higher unemployment

Faster disinflations are associated with
small sacrifice ratios (Lucas/Sargent)

Sacrifice ratios are smaller in countries that
have shorter wage contracts (Fischer &
Taylor)
Blanchard: Macroeconomics
Chapter 9: Inflation, Activity, and Money Growth
Slide #26