Introduction to Macro
Policy and Models
The Policy Tradeoff:
Unemployment vs.
Changes in Inflation
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Focus Today
Simple Micro: Prices, Demand and Supply
 Simple Dynamics: Disequilibrium Means
Change
 An example central to policy choices:
managing the economy to produce a
desired outcome

Simple Micro in the Labor Market :
Prices, Demand and Supply
 Demand:
More Workers/Hours Will Be
Demanded by Employers the Lower the
Real Wage, Other Things Equal
 Supply: More Hours Will Be Supplied by
Individuals the Higher the Real Wage
 Equilibrium: Demand=Supply
»All Those Wanting to Work at the
Current Real Wage Can Find Work
after a Reasonable Period of Search
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Simple Micro in the Labor Market :
Prices, Demand and Supply
REAL
WAGE
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DEMAND
EQUILIBRIUM
SUPPLY
WORKERS or HOURS DEMANDED AND SUPPLIED
Simple Dynamics: Disequilibrium
Means Change in the Labor Market
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Unemployed Workers:
– Voluntary, as in searching for a job at a
wage higher than they or their peers are
being offered: not a sign of
disequilibrium
– Involuntary: Would accept the
prevailing wage but no offer
forthcoming.
»By definition, Supply greater than
Demand...at the prevailing wage
 Involuntary Unemployment Creates
Pressure for (Real) Wages to Fall

Simple Dynamics: Disequilibrium
Means Change in the Labor Market
REAL
WAGE
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DEMAND
DISEQUILIBRIUM
SUPPLY
INVOLUNTARY
UNEMPLOYMENT
WORKERS / HOURS DEMANDED AND SUPPLIED
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Fluctuations in Unemployment
10
9
8
7
6
5
4
3
2
1
0
Job Losers
Reenter
New Entrants
Job Leavers
1967
1971
1975
1979
1983
1987
1991
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Fluctuations in Unemployment
DEMOGRAPHICS AND THE UNEMPLOYMENT RATE
6.4
25
6.2
23
6
21
5.8
19
5.6
17
5.4
15
5.2
13
5
11
4.8
19
50
19
52
19
54
19
56
19
58
19
60
19
62
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
27
"YOUNG ADULT SHARE OF POPULATION'
"NAIRU"
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Fluctuations in Unemployment
12
10
8
6
4
2
0
1949 1955 1961 1967 1973 1979 1985 1991 1997
Full Employment Unemployment Rate
Unemployment Rate
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THE APPARENT POLICY OPTIONS
IN THE 1960s
6
1969
CPI INFLATION RATE
5
4
3
1965
2
1962
1
1959
0
-
1.0
2.0
3.0
4.0
5.0
UNEMPLOYMENT RATE
6.0
7.0
8.0
19
48
19
50
19
52
19
54
19
56
19
58
19
60
19
62
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
PERCENT
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A LONGER PERSPECTIVE
16
14
12
10
8
6
4
2
0
-2
UNEMPLOYMENT RATE
CPI INFLATION RATE
THE LONG-TERM POLICY
CHOICES AREN'T AS OBVIOUS
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16
14
1974
1980
12
1947
INFLATION
10
8
6
1959
4
1983
2
0
0
2
4
6
-2
UNEMPLOYMENT
8
10
12
The Equation
for Wage Inflation
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RW=RP\1+A0-A1*(U-U@VOL)
The rate of change of wages (RW) equals
 the rate of change in prices (RP) in the
past year (“\1”) as a proxy for expected
inflation
 plus a constant (A0) for productivity
growth and other factors not defined here
 minus an adjustment for the existence of
involuntarily unemployed workers:total
unemployment (U) - voluntary (U@VOL)
A Companion Equation
for Price Inflation

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If prices are a simple “mark-up” on
wages..
P
=K*W
hence RP = RK + RW

..and this markup falls when the economy
is sluggish
»RK = B0 - B1 * (U-U@VOL)

Then:
RP = B0 - B1 * (U-U@VOL) + RW
The Final Form Model
of Price Inflation

RP = B0 - B1 * (U-U@VOL) + RW

AND, EARLIER,
RW=RP\1+A0-A1*(U-U@VOL)

THUS
RP=(A0+B0)-(A1+B1)*(U-U@VOL)+RP\1

OR RP-RP\1 =
THE CHANGE IN INFLATION=
(A0+B0) - (A1+B1)*(U-U@VOL)
The acceleration in prices is tied to the level of excess demand.
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Real Wages Accelerated As Usual after Q1 1997,
As Unemployment Fell Below 5.5%
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8%
Inflation-Igniting Threshold:
(5.5% unemployment)
Inflation (%)
7%
6%
Unemployment
Rate
5%
4%
3%
Nominal
Wage Inflation
2%
Real Wage Inflation
1%
0%
(1%)
1995
1996
1997
1998
Useful Inflation Rules of Thumb
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(Validated 1959-93)
Consumer price inflation will rise...
• ...By 0.5 for each percentage point the unemployment
rate falls below the full employment norm.
• ...By 0.1 for each percentage point increase in wholesale
energy prices.
Wholesale price inflation (for finished goods) will
rise...
• ...By the same 0.4 for each percentage point the
unemployment rate falls below the full employment norm.
• ...By 0.2 for each percentage point increase in wholesale
energy prices.
The Track Record for the CPI Rule
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(The Actual and Predicted Changes in CPI
Inflation)
(Percentage points)
History
Forecast
14
12
10
8
6
4
2
0
-2
-4
-6
1961
1966
1971
Consumer Price
Inflation
1976
1981
1986
Actual
1991
Predicted
1996
The Policy Tradeoff: Unemployment
vs. Changes in Inflation
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RP-RP\1=
THE CHANGE IN INFLATION=
-0.5 * (U-U@VOL)
 THIS IS THE TRADEOFF FACING ANY
POLICY-MAKER WITH TARGETS
INVOLVING BOTH THE INFLATION RATE
AND THE UNEMPLOYMENT RATE

The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 Two
endogenous variables: RP and U
 In terms of the earlier model, think of U as
varying inversely with GNP, hence the
endogenous variables are RP and GNP
 If these are the only targets policy-makers
care about, then they need only two policy
instruments to achieve them...
....if we achieve perfect coordination..
....and have perfect system knowledge.
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The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 The
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first priority of the Federal Reserve, the
manager of one instrument--credit policy, is
one target--inflation control.
– The second priority/target is growth.
 The first priority of elected officials, the
managers of other instruments--taxes and
government spending, is usually
unemployment / growth
– Their second priority is inflation control.
 In practice, they do not collaborate well.
The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 Other
problems, beyond lack of
collaboration, preventing simple
achievement of inflation and growth goals.
– Political disagreement on targets.
– Scientific disagreement on, or stubborn
refusal to recognize, the “model”
– External shocks without adequate
warning.
– Desire for policy stability.
– .....
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The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 Short-term
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interest rates, managed by
the Fed, reveal Fed sensitivity to
inflation, unemployment. and policy
stability. They also reveal a lack of
complete foresight.
THE FED REACTS PREDICTABLY
TO THE ECONOMY
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18
16
14
10
8
6
4
2
FEDERAL FUNDS RATE
INFLATION+EMPLOYMENT
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
19
73
19
71
19
69
19
67
19
65
19
63
19
61
19
59
19
57
0
19
55
PERCENT
12