ch09 5e

Inflation,
Inflation, Activity,
Activity,
and
and Nominal
Nominal
Money
Money Growth
Growth
CHAPTER 9
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
9-1 Output, Unemployment, and Inflation
This chapter characterizes the economy by three

relations:
 Okun’s Law, which relates the change in

Chapter 9: Inflation, Activity, and Nominal Money Growth
unemployment to output growth.
 The Phillips curve, which relates the changes in

inflation to unemployment.
 The aggregate demand relation, which relates output

growth to both nominal money growth and inflation.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 2 of 30
Okun’s Law
ut  ut 1   g yt
According to the equation above, the change in the

unemployment rate should be equal to the negative
of the growth rate of output.
For example, if output growth is 4%, then the

unemployment rate should decline by 4%.
Okun’s Law
The actual relation between output growth

and the change in the unemployment rate
is known as Okun’s law.
Using thirty years of data, the line that best

fits the data is given by:
ut  ut 1   0.4( g yt  3%)
Okun’s Law
Figure 9 - 1
Changes in the
Unemployment Rate
Versus Output Growth in
the United States since
1970
High output growth is
associated with a reduction in
the unemployment rate; low
output growth is associated
with an increase in the
unemployment rate.
Okun’s Law
ut  ut 1   0.4( g yt  3%)
According to the equation above,
If g yt  3% , then ut  ut 1   0.4(  )  0
If g yt  3% , then ut  ut 1   0.4( )  0
If g yt  3% , then ut  ut 1   0.4(0)  0
To maintain the unemployment rate constant, output growth

must be 3% per year. This growth rate of output is called the
normal growth rate.
Okun’s Law
ut  ut 1   0.4( g yt  3%)
According to the equation above, output growth 1% above normal
leads only to a 0.4% reduction in unemployment, for two reasons:
1. Labor hoarding: firms prefer to keep workers

rather than lay them off when output decreases.
2. When employment increases, not all new jobs are

filled by the unemployed. A 0.6% increase in the
employment rate leads to only a 0.4% decrease in
the unemployment rate.
Okun’s Law
ut  ut 1   0.4( g yt  3%)
Using letters rather than numbers:
ut  ut 1    ( g yt  g y )
Output growth above (below) normal leads to a decrease

(increase) in the unemployment rate. This is Okun’s law:
g yt  g y  ut  ut 1
g yt  g y  ut  ut 1
The Phillips Curve
 t   e t   (ut  un )
Inflation depends on expected inflation and on the deviation of

unemployment from the natural rate of unemployment. When et is well
approximated by t-1, then:
 t   t 1    (ut  un )
According to the Phillips curve,
ut  un   t   t 1
ut  un   t   t 1
The Aggregate Demand Relation
The aggregate demand relation, as stated in Chapter 7,

adding the time indices:
 Mt 
AD Relation Yt  Y  , Gt , Tt 
 Pt 
Ignoring changes in output caused by other than changes in

the real money stock, then:
 Mt 
Yt  Y  
 Pt 
Okun’s Law across Countries
The coefficient β in Okun’s law gives the effect on the

unemployment rate of deviations of output growth from normal.
A value of β of 0.4 tells us that output growth 1% above the

normal growth rate for 1 year decreases the unemployment
rate by 0.4%.
Table 1 Okun’s Law Coefficients Across Countries and Time

Country 1960-1980 1981-2006
United States 0.39 0.42
Germany 0.20 0.29
United Kingdom 0.15 0.51
Japan 0.02 0.11
The Aggregate Demand Relation
Mt
Yt  
Pt
Keep in mind this simple relation hides the mechanism you

saw in the IS-LM model:
 An increase in the real money stock leads to a
decrease in the interest rate.
 The decrease in the interest rate leads to an increase
in the demand for goods and therefore, to an increase
in output.
9-2 The Effects of Money Growth
 Okun’s law relates the change in the unemployment rate

to the deviation of output growth from normal:

ut  ut 1   g gt  g y 
 The Phillips curve relates the change in inflation to the

deviation of the unemployment rate from the natural rate:
t  t 1  aut  un 
 The aggregate demand relation relates output growth to

the difference between nominal money growth and
inflation.
gyt  gmt  t
Figure 9 - 2
Output Growth, Unemployment,
Inflation, and Nominal Money Growth
The Medium Run
Assume that the central bank maintains a constant growth
rate of nominal money, call it gm. In this case, the values
of output growth, unemployment, and inflation in the
medium run:
 Output must grow at its normal rate of growth, g y.

 If we define adjusted nominal money growth as
equal to nominal money growth minus normal output
growth, then inflation equals adjusted nominal money
growth.
 The unemployment rate must be equal to the natural

rate of unemployment.
The Short Run
Now suppose that the central bank decides to decrease
nominal money growth. What will happen in the short run?
 Given the initial rate of inflation, lower nominal money

growth leads to lower real nominal money growth , and
thus to a decrease in output growth.
 Now, look at Okun’s law, output growth below normal

leads to an increase in unemployment.
 Now, look at the Phillips curve relation. Unemployment

above the natural rate leads to a decrease in inflation.
The Short Run
In words: In the short run, monetary tightening leads to
a slowdown in growth and a temporary increase in
unemployment. In the medium run, output growth
returns to normal, and the unemployment rate returns to

the natural rate.
Table 9-1 The Effects of Monetary Tightening

Year 0 Year 1 Year 2 Year 3
1 Real money growth % (gm-π) 3.0 0.5 5.5 3.0
2 Output growth % (gy) 3.0 0.5 5.5 3.0
3 Unemployment rate % (u) 6.0 7.0 6.0 6.0
4 Inflation gate % (π) 5.0 4.0 4.0 4.0
5 (Nominal money growth) % (gm) 8.0 4.5 9.5 7.0
9-3 Disinflation
A First Pass
We know from the previous section that lower

inflation requires lower money growth. We also
know that lower money growth implies an increase in

unemployment for some time. Now we discuss at
what pace the central bank should proceed.
9-3 Disinflation
A First Pass
 t   t 1    (ut  un )
In the Phillips curve relation above, disinflation—a

decrease in inflation—can be obtained only at the cost
of higher unemployment.
( t   t 1 )  0  (ut  un )  0  ut  un
A point-year of excess unemployment is a difference
between the actual and the natural unemployment rate
of one percentage point for one year.
9-3 Disinflation
A First Pass
For example, let’s assume that  =1
 Suppose the central bank wants to achieve the reduction in

inflation in 1 year, then 1 year of unemployment at 10% above

the natural rate is required.
 Suppose the central bank wants to achieve the reduction in

inflation over 2 years, then 2 years of unemployment at 5%
above the natural rate is required.
 By the same reasoning, reducing inflation over 5 years

requires 5 years of unemployment at 2% above the natural
rate (five times 2% = 10%); reducing inflation over 10 years
requires 10 year of unemployment at 1% above the natural
rate.
9-3 Disinflation
A First Pass
 t   t 1    (ut  un )
The sacrifice ratio is the number of point-years of

excess unemployment needed to achieve a decrease
in inflation of 1%.
For example, if  is roughly equal to one, as the

estimated Phillips curve suggests, then the sacrifice
ratio is roughly equal to one.
9-3 Disinflation
Expectations and Credibility: The Lucas Critique
The Lucas critique states that it is unrealistic to

assume that wage setters would not consider
changes in policy when forming their expectation.
If wage setters could be convinced that inflation was

indeed going to be lower than in the past, they would
decrease their expectations of inflation, which would
in turn reduce actual inflation, without the need for a
change in the unemployment rate.
9-3 Disinflation
Expectations and Credibility: The Lucas Critique
Thomas Sargent, who worked with Robert Lucas,

argued that in order to achieve disinflation, any
increase in unemployment would have to be only

small.
The essential ingredient of successful disinflation, he

argued, was credibility of monetary policy—the
belief by wage setters that the central bank was truly
committed to reducing inflation. The central bank
should aim for fast disinflation.
9-3 Disinflation
Nominal Rigidities and Contracts
A contrary view was taken by Stanley Fischer and

John Taylor. They emphasized the presence of
nominal rigidities, or the fact that many wages

and prices are not readjusted when there is a
change in policy.
If wages are set before the change in policy,

inflation would already be built into existing wage
agreements.
9-3 Disinflation
While Fischer argued that even with credibility, too

rapid a decrease in nominal money growth would lead
to higher unemployment, Taylor’s argument went one
step further.
He argued that wage contracts are not all signed at

the same time, but that they are staggered over time.
He showed that this staggering of wage decisions

imposed strong limits on how fast disinflation could
proceed without triggering higher unemployment.
9-3 Disinflation
Figure 9 - 3
Disinflation Without
Unemployment in the
Taylor Model
If wage decisions are
staggered, disinflation
must be phased in slowly
to avoid an increase in
unemployment.
U.S. Disinflation, 1979–1985
Figure 1 A sharp increase in the federal funds rate from September

1979 to April 1980 was followed by a sharp decline in mid-
The Federal Funds Rate
1980, and then a second and sustained increase from
and Inflation, 1979-1984

January 1981 on, lasting for most of 1981 and 1982.
U.S. Disinflation, 1979–1985
Table 1 Inflation and Unemployment, 1979-1985

1979 1980 1981 1982 1983 1984 1985
GDP growth (%) 2.5 0.5 1.8 2.2 3.9 6.2 3.2
Unemployment rate (%) 5.8 7.1 7.6 9.7 9.6 7.5 7.2
CPI inflation (%) 13.3 12.5 8.9 3.8 3.8 3.9 3.8
Cumulative unemployment 1.0 2.6 6.3 9.9 11.4 12.6
Cumulative disinflation 0.8 4.4 9.5 9.5 9.4 9.5
Sacrifice ratio 1.25 0.59 0.66 1.04 1.21 1.32
Cumulative unemployment is the sum of point-years of

excess unemployment from 1980 on, assuming a natural
rate of unemployment of 6%. 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.
9-3 Disinflation
In 1993, Laurence Ball, from Johns Hopkins University

estimated sacrifice ratios for 65 disinflation episodes in
19 OECD countries over the last 30 years. He reached
three main conclusions:
 Disinflations typically lead to a period of higher

unemployment.
 Faster disinflations are associated with smaller

sacrifice ratios.
 Sacrifice ratios are smaller in countries that have

shorter wage contracts.
Key Terms
 Okun’s law  sacrifice ratio

 normal growth rate  Lucas critique
 labor hoarding  credibility
 adjusted nominal money growth  nominal rigidities
 disinflation  staggering of wage decisions

 point-year of excess unemployment

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Inflation,

This chapter characterizes the economy by three

 Okun’s Law, which relates the change in

unemployment to output growth.

 The Phillips curve, which relates the changes in

 The aggregate demand relation, which relates output

According to the equation above, the change in the

For example, if output growth is 4%, then the

The actual relation between output growth

is known as Okun’s law.

Using thirty years of data, the line that best

According to the equation above,

To maintain the unemployment rate constant, output growth

leads only to a 0.4% reduction in unemployment, for two reasons:

1. Labor hoarding: firms prefer to keep workers

2. When employment increases, not all new jobs are

Using letters rather than numbers:

Output growth above (below) normal leads to a decrease

Inflation depends on expected inflation and on the deviation of

The aggregate demand relation, as stated in Chapter 7,

Ignoring changes in output caused by other than changes in

The coefficient β in Okun’s law gives the effect on the

A value of β of 0.4 tells us that output growth 1% above the

Table 1 Okun’s Law Coefficients Across Countries and Time

Keep in mind this simple relation hides the mechanism you

 Okun’s law relates the change in the unemployment rate

 The Phillips curve relates the change in inflation to the

 The aggregate demand relation relates output growth to

 Output must grow at its normal rate of growth, g y.

 The unemployment rate must be equal to the natural

 Given the initial rate of inflation, lower nominal money

 Now, look at Okun’s law, output growth below normal

 Now, look at the Phillips curve relation. Unemployment

returns to normal, and the unemployment rate returns to

Table 9-1 The Effects of Monetary Tightening

We know from the previous section that lower

know that lower money growth implies an increase in

In the Phillips curve relation above, disinflation—a

 Suppose the central bank wants to achieve the reduction in

inflation in 1 year, then 1 year of unemployment at 10% above

 Suppose the central bank wants to achieve the reduction in

 By the same reasoning, reducing inflation over 5 years

The sacrifice ratio is the number of point-years of

For example, if  is roughly equal to one, as the

The Lucas critique states that it is unrealistic to

changes in policy when forming their expectation.

If wage setters could be convinced that inflation was

Thomas Sargent, who worked with Robert Lucas,

increase in unemployment would have to be only

The essential ingredient of successful disinflation, he

A contrary view was taken by Stanley Fischer and

nominal rigidities, or the fact that many wages

If wages are set before the change in policy,

While Fischer argued that even with credibility, too

He argued that wage contracts are not all signed at

He showed that this staggering of wage decisions

Figure 1 A sharp increase in the federal funds rate from September

and Inflation, 1979-1984

Table 1 Inflation and Unemployment, 1979-1985