PRINCIPLES OF MACROECONOMICS
WEEK 7 (LECTURES 17-19)
Ranjit Dighe
Oct. 11-15, 1999

[These lectures correspond to parts of McConnell's Chapters 7 and 8. For information on the Phillips Curve, skip ahead to pages 337-339 of Chapter 16.]

LECTURE 17
Mon., Oct. 11, 1999

O.  IMPEDIMENTA

Today:
I.   Unemployment (finish)
II.  Inflation (begin)

* On the last quiz: I will never ask a question to which the answer is "voluntary unemployment." Your total score in this class will be higher if you never write "voluntary unemployment" on a quiz or test than if you do.
 

I.  UNEMPLOYMENT (finish)

* Three types of unemployment:
(1) frictional ("search") unemployment: Arises from normal turnover (new entrants to labor force, quits) of the job market. Exs.: recent college graduates, women who re-enter the labor force after having children.
(2) structural ("long-term mismatch") unemployment: Arises from changes in the structure of the economy that result in a significant loss of jobs in certain industries. Exs.: steel/textile/auto workers after plant closings/layoffs, laid-off workers in some defense-related industries.
(3) cyclical unemployment: arises when the overall demand for labor is low because of insufficient aggregate demand.
-- Much of the unemployment in recessions and depressions is cyclical.

* The relationship between unemployment and GDP:
Okun's Law: the unemployment rate decreases about 1 % point for every 2% increase in GDP relative to potential GDP
-- i.e., every 2-percentage-point increase in the GDP ratio, or
every 2-percentage-point decrease in the GDP gap.
---- In real life, the numerical relationship is not so tight. Sometimes, for ex., the unemployment rate rises even when GDP rises, as in early 1990; "growth recession"--economy growing, but too slowly to provide jobs for all new entrants to labor force. General pattern of unemployment rate falling when GDP is rising is observed, however. Also, Okun's Law explains mainly cyclical unemployment, not the other two kinds, which have different causes.
---- The numerical relationship between unemployment and GDP differs from country to country. Although a 1% increase in the unemployment rate is associated with a drop of about 2% in GDP (relative to potential GDP) in the U.S, in Japan a 1% increase in the unemployment rate is associated with a drop of about 10% in GDP relative to potential GDP. Why: "Guaranteed lifetime employment" is the norm in Japan, such that layoffs and firings are very uncommon and reductions in the workweek so as to preserve people's jobs ("work sharing") are much more common than in the U.S. From WW2 through the mid-1990s, Japan's unemployment rate was never any higher than 3.5%. Currently, however, Japan is mired in a decade-long economic slump and their unemployment rate is a bit higher than America's.
 

II. INFLATION

* Defns.:

INFLATION: a persistent increase in the overall price level.
-- There are different measures of inflation that correspond to different price levels. The most commonly used price level in calculating the rate of inflation is the consumer price index (CPI), which measures the cost of purchasing a "basket" of certain consumer goods (including basic items like food, clothing, rent, and transportation). The producer price index, formerly called the wholesale price index, measures the cost of industrial commodities at the wholesale level; hence it measures the prices that companies receive for the goods they produce, as opposed to the retail prices that we pay. The broadest measure of the price level is the GDP price index, or GDP implicit price deflator, which measures the cost of purchasing all of the goods and services in GDP; so it includes the prices not just of consumer goods but also of investment goods, government-purchased goods and services, exports, and imports.
-- The inflation rate averaged 3.9% from 1982-1990 and is currently about 2%. It has fallen fairly steadily since the early 1990s.

INFLATION RATE: the annual percent change in the overall price level (usually in the CPI)
-- Ex.: If the CPI was 152.4 in 1995 and 156.9 in 1996 (meaning that prices in 1995 and 1996 were 152.4% and 156.9% as high as prices were in the base year, which was 1982-84), then:
         1996 inflation rate = {(1996 price level)/(1995 price level)} - 1 * 100%
                                         = {156.9/152.4 - 1} * 100%
                                         = {1.0295 - 1} * 100%
                                         = .0295 * 100%
                                         = 2.95%

Defns.

DEFLATION: a persistent decrease in the overall price level.
-- has not occurred in the U.S. since the Great Depression of the 1930s.

DISINFLATION: a decline in the rate of inflation
-- Ex.: in the early 1980s, inflation was reduced from 10+% in 1979-81 to about 4% by 1984.

How to construct a price index:
A price index measures the cost of buying a certain "basket" of goods, so one must total up the dollar cost of buying given quantities of all of the items in the basket. Then, so that we may more easily compare price levels for different years, we index those cost totals to the however much it costs to buy that basket of goods in the base year, which is whatever year we choose to be our basis of comparison. For each year, we compute the price index by dividing the total cost of the basket of goods in that year by the total cost of that basket of goods in the base year, and then we multiply by 100. So the price index for the base year is always 100, because we're dividing a number by itself and then multiplying by 100. If the same basket of goods costs 4% more (i.e., 104% as much) in the next year, then the next year's price index is 104.

-- Ex.: Imagine the same small island economy that we used in our nominal-vs.-real GDP example on Mon., Sept. 27. In 1995, which we will use as our base year, the average person there consumed just three commodities -- beer, pretzels, and bicycles -- in the following quantities:
 

1995
Commodity p q p * q
Case of beer  $20 1 $20
Bag of pretzels $1 20 + $20
Bicycle $200  $200 1 + $200
TOTAL COST OF GOODS $240

-- Since 1995 is the base year, the price index for 1995 is: {$240/$240} * 100 = 100
-- In 1996, the price of beer was still $20, and the price of a bag of pretzels rose to $1.50 and the price of a bike rose to $210. Now that same basket of goods costs a bit more:
 

1996
Commodity p q p * q
Case of beer  $20 1 $20
Bag of pretzels $1.50 20 + $30
Bicycle $200  $210 1 + $210
TOTAL COST OF GOODS $260

-- In 1996, the price index was: {$260/$240} * 100 = 1.0833 * 100 = 108.33

-- The 1996 inflation rate was just the difference between the two, or 8.33%. To verify:
         1996 inflation rate = {(108.33/100) - 1} * 100
                                       = (1.0833 - 1) * 100
                                       = .0833 * 100
                                       = 8.33%

***

PRINCIPLES OF MACROECONOMICS
WEEK 7, LECTURE 18
Wed., Oct. 13, 1999

Today:
I.   Costs of inflation
II.  Causes of inflation

I.   COSTS OF INFLATION

Inflation and unemployment are perhaps the two most visible macroeconomic problems. The costs of unemployment are clear enough -- lost output, a lower standard of living, the despondency of joblessness, etc. -- and arguably are a lot more severe than the costs of inflation. When unemployment rates rise, suicide, crime, and divorce rates rise, too. People don't kill themselves over inflation, by contrast. With that in mind...

Q: What are the costs of inflation?

A:

(1) Arbitary redistribution of income
(a) People whose incomes do not increase at the same rate as the price level will lose purchasing power -- i.e., their real incomes will fall. Inflations are rarely balanced -- real wages go up for some people, down for others. People's whose incomes are not "indexed" to inflation (some pensioners, welfare recipients, people with multi-year fixed-wage contracts) will see their real incomes fall.
-- Historically, wage increases have kept pace with price increases, so that real wages on average have risen or stayed the same, despite inflation.
-- Still, since inflations are rarely balanced, some people's real incomes do fall. If inflation causes a lot of people's real incomes to fall, then complaints about inflation will tend to be widespread.
(b) Inflation redistributes income from creditors to debtors (i.e., from savers and lenders to borrowers)
-- Defn.: REAL INTEREST RATE. The real, or inflation-adjusted, interest rate is computed as:

real interest rate = interest rate - inflation rate
---- An unanticipated inflation lowers the real interest rate on existing loans. Ex.: If you borrow money at 10% today, when inflation is 2%, then you're probably expecting to pay a real interest rate of 8% (10% - 2%). If inflation then rises to 10%, then the real interest rate is 0%, so you're in effect getting an interest-free loan. That's great news for you, but bad news for the bank. Thus inflation is good for borrowers and bad for lenders.
---- Note: an unanticipated deflation has just the opposite effect: if you borrow money, prices fall (and your salary probably does, too), but your debt and interest payments are still the same, so the burden of your debt is greater.
---- Note also: if the inflation is anticipated, lenders can just raise their nominal interest rates so that the real interest rate is unchanged. When the inflation rate is high, (nominal) interest rates are high, too.
---- Aside: "Redistribution of income" is typically taken to mean "from rich to poor"-- e.g., tax the rich, feed the poor. That's not precisely what "redistribution of income" means in this case, yet some people say "inflation is good because it helps poor people." This is partly true in the sense that poor people tend to be debtors, while rich people tend to be creditors. But the poorest of the poor typically live on fixed incomes (e.g., welfare) or receive wages (e.g., the minimum wage) that are not indexed to inflation.

(2) Inefficient allocation of resources
-- Inflation robs people of information about relative prices, thereby making it harder for them to get the best deals.
---- Ex.: You go to the supermarket and all prices have doubled from last week --> you might think, "I'm never shopping here again!" You drive to another supermarket and find that prices have doubled there, too. Disgusted, you drive to a third supermarket, only to find that they too are charging twice as much as last week. By now you realize that prices have doubled everywhere, but in the meantime you've wasted quite a bit of time looking around for a cheaper supermarket.
---- Without knowing the relative prices of the goods you might consume, it's easy to make bad decisions, and very hard to maximize your consumer satisfaction according to the Econ 101 principle of buying more and more of whatever goods give you the most marginal utility per price, until the marginal utility per price of every good you consume is the same. That's hard to do when those prices keep changing.
-- People waste more time making trips to the bank, because the nominal interest rate goes up as a result of a higher inflation rate. When your bank is paying higher rates of interest, you carry less cash, since cash pays no interest, and leave more money in the bank. The only way to do this without cutting back on your spending is to make smaller but more frequent withdrawals from your bank account -- say, withdrawing $20 once a day instead of $140 once a week. Making all those extra trips to the bank tends to be time-consuming and very inconvenient. Economists refer to those extra trips to the bank as the "shoe-leather costs of inflation" (since you might literally wear out the soles of your shoes more quickly if you have to make all these extra trips to the bank).

(3) Increased investment risk and (possibly) slower long-term economic growth
-- When unanticipated inflation occurs regularly, the degree of risk associated with new investments increases. Uncertainty about future inflation may inhibit people from investing in capital and long-term projects. Lower investment lowers the long-term rate of economic growth.

II.   CAUSES OF INFLATION

Q: What causes inflation?

A: There are two main types of inflation:

(1) Demand-pull inflation -- inflation that is initiated by an increase in demand-driven economic growth. Demand-pull inflation can be caused by any of the following: increased government spending, a "consumption binge" in which households try to consume a lot more, an "investment binge" in which firms rush to build new plant and equipment, or a big increase in the supply of money and credit that causes people and firms to borrow more money to finance new consumption or investment.
-- Exs.: the inflation of the late 1960s was fueled by the government's high levels of spending on the Vietnam War; the rapid inflation of 1977-79 was fueled by the Federal Reserve's rapid expansion of bank credit.

(2) Cost-push, or supply-side, inflation -- inflation that is initiated by an increase in input or materials costs (independent of demand shifts). For example, a big increase in wages (say, because of stronger unions) would raise production costs and cause firms to pass on those higher costs in the form of higher prices. So would an increase in energy costs, since energy is necessary for all types of industrial production.
-- Exs.: the OPEC (Oil Producers' Exporting Cartel) oil shocks of 1973-74 and 1979-80 caused big increases in the inflation rate because oil is a vital input in production and because gasoline is a big part of consumers' budgets.
-- Closely related is "inertial" inflation, occurs when firms raise their prices because they expect other prices to go up, too. Expectations of higher inflation in the future tend to become self-fulfilling.

***

PRINCIPLES OF MACROECONOMICS
WEEK 7, LECTURE 19
Fri., Oct. 15, 1999

Today:
I.   Hyperinflation
II.  The "Phillips Curve" tradeoff between inflation and unemployment
 

I.  HYPERINFLATION

Defn. HYPERINFLATION: a very rapid rise in the price level, usually by more than 1000%.

The United States has never experienced a hyperinflation in its modern history, but it did during the Revolutionary War, when the value of a "Continental" dollar at war's end was only one-hundredth of its earlier value. Also, the Confederacy experienced a hyperinflation of its currency during the Civil War.

The most famous hyperinflation occurred in Germany during the 1920s and led to a total breakdown of German society that helped pave the way for Adolf Hitler's rise to power.
-- After Germany's defeat in World War I in the late 1910s, the country faced massive war-related debts and a huge bill for reparations payments to the Allies. Unable to raise such huge sums through taxes, the German Weimar Republic attempted to pay its bills the old-fashioned way -- by printing money.
-- When a government tries to finance its spending by printing money, the typical result is a massive inflation. Germany's was all the more so. To quote McConnell (p. 168): "During 1922 the German price level went up 5,470 percent. In 1923, the situation worsened; the German price level rose 1,300,000,000,000 [1.3 trillion] times. By October of 1923, the postage on the lightest letter sent from Germany to the United States was 200,000 marks. Butter cost 1.5 million marks per pound, meat 2 million marks, a loaf of bread 200,000 marks, and an egg 60,000 marks. Prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch. Sometimes customers had to pay double the price listed on the menu when they ordered."

II.    THE "PHILLIPS CURVE" TRADEOFF BETWEEN INFLATION AND
        UNEMPLOYMENT

In general, there is a tradeoff between inflation and unemployment. We'd like both to be lower, but:
in the short term
we can't lower inflation without throwing lots of people out of work, and
we can't reduce unemployment without generating higher inflation.

Recall the definition of potential GDP as the highest level of (real) GDP that the economy can sustain without causing the inflation rate to accelerate.
-- Just as inflation will accelerate if GDP grows beyond potential GDP, so will inflation accelerate if the unemployment rate drops below a certain level. (This is logical enough, considering Okun's Law: a 2 %-point increase in GDP relative to potential GDP is associated with a 1 %-point drop in unemployment.) We call that minimum sustainable rate of unemployment the non-accelerating-inflation rate of unemployment (NAIRU). It is the unemployment-rate counterpart to potential GDP.
-- NAIRU: the lowest level of unemployment that the economy sustain without causing inflation to accelerate; again, the non-accelerating-inflation rate of unemployment.
-- The NAIRU is sometimes called the "target" rate of unemployment, since it tends to be the rate that government and Federal Reserve policymakers try to aim for. We'd like unemployment to be low and, for most of us, a little inflation in exchange for low unemployment is acceptable, but accelerating inflation is out of the question.
-- McConnell's book refers to the NAIRU by the name "natural rate of unemployment," which is a usage I believe should be avoided at all costs. The word "natural" falsely implies that this certain level of unemployment is all voluntary and even desirable, which of course it isn't, and the book concedes this. So why go on using the term "natural rate of unemployment"? "Non-accelerating-inflation rate of unemployment" is more accurate, and "NAIRU" (pronounced like "Nehru") is easy enough to pronounce.

Exactly how high is the NAIRU? Nobody knows for sure. My best guess is about 4%, maybe 4.5%
-- The temptation is to say the NAIRU is whatever the unemployment rate has been for the last few years, as long as we're not obviously in a recession. It was long thought to be around 6% (from about the mid-1970s to the mid-1990s). More recently, many economists have said it's 5.5%. In recent years, as unemployment has fallen all the way to 4.2% with few visible signs of higher inflation, it appears the NAIRU has fallen, too, perhaps to 4 or 4.5%. Yet economists in general and Federal Reserve policymakers in particular seem slow to adjust their estimates of the NAIRU; McConnell's textbook estimates that the NAIRU is 5.5%, which to me seems way too high.

Even when unemployment is higher than the NAIRU and the economy has some slack in it, the inflation-unemployment tradeoff is still present -- lower rates of unemployment will be associated with higher rates of inflation.

We illustrate this tradeoff between inflation and unemployment with a famous graph called the Phillips Curve, named for British economist A.W. Phillips, who first noticed this tradeoff in the 1940s. The Phillips Curve is drawn on a graph with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. It slopes downward and becomes flatter and flatter as you follow it from left to right. We can think of the Phillips Curve as the tradeoff between inflation and unemployment (two "bads") or, equivalently, between higher real GDP and lower prices (two "goods").
-- [I drew the Phillips Curve on the blackboard several times. For illustrations of it, refer to Figures 16-7 and 16-8 of McConnell's textbook.]
-- In the 1950s and 1960s, the Phillips Curve was extremely stable, in that the unemployment and inflation data fit a Phillips Curve extremely well. In periods of high unemployment (like recessions), inflation was low. And when the economy grew rapidly and unemployment fell, inflation rose. The economic policy debate of that time centered around where we should be on that curve. Conservatives favored reducing inflation (at the expense of higher unemployment); liberals favored reducing unemployment (at the expense of higher inflation). During the 1960s, as the economy underwent its longest-ever expansion, fueled largely by Vietnam War spending, we moved "up" the Phillips Curve toward lower unemployment and higher inflation.
-- In the 1970s, the data did not fit a single Phillips Curve at all well. With the OPEC oil shocks, we saw inflation and unemployment rise at the same time, which had once been thought impossible. The term STAGFLATION was coined to refer to the combination of high unemployment (i.e., a stagnant economy) and high inflation.
-- Apparently, the Phillips Curve shifted upward twice during the 1970s, first in 1973-74 with the first OPEC oil shock and then in 1979-80 with the second OPEC oil shock.
-- The Phillips Curve seems to have shifted downwards in the early 1980s and during the 1990s, as people came to expect lower inflation rates and as oil prices fell.