Chapter 9. Inflation, Activity, and

Nominal Money Growth

I. Motivating Questions

How Are Output Growth, the Inflation Rate, and the Unemployment Rate Determined in the Medium Run?

The medium-run economy consists of three relationships: Okun’s law, which links output growth and unemployment; the aggregate supply relation (the Phillips curve), which links inflation and unemployment; and the aggregate demand relation (expressed in growth rates and simplified to include only the real money stock), which links money growth, inflation, and output growth. Medium-run equilibrium is characterized by a constant unemployment rate (the natural rate), a constant growth rate of output (the so-called normal growth rate), and an inflation rate that depends on the growth rate of money. In the medium run, the natural rate of unemployment and the normal growth rate of output are independent of the growth rate of money.

II. Why the Answer Matters

Essentially, this chapter expresses the AD-AS analysis of Chapter 7 in terms of growth rates. This exercise matches the equations of the model with the observed relationships in the data and yields a fundamental result: in the medium run, money growth determines inflation, but does not affect output growth or unemployment. This framework allows for analysis of monetary policy decisions more closely related to real events than one-time changes in the money stock. The cost of disinflation and the scope for monetary policy to affect output are ongoing questions facing macroeconomic policymakers.

III. Key Tools, Concepts, and Assumptions

1. Tools and Concepts

i. Okun’s law is a negative relationship between the change in the unemployment rate and the difference between the growth rate of output and its normal rate, which is the sum of average annual productivity growth and labor force growth.

ii. A point-year of excess unemployment is one year of an unemployment rate one percentage point above the natural rate. The sacrifice ratio is the number of point years of excess unemployment required to reduce the inflation rate by one percent.

iii. The Lucas critique is the argument that historical relationships between macroeconomic variables may provide a misleading guide to the effects of policy changes, since the relationships may depend upon the policy environment.

IV. Summary of the Material

1. Output, Unemployment, and Inflation

The dynamic model presented in this chapter has three ingredients: Okun’s law, the aggregate supply relation expressed in terms of growth rates and aggregate demand relation expressed in terms of growth rates. The aggregate supply relation is the Phillips curve.

i. Okun’s Law. Okun’s law is a relationship between changes in the unemployment rate and the growth rate of output. The model presented in the text, with no productivity growth and a fixed labor force, implies that the unemployment rate should fall when output growth is positive and rise when growth is negative (see Part VI below for a formal derivation). In fact, the empirical relationship between the unemployment rate and output growth in the United States since 1960 is given by

u_t-u_t-1=-0.4(g_y,t-3%), (9.1)

where g_y,t is the growth rate of output at time t. The observed relationship differs from the one implied by the basic model of the text in two fundamental ways. First, output growth must exceed 3% in order for the unemployment rate to fall. The growth rate required to maintain a constant unemployment rate is called the normal growth rate. Second, the coefficient on output growth is not -1, but -0.4.

The 3% threshold for output growth arises from productivity growth and labor force growth. Productivity growth implies that fewer workers are required to produce a given quantity of goods. Thus, for employment to remain constant, output growth must match productivity growth. Labor force growth implies that unemployment will increase unless employment grows correspondingly. In the United States, the sum of productivity growth and labor force growth has been about 3% per year since 1960. Therefore, output must grow by at least 3% to prevent an increase in the unemployment rate.

The coefficient of -0.4 arises for two reasons. First, firms do not adjust employment one for one with output growth. Some workers are needed to operate a firm regardless of output. In addition, firms may hoard (not fire) workers in bad times to avoid the cost of training new workers in good times. Second, an increase in the employment rate tends to increase the labor force participation rate, which limits the effect of output growth on the observed unemployment rate.

In symbols, Okun’s law can be written as

u_t-u_t-1=-(g_y,t-g_y), (9.2)

ii. The Aggregate Supply Relation. The aggregate supply relation is the Phillips curve. The text uses the accelerationist Phillips curve from Chapter 8 for the medium-run model. If expected inflation equals lagged inflation, then the Phillips curve is

π_t-π_t-1=-(u_t –u_n). (9.3)