V. Pedagogy

Inflation is not a familiar phenomenon to U.S. students today. The Volcker disinflation episode is ancient history to them. Many will have never heard of Volcker. The cost of the Volcker disinflation can perhaps be cited as a factor that leads to fear of inflation—and the costs of disinflation—today.

VI. Extensions

Instructors could supplement the informal discussion of normal output growth with a formal derivation. Suppose Y=AN. Then,

∆Y/Y ≈ ∆A/A+∆N/N. (9.6)

The definition of the employment rate, N=L(1-u), implies that

∆N=∆L(1-u)-L∆u,

or

∆u=-∆N/L –N∆L/(L²)=(N/L)[( ∆L/L)- (∆N/N)] ≈ (∆L/L)- (∆N/N), (9.7)

where the last approximation is valid if u is small, so that N/L ≈ 1. Substituting equation (9.6) into equation (9.7) implies

∆u =-(∆Y/Y-∆A/A-∆L/L).

Normal output growth is productivity growth (∆A/A) plus labor force growth (∆L/L). The unemployment rate declines when output grows faster than its normal rate.

VII. Observations

Although the model in this chapter abstracts from fiscal policy, there is an important historical mechanism by which fiscal policy has been linked to inflation. Governments that run persistent budget deficits sometimes resort to money creation to finance them. The money creation leads to inflation. Indeed, every historical episode of hyperinflation has been associated with monetary financing of budget deficits. Chapter 23 discusses hyperinflation.

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