Macroeconomics - Unit 4: Unemployment and Inflation Role of Expectations I. Expectations of Inflation a. If inflation is anticipated people can adjust their nominal incomes to reflect the expected price level rises b. If inflation is anticipated, banks can adjust their terms of their loans to borrowers II. Expected inflation rate a. At full employment the inflation rate = the expected inflation rate b. The expected inflation rate is the inflation rate that people forecast and use to set the money wage rate and other money prices c. If expectations about the inflation rate are correct, the price level will rise by expected inflation rate and therefore the real wage rate remains constant at is full employment equilibrium level. Real GDP remains at potential GDP and unemployment remains at the natural rate. d. The long-run Philips curve = the relationship between inflation and unemployment when the inflation rate equals the expected inflation rate e. The short-run Philips curve = the tradeoff between inflation and unemployment at a particular expected inflation rate i. When the expected inflation rate changes, the short-run Phillips curve shifts to intersect the long-run Phillips curve at the new expected inflation rate III. The Natural Rate Hypothesis a. The proposition that when the money growth rate changes (and the aggregate demand growth rate changes) the unemployment rate changes temporarily and eventually returns to the natural unemployment rate b. Changes in the Natural Unemployment Rate i. If the natural unemployment rate changes both the long run and short run Phillips curve shift 1. Increase/decrease in number of job searchers 2. Structural change in the labor market 3. Technological change resulting in increase in productivity IV. What determines the expected inflation rate? a. Data on past inflation b. Science of economics – studies forces that cause inflation i. AS/AD model 1. Money growth rate determines the growth of AD in the long run 2. Trend of the growth rate of real GDP = the growth rate of AS in the long run 3. Trend money growth rate minus the trend real GDP = the trend inflation rate ii. Expansion = inflation rate rises above the trend inflation rate iii. Recession = inflation rate falls below the trend inflation rate iv. Fed determines money growth rate so the major ingredient in a forecast of inflation is a forecast of the Fed’s actions c. Rational expectation i. When all relevant data and economic science are used to forecast inflation ii. The rational expectation of the inflation rate is a forecast based on the Fed’s forecasted monetary policy along with forecasts of other forces that influence aggregate demand and aggregate supply V. What can policy do to lower expected inflation (i.e. address an “inflationary gap”)? a. A surprise inflation reduction i. With inflation at 10 percent and unemployment is at its natural rate of 6% ii. Draw LRPC and SRPC at these levels iii. No one is expecting the Fed to changes its policy but the Fed DOES change its policy and starts to slow inflation to a target rate of 3 percent a year 1. Fed raises interest rates and slows money growth 2. With no change in expected inflation, money wage rates continue to rise by the same amount but aggregate demand growth slows 3. Unemployment rate rises and the inflation rate falls 4. Gradually the expected inflation rates falls and the short run Phillips curve shifts downward (draw new SRPC) 5. The Fed slows inflation but at the cost of recession 6. Eventually the unemployment returns to its natural rate at the lower inflation rate. b. A credible announced inflation reduction i. The Fed announces its intention to bring the inflation rate down and people believe this intention is credible ii. The expected inflation rate falls thus causing the rate of increase in the money wage rate to slow iii. Lower expected inflation rate shifts the SRPC downward – the inflation rate to 3% a year, but the unemployment rate remains at the natural rate of 6% iv. Announced inflation reduction lowers the inflation rate but without the accompanying loss of output or increase in unemployment .