2. Measuring the natural rate of unemployment
a. Policymakers need a measure of the natural rate of unemployment to use the unemployment rate
for setting policy
b. Economists disagree about how to measure the natural rate of unemployment and the CBO has
often revised its measure
1. Perfectly anticipated inflation
a. No effects if all prices and wages keep up with inflation
b. Even returns on assets may rise exactly with inflation
c. Shoe-leather costs: People spend resources to economize on currency holdings;
the estimated cost of 10% inflation is 0.3% of GNP
Policy Application
Two other costs of anticipated inflation are increased taxation on capital income and the
mortgage-tilt problem.
Because taxes are based on the dollar value of interest that savers receive, the higher the inflation rate
is, the larger is the government’s tax revenue as a proportion of a saver’s real
return. The increase in the government’s effective real tax rate represents a distortion to the economy—
higher anticipated inflation reduces saving and investment.
Another cost of perfectly anticipated inflation is the problem of “tilting” the real value of loan
payments over time. To see this, suppose inflation were zero and you borrowed $100,000 to buy a house,
10% per year, your monthly payment would be $880. In real terms, the value of the monthly payment
would be very high initially but decline steadily over time. The real value of your final payment would be
30 years in the future at an interest rate of 5% is given by the formula 1/1.0530 $0.23.) A graph of the
real payment amount tilts downward, so this phenomenon is often referred to as the
mortgage-tilt problem. The tilt is greater, the higher is the inflation rate. Because of the
mortgage-tilt problem, homeowners face higher real payments early in the lives of their loans, when they
2. Unanticipated inflation ( e)
a. Realized real returns differ from expected real returns
(1) Expected r i e
(2) Actual r i
(3) Actual r differs from expected r by e –
1998.
e. Loss of valuable signals provided by prices
(1) Confusion over changes in aggregate prices vs. changes in relative prices
(2) People expend resources to extract correct signals from prices
3. The costs of hyperinflation
a. Hyperinflation is a very high, sustained inflation (for example, 50% or more per month)
to 55.6 billion percent in 2008, before dropping to 6.5% in 2009
Data Application
There are many wonderful stories one can tell to illustrate the problems that arise in hyperinflations. For
example, there’s the story about the person who goes to the bank with a wheelbarrow full of money, but
can’t get the wheelbarrow through the bank’s door. He goes
1990s.
V. Fighting inflation: The Role of Inflationary Expectations (Sec. 12.5)
1. Developing or war–torn countries may not be able to raise taxes or borrow, so they print money to
finance spending
2. Industrialized countries may try to use expansionary monetary policy to fight recessions, then not
tighten monetary policy enough later
1. But disinflations may lead to recessions
2. An unexpected reduction in inflation leads to a rise in unemployment along the Phillips curve
Data Application
There are many problems with price indexes; they are imperfect measures of price changes. What do the
indexes do when new goods are introduced? What happens as more efficient stores replace stores that had
125, Economic Activity Section, Board of Governors of the Federal Reserve System, April 1992.
C. The costs of disinflation could be reduced if expected inflation fell at the same time actual inflation
1. The classical prescription for disinflation is cold turkey—a rapid and decisive reduction in money
growth
a. Proponents argue that the economy will adjust fairly quickly, with low costs of adjustment, if
the policy is announced well in advance
b. Keynesians disagree
2. The Keynesian prescription for disinflation is gradualism
a. A gradual approach gives prices and wages time to adjust to the disinflation
Policy Application
In the late 1980s the Federal Reserve embarked on an attempt at gradualism, at least in their
stated ranges for the M2 monetary aggregate. The Fed lowered the growth range for M2 by roughly ½
1. When unanticipated tight monetary and fiscal policies are used to reduce inflation, they reduce
output and employment for a time, a cost that must be weighed against the benefits of lower
2. Economists use the sacrifice ratio as a measure of the costs
a. The sacrifice ratio is the number of percentage points of output lost in reducing inflation by
8.83 percentage points in the early 1980s, with a loss in output of
16.18 percent of the nation’s potential output
(1) The sacrifice ratio was 16.18 divided by 8.83, which equals 1.832
3. Ball studied the sacrifice ratios for many different disinflations around the world in the 1960s,
1970s, and 1980s
a. The sacrifice ratios varied substantially across countries, from less than 1 to almost 3
4. Ball’s results should be interpreted with caution, since it isn’t easy to calculate the loss
of output and because supply shocks can distort the calculation of the sacrifice ratio
28.
F. Wage and price controls
1. Pro: Controls would hold down inflation, thus lowering expected inflation and reducing the costs
of disinflation
2. Con: Controls lead to shortages and inefficiency; once controls are lifted, prices will rise again
3. The outcome of wage and price controls may depend on what happens with fiscal and monetary
policy
4. The Nixon wage-price controls from August 1971 to April 1974 led to shortages in many products;
the controls reduced inflation when they were in effect, but prices returned to where they would
1. Key determinant of the costs of disinflation: how quickly expected inflation adjusts
2. This depends on credibility of disinflation policy; if people believe the government and if the
government carries through with its policy, expected inflation should drop rapidly
3. Credibility can be enhanced if the government gets a reputation for carrying out its promises
4. Also, having a strong and independent central bank that is committed to low inflation provides
credibility
1. Fed chairmen Volcker and Greenspan gradually reduced the inflation rate in the 1980s and 1990s
a. They sought to eliminate inflation as a source of economic instability
2. To judge the Fed’s success, we look at inflation expectations (text Fig. 12.10)
a. Inflation expectations were erratic before 1990
3. Inflation expectations were slow to decline initially (in the late 1970s and early 1980s) because
Volcker and the Fed lacked credibility
4. But as inflation continued to fall, the Fed’s credibility increased, and inflation expectations declined
gradually
5. To solidify those expectations, the Fed declared a 2% long-run inflation target in 2012
Data Application
In the severe recession that began in December 2007 and was precipitated by the housing crisis, inflation
declined substantially. Some analysts thought that inflation fell mainly because of the decline in housing
5. Wage and price controls
10% per year, your monthly payment would be $880. In real terms, the value of the monthly payment
would be very high initially but decline steadily over time. The real value of your final payment would be
30 years in the future at an interest rate of 5% is given by the formula 1/1.0530 $0.23.) A graph of the
real payment amount tilts downward, so this phenomenon is often referred to as the
mortgage-tilt problem. The tilt is greater, the higher is the inflation rate. Because of the
mortgage-tilt problem, homeowners face higher real payments early in the lives of their loans, when they
2. Unanticipated inflation ( e)
a. Realized real returns differ from expected real returns
(1) Expected r i e
(2) Actual r i
(3) Actual r differs from expected r by e –
1998.
e. Loss of valuable signals provided by prices
(1) Confusion over changes in aggregate prices vs. changes in relative prices
(2) People expend resources to extract correct signals from prices
3. The costs of hyperinflation
a. Hyperinflation is a very high, sustained inflation (for example, 50% or more per month)
to 55.6 billion percent in 2008, before dropping to 6.5% in 2009
Data Application
There are many wonderful stories one can tell to illustrate the problems that arise in hyperinflations. For
example, there’s the story about the person who goes to the bank with a wheelbarrow full of money, but
can’t get the wheelbarrow through the bank’s door. He goes
1990s.
V. Fighting inflation: The Role of Inflationary Expectations (Sec. 12.5)
1. Developing or war–torn countries may not be able to raise taxes or borrow, so they print money to
finance spending
2. Industrialized countries may try to use expansionary monetary policy to fight recessions, then not
tighten monetary policy enough later
1. But disinflations may lead to recessions
2. An unexpected reduction in inflation leads to a rise in unemployment along the Phillips curve
Data Application
There are many problems with price indexes; they are imperfect measures of price changes. What do the
indexes do when new goods are introduced? What happens as more efficient stores replace stores that had
125, Economic Activity Section, Board of Governors of the Federal Reserve System, April 1992.
C. The costs of disinflation could be reduced if expected inflation fell at the same time actual inflation
1. The classical prescription for disinflation is cold turkey—a rapid and decisive reduction in money
growth
a. Proponents argue that the economy will adjust fairly quickly, with low costs of adjustment, if
the policy is announced well in advance
b. Keynesians disagree
2. The Keynesian prescription for disinflation is gradualism
a. A gradual approach gives prices and wages time to adjust to the disinflation
Policy Application
In the late 1980s the Federal Reserve embarked on an attempt at gradualism, at least in their
stated ranges for the M2 monetary aggregate. The Fed lowered the growth range for M2 by roughly ½
1. When unanticipated tight monetary and fiscal policies are used to reduce inflation, they reduce
output and employment for a time, a cost that must be weighed against the benefits of lower
2. Economists use the sacrifice ratio as a measure of the costs
a. The sacrifice ratio is the number of percentage points of output lost in reducing inflation by
8.83 percentage points in the early 1980s, with a loss in output of
16.18 percent of the nation’s potential output
(1) The sacrifice ratio was 16.18 divided by 8.83, which equals 1.832
3. Ball studied the sacrifice ratios for many different disinflations around the world in the 1960s,
1970s, and 1980s
a. The sacrifice ratios varied substantially across countries, from less than 1 to almost 3
4. Ball’s results should be interpreted with caution, since it isn’t easy to calculate the loss
of output and because supply shocks can distort the calculation of the sacrifice ratio
28.
F. Wage and price controls
1. Pro: Controls would hold down inflation, thus lowering expected inflation and reducing the costs
of disinflation
2. Con: Controls lead to shortages and inefficiency; once controls are lifted, prices will rise again
3. The outcome of wage and price controls may depend on what happens with fiscal and monetary
policy
4. The Nixon wage-price controls from August 1971 to April 1974 led to shortages in many products;
the controls reduced inflation when they were in effect, but prices returned to where they would
1. Key determinant of the costs of disinflation: how quickly expected inflation adjusts
2. This depends on credibility of disinflation policy; if people believe the government and if the
government carries through with its policy, expected inflation should drop rapidly
3. Credibility can be enhanced if the government gets a reputation for carrying out its promises
4. Also, having a strong and independent central bank that is committed to low inflation provides
credibility
1. Fed chairmen Volcker and Greenspan gradually reduced the inflation rate in the 1980s and 1990s
a. They sought to eliminate inflation as a source of economic instability
2. To judge the Fed’s success, we look at inflation expectations (text Fig. 12.10)
a. Inflation expectations were erratic before 1990
3. Inflation expectations were slow to decline initially (in the late 1970s and early 1980s) because
Volcker and the Fed lacked credibility
4. But as inflation continued to fall, the Fed’s credibility increased, and inflation expectations declined
gradually
5. To solidify those expectations, the Fed declared a 2% long-run inflation target in 2012
Data Application
In the severe recession that began in December 2007 and was precipitated by the housing crisis, inflation
declined substantially. Some analysts thought that inflation fell mainly because of the decline in housing
5. Wage and price controls