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Chapter 17
Unemployment,
Inflation, and Growth
Introduction
• In Chapter 4, 5, 6, we have studied a classical
model of the complete economy, but said little
about economic growth, inflation and
unemployment because the model is static.
• In this chapter, we start to study these dynamic
issues based on the classical model of AD, the
new-Keynesian theory of AS and wage equation.
• The reason we use the classical AD is that it is
simpler.
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Introduction
• Advantage of using the classical AD :
-- We can highlight the most important advances in
the economic dynamics that occurred over the
past 20 years without getting bogged down in
details.
• Disadvantage :
-- It makes the false assumption that the propensity
to hold money is independent of the interest rate
and then is unable to account for channels
through which fiscal policy influences AD.
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Introduction
• Steps :
1. We alter the classical AD and the Keynesian
AS to explain how variables change over time
by allowing for productivity growth.
2. Plot the dynamic AD curve and the short-run
dynamic AS curve on a graph of inflation
against growth.
3. We can show how AS and AD interact to
determine all of the endogenous variables of
our theory.
4
The Classical Approach to Inflation
and Growth
• We build the dynamic new-Keynesian theory of
AD and AS in two stages.
1. We explore how the dynamic model works if
unemployment is always as the natural rate. (the
classical approach)
2. Then, we study the new-Keynesian wage
equation, a theory that explains how the nominal
wage changes over time when unemployment
fluctuates from its natural rate.
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Natural Paths and Natural Rates
• In a dynamic, growing economy, when a firm
pays a turnover cost to manage its pool of
workers, the natural unemployment rate and the
natural level of employment remain constant
each period, just as in the static economy.
• However, the natural level of output and the
natural real wage grow from one year to the
next as technology improves.
The list of natural level of output (efficiency
wage levels) one for each year, is called the
natural output path (the natural real wage
path).
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GDP and Its Natural Path
Figure 17.1
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The Classical Dynamic AD Curve
• The classical AD (Chapter 5) is :
M  kP Y
This is the static version of the quantity theory of
money, based on 3 assumptions:
1. The quantity of money demand is proportional
to income (Y).
2. MS=MD.
3. The propensity to hold money (V) is constant.
8
The Classical Dynamic AD Curve
• The classical AD can be written in the form of
proportional changes :

ln M  lnV  ln P  ln Y
P M Y


P
M
Y
P M Y
,
,
P
M
Y
where the variables
are referred as
the price inflation rate, the money growth rate
and the GDP growth rate.
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The Classical Dynamic AD Curve
P M Y


P
M
Y
• When we develop the theory according to
growth rates, the outcome is the dynamic
theory of aggregate demand.
10
The Classical Dynamic AS Curve
• We amend the efficiency wage model of
unemployment and allow for changes in
productivity (exogenous discovery of new
technology) from one year to the next.
• This form the basis of the dynamic theory of AS
because it predicts that GDP will grow each year
even if employment does not.
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The Classical Dynamic AS Curve
• Two versions of the dynamic theory of AS:
1. The classical version:
We assume the real wage always grows at the
natural rate of productivity growth.
(unemployment is always at its natural rate)
2. The new-Keynesian version:
Real wage growth can differ from its natural
rate.
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The Classical Dynamic AS Curve
• In the classical dynamic theory of AS,
employment is equal to its natural level, L* . (We
assume that the population or the labor force are
constant for simplicity)
• Then, the classical dynamic AS curve is
Y
Y
GDP growth
rate
Y *


g
Y*
Natural GDP Productivity
growth rate
growth rate
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Growth and the Real Wage
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Growth and the Real Wage
Figure 17.2B
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The Classical Dynamic AD-AS Curve
We can plot the classical dynamic AD and AS curve in a
 P Y 
,

 graph.
 P Y 
P
M
Y
Dynamic AD :


(slople=-1)
P
M
Y
Y
Y *
Dynamic AS :

 g (vertical)
Y
Y*
P M
Y
Intersection:

 g,
 g.
P
M
Y
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Inflation and Growth (the Classical Case)
Figure 17.3
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The Wage Equation in the Classical Model
• How is the real wage chosen each period in the
dynamic classical theory?
• By the assumption of perfect competitive market
(zero profit) and L=L*, we must have
MPL  W / P
which implies
growth rate of MPL  g  growth rate of w / P
w
w

P
P
 g.
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FOCUS ON THE FACTS
The Third Industrial Revolution?
Box 17.1
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The New Keynesian Approach
• The new-Keynesian theory of aggregate supply
is more realistic than the classical theory and
allows unemployment to fluctuate from its
natural rate.
• In the new-Keynesian model, GDP may depart
from its natural path for short periods, but it
tends to return to the natural path in the long run.
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The New Keynesian Approach
• Three elements of the new-Keynesian approach
to aggregate supply:
1. A theory of wage determination.
2. A theory that explains how inflation and growth
are related in the short run, the period during
which the real wage differs from its natural
growth path.
3. The third explains how inflation and growth are
related to each other when the real wage is on its
natural growth path (long-run, the classical AS).
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Aggregate Supply and the Real Wage
• In the short run, the real wage can differ from its
natural path, changes in the real wage will relate
to changes in employment and therefore to
growth.
• If the real wage grows slower (faster) than its
natural rate, firm will increase (decrease)
employment and then raise (lower) GDP above
(below) its natural rate.
Excess Output growth is inversely related to
excess real wage growth along the aggregate
supply curve.
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Real Wage Growth and Aggregate Supply:
The New-Keynesian Model
Figure 17.4A
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Real Wage Growth and Aggregate Supply:
The New-Keynesian Model
Figure 17.4B
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The Dynamic New Keynesian AS Curve
• In the previous section, we know that the growth
rate of the real wage will equal the output
(productivity) growth rate (g) in the long run.
w
P
Y

 g 
w
P
Y
• In the short run, excess output growth is
inversely related to excess real wage growth
along the aggregate supply curve and may be
modeled as w P

 Y
w

 g  b 
 g
P
 Y

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The Dynamic New Keynesian AS Curve
P

P
Rate of price


 w
 Y
 g   b
 g

 w
 Y


Excess wage Excess GDP
inflation
inflation
growth
The dynamic new-Keynesian aggregate supply curve
• Assume that the nominal wage grows at the rate
of productivity growth, g, then
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The Dynamic New Keynesian AS Curve
P

P
Rate of price


 w
 Y
 g   b
 g

 w
 Y


Excess wage Excess GDP
inflation
inflation
growth
The dynamic new-Keynesian aggregate supply curve
• Assume that the nominal wage grows at the rate
of productivity growth, g, then
P
P


 Y
b
 g
 Y

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The Dynamic New Keynesian AS Curve
P
P


 w
 g

 w


 Y
 b
 g
 Y

• Assume that the nominal wage grows at the rate
of productivity growth, g, then
P
w P
If
0 

 g,
P
w
P
P
w P
If
0 

 g,
P
w
P
P
w P
If
0 

 g,
P
w
P
L
 0,
L
L
 0,
L
L
 0,
L
Y
 g.
Y
Y
 g.
Y
Y
 g.
Y
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The Dynamic New Keynesian AS Curve
P
P


 w
 g

 w


 Y
 b
 g
 Y

• We can discuss the case that the excess nominal
wage inflation is non-zero.
• Figure 17.5 graphs the new-Keynesian dynamic
aggregate supply curve (SRAS) and its position
depends on excess nominal wage inflation,
 w / w  g (the intercept).
The purple line is the long run (classical)
dynamic aggregate supply curve (LRAS).
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Dynamic Aggregate Supply in the
New-Keynesian Model
Figure 17.5
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The Dynamic New Keynesian AS Curve
P
P


 w
 g

 w


 Y
 b
 g
 Y

• SRAS and LRAS intersect when price inflation
equals excess wage inflation, i.e. the real wage
and output rates both grow at the natural rate, g.
• If price inflation exceeds (is less than) the
excess nominal wage inflation, output growth
must be more (less) than g.
• But what determines excess wage inflation ?
-- the new-Keynesian wage equation.
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The New-Keynesian Wage Equation
• In the classical theory, the real wage follows its
natural path, and there are never any
opportunities for firms to make extra profits by
offering to trade with workers at a either lower
or higher real wage.
• In the new-Keynesian model, the real wage is
not necessary equal to the natural rate.
• However, it always moving toward its natural
path although adjustment takes time.
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The New-Keynesian Wage Equation
• For example, if the real wage rate is higher than
its natural rate and the unemployment is thus
above the natural rate.
Hence, firms can lower the wage rate and lower
its cost due to excess supply of labor until the
real wage returns to its natural rate.
This idea is modeled as
 w P E 

  g  c U  U *

P 
 w
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The New-Keynesian Wage Equation

 w
 g

 w

Excess wage
inflation
P E


P
Expected price
inflation
c U  U * 
Excess
unemployment
• This is the new-Keynesian wage equation.
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The New-Keynesian Wage Equation

 w
 g

 w


P E
P

c U  U *
• Expected price inflation influences wage
inflation because wages are typically set for a
period of time.
• Unemployment influences wage inflation
because if U is different from U*, all of the
possible gains from trade between workers and
firm have not been exploited, leaving an
opportunity for firm to profit.
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The New-Keynesian Wage Equation

 w
 g

 w


P E
P

c U  U *
• The parameter c determines how fast the real
wage returns to its natural path.
• If firms are very quick (slow) to react to profit
opportunities, the parameter c will be very large
(small), and the profit opportunities will quickly
(slowly) disappear.
• For large c, the model will behave like the
classical model.
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Wage Adjustment and the Phillips Curve

 w

g


w



P E
P
 c U  U *
• What evidence do we have for the newKeynesian theory of wage adjustment?
We can check the theory by searching for the
existence of a relationship between wage
inflation and unemployment by controlling the
variable, expected price inflation.
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Wage Adjustment and the Phillips Curve
• For the period, 1949-1969, expected price
inflation might reasonable be expected to have
been constant. (Figure 17.6)
-- Price inflation from 1949 to 1965 hovered at
around 2% per year.
-- After 1956, inflation began to increase at a faster
rate, but it is reasonable to workers and firm took
some time to adjust their expectations to the
changing conditions.
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The History of Inflation, 1949–1969
Figure 17.6A
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The History of Inflation, 1949–1969
Figure 17.6B
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Wage Adjustment and the Phillips Curve
• If both this assumption and the new-Keynesian
wage equation are correct, we should see a
negative relationship between wage inflation and
unemployment.
• Figure 17.7 presents evidence on the relationship.
• A.W. Phillips first noticed the stability of this
relationship and so called the Phillips curve which
provided an important stimulus to the research of
theorists working on the dynamic new-Keynesian
model.
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Wage, Inflation, and Unemployment
Figure 17.7A
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Wage, Inflation, and Unemployment
Figure 17.7B
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The Dynamic New-Keynesian Model
• The three pieces of the dynamic new-Keynesian
model :
1. The dynamic aggregate demand curve.
P / P  M / M
 Y / Y
2. The dynamic short-run aggregate supply curve.
P
P


 w
 g

 w


 Y
 b
 g
 Y

3. The new-Keynesian wage equation.

 w
 g

 w


P E
P
 c U  U *
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The Three Pieces of the Dynamic
New-Keynesian Model
Figure 17.8A
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The Three Pieces of the Dynamic
New-Keynesian Model
Figure 17.8B
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The Three Pieces of the Dynamic
New-Keynesian Model
Figure 17.8C
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Inflation and Growth when Expectation
are Fixed
• If the expected price inflation is assumed to be
fixed (like in the U.S. in the 1950s), excess wage
inflation depends only on whether the
unemployment rate is current higher or lower
than its natural rate. (Figure 17.8A)
• Because wage are typically set in advance, the
determination of nominal wage inflation occurs
before the determination of price inflation and
growth.
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Inflation and Growth when Expectation
are Fixed
• Once the wage inflation rate is known, the
position of the new-Keynesian (short-run) AS
curve is then determined.
• Inflation and growth are then determined at the
point where the short-run AS (Figure 17.8B)
intersects the aggregate demand curve (Figure
17.8A).
• Typically, both the demand and the supply curve
fluctuate from one year to the next.
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Inflation and Growth when Expectation
are Fixed
• Typically, both the demand and the supply curve
fluctuate from one year to the next.
-- If money growth is higher (lower) than average,
the AD curve will shift to the right (left) and
growth and inflation will be higher (lower) than
the average.
-- If the productivity growth rate (g) is higher
(lower) than average, the short-run AS curve will
shift to the right (left) and inflation and growth
will be higher (lower) than average.
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Inflation and Growth under Changing
Expectations
• The results of previous section are based on a
condition where the price inflation is stable.
• If the price inflation rate changes to a higher
level for a long time, the expected price inflation
rate will be raised.
 The positions of the wage equation and the
dynamic AS curve will shift upward.
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More-Realistic Theories of AD
• In this chapter, we justified our use of the
classical theory of aggregate demand rather than
the Keynesian theory on the ground of simplicity.
• What’s different if we adopt the Keynesian?
-- The long-run properties are the same – inflation is
determined by the rate of money creation and
output growth is determined by its natural rate.
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More-Realistic Theories of AD
• What’s different if we adopt the Keynesian?
-- In the short-run, variables other than the rate of
money creation, like the government policy, can
shift the dynamic AD curve.
Besides, changes in the interest rate interact with
money creation and inflation , and these
interaction add further dynamic elements to the
adjustment path from the short run to the long
run.
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Homework
Question 5, 7, 10, 11
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END