Unemployment,

Inflation and
Growth
 Money and Prices
• The quantity theory of money
• The equation of exchange: MV = PY
– M money supply
– V velocity of circulation
– P price level (number of times greater
than in base year)
– Y real value of output at base-year prices
– MV = PQ
• The link between money and prices
– quantity theory holds if V and Y are determined
independently of M
 Money and Prices
• Assumptions about the velocity of
circulation
– the short run
• uncertain relationship between money and
prices
• the monetary transmission mechanism
– the money–interest rate link
– the interest rate–spending link

– the long run

• the theory of portfolio balance
 Money and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence
 Different aggregate supply curves

AS
Price level

National output
 Different aggregate supply curves

AS
Price level

P1

AD1
O Y1
National output
 Different aggregate supply curves

AS
Price level

P2
P1
AD2

AD1
O Y1 Y2
National output
 Short-run response of a profit-maximising
firm to a rise in demand
£
MC

P1

AR1

Q1 Q
MR1
 Short-run response of a profit-maximising
firm to a rise in demand
£
MC

P1

AR2
AR1

Q1 MR2 Q
MR1
 Short-run response of a profit-maximising
firm to a rise in demand
£
MC

P2
P1

AR2
AR1

Q1 Q2 MR2 Q
MR1
 Money and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence

– the long run aggregate supply curve

 Money and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence

– the long run aggregate supply curve

• relatively inelastic
 Different aggregate supply curves
AS
Price level

O Y
National output
 Different aggregate supply curves
AS
Price level

P1

AD1
O Y
National output
 Different aggregate supply curves
AS
Price level

P2

P1
AD2

AD1
O Y
National output
 Money and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence

– the long run aggregate supply curve

• relatively inelastic
– the interdependence of markets
 Money and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence

– the long run aggregate supply curve

• relatively inelastic
– the interdependence of markets
– the flexibility of prices
 The long-run aggregate supply curve
when firms are interdependent

SRAS1
(expected price level = P1)
Price level

P1
a

AD1
O Q1
National output
 The long-run aggregate supply curve
when firms are interdependent

SRAS2
(expected price level = P3 )
SRAS1
(expected price level = P1)
c
Price level

P3
P2 b
P1
a

AD2

AD1
O Q1 Q2
National output
 The long-run aggregate supply curve
when firms are interdependent
LRAS
SRAS2
(expected price level = P3 )
SRAS1
(expected price level = P1)
c
Price level

P3
P2 b
P1
a

AD2

AD1
O Qn Q2
National output
 Money and Prices
• Assumptions about output and prices
– the short-run aggregate supply curve
• relatively elastic in short run
– stickiness of wages and prices
– confidence

– the long run aggregate supply curve

• relatively inelastic
– the interdependence of markets
– the flexibility of prices

• the effects of investment on aggregate supply

 Effect of investment on the long-run AS curve

AS1(shortrun)
Price level

AD1

National output
 Effect of investment on the long-run AS curve

AS1(shortrun)
AS2(shortrun)

b AS (longrun)
Price level

d
a

AD2
AD1

National output
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
. A Phillips curve
P (%)

. b
P2

. a
P1

O U2 U1 U (%)
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
– accelerating inflation
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
– accelerating inflation
• when unemployment is kept below the ‘natural’
level
.
The accelerationist theory of inflation
P (%)
20

16

12

8
b

4 a
6 8 . U (%)
I (Pe = 0)
.
The accelerationist theory of inflation
P (%)
20

f
16

12
d
.
8 IV (Pe = 12%)
b c .
III (Pe = 8%)
.
4 a II (Pe = 4%)

6 8 . U (%)
I (Pe = 0)
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
– accelerating inflation
• when unemployment is kept below the ‘natural’
level
– the long-run Phillips curve
.
P (%) The long-run Phillips curve
20

16

12

6 8 U (%)
U
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
– accelerating inflation
• when unemployment is kept below the ‘natural’
level
– the long-run Phillips curve
– effects of deflationary policies
.
The effects of deflation
P (%)
24
22
J
20 k

18
.
16 X (Pe = 20%)
14
12
10
8
6
4
8 1 U (%)
2
3
.
The effects of deflation
P (%)
24
22
J
20 k

18 l
.
16 m X (Pe = 20%)
.
14 XI (Pe = 18%)
.
12 XII (Pe = 16%)
10
8
6
4
8 1 U (%)
2
3
.
The effects of deflation
P (%)
24
22
J
20 k

18 l
16 m

14
12
10
8
6
a
4
8 1 U (%)
2
3
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
– accelerating inflation
• when unemployment is kept below the ‘natural’
level
– the long-run Phillips curve
– effects of deflationary policies
• Phillips loops
. Clockwise Phillips loops
P (%)
20

b
a
Year 2

Un U (%)
Year 0, 1
. Clockwise Phillips loops
P (%)
20

f
e

Year 5
c
Year 4

Year 3
b
a
Year 2

Un U (%)
Year 0, 1
. Clockwise Phillips loops
P (%)
20

f
e

g
d

h Year 5, 8
c
Year 4, 7
i

Year 3, 8
b J
a Year 2, 9

Un U (%)
Year 0, 1, 10
 Inflation and Unemployment:
Introducing Expectations
• Expectations augmented Phillips curve
– adaptive expectations
• The accelerationist theory
– accelerating inflation
• when unemployment is kept below the ‘natural’
level
– the long-run Phillips curve
– effects of deflationary policies
• Phillips loops
• Policy implications
Inflation and Unemployment: New
Classical Views
• Assumption of flexible wages and prices
• Rational expectations
– meaning of rational expectations
– imperfect information
– implications for AS and the Phillips curve
– policy implications
• Real business cycles
– fluctuations in aggregate supply
– causes of changes in aggregate supply
– policy implications
Inflation and Unemployment:
Keynesian Views
• Changes in equilibrium unemployment
– structural unemployment
– hysteresis
• The persistence of demand-deficient
unemployment
– payment of efficiency wages
– insider power
• Incorporation of expectations
– expansion of aggregate demand
– contraction of aggregate demand
• Keynesian criticism of non-intervention
Common ground between economists?

• Short-run effect of changes in AD

– major effect on output and employment
– relatively small effect on prices
• Long-run effect of changes in AD
– relatively small effect on output and jobs
– relatively large effect on prices
– some Keynesians disagree
• stress long-run effects of changes in AD on
investment
• Importance of expectations
 Demand-side Policy
• Attitudes towards demand management
• Case against discretion
– time lags
– problem of over-correction
– government may ignore long-term
consequences
• Case for rules
– help to reduce inflationary expectations
– create a stable environment for investment
and growth
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
 Demand-side Policy
• Case against rules
– can cause severe fluctuations in interest
rates and can cause greater instability
– which rule to choose?
– rules may conflict
– rules may become unsuitable
• Case for discretion
– fine tuning can be improved by better
forecasting and quick-acting policies
– allows governments to respond to changing
circumstances
 Demand-side Policy
• Demand-side policy in the UK
– increasingly rules-based
– fiscal policy
• 'golden rule'
• but some flexibility
– monetary policy
• target of 2% inflation set by government
• Monetary Policy Committee adjusts interest rates
to meet this 2% target
• benefits of transparency
• benefits for expectations
 Long-term Economic Growth

• Growth over the decades

 UK GDP at market prices (1995=100)

120

110

100
Real GDP (1995 = 100)

90

80

70

60

50

40
 UK GDP at market prices (1995=100)

120

110

100
Real GDP (1995 = 100)

90

80

70

60

50

40
 Long-term Economic Growth

• The causes of economic growth

– increase in quantity of factors
– increase in productivity of factors
• Capital accumulation
– a simple model of economic growth
• effect of an increase in capital
• diminishing returns
• steady-state national income
Output (Y), Investment (I), Depreciation (D) Steady-state output

Output (Y)

f
Y1

a Depreciation (D)
Y0

Investment (I)
g
I0
b
D0 c

O K0 K1
Capital stock (K)
 Long-term Economic Growth

• The causes of economic growth

– increase in quantity of factors
– increase in productivity of factors
• Capital accumulation
– a simple model of economic growth
• effect of an increase in capital
• diminishing returns
• steady-state national income
– effect of an increase in the saving rate
 Effect of an increase in the rate of saving and investment
Output (Y), Investment (I), Depreciation (D)

m Y
Y2
f
Y1

n I2
h
I1
g

K1 K2
Capital stock (K)
 Long-term Economic Growth

• Technological progress
– effect on steady-state output
Output (Y), Investment (I), Depreciation (D) Effect of a technological advance

p Y2
Y2
Y1

f
Y1
D

n I2
h
I1
g

K1 K2
Capital stock (K)
 Long-term Economic Growth

• Technological progress
– effect on steady-state output
– endogenous growth theory
 Long-term Economic Growth

• Productivity and economic growth

– importance of productivity
– determinants of productivity
• private investment
• public investment in infrastructure and
education
• innovation
• business environment
• management and entrepreneurial activity
 Supply-side Policy

• The use of supply-side policies

– to reduce unemployment

– to reduce inflation

– to increase economic growth

• Market-orientated supply-side policies

– reducing government expenditure

Government expenditure (central plus local) as a
percentage of GDP
Government expenditure (central plus local) as a
percentage of GDP
Government expenditure (central plus local) as a
percentage of GDP
Government expenditure (central plus local) as a
percentage of GDP
Government expenditure (central plus local) as a
percentage of GDP
Government expenditure (central plus local) as a
percentage of GDP
Government expenditure (central plus local) as a
percentage of GDP
 Supply-side Policy

• Market-orientated supply-side policies

– reducing government expenditure

– tax cuts
 Supply-side Policy

• Market-orientated supply-side policies

– reducing government expenditure

– tax cuts
• effects on labour supply and employment
 Supply-side Policy

• Market-orientated supply-side policies

– reducing government expenditure

– tax cuts
• effects on labour supply and employment

• importance of incentives
 Supply-side Policy

• Market-orientated supply-side policies

– reducing government expenditure

– tax cuts
• effects on labour supply and employment

• importance of incentives

• effects on imports
 Supply-side Policy

• Market-orientated supply-side policies

– reducing government expenditure

– tax cuts
• effects on labour supply and employment

• importance of incentives

• effects on imports

• tax cuts for business

 Supply-side Policy

• Market-orientated supply-side policies (cont.)

– reducing the power of labour
– reducing welfare
– policies to encourage competition
• privatisation
• deregulation
• introducing market relationships into the public sector
• the Private Finance Initiative
• free trade and capital movements
 Supply-side Policy

• Background to interventionist policy

– the UK's poor productivity record
 Productivity in selected countries, 2001 (UK = 100)

Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
 Productivity in selected countries, 2001 (UK = 100)

Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
 Productivity in selected countries, 2001 (UK = 100)

Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
 Productivity in selected countries, 2001 (UK = 100)

Source: Budget 2003, Economic and Fiscal Strategy Report (HM Treasury, 2003)
 Supply-side Policy

• Background to interventionist policy

– the UK's poor productivity record

– the UK's poor investment record

Gross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDP
Gross fixed capital formation as % of GDP
 Supply-side Policy
• Interventionist supply-side policy
– failure of the market to provide adequate
training, R&D and investment
– help to firms
• direct provision
• finance for research and development
• assistance to small firms
• advice and persuasion
• information
– infrastructure development
– training and education