Week 5: Unemployment, Inflation, and Stagflation Flashcards
Why is the distinction between cyclical, frictional, and structural unemployment important?
Cyclical unemployement due to recession can be cured with expansionary fiscal or monetary policy. Structural unemployement is harder to fixs and requires more targeted policies such as job retraining.
Explain Okun’s law.
Used to measure the cost of unemployement. For every 2% GDP fall, unemployement rises by 1%. Actual GDP must grow as rapidly as potential GDP just to keep the unemployement rate from rising.
What is the core or inertial rate of inflation?
Rate of inflation that tends to persist at the same rate until a demand or supply side shock changes things.
Why are inflationary expectations important?
Because the expectation of inflation can significantly contribute to actual inflation.
What are adaptive expectations?
People believe next years rate of inflation will be the same as last year’s rate.
Illustrate how adaptive expectations lead to an inertial inflation rate.
Inflationary expectations get built into an economy and expectations become reality. e.g. because of the higher wage raise (adjusted with expected inflation) there is higher wage pressure on your company, so it has to raise prices of its good => the core rate of inflation is maintained.
What relationship does the Phillips Curve purport to illustrate?
The stable tradeoff beween inflation (Y axis) and unemployement (X-axis). high inflation and low unemployement and vice versa. Policy implication: you can use expansionary policies to reduce unemployement and the only price will be a bit more inflation.
What happened in the 1970s to shake economists’ faith in the Phillips Curve?
The curve become a curl => stagflation. i.e. the curve shifts outwards, then a little bit inwards, then outwards,….
What is the standard explanation of the Phillips Curve breakdown?
Series of supply shocks drove curve outwards => unstable times. In stable times policy makers can still use expansionary tactics to fight unemployement at the cost of a little inflation.
According to the Monetarists, the disappearance of the Phillips Curve in the 1970s may best be explained through what two things?
The natural rate of unemployement. And distinguishing between a short run and a long run Phillips curve. In the short run inflation stays low because people don’t expect high inflation (adaptive inflation), however when they do notice there is inflation, they demand higher wages. Which results in a shift of the philips curve outwards.
What is the natural or lowest sustainable rate of unemployment?
Key concept of monetarism. Lowest sustainable rate of unemployement without causing inflation. Implies long run philips curve is vertical, rather then downward sloping.
What are the policy implications of the Monetarist’s natural rate theory, particularly with regard to Keynesian activism?
1) Expansionary fiscal policy can drive the unemployement under the natural rate temporarily.
2) The keynesian joy ride will eventually come to an end and cause inflation.
3) If a nation continues to use Keynesian tactics, it will result in inflationary spiral in the long run.
Is the natural rate of unemployment constant?
The natural rate changes as the structure of an economy changes. E.G. through supply side shocks.
How do the Monetarists stop an inflationary spiral?
Stop using expansionary policy and allow economy to return to natural rate of unemployement. But even if we stop the upward inflationary spircal, we still have significant inflations because a higher core rate of inflation has been built into the economy.
Contrast the traditional Keynesian versus Monetarist approaches to wringing inflation out of the economy. Why does neither have political appeal?
Keynesian: Incomes policy (impose wage and price controls until inflation dissipates) => this may not work and goes against free market capitalism.
Monetarism: Push actual inflation rate below expected inflation rate => to achieve this the actual unemployement rate must be above the natural rate => induces a recession.
