Question

Q. Suppose that natural real GDP is constant. For every 1 percent increase in the rate of inflation above its expected level, firms are willing to increase real GDP by 1 percent. The expected rate of inflation in the current period equals the actual rate of inflation in the previous period. Initially the output ratio is 100 and the actual and expected inflation rates equal 2 percent.

(a) Compute points on the short-run Phillips Curve when the inflation rate equals 0, 1, 2, 3, 4, and 5. Graph the short-run Phillips Curve.

(b) What is the growth rate of nominal GDP in the economy? Suppose that due to baby boomers becoming eligible for Medicare, there is a permanent increase in the growth rate of the federal government’s spending. That increase causes the growth rate of nominal GDP to accelerate to 4 percent.

(c) Use the short-run Phillips Curve to explain what the rate of inflation and the output ratio are in the first period after the increase in the growth rate of nominal GDP.

(d) Explain what the inflation rate is in the long run, given the increase in the growth rate of nominal GDP, and describe how the economy adjusts to the long-run equilibrium.

Answer 1

Sustained long-term economic growth comes from increases in worker productivity, which essentially means how well we do things. In other words, how efficient is your nation with its time and workers? Labor productivity is the value that each employed person creates per unit of his or her input. The easiest way to comprehend labor productivity is to imagine a Canadian worker who can make 10 loaves of bread in an hour versus a U.S. worker who in the same hour can make only two loaves of bread. In this fictional example, the Canadians are more productive. Being more productive essentially means you can do more in the same amount of time. This in turn frees up resources to be used elsewhere.

What determines how productive workers are? The answer is pretty intuitive. The first determinant of labor productivity is human capital. Human capital is the accumulated knowledge (from education and experience), skills, and expertise that the average worker in an economy possesses. Typically the higher the average level of education in an economy, the higher the accumulated human capital and the higher the labor productivity.

The second factor that determines labor productivity is technological change. Technological change is a combination of invention—advances in knowledge—and innovation, which is putting that advance to use in a new product or service. For example, the transistor was invented in 1947. It allowed us to miniaturize the footprint of electronic devices and use less power than the tube technology that came before it. Innovations since then have produced smaller and better transistors that that are ubiquitous in products as varied as smart-phones, computers, and escalators. The development of the transistor has allowed workers to be anywhere with smaller devices. These devices can be used to communicate with other workers, measure product quality or do any other task in less time, improving worker productivity.

The third factor that determines labor productivity is economies of scale. Recall that economies of scale are the cost advantages that industries obtain due to size. (Read more about economies of scale in Cost and Industry Structure.) Consider again the case of the fictional Canadian worker who could produce 10 loaves of bread in an hour. If this difference in productivity was due only to economies of scale, it could be that Canadian workers had access to a large industrial-size oven while the U.S. worker was using a standard residential size oven.

a) Short-run Phillips curve . Every point represents a combination of unemployment and inflation that an economy might experience given current expectations about inflation. For example, an economy that is on point 1 in Figure 1 above currently has an unemployment rate of 5\%5%5, percent and an inflation rate of 2\%2%2, percent. At point 2, the unemployment rate decreases to 3% and the rate of inflation increases to 7\%7%7, percent, moving along the SRPCSRPCS, R, P, C to the left. Movements along an SRPC, such as a movement from point 1 to point 2, indicate aggregate demand (ADADA, D) has changed. Shifts of the SRPCSRPCS, R, P, C, such as a movement from point 2 to point 3, indicate a change in short-run aggregate supply (SRASSRASS, R, A, S).

1. The long-run Phillips curve (LRPCLRPCL, R, P, C). The LRPCLRPCL, R, P, C is vertical at the natural rate of unemployment. Figure 1 tells us that this economy’s natural rate of unemployment is 5\%5%5, percent.

Key Takeaways

The economy is always operating somewhere along a short-run Phillips curve

Like the production possibilities curve and the AD-AS model, the short-run Phillips curve can be used to represent the state of an economy.

The table below summarizes how different stages in the business cycle can be represented as different points along the short-run Phillips curve.

The Phillips curve is a graph illustrating the relationship between inflation and the unemployment rate. The Phillips curve is a dynamic representation of the economy; it shows how quickly prices are rising through time for a given rate of unemployment. The relationship between inflation and unemployment depends upon the time frame. The short-run Phillips curve, illustrated in the figure titled "The Phillips Curve", shows that the relationship between the inflation rate () and unemployment is negative. When inflation rises, unemployment falls and vice versa.

This relationship helps to explain the adage "there is no good news in economics." When one side of the economy is doing well, the other side tends to do poorly. For example, if unemployment is low, inflation tends to be relatively high. Journalists often focus on the parts of the economy doing poorly. Because of the relationship represented in the Phillips curve, economists in the late 1950s and 1960s thought that all the Federal Reserve or government had to do was to pick the point on the short-run Phillips curve that they wanted the economy to be on. If they wanted to have less unemployment and operate, for example, at point B on the graph instead of point A, then they had to live with more inflation. This simplistic notion turned out to be false in the 1970s, forcing economists to rethink the whole notion of the Phillips curve.

b)

The Congressional Budget Office regularly publishes reports that present projections of what federal deficits, debt, revenues, and spending—and the economic path underlying them—would be for the current year and for the following 10 years and beyond if existing laws governing taxes and spending generally remained unchanged. This report is the latest in that series—and it shows a cumulative 10-year deficit that is slightly larger and a cumulative 30-year deficit that is notably larger than those in CBO’s previous projections.

• The Budget. In CBO’s projections, the federal budget deficit is $1.0 trillion in 2020 and averages $1.3 trillion between 2021 and 2030. Projected deficits rise from 4.6 percent of gross domestic product (GDP) in 2020 to 5.4 percent in 2030.

  Other than a six-year period during and immediately after World War II, the deficit over the past century has not exceeded 4.0 percent for more than five consecutive years. And during the past 50 years, deficits have averaged 1.5 percent of GDP when the economy was relatively strong (as it is now).

  Because of the large deficits, federal debt held by the public is projected to grow, from 81 percent of GDP in 2020 to 98 percent in 2030 (its highest percentage since 1946). By 2050, debt would be 180 percent of GDP—far higher than it has ever been.

• The Economy. In 2020, inflation-adjusted GDP is projected to grow by 2.2 percent, largely because of continued strength in consumer spending and a rebound in business fixed investment. Output is projected to be higher than the economy’s maximum sustainable output this year to a greater degree than it has been in recent years, leading to higher inflation and interest rates after a period in which both were low, on average. Continued strength in the demand for labor keeps the unemployment rate low and drives employment and wages higher.

  After 2020, economic growth is projected to slow. From 2021 to 2030, output is projected to grow at an average annual rate of 1.7 percent, roughly the same rate as potential growth. That average growth rate of output is less than its long-term historical average, primarily because the labor force is expected to grow more slowly than it has in the past. Over that same period, the interest rate on 10-year Treasury notes is projected to rise gradually, reaching 3.1 percent in 2030 (see Chapter 2).

• Changes Since CBO’s Previous Projections. CBO’s estimate of the deficit for 2020 is now $8 billion more—and its projection of the cumulative deficit over the 2020–2029 period, $160 billion more—than the agency projected in August 2019. That 10-year increase is the net result of changes that go in opposite directions. Lower projected interest rates and higher estimates of wages, salaries, and proprietors’ income reduced projected deficits, but a combination of recent legislation and other changes increased them

  Relative to the projections in CBO’s long-term budget outlook, last published in June 2019, debt held by the public as a percentage of GDP in 2049 is now projected to be 30 percentage points higher. That increase is largely the result of legislation enacted since June—which decreased revenues and increased discretionary outlays—and of lower projected GDP.

c)In 1958, when A.W.H. Phillips released a study of wages in the United Kingdom, he found that there was an inverse relationship between inflation and unemployment. In other words, when unemployment was high, inflation was low; and when unemployment was low, inflation rose rapidly. Economists call this the Phillips Curve. The Phillips Curve illustrates the relationship between the rate of inflation and the unemployment rate. In this lesson, we're talking about the factors that lead to a shift in the Phillips Curve.

Inflation unemployment are closely related to aggregate supply, because it takes workers to produce the supply of goods and wages tend to be one of the largest expenses for businesses. Because of this connection, whatever events lead to a shift in aggregate supply will also lead to a shift in the short run Phillips Curve, whether they are positive or negative.

Let's visit the town of Ceelo to find out what factors will lead to a shift in the Phillips Curve. First, we'll talk about a rightward shift (or increase), then a leftward shift (or decrease).

In the town of Ceelo, we find that Bob the business owner is busy mowing lawns. On his breaks, he's drinking energy drinks, listening to his tunes on his mePhone and reading the latest edition of the popular magazine 'Landscaper's Dream.'

The Phillips Curve Shifts to the Right

Suppose that this year prices in the town of Ceelo are 3% higher than they were last year, and inflation has been 3% over the last several years. In this case, consumers and businesses in the town would probably expect prices to go up by 3% this year. This means that Bob would set his prices 3% higher, and Bob's workers would expect a cost-of-living adjustment in their wages of 3%. Now, suppose that instead of 3%, inflation was actually 4% this year. It was 3% for several years in a row, but now all of a sudden, it's 4%. Observing this trend, Bob may expect inflation to go up by 5% next year, and raise prices by this amount. Bob's workers may expect more inflation as well and negotiate their wages even higher. Increases in expected inflation like this cause a rightward shift to the short run Phillips Curve.

d)

The Inflation Rate in the Long Run

What factors determine the inflation rate? The price level is determined by the intersection of aggregate demand and short-run aggregate supply; anything that shifts either of these two curves changes the price level and thus affects the inflation rate. We have seen how these shifts can generate different inflation–unemployment combinations in the short run. In the long run, the rate of inflation will be determined by two factors: the rate of money growth and the rate of economic growth.

Economists generally agree that the rate of money growth is one determinant of an economy’s inflation rate in the long run. The conceptual basis for that conclusion lies in the equation of exchange: MV = PY. That is, the money supply times the velocity of money equals the price level times the value of real GDP.

Given the equation of exchange, which holds by definition, we learned in the chapter on monetary policy that the sum of the percentage rates of change in M and V will be roughly equal to the sum of the percentage rates of change in P and Y. That is

%ΔM+%ΔV≅%ΔP+%ΔY%ΔM+%ΔV≅%ΔP+%ΔY

Suppose that velocity is stable in the long run, so that %ΔV equals zero. Then, the inflation rate (%ΔP) roughly equals the percentage rate of change in the money supply minus the percentage rate of change in real GDP:

%ΔP≅%ΔM−%ΔY%ΔP≅%ΔM−%ΔY

In the long run, real GDP moves to its potential level, YP. Thus, in the long run we can write  as follows:

%ΔP≅%ΔM−%ΔYP%ΔP≅%ΔM−%ΔYP

There is a limit to how fast the economy’s potential output can grow. Economists generally agree that potential output increases at only about a 2% to 3% annual rate in the United States. Given that the economy stays close to its potential, this puts a rough limit on the speed with which Y can grow. Velocity can vary, but it is not likely to change at a rapid rate over a sustained period. These two facts suggest that very rapid increases in the quantity of money, M, will inevitably produce very rapid increases in the price level, P. If the money supply grows more slowly than potential output, then the right-hand side of equation 3  will be negative. The price level will fall; the economy experiences deflation.

Nominal gross domestic product is gross domestic product (GDP) evaluated at current market prices. GDP is the monetary value of all the goods and services produced in a country. Nominal differs from real GDP in that it includes changes in prices due to inflation, which reflects the rate of price increases in an economy.

KEY TAKEAWAYS

• Nominal GDP is an assessment of economic production in an economy but includes the current prices of goods and services in its calculation.
• GDP is typically measured as the monetary value of goods and services produced.
• Since nominal GDP doesn't remove the pace of rising prices when comparing one period to another, it can inflate the growth figure.

Uerstanding Nominal Gross Domestic Product:

Nominal GDP is an assessment of economic production in an economy that includes current prices in its calculation. In other words, it doesn't strip out inflation or the pace of rising prices, which can inflate the growth figure. All goods and services counted in nominal GDP are valued at the prices that are actually sold for in that year.

Because it is measured in current prices, growing nominal GDP from year to year might reflect a rise in prices as opposed to growth in the amount of goods and services produced. If all prices rise more or less together, known as inflation, then this will make nominal GDP appear greater. Inflation is a negative force for economic participants because it diminishes the purchasing power of income and savings, both for consumers and investors.

Inflation is most commonly measured using the consumer price index(CPI) or the producer price index(PPI). The CPI measures price changes from the buyer's perspective or how they impact the consumer. The PPI, on the other hand, measures the average change of selling prices that are paid to producers in the economy.

Gross Domestic Product

The Gross domestic Product (GDP) is the market value of all final goods and services produced within a country in a given period of time. The GDP is the officially recognized totals. The following equation is used to calculate the GDP:

GDP=C+I+G+(X−M)GDP=C+I+G+(X−M)

Written out, the equation for calculating GDP is:

GDP = private consumption + gross investment + government investment + government spending + (exports – imports).

For the gross domestic product, “gross” means that the GDP measures production regardless of the various uses to which the product can be put. Production can be used for immediate consumption, for investment into fixed assets or inventories, or for replacing fixed assets that have depreciated. “Domestic” means that the measurement of GDP contains only products from within its borders.

Nominal GDP

The nominal GDP is the value of all the final goods and services that an economy produced during a given year. It is calculated by using the prices that are current in the year in which the output is produced. In economics, a nominal value is expressed in monetary terms. For example, a nominal value can change due to shifts in quantity and price. The nominal GDP takes into account all of the changes that occurred for all goods and services produced during a given year. If prices change from one period to the next and the output does not change, the nominal GDP would change even though the output remained constant.

In economics, real value is not influenced by changes in price, it is only impacted by changes in quantity. Real values measure the purchasing power net of any price changes over time. The real GDP determines the purchasing power net of price changes for a given year. Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.

The GDP Deflator

The GDP deflator is a price index that measures inflation or deflation in an economy by calculating a ratio of nominal GDP to real GDP.