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1 MONEY GROWTH, INFLATION, AND INTEREST RATES (3 of 3)

1 MONEY GROWTH, INFLATION, AND INTEREST RATES (3 of 3)

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APPLICATION 1



SHIFTS IN THE NATURAL RATE OF UNEMPLOYMENT



APPLYING THE CONCEPTS #1: How can data on vacancies and unemployment be used to measure shifts in the natural rate?



The natural rate of unemployment changes over time.



Policy makers need to know what the natural rate is to avoid unnecessary unemployment and inflation.



One way to estimate is to look at the Beveridge Curve, the relationship between job vacancies and the unemployment rate.



Economist William Dickens tracked the natural rate in recent decades:
Five percent in the mid 1960s
Peaked near seven percent in the late 1970s and early 1980s
Falling through the 1990s and reached five percent in 2000

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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (2 of 4)

Are the Public’s Expectations About Inflation Rational?


Rational expectations
The economic theory that analyzes how the public forms expectations in such a manner that, on
correctly.

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average, they forecast the future

16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (3 of 4)

U.S. Inflation and Unemployment in the 1980s
Inflation rose and the unemployment rate fell below the natural rate.

Inflation later fell as unemployment exceeded the natural rate.

SOURCE: Economic Report of the President (Washington, D.C.: U.S.
Government Printing Office, yearly).

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16.2 UNDERSTANDING THE EXPECTATIONS
PHILLIPS CURVE: THE RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION (4 of 4)

Shifts in the Natural Rate of Unemployment in the 1990s



What factors can shift the natural rate of unemployment?



Demographics



Institutional changes



The recent history of the economy



Changes in growth of labor productivity

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16.3 HOW THE CREDIBILITY OF A NATION’S
CENTRAL BANK AFFECTS INFLATION (1 of 2)

If workers push up their nominal wages, the aggregate supply curve will
shift from AS0 to AS1.

If the Fed keeps aggregate demand constant at AD0, a recession will
occur at point a, and the economy will eventually return to full
employment at point c.

If the Fed increases aggregate demand, the economy remains at full
employment at b, but with a higher price level.

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16.3 HOW THE CREDIBILITY OF A NATION’S
CENTRAL BANK AFFECTS INFLATION (2 of 2)

Countries in which central banks are more independent from the rest of the
government have, on average, lower inflation rates.

SOURCE: Based on selected data in Table 5 of “Measuring the Independence
of Central Banks and Its Effect on Policy Outcomes,” Alex Cukierman, Steven
Webb, and Bilin Neyapti, The World Bank Economic Review, 6:3, 353–398.

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APPLICATION 2



ESTIMATING THE NATURAL REAL INTEREST RATE



APPLYING THE CONCEPTS #2: How does the Fed use the concept of the natural interest rate to conduct monetary policy?

In addition to being concerned about shifts in the natural rate of unemployment, the Fed also worries about shifts in the natural rate of interest.

The natural rate of interest is defined as the real interest rate consistent with full employment after temporary demand and supply shocks have subsided.

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16.4 INFLATION AND THE VELOCITY OF MONEY (1 of 3)


Velocity of money
The rate at which money turns over during the year. It is calculated as nominal GDP divided by the money supply.

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16.4 INFLATION AND THE VELOCITY OF MONEY (2 of 3)


Quantity equation
The equation that links money, velocity, prices, and real output. In symbols, we have M × V = P × y.

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▼FIGURE 16.4
The Velocity of M2, 1959–2011

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16.4 INFLATION AND THE VELOCITY OF MONEY (3 of 3)


Growth version of the quantity equation
An equation that links the growth rates of money, velocity, prices, and real output.





growth rate of money + growth rate of velocity
= growth rate of prices + growth rate of real output

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