Macroeconomics. Note: Lectures cannot be reprinted or distributed without express written consent of Erik Hurst. 1

Transcription

1 Summer 2018 Macroeconomics Note: Lectures cannot be reprinted or distributed without express written consent of Erik Hurst. 1

2 Question: How Healthy is the Current US Labor Market? 2

3 Unemployment Rate: 1970M1 2018M5 Note: Throughout class shaded years on similar graphs are recessions 3

4 Unemployment Duration: 1970M1 2018M5 4

5 How is Unemployment Measured? Standardized Definition of the Unemployment Rate: Unemployed = jobless but looking for a job Labor Force = #Employed + #Unemployed Unemployment Rate = (# Unemployed) / (Labor Force) This is the definition used in most countries, including the U.S. U.S. data: U.S. measurement details: Issues: Discouraged Workers, Underemployed, Measurement Issues 5

6 Components of Unemployment Flow of people into the unemployment pool o Flow into unemployment from employment (job loss) o Flow into unemployment from out of labor force (stop being discouraged) Flow of people out of the unemployment pool o Flow out of unemployment into employment (job finding) o Flow out of unemployment out of labor force (discouraged workers) 6

7 A Few More Definitions Labor Force Participation Rate o Labor Force/ Population (age 16+) Employment Rate o Employed / Population (age 16+) o Employment rate defined out of total population as opposed to labor force. o Also referred to as employment to population rate (EPOP). 7

8 Labor Force Participation Rate 8

9 Employment to Population Rate: Men 9

10 Employment to Population Rate: Men

11 Employment to Population Rate: Men

12 Employment to Population Rate: Men

13 Employment to Population Rate: Men

14 Employment to Population Rate: Men

15 Fraction of Men Working Zero Weeks During Prior Year, March CPS

16 Employment to Population Rate: Men (Not in School) 16

17 Employment to Population Rate: Women

18 Employment to Population Rate: Women

19 Take Away 1 Unemployment rate is giving a misleading statistic of the US labor market Unemployment rate is low by historical standards (and back to early 2000 levels). Employment rate for prime age workers is still WELL below 2000 levels. o Declines are particularly pronounced for less educated individuals. Workers have left the labor force and are no longer looking for jobs. While the labor market is improving, its health is still quite a bit below early 2000s levels. 19

20 Inflation Adjusted Wages, Men (Education and Age Adjusted) 20

21 Types of Unemployment Frictional Unemployment: Result of Matching Behavior between Firms and Workers. Structural Unemployment: Result of Mismatch of Skills and Employer Needs Cyclical Unemployment: Result of output being below full-employment. Individuals have the desire to work and the skills to work, yet cannot find a job. Is Zero Unemployment a Reasonable Policy Goal? No! Frictional and Structural Unemployment may be desirable (unavoidable). 21

22 Why is the Distinction Important? How much of the current unemployment is structural vs. cyclical? This is a current debate among policy makers (and a question I am trying to answer in my own research) Why could there be structural unemployment? o Some industries have been in secular decline during the 2000s (manufacturing). The jobs being created now are not in those industries. o Former workers in manufacturing need to be reallocated to other sectors. 22

23 Some Other Labor Market Facts 23

24 Bring Some Research into the Classroom A large amount of my current work has been trying to understand the current low employment rates of prime age workers. We will talk about much of my current work as well as frontier research from other top academic economists as the course progresses. Today: Talk about the role of declining manufacturing sector in contributing to low employment rates of prime age workers. Highlight that automation not trade has been a key driver of the declining manufacturing sector. Show how the decline in the manufacturing sector is associated with many other social phenomenon.

25 U.S. Manufacturing Employment, BLS ~ -1.7 million ~ -0.3 million ~ -6.0 million ~ million

26 U.S. Manufacturing Establishments - 75,000 Establishments

27 U.S. Manufacturing Establishments - 75,000 Establishments Despite falling employment and establishments, real manufacturing output rose slightly during 2000s (~7%)

28 Labor Share Index (1987 = 100) Labor Share = Share of earnings to workers out of output

29 Capital Intensity Index (1987 = 100) Ratio of capital services to hours worked in the production process.

30 Share of Production Workers in Manufacturing Industry: Age 21-55, CPS

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32 Regional Identification Can we use regional variation to get causal estimates of the effects of local manufacturing declines on local labor market outcomes? Yes Places that were historically centered around manufacturing experienced much larger declines in employment and wages!

33 Distribution of Manufacturing Activity in US in 2000 Share of individuals working in manufacturing (commuting zone)

34 Change in Manufacturing Share vs Change in Employment Rate, Prime Age Men Each circle is a commuting zone (MSA) size of circle is population size of commuting zone.

35 Change in Manufacturing Share vs Change in Employment Rate, Prime Age Women

36 Question: Is Manufacturing Decline Related to Political Shifts? 36

37 Shift towards Republican Presidential Voting 2016 Vote Share Republican 2016 Vote Share Republican 2012 (by county)

38 Shift towards Republican Presidential Voting 2016 Vote Share Republican 2016 Vote Share Republican 2012 (by state)

39 Question: Is Manufacturing Decline Related to Increased Opioid Use? 39

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43 Back to the Course

44 Questions We Will Address In This Course 1. What causes recessions? What causes unemployment? 2. What caused the Great Recession? Is another recession on the horizon? 3. What is the link between the banking sector and real economic activity? 4. Should we be concerned with inflation? What about deflation? 5. What causes inflation/deflation? 6. How can policy makers (Fed/Congress/President) influence economic activity in the short run (fight inflation and recessions) and in the long run (promote economic growth)? 7. What are the pitfalls of government intervention? 8. What makes economies grow in the LONG RUN? 9. How worried should we be about long run government deficits? What are the costs/benefits of altering the nature of the Federal Reserve? 10. What is the influence of China and India on the U.S. economy? 11. Brexit? 12. What are costs/benefits of altered immigration policy or changes in minimum wage laws? 44

45 Caveat #1 My course takes the perspective of analyzing any large macroeconomy (with respect to the models we build). The examples will come primarily from the U.S. (because that is what I study) However, the insights apply equally well to all large developed economies including: The European Union Japan Canada, Australia, etc. The models you will learn in this class also explain consumer, business, and government behavior for all economies (China, India, etc.). 45

46 Caveat #2 The course takes time to build. Our goal is to construct and analyze the economy as a whole. To do that, we separately build the parts. After we build the parts, we put them together to see how they interact. At certain points in the class, you may feel that we are losing sight of the big picture and you may feel lost. That is common. But, I promise, by week 7 or 8 everything will come together (it always does). 46

47 TOPIC 1 A Introduction to Macro Data 47

48 Goals of the Lecture What is Gross Domestic Product (GDP)? Why do we care about it? How do we measure standard of living over time? What are the definitions of the major economic expenditure components? What are the trends in these components over time? What is the difference between Real and Nominal variables? How is Inflation measured? Why do we care about Inflation? What have been the predominant relationships between Inflation and GDP over the last four decades? NOTE: This lecture will likely go into next week. This is by design. It does not mean we will be short-changed on other material later in the class. 48

49 Part A: Measuring GDP (Production) 49

50 Gross Domestic Product (GDP) GDP is a measure of output. Why Do We Care? Because output is highly correlated (at certain times) with other things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc ) Formal Definition: GDP is the Market Value of all Final Goods and Services Newly Produced on Domestic Soil During a Given Time Period (different than GNP) 50

51 Production Equals Expenditure GDP is a measure of Market Production! GDP = Expenditure = Income = Y (the symbol we will use) (in macroeconomic equilibrium) What is produced in the market has to show up as being purchased or held by some economic agent. Who are the economic agents we will consider on the expenditure side? Consumers (refer to expenditure of consumers as consumption ) Businesses (refer to expenditure of firms as investment ) Governments (refer to expenditures of governments as government spending ) Foreign Sector (refer to expenditures of foreign sector as exports ) 51

52 A Simple Example What is produced has to be purchased by someone (including the producer). Suppose I produce a cell phone. If so, I could: sell it to domestic customers (Consumption (C)) sell it to domestic businesses (Investment (I)) keep it as inventory (Investment (I)) sell it to domestic government (Government spending (G)) sell it to foreign consumers, businesses or governments (Export (X)) 52

53 A Key Equation Define Aggregate Expenditure: Y = C + I + G + X IM Only four economic agents can spend on domestic production: domestic consumers (C), domestic firms (I), domestic governments (G) and foreign consumers, firms, and governments (X) Note: Need to net out imports (IM) goods that are purchased by domestic consumers, businesses and governments that were produced abroad. Note: Define net exports (NX) as exports imports (X IM) We will develop models for each sub component of the expenditure side of the economy (C, I, G, and NX). 53

54 Production Also Equals Income What is Produced is Also a Measure of Income. If you pay a $1 for something, that $1 has to end up in someone s pocket as: Wages/Salary (compensation for workers who make production) Profits (compensation for self employed) Rents (compensation for land owners) Interest (compensation for debt owners) Dividends (compensation for equity owners) Notice, wages are only one component of income (Y does not equal wages)! (Although, under certain production functions, they will be proportional to each other). 54

55 Stop and Pause By definition.. Production = Income = Expenditure = Y What is produced has to be purchased by someone (accounting for inventory changes). Value of what is purchased has to end up as income in somebody s pocket! In our class, we realize that the terms are interchangeable in equilibrium. 55

56 Measuring GDP in Practice Production Method: Measure the Value Added summed Across Industries (value added = sale price - cost of raw materials) Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX) Income Method: Labor Income (wages/salary) + Capital Income (rent, interest, dividends, profits). In our class, we will model the production side of economy (supply side) and the expenditure side of the economy (demand side). Prices will always adjust to equate supply and demand such that Y (production) 56 always equals Y (expenditure).

57 What GDP is NOT! GDP is not, or never claims to be, an absolute measure of well-being! Size effects : But even GDP per capita is not a perfect measure of welfare The gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud to be Americans. U.S. Senator Robert F. Kennedy,

58 More on What GDP Is Not GDP Does Not Measure: Non-Market Activity (home production, leisure, black market activity) Environmental Quality/Natural Resource Depletion Life Expectancy and Health Income Distribution Crime/Safety Remember how we measure GDP (i.e., how does one measure safety ). Ideally, what we would like to measure is quality of one s life: Present discounted value of utility from one s own consumption and leisure and that of one s loved ones. Readings: #18, 19 58

59 Part B: Some Thoughts To Help You Frame the Course (You can read this sub-section on your own) 59

60 Defining the Expenditure Components (formally) Consumption (C): The Sum of Durables, Non-Durables and Services Purchased Domestically by Non- Businesses and Non-Governments (ie, individual consumers). Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables). Does Not Include Purchases of New Housing. Investment (I): The Sum of Durables, Non-Durables and Services Purchased Domestically by Businesses Includes Business and Residential Structures, Equipment and Inventory Investment Land purchases are NOT counted as part of GDP (land is not produced!!) Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production they are saving!) There is a difference between financial and economic investment!!!!!!! 60

61 More On Expenditure/Production Components Government Spending (G): Goods and Services Purchased by the domestic government. For the U.S., 2/3 of this is at the state level (police and fire protection, school teachers, snow plowing) and 1/3 is at the federal level (President, Post Office, Missiles). NOTE: Welfare and Social Security are NOT Government Spending. These are Transfer Payments. Nothing is Produced in this Case. Net Exports (NX): Exports (X) - Imports (IM); Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil Imports: The Amount of Goods Produced on Foreign Soil Purchased Domestically. 61

62 Measuring Expenditure (Demand Side) Only include expenditures for goods that are produced. If I give $10 to a movie theater to watch a movie, it is counted as expenditure. If I give $10 to my nephew for a birthday present, it is not counted as expenditure. If I give $10 to the ATM machine to put in my savings account, it is not counted as expenditure. The second example would be considered a transfer (once I give $10 to my nephew, he can go to the movies if he wanted to once that $10 is spent, it will show up in GDP). Transfers are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged. The third example is considered saving (I am delaying expenditure until the future). Once I spend the $10 in the future, it will show up in GDP. In the meantime, someone may borrow the $10 from the bank and spend it. Interest rates will adjust to make sure savings equal investment. 62

63 Where we are headed by the end of the course: The role of prices in equilibrating markets Prices ensure that we are always in equilibrium 4 key prices in our class Price of output (e.g., CPI) P (Topic 1) Price of labor (real wages) W/P (Topic 2) Price of money (loans real interest rates) r (Topic 5) Price of foreign currency (exchange rate) $ or e (Topic 8) We will develop (from fundamentals) these 4 markets in our class. All are determined by supply forces and demand forces. 63

64 The 4 Markets We Will Build 1) Labor Demand vs. Labor Supply (determines N and W/P) (Topic 2) Necessary to compute the supply side of economy Key to where recessions come from (frictions in the labor market) 2) IS-LM market (determines r and Y (via I)) (Topics 5 and 6) Interest rates determine firm investment Key to central bank policy (sets r) Key to understanding banking crises. 3) Aggregate Demand vs. Aggregate Supply (determines P and Y) (Topics 6 and 7) Key to understanding where inflation comes from. 64

65 The 4 Markets We Will Build (continued) 4) Foreign Exchange Market (determines value of currency and NX) We will focus on this market in last week of class. Key to understanding the interaction of macro link across countries. Notice: All markets help to pin down the level of Y in the economy These four markets (and their components) will determine everything we want to know about the macroeconomy (production, inflation, economic growth, unemployment, interest rates, budget deficits, trade deficits, etc.) For the next 7 weeks, we will build the underpinnings of these markets. In doing so, we will uncover how these markets work and what factors influence these markets. 65

66 Part C: Deriving Another Important Equation 66

67 Defining Savings (Store this Away ) Y d = Disposable Income = Y - T + Tr (definition) (1) T Tr = Taxes = Transfers (ie, Welfare) Y d = C + S HH (Only can save or spend disposable income) (2) S HH = Personal (Household or Private) Saving S HH = Y - T + Tr C <<Combine (1) and (2)>> (3) Personal Savings Rate = S HH /Y d For simplicity, we are going to abstract from business saving (things like retained earnings and depreciation). For those interested in more of these accounting relationships, see the text. 67

68 A Look at Actual U.S. Household Saving Rates: 1970M1 2018M4 Remember: Shaded areas are recessions. 68

69 Saving Identities (continued) S govt = T - (G + Tr) (Definition of government surplus) (4) S govt = Government (Public) Saving Includes Federal, State and Local Saving What government collects (T) less what they pay out (G and Tr) S = S HH + S govt = Y - C - G = I + NX (combine (3) and (4)) (5) S = National Savings Restate (5): S = Y - C G <<Combine (3) and (5)>> (6) S = I + NX <<Combine (6) and Y = C+I+G+NX>> (7) 69

70 Summary: Our Second Key Equation S = I + NX We will use this equation for the rest of the class! National savings, goes into a bank. Firms looking to borrow, go to the bank. Firms can only borrow what is in the bank. In a world where NX = 0, interest rates will adjust such that savings will always equal investment (I=S this will be our IS curve later in the course). What is the role of NX? (International savings discuss later in class) 70

71 Part D: Measuring Prices 71

72 Prices and Inflation Why is it important to measure prices of goods and services? o Prices are a key metric of measurement (we measure GDP in prices). - The metric changes over time given that prices change over time. o Changes in prices (inflation) are of independent interest in the macroeconomy. - Inflation is just the percentage growth rate in prices. 72

73 Prices as Measurement Measures macro prices of goods and services through price indices Price Indices track the relative change in the prices for a basket of many goods (intended to be representative of all goods) compared to the same basket of goods in a base year. The base year is the anchor for the price index and all subsequent price indices are relative to the base year. GDP Deflator (one prominent price index): Value of Current Output at Current Prices / Value of Current Output at Base Year Prices Another prominent price index is the CPI (consumer price index) measures price changes of consumer goods. I will often use the CPI as our measure 73of a price index in this class.

74 Example of Price Index Calculation (Continued) Nominal GDP is output valued at Current Prices Comparing Nominal GDPs over time can become problematic. Confuse Changes in Output (production) with Changes in Prices Real GDP is output valued at some Constant Level of Prices (prices in a base year). Real GDP(t) = Nominal GDP(t) / Price Index (t) Growth in Real GDP: % Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)]/real GDP (t) or (approximately) % Δ in Real GDP = % Δ in Nominal GDP - % Δ in P See Supplemental Notes 1 (Real vs. Nominal Variables) for examples. 74

75 Technical Notes on Price Indices Need to Pick a Basket of Goods (cannot measure all prices) Ideal/Representative Basket of Goods Changes Over Time Invention (Computers, Cell Phones, VCRs, DVDs). Quality Improvements (Anti-Lock Brakes) Could differ by place or person? Criticism of Price Indices: Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time. How do we account for sales? Additionally - technology advances drive down the price of same goods over time. 75

76 Technical Notes on Price Indices Boskin Report (1996) Concludes that CPI Overstates Inflation by 1.1% per year. Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure). Measures to Get Around Problems with CPI - Chain Weighting Read Text to get a sense of chain weighting. 76

77 Technical Notes on Price Indices Which is better: Real or Nominal? In this class, we will focus on the Real! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices. From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told. ie, Y = Real GDP, C = Real Consumption, G = Real Government Purchases, etc... 77

78 Part E: Recessions and Inflation Over the Last 50 Years 78

79 What is a Recession? Rule of Thumb - 2 or more quarters of negative real GDP growth Most Economies are usually not in recession U.S. average postwar expansion: 80+ months (and getting longer over time) U.S. average postwar recession: 11 months (roughly constant over time) Previous Recession: 19 months (December 2007 June 2009) Current Expansion: 116 months (July today) The 1990s experienced the longest expansion since 1850 (the second longest is the current expansion!!) For Information on Business Cycle Dates see: 79

80 A Look at U.S. Nominal GDP: 1970Q1 2018Q1 80

81 A Look at U.S. Inflation: 1970M1 2018M5 81

82 A Look at U.S. Real GDP: 1970Q1 2018Q1 82

83 Real GDP and Inflation Over the Last Three Decades? High or Rising Inflation: Low or Falling Inflation: (sustained) High Growth in GDP: (sustained) Negative Growth in GDP: ) Sometimes Negative Growth in GDP and Rising Inflation (70s) 2) Sometimes Negative Growth in GDP and Falling Inflation (80s and 90s) Need Theory to Explain Both Sets of Facts!!!! 83

84 More On Recessions Dates Length 2/61-11/69 Expansion 106 months 12/69-10/70 Recessions 11 months 11/70-10/73 Expansion 36 months 11/73-2/75 Recession 16 months 3/75-12/79 Expansion 58 months 1/80-6/80 Recession 6 months 7/80-6/81 Expansion 12 months 7/81-10/82 Recession 16 months 11/82-6/90 Expansion 92 months 7/90-2/91 Recession 8 months 3/91-3/01 Expansion 121 months 4/01-12/01 Recession 8 months 1/02-11/07 Expansion 71 months 12/07-6/09 Recession 19 months 7/09 - current Expansion 116 months 84

85 Great Moderation? Dates Length 2/61-11/69 Expansion 106 months 12/69-10/70 Recessions 11 months 11/70-10/73 Expansion 36 months 11/73-2/75 Recession 16 months 3/75-12/79 Expansion 58 months 1/80-6/80 Recession 6 months 7/80-6/81 Expansion 12 months 7/81-10/82 Recession 16 months 11/82-6/90 Expansion 92 months 7/90-2/91 Recession 8 months 3/91-3/01 Expansion 121 months 4/01-12/01 Recession 8 months 1/02-11/07 Expansion 71 months 12/07-6/09 Recession 19 months 7/09 - current Expansion 116 months 49 months of recession in 21 years ( ) The Great Moderation 16 months of recession in 24 years ( ) 85

86 Is the Great Moderation Dead? I do not think so. My interpretation: Great Moderation refers to the fact that the economy is better at minimizing the impact of any given shock now relative to 30 years ago. It does not mean that: There will not be bad shocks There will not be new shocks Why? The economy is more flexible (inventory management, credit) We have gotten better at conducting macroeconomic policy! 86

87 Foreshadowing the rest of the course Assume aggregate demand (drawn in {Y,P} space) slopes down I will prove this to you later in the course Assume short run aggregate supply (drawn in {Y,P} space) slopes up I will prove this to you later in the course I will also distinguish between short run and long run aggregate supply 87

88 Foreshadowing the Rest of the Course: Demand Shocks The relationship between inflation and output when aggregate demand shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) Long Run AS P Short Run AS P P b a AD AD Y Y* Y If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y ). Prices will fall (from P to P ). Demand shocks cause prices and output to move in the same direction. (You should be able to illustrate a positive demand shock) 88

89 Foreshadowing the Rest of the Course: Supply Shocks The relationship between inflation and output when aggregate supply shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) Long Run AS Short Run AS P P c Short Run AS P a AD AD AD Y Y* Y If the economy receives a negative short run aggregate supply shock, short run equilibrium will move from point (a) to point (c). Output will fall (from Y* to Y ). Prices will rise (from P to P ). Supply shocks cause prices and output to move in opposite directions. (You should be able to illustrate a positive supply shock) 89

90 Part F: Business Cycles vs. Long Run Growth 90

91 Macroeconomic Goals Promote Economic Growth o o o o Minimize uncertainty Minimize distortions in the economy (create level playing field) Create incentives for efficient economic transactions Bottom line: Maximize trend growth Promote Economic Stability o o o Keep the unemployment rate low Keep inflation in check Refer to this as managing business cycles minimize the deviations (cycles) around the trend. Note: Lower uncertainty leads to greater economic activity 91

92 Why We Care About Inflation 92

93 Interest Rates i 0,1 = the nominal interest rate between periods 0 and 1 (the nominal return on the asset) π e 0,1 = the expected inflation rate between periods 0 and 1 r e 0,1 = the expected real interest rate between periods 0 and 1 Definitions r e 0,1 = i 0,1 - π e 0,1 (or i 0,1 = π e 0,1 + r e 0,1) r a 0,1 = i 0,1 - π a 0,1 (or i 0,1 = π a 0,1 + r a 0,1) where r a and π a are the actual real interest rate and inflation 93

94 Interest Rate Notes The Formula given is approximate. The approximation is less accurate the higher the levels of inflation and nominal interest rates. The exact formula is r e = (1 + i) / (1 + л e ) - 1 Central Banks are very interested in r since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting i, but the Central Banks are really trying to set r. 3 easy ways of measuring expected inflation: Recent actual inflation (see Survey of forecasters (see Interest rate spread on nominal vs. inflation-indexed securities (WSJ). See for other macro forecasts 94

95 Why We Care About Inflation Note: We will have a whole lecture on this later in the course Inflation is Unpredictable Indexing Costs (even if you know the inflation rate - you have to deal with it). Menu Costs (have have to go and re-price everything) Shoe-Leather Costs (you want to hold less cash - have to go to the bank more often). Caveat: There may be some benefits to small inflation rates - more on this later. 95

96 Why We Care About Inflation An Example of how inflation can affect real returns. Suppose we agree that a real rate of 0.05 over the next year is fair. borrowing rate, salary growth rate, etc. Suppose we also agree that expected inflation over the next year is We should then set the nominal return equal to 0.12 (i = r e + л e ) Summary: i = 0.12 r e = 0.05 л e =

97 Why We Care About Inflation Suppose that actual inflation is 0.10 (л a > л e ) In this case, r a = 0.02 (r a = i - л a ) Borrowers/Firms are better off Lenders/Workers worse off Suppose that actual inflation is 0.03 (л a < л e ) In this case, r a = 0.09 (r a = i - л a ) Borrowers/Firms are worse off Lenders/Workers better off It has been shown that higher inflation rates are correlated with more variability. People/Firms Don t Like the Uncertainty 97