A “Textbook”-Model of Inflation and Unemployment

Abstract

A “Textbook”-Model of Inflation and Unemployment

This paper investigates the dynamic structure underlying the simple macroeconomic model suggested by J. Vanderkamp and R. Dornbusch. This model allows an analysis of the interaction of a change in the rate of money supply with the rate of real growth and the rate of inflation. A “monetary impulse” affects both the rate of real growth and the rate of inflation. It is shown that the adjustment process in the short-run (i.e. before inflationary expectations are revised) is exclusively explained by a shift in the Okun curve, leading to a short-run equilibrium, with a reduced rate of unemployment and a higher rate of inflation. In the long-run inflationary expectations adjust according to an adaptive expectations formation process. The long-run adjustment process is characterized by a shift in both the Phillips curve and the Okun curve. This process can be modeled by a system of difference-equations of the second order. It has been proven in the paper that this system generates cycles, but that under most plausible economic assumptions. The time-path of the rate of inflation, the rate of “expected” inflation and the rate of unemployment approaches the long-run equilibrium position with dampened oscillations. During the long-run adjustment process stagflation phenomena with a rising rate of unemployment and high rates of inflation may occur.