Transcript The Short-Run Tradeoff between Inflation and Unemployment

The Short-Run Tradeoff
between Inflation and
Unemployment
Week 12
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Unemployment and Inflation


The natural rate of unemployment depends on various features
of the labor market.
Examples include minimum-wage laws, the market power of
unions, the role of efficiency wages, and the effectiveness of job
search.
 The inflation rate depends primarily on growth in the quantity of
money, controlled by the Fed.
 The misery index, one measure of the “health” of the economy, adds
together the inflation rate and unemployment rate.
 Society faces a short-run tradeoff between unemployment and
inflation.
 If policymakers expand aggregate
demand, they can lower
unemployment, but only at the cost of higher inflation.
 If they contract aggregate demand, they can lower inflation, but at the
cost of temporarily higher unemployment.
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The Phillips Curve...
Inflation
Rate
(percent
per year)
• The Phillips curve illustrates the shortrun relationship between inflation and
unemployment.
B
6
A
2
Phillips curve
0
4
7
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Unemployment
3
Rate (percent)
Aggregate Demand, Aggregate Supply, and the
Phillips Curve
The Phillips curve shows the short-run combinations
of unemployment and inflation that arise as shifts in
the aggregate demand curve move the economy
along the short-run aggregate supply curve.
The greater the aggregate demand for goods and
services, the greater is the economy’s output,
and the higher is the overall price level.
A higher level of output results in a lower level
of unemployment.
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How the Phillips Curve is Related to the Model
of Aggregate Demand (AD) and Aggregate
Supply (AS)...
(a) The Model of AD and AS
(b) The Phillips Curve
106
Short-run Inflation Rate
AS
(percent per
year)
B
102
A
Price Level
High AD
A
2
Low AD
0
B
6
8,000
7,500
(unemployment
(unemployment
is 7%)
is 7%)
0
Phillips curve
7
4
(output is (output is
8,000)
7,500)
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Unemployment
Rate (percent)
5
Shifts in the Phillips Curve: The Role of
Expectations
The Phillips curve seems to offer policymakers a
menu of possible inflation and unemployment
outcomes.
The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps concluded
that inflation and unemployment are unrelated in
the long run.
As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
Monetary policy could be effective in the
short run but not in the long run.
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The Long-Run Phillips Curve...
Inflation
Rate
1. When the
Fed
increases
the growth
rate of the
money
supply, the
rate of
inflation
increases…
Long-run
Phillips curve
High
inflation
B
Low
inflation
0
A
Natural rate of
unemployment
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2. … but
unemploymen
t remains at
its natural rate
in the long
run.
Unemployment
Rate
7
How the Phillips Curve is Related to the
Model of Aggregate Demand and
Aggregate Supply…
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
Long-run aggregate
supply
P2
2. …raises the
price level…
Inflation
Rate
Long-run Phillips
curve
3. …and
increases the
B inflation
rate…
1. An increase in the
money supply
increases aggregate
demand…
P1
0
(b) The Phillips Curve
A
AD2
Natural rate
of output
Aggregate
demand, AD1
Quantity of
Output
0
Natural rate of
unemployment
4. …but leaves output and
Pengantar
unemployment
atEkonomi
their2 natural rates.
Unemployment Rate
8
Expectations and the
Short-Run Phillips Curve
Expected inflation measures how much people
expect the overall price level to change.
In the long run, expected inflation adjusts to
changes in actual inflation.
The Fed’s ability to create unexpected
inflation exists only in the short run.
Once people anticipate inflation, the only way to
get unemployment below the natural rate is for
actual inflation to be above the anticipated rate.
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Expectations and the
Short-Run Phillips Curve
Unemployment
Rate
rate of
a ( Actual Infl
=Natural
unemployment -
- Expected Infl)
This equation relates the unemployment rate
to the natural rate of unemployment, actual
inflation, and expected inflation.
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How Expected Inflation Shifts the Short-Run
Phillips Curve...
Inflation
Rate
Long-run
Phillips curve
B
0
1.
Expansionary
policy moves
the economy
up along the
short-run
Phillips
curve...
C
A
Natural
of
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unemployment
2. …but in the long-run,
expected inflation rises,
and the short-run
Phillips curve shifts to
the right.
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected inflation
Unemployment11
Rate
The Natural-Rate Hypothesis
The view that unemployment eventually
returns to its natural rate, regardless of the
rate of inflation, is called the natural-rate
hypothesis.
Historical observations support the naturalrate hypothesis.
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The Natural Experiment for the Natural
Rate Hypothesis
The concept of a stable Phillips curve
broke down in the in the early ’70s.
During the ’70s and ’80s, the economy
experienced high inflation and high
unemployment simultaneously.
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The Phillips Curve in the 1960s...
Inflation Rate
(percent per year)
10
8
6
1968
4
1967
1966
1962
1965
1961
1964
1963
2
0
1
2
3
4
5
6
7
Unemployment Rate (percent)
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8
9
10
14
The Breakdown of the Phillips Curve...
Inflation Rate
(percent per year)
10
8
1973
6
1969
1968
4
1967
1971
1970 1972
1966
1962
1965
1964
2
0
1963
1961
1
2
3
4
5
6
7
Unemployment Rate (percent)
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9
10
15
Shifts in the Phillips Curve: The Role of
Supply Shocks
Historical events have shown that the
short-run Phillips curve can shift due to
changes in expectations.
The short-run Phillips curve also shifts
because of shocks to aggregate supply.
 Major
adverse changes in aggregate supply can
worsen the short-run tradeoff between
unemployment and inflation.
 An adverse supply shock gives policymakers a
less favorable tradeoff between inflation and
unemployment.
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Shifts in the Phillips Curve: The Role of
Supply Shocks
A supply shock is an event that directly affects firms’
costs of production and thus the prices they charge.
It shifts the economy’s aggregate supply curve...
… and as a result, the Phillips curve.

In the 1970s, policymakers faced two choices when OPEC
cut output and raised worldwide prices of petroleum.
 Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
 Fight inflation by contracting aggregate demand and
endure even higher unemployment.
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An Adverse Shock to Aggregate Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
3. …and raises
the price level…
(b) The Phillips Curve
4. …giving
policymakers a less
favorable tradeoff
between
unemployment and
inflation.
Inflation
Rate
AS2 Aggregate
supply, AS1
P2
B
A
P1
0
Y2
Y1
2. …lowers
output…
B
1. An adverse
shift in
aggregate
supply…
Aggregate
demand
Quantity of
Output
A
PC2
0
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Phillips curve, PC1
Unemployment Rate
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The Supply Shocks of the 1970s...
Inflation Rate
(percent per year)
10
1980
1974
8
6
1973
4
1981
1975
1979
1978
1977
1976
1972
2
0
1
2
3
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8
9 10 Unemployment
19
Rate (percent)
The Cost of Reducing Inflation
 To reduce inflation, the Fed has to pursue contractionary monetary
policy.
 When the Fed slows the rate of money growth, it contracts aggregate
demand.
 This reduces the quantity of goods and services that firms produce.
 This leads to a rise in unemployment.
 To reduce inflation, an economy must endure a period of high
unemployment and low output.
 When the Fed combats inflation, the economy moves down the
short-run Phillips curve.
 The economy experiences lower inflation but at the cost of higher
unemployment.
 The sacrifice ratio is the number of percentage points of annual output
that is lost in the process of reducing inflation by one percentage point.
 An estimate of the sacrifice ratio is five.
 To reduce inflation from about 10% in 1979-1981 to 4% would have
required an estimated sacrifice of 30% of annual output!
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Disinflationary Monetary Policy in the Short Run and the Long
Run...
Inflation
Rate
Long-run
Phillips curve
A
1. Contractionary policy
moves the economy
down along the short-run
Phillips curve...
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
Rate
2. ... but in the long run, expected inflation falls
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and the short-run Phillips curve shifts to the left.
Rational Expectations
• The theory of rational expectations suggests that
people optimally use all the information they have,
including information about government policies,
when forecasting the future.
 Expected inflation explains why there is a tradeoff between inflation
and unemployment in the short run but not in the long run.
 How quickly the short-run tradeoff disappears depends on how
quickly expectations adjust.

The theory of rational expectations suggests that the sacrifice-ratio
could be much smaller than estimated.
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The Volcker Disinflation
When Paul Volcker was Fed chairman in
the 1970s, inflation was widely viewed as
one of the nation’s foremost problems.
Volcker succeeded in reducing inflation
(from 10% to 4%), but at the cost of high
employment (about 10% in 1983).
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The Volcker Disinflation...
Inflation Rate
(percent per year)
10
A
1980 1981
1979
8
1982
6
1984
B
1987
1983
1985
C
1986
4
2
0
1
2
3
4
5
6
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8
9 10 Unemployment
Rate (percent)
24
The Greenspan Era...
Inflation Rate
(percent per year)
10
8
6
1990 1991
1989
1984
1988
1985
1987
1992
1995
1994 1993
1986
4
2
00
1
2
3
4
5
6
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8
9 10
Unemployment
Rate (percent)
25
The Greenspan Era
Alan Greenspan’s term as Fed chairman
began with a favorable supply shock.
 In
1986, OPEC members abandoned their
agreement to restrict supply.
 This led to falling inflation and falling
unemployment.
 Fluctuations in inflation and
unemployment in recent years have been
relatively small due to the Fed’s actions.
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Summary
 The Phillips curve describes a negative relationship between inflation and
unemployment.
 By expanding aggregate demand, policymakers can choose a point on the
Phillips curve with higher inflation and lower unemployment.
 By contracting aggregate demand, policymakers can choose a point on the
Phillips curve with lower inflation and higher unemployment.
 The tradeoff between inflation and unemployment described by the
Phillips curve holds only in the short run.
 The long-run Phillips curve is vertical at the natural rate of
unemployment.
 The short-run Phillips curve also shifts because of shocks to aggregate
supply.
 An adverse supply shock gives policymakers a less favorable tradeoff
between inflation and unemployment.
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Summary
 When the Fed contracts growth in the money supply to
reduce inflation, it moves the economy along the shortrun Phillips curve.
 This results in temporarily high unemployment.
 The cost of disinflation depends on how quickly
expectations of inflation fall.
 Because monetary and fiscal policy can influence
aggregate demand, the government sometimes uses
these policy instruments in an attempt to stabilize the
economy.
 Changes in attitudes by households and firms shift
aggregate demand; if the government does not respond,
the result is undesirable and unnecessary fluctuations in
output and employment.
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