Document35

• 1.35 The Short-Run Tradeoff between Inflation and Unemployment

2. 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.

3. Unemployment and Inflation

• 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.

4. THE PHILLIPS CURVE

• ThePhillips curveillustrates the short-run relationship between inflation and unemployment.

5. Figure 1 The Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Copyright 2004South-Western Phillips curve 4 B 6 7 A 2 6. 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.

7. Aggregate Demand, Aggregate Supply, and the Phillips Curve

• The greater the aggregate demand for goods and services, the greater is the economys output, and the higher is the overall price level.

• A higher level of output results in a lower level of unemployment.

8. Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output 0 (a) The Model of Aggregate Demand and Aggregate SupplyUnemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level (b) The Phillips Curve Copyright 2004South-Western Short-run aggregate supply Phillips curve Low aggregate demand High aggregate demand (output is 8,000) B 4 6 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7,500 102 A 9. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS

• The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

10. 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 thenatural rate of unemployment .

• • Monetary policy could be effective in the short run but not in the long run.

11. Figure 3 The Long-Run Phillips Curve Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve Copyright 2004South-Western B High inflation Low inflation A 2. . . . but unemployment remains at its natural rate in the long run. 1. When theFed increasesthe growth rateof the moneysupply, therate of inflationincreases . . . 12. Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level Long-run aggregate supply Long-run Phillips curve (a) The Model of Aggregate Demand and Aggregate SupplyUnemployment Rate 0 Inflation Rate (b) The Phillips Curve Copyright 2004South-Western P Aggregate demand,AD 2. . . . raises the price level . . .1. An increase inthe money supply increases aggregate demand . . .A AD 2 B A 4. . . . but leaves output and unemployment at their natural rates. 3. . . . and increases the inflation rate . . .P 2 B 13. Expectations and the Short-Run Phillips Curve

• Expected inflation measures how much people expect the overall price level to change.

14. Expectations and the Short-Run Phillips Curve

• In the long run, expected inflation adjusts to changes in actual inflation.

• The Feds 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.

15.

• This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.

Expectations and the Short-Run Phillips Curve Unemployment Rate = 16. Figure 5 How Expected Inflation Shifts the Short-Run Phillips Curve Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve Copyright 2004South-Western Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along theshort-run Phillips curve . . .2. . . . but in the long run, expected inflation rises, and the short-runPhillips curve shifts to the right. C B A 17. The Natural Experiment for the Natural-Rate Hypothesis

• The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called thenatural-rate hypothesis .

• Historical observations support the natural-rate hypothesis.

18. 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.

19. Figure 6 The Phillips Curve in the 1960s 1 2 3 4 5 6 7 8 9 10 0 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) Copyright 2004South-Western 1968 1966 1961 1962 1963 1967 1965 1964 20. Figure 7 The Breakdown of the Phillips Curve 1 2 3 4 5 6 7 8 9 10 0 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) Copyright 2004South-Western 1973 1966 1972 1971 1961 1962 1963 1967 1968 1969 1970 1965 1964 21. 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.

22. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

• 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 adversesupply shockgives policymakers a less favorable tradeoff between inflation and unemployment.

23. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

• Asupply shockis an event that directly alters the firms costs, and, as a result, the prices they charge.

• This shifts the economys aggregate supply curve. . .

• . . . and as a result, the Phillips curve.

24. Figure 8 An Adverse Shock to Aggregate Supply Quantity of Output 0 Price Level Aggregate demand (a) The Model of Aggregate Demand and Aggregate SupplyUnemployment Rate 0 Inflation Rate (b) The Phillips Curve Aggregate supply,AS Phillips curve,P C Copyright 2004South-Western 3. . . . and raisesthe pricelevel . . .AS 2 A 1. An adverse shift in aggregatesupply . . .4. . . . giving policymakersa less favorable tradeoff between unemployment and inflation. B P 2 Y 2 P A Y 2. . . . lowers output . . .PC 2 B 25. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

• 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.

26. Figure 9 The Supply Shocks of the 1970s 1 2 3 4 5 6 7 8 9 10 0 2 4 6 8 10 Unemployment Rate (percent) Inflation Rate (percent per year) Copyright 2004South-Western 1972 1975 1981 1976 1978 1979 1980 1973 1974 1977 27. THE COST OF REDUCING INFLATION

• To reduce inflation, the Fed has to pursue contractionary monetarypolicy .

• 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.

28. Figure 10 Disinflationary Monetary Policy in the Short Run and the Long Run Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve Copyright 2004South-Western Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Contractionary policy moves the economy down along theshort-run Phillips curve . . .2. . . . but in the long run, expected inflation falls, and the short-runPhillips curve shifts to the left. B C A 29. THE COST OF REDUCING INFLATION

• 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.

30. THE COST OF REDUCING INFLATION

• Thesacrifice ratiois 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 isfive .

• • To reduce inflation from about 10% in1979-1981