Chapter 12

Unemployment and Inflation

I. Unemployment and Inflation: Is There a Trade-off? (Sec. 12.1)

• A) Many people think there is a trade-off between inflation and unemployment

• 1. The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain

• 2. Since then economists have looked at the relationship between unemployment and inflation

• 3. In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables

• 4. The United States appears to be on one Phillips curve in the 1960s (text Figure 12.1)

B) The expectations-augmented Phillips curve

• Friedman and Phelps: The cyclical unemployment rate depends only on unanticipated inflation

a. First case: anticipated increase in money supply

• (1) AD shifts up and SRAS shifts up, with no misperceptions

• (2) Result: P rises, Y unchanged

• (3) Inflation rises with no change in unemployment

b. Second case: unanticipated increase in money supply

• Result: P rises and Y rises as misperceptions occur

• So higher inflation occurs with lower unemployment

• Long run: P rises further, Y declines to full-employment level

c. Expectations-augmented Phillips curve:

= e – h(u –un ) (12.1)

• (1) When = e, u =un

• (2)When < e, u > un

• (3) When > e, u < un

C) The shifting Phillips curve

• 1. The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment

•2. Changes in the expected rate of inflation

3. Changes in the natural rate of unemployment

• a. For a given natural rate of unemployment, the Phillips curve shows the trade-off between unemployment and unanticipated inflation

• b. A higher natural rate of unemployment shifts the Phillips curve to the right

4. Supply shocks and the Phillips curve

• a. A supply shock increases both expected inflation and the natural rate of unemployment

• b. So an adverse supply shock shifts the Phillips curve up and to the right

• c. The Phillips curve will be unstable in periods with many supply shocks

5. The shifting Phillips curve in practice

• a. Why did the original Phillips curve relationship apply to many historical cases?

• b. Why did the U.S. Phillips curve disappear after 1970?

D) Macroeconomic policy and the Phillips curve

• 1. Can the Phillips curve be exploited by policymakers? Can they choose the optimal combination of unemployment and inflation?

• a. Classical model: NO

• b. Keynesian model: YES, temporarily

2. Box 12.1: The Lucas critique

• When the rules of the game change, behavior changes

• Lucas applied this idea to macroeconomics, arguing that historical relationships between variables won’t hold up if there’s been a major policy change

• Evaluating policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary

E) The long-run Phillips curve

• 1. Long run: u = un for both Keynesians and classicals

• 2. The long-run Phillips curve is vertical, since when = e, u = un (Figure 12.5; like text Figure 12.8)

• 3. Changes in the level of money supply have no long-run real effects; changes in the growth rate of money supply have no long-run real effects, either

II. The Problem of Unemployment

• A) The costs of unemployment

• 1. Loss in output from idle resources

• 2. Personal or psychological cost to workers and their families

• 3. There are some offsetting factors

B) The long-term behavior of the unemployment rate

• 1. The changing natural rate• a. How do we calculate the natural rate of unemployment?

• b. CBO’s estimates: 5% to 5½% today, similar to 1950s and 1960s; over 6% in 1970s and 1980s

• c. Why did the natural rate rise from the 1950s to the late 1970s?

• d. Since 1980, demographic forces have reduced the natural rate of unemployment

• e. Some economists think the natural rate of unemployment is 4.5% or even lower

• f. Increased labor productivity may increase the natural rate of unemployment

2. Hysteresis in unemployment

• a. Europe’s unemployment rates rose dramatically from the 1970s to the 1980s

• b. Hysteresis: The natural rate of unemployment rises as the actual unemployment rate rises

• c. Caused partly by deteriorating skills of the unemployed, which increases the mismatch problem

• d. Caused partly by restrictions on firms’ ability to fire workers, making them reluctant to hire workers in good times

• e. Caused partly by union-firm bargaining, as suggested by insider-outsider theory

f. Box 12.2: The effect of unemployment insurance on unemployment

• (1) The rise in the natural rate of unemployment is caused partly by the unemployment insurance (UI) system

• (2) The longer duration of UI benefits in Europe than in the United States accounts

• (3) But it doesn’t look like there’s much evidence that higher UI benefits increase the unemployment rate

C) Policies to reduce the natural rate of unemployment • 1. Government support for job training

and worker relocation

• 2. Increased labor market flexibility

• 3. Unemployment insurance reform

• 4. A high-pressure economy?

III. The Problem of Inflation (Sec. 12.3)

• A) The costs of inflation• 1. Perfectly anticipated inflation• a. No effects if all prices and wages keep up

with inflation• b. Even returns on assets may rise exactly

with inflation• c. Shoe-leather costs: People spend

resources to economize on currency holdings; the estimated cost of 10% inflation is 0.3% of GNP

• d. Menu costs: the costs of changing prices (but technology may mitigate this somewhat sun as the introduction of electronic scanners)

2. Unanticipated inflation ( – e)• a. Realized real returns differ from expected real

returns

• b. Similar effect on wages and salaries ( set in advance)

• c. Result: transfer of wealth

• d. So people want to avoid risk of unanticipated inflation

(2) Box 12.3: Indexed contracts

• (a) People could use indexed contracts to avoid the risk of transferring wealth

• (b) Most U.S. financial contracts are not indexed, with the exception of some long-term contracts

• (c) Many U.S. labor contracts are indexed by COLAs (cost-of-living adjustments)

• (d) Indexed contracts are more prevalent in countries with high inflation

• (e.) Loss of valuable signals provided by prices

3. The costs of hyperinflation • a. Hyperinflation is a very high, sustained

inflation (for example, 50% or more per month)• b. There are large shoe-leather costs, as

people minimize cash balances• c. People spend many resources getting rid

of money as fast as possible• d. Tax collections fall, as people pay taxes

with money whose value has declined sharply• e. Prices become worthless as signals, so

markets become inefficient

B) Fighting inflation: The role of inflationary expectations

• 1. If rapid money growth causes inflation, why do central banks allow the money supply to grow rapidly?

• 2. Disinflation is a reduction in the rate of inflation

• 3. The costs of disinflation could be reduced if expected inflation fell at the same time actual inflation fell

• 4. Rapid versus gradual disinflation

• a. The classical prescription for disinflation is cold turkey

• (2) Keynesians disagree

• b. The Keynesian prescription for disinflation is gradualism

5. The sacrifice ratio

• a. When unanticipated tight monetary and fiscal policies are used to reduce inflation, they reduce output and employment for a time, a cost that must be weighed against the benefits of lower inflation

• b. Economists use the sacrifice ratio as a measure of the costs

• c. Ball studied the sacrifice ratios for many different disinflations around the world

• d. Ball’s results should be interpreted with caution,

6. Wage and price controls

• a. Pro: Controls would hold down inflation, thus lowering expected inflation and reducing the costs of disinflation

• b. Con: Controls lead to shortages and inefficiency; once controls are lifted, prices will rise again

• c. The outcome of wage and price controls may depend on what happens with fiscal and monetary policy

• d. The Nixon

7. Credibility and reputation• a. Key determinant of the costs of

disinflation: how quickly expected inflation adjusts

• b. This depends on credibility of disinflation policy

• c. Credibility can be enhanced if the government gets a reputation for carrying out its promises

• d. Also, having a strong and independent central bank that is committed to low inflation provides credibility