Chapter 35 - The short-run treade-off between inflation and unemployment [Compatibility Mode].pdf

8/11/2019 Chapter 35 - The short-run treade-off between inflation and unemployment [Compatibility Mode].pdf

http://slidepdf.com/reader/full/chapter-35-the-short-run-treade-off-between-inflation-and-unemployment-compatibility 1/21

7/27/2012

1

Chapter

The Short-Run Trade-off

between Inflation and

Unemployment

35

The Phillips Curve

• Phillips curve

– Shows the short-run trade-off

– Between inflation and unemployment

• Origins of the Phillips curve

– 1958, economist A. W. Phillips

• “The relationship between unemployment and

the rate of change of money wages in the United

Kingdom, 1861–1957”

• Negative correlation between the rate of

unemployment and the rate of inflation

2





7/27/2012

3

The Phillips Curve

• Aggregate demand (AD), aggregate supply(AS), and the Phillips curve

• Phillips curve

– Combinations of inflation and unemployment

– That arise in the short run

– As shifts in the aggregate-demand curve

– Move the economy along the short-run

aggregate-supply curve

5

The Phillips Curve

• AD, AS, and the Phillips curve

• Higher aggregate-demand

– Higher output & Higher price level

– Lower unemployment & Higher inflation

• Lower aggregate-demand

– Lower output & Lower price level

– Higher unemployment & Lower inflation

6







7/27/2012

6

Figure

How the long-run Phillips curve is related to the modelof aggregate demand and aggregate supply

4

11

Price

level

Panel (a) shows the model of AD and AS with a vertical aggregate-supply curve. When expansionary monetary

policy shifts the AD curve to the right from AD1 to AD2, the equilibrium moves from point A to point B. The price

level rises from P1 to P2, while output remains the same. Panel (b) shows the long-run Phillips curve, which is

vertical at the natural rate of unemployment. In the long run, expansionary monetary policy moves the economy

from lower inflation (point A) to higher inflation (point B) without changing the rate of unemployment

Quantity of output0

(a) The Model of AD and AS

InflationRate

Unemployment

Rate

0

(b) The Phillips Curve

Aggregate demand, AD1

AD2

Long-run

aggregate supply

Natural rate

of output

P1

A

P2

B

Long-run

Phillips curve

Natural rate

of output

B

A

1. An increase in

the money supply

increases aggregate

demand . . .

2. . . . raises

the pricelevel . . .

3. . . . and

increases theinflation rate . . .

4. . . . but leaves output and unemployment

at their natural rates.

Shifts in Phillips Curve: Role of Expectations

• The meaning of “natural”

– Natural rate of unemployment

• Unemployment rate toward which the economy

gravitates in the long run

• Not necessarily socially desirable

• Not constant over time

– Labor-market policies

• Affect the natural rate of unemployment

• Shift the Phillips curve

12



7/27/2012

7


• The meaning of “natural”

– Policy change - reduce the natural rate of

unemployment

• Long-run Phillips curve shifts left

• Long-run aggregate-supply shifts right

• For any given rate of money growth and inflation

– Lower unemployment

– Higher output

13


• Reconciling theory and evidence

• Expected inflation

• Determines - position of short-run AS curve

• Short run

– The Fed can take

• Expected inflation & short-run AS curve

• As already determined

14



7/27/2012

8



• Short run

– Money supply changes

• AD curve shifts along a given short-run AS curve

• Unexpected fluctuations in

– Output & prices

– Unemployment & inflation

• Downward-sloping Phillips

15



• Long run

– People - expect whatever inflation rate the

Fed chooses to produce

• Nominal wages - adjust to keep pace with

inflation

• Long-run aggregate-supply curve is vertical

16



7/27/2012

9



• Long run

– Money supply changes

• AD curve shifts along a vertical long-run AS

• No fluctuations in

– Output & unemployment

• Unemployment – natural rate

– Vertical long-run Phillips curve

17


• The short-run Phillips curve

u = un – a ( -e )

Where a - parameter that measures how much

unemployment responds to unexpected inflation

• No stable short-run Phillips curve

– Each short-run Phillips curve

• Reflects a particular expected rate of inflation

– Expected inflation – changes• Short-run Phillips curve shifts

18





7/27/2012

11


• Natural experiment for natural-rate hypothesis

– Expansionary fiscal policy

• Government spending rose (the late 1960s,

1970s) in Vietnam War

• Money supply – rose 7% per year

• Inflation (2-4% per year)

• Unemployment fell

• Trade-off

21

Figure

The Phillips Curve in the 1960s

6

22

This figure uses annual data from 1961 to 1968 on the unemployment rate and on

the inflation rate (as measured by the GDP deflator) to show the negativerelationship between inflation and unemployment.



7/27/2012

12


• Natural experiment for natural-rate hypothesis

• By the late 1970s (long-run)

– Monetary policy (1970s)

• The Fed – try to hold down interest rates

• Money supply – rose 13% per year

• Inflation – stayed high

– Unemployment – natural rate

– No trade-off

23

Figure

The breakdown of the Phillips Curve

7

24

This figure shows annual data from 1961 to 1973 on the unemployment rate and on the

inflation rate (as measured by the GDP deflator). The Phillips curve of the 1960s breaks

down in the early 1970s, just as Friedman and Phelps had predicted. Notice that the points

labeled A, B, and C in this figure correspond roughly to the points in Figure 5.



7/27/2012

13

Shifts in Phillips Curve: Role of Supply Shocks

• Supply shock

– Event that directly alters firms’ costs and

prices

– Shifts economy’s aggregate-supply curve

– Shifts the Phillips curve

25


• Increase in oil price

– Aggregate-supply curve shifts left

– Stagflation

• Lower output

• Higher prices

– Short-run Phillips curve shifts right

• Higher unemployment

• Higher inflation

26



7/27/2012

14

Figure

An adverse shock to aggregate supply

8

27

Price

level

Panel (a) shows the model of aggregate demand and aggregate supply. W hen the aggregate-supply curve shifts

to the left from AS1 to AS2, the equilibrium moves f rom point A to point B. Output falls from Y1 to Y2, and the price

level rises from P1 to P2. Panel (b) shows the short-run trade-off between inflation and unemployment. The

adverse shift in aggregate supply moves the economy from a point with lower unemployment and lower inflation

(point A) to a point with higher unemployment and higher inflation (point B). The short-run Phillips curve shiftsto the right from PC1 to PC2. Policymakers now face a worse trade-off between inflation and unemployment.

Quantity of output0

(a) The Model of AD and AS

Inflation

Rate

Unemployment

Rate

0

(b) The Phillips Curve

Phillips curve, PC1

Aggregate

demand

Aggregate

supply, AS1

Y2

P1

A

Y1

AS2

PC2

A

BP2

B

1. An adverse shift

in aggregate supply . . .

2. . . . lowers output . . .

3. . . . and raises

the price level . . .

4. . . . giving policymakers

a less favorable trade-off

between unemployment

and inflation.


• Increase in oil price

– Aggregate-supply curve shifts left

– Short-run Phillips curve shifts right

• If temporary – revert back

• If permanent – needs government intervention

– 1970s in U.S.

• The Fed – higher money growth

– Increase AD

– To accommodate the adverse supply shock

– Higher inflation

28



7/27/2012

15

Figure

The supply shocks of the 1970s

9

29


inflation rate (as measured by the GDP deflator). In the periods 1973–1975 and 1978–

1981, increases in world oil prices led to higher inflation and higher unemployment.

The Cost of Reducing Inflation

• October 1979

– OPEC - second oil shock

– The Fed – policy of disinflation

• Contractionary monetary policy

– Aggregate demand – contracts

• Higher unemployment & Lower inflation

– Over time• Phillips curve shifts left

– Lower inflation

– Unemployment – natural rate30



7/27/2012

16

Figure

Disinflationary monetary policy in short run & long run

10

31

Inflation

Rate

Unemployment Rate

When the Fed pursues contractionary monetary policy to reduce inflation, the economy moves

along a short-run Phillips curve from point A to point B. Over time, expected inflation falls, and the

short-run Phillips curve shifts downward. When the economy reaches point C, unemployment is

back at its natural rate

Long-run

Phillips curve

Natural rate of

unemployment

1. Contractionary policy moves

the economy down along the

short-run Phillips curve . . .

Short-run Phillips curve

with low expected inflation

C Short-run Phillips curve

with high expected

inflation

A

B

2. . . . but in the long run, expected

inflation falls, and the short-run

Phillips curve shifts to the left


• Sacrifice ratio

– Number of percentage points of annual

output

• Lost in the process of reducing inflation by 1

percentage point

• Rational expectations

– People optimally use all information they

have including information about governmentpolicies when forecasting the future

32



7/27/2012

17


• Possibility of costless disinflation

– With rational expectations

• Smaller sacrifice ratio

– If government - credible commitment to a

policy of low inflation

• People – rational

– Lower heir expectations of inflation immediately

• Short-run Phillips curve - shift downward• Economy - low inflation quickly

– Without costs

» Temporarily high unemployment & low output33


• The Volker disinflation

– Paul Volker – chairman of the Fed, 1979

– Peak inflation: 10%

• Sacrifice ratio = 5

– Reducing inflation – great cost


– Reducing inflation – smaller cost

– 1984 inflation : 4% due to Monetary policy• Cost: recession

– High unemployment: 10%

– Low output34



7/27/2012

18

Figure

The Volcker Disinflation

11

35


inflation rate (as measured by the GDP deflator). The reduction in inflation during this period

came at the cost of very high unemployment in 1982 and 1983. Note that the points labeled

A, B, and C in this f igure correspond roughly to the points in Figure 10.


• The Volker disinflation


– Costless disinflation

• Volker disinflation

– Cost – not as large as predicted

– The public – did not believe them

• When he announced monetary policy to reduceinflation

36



7/27/2012

19


• The Greenspan era

• Alan Greenspan – chair of the Fed, 1987

– Favorable supply shock (OPEC, 1986)

• Falling inflation & falling unemployment

– 1989-1990: high inflation & low

unemployment

• The Fed – raised interest rates

– Contracted aggregate demand

– 1990s – economic prosperity

• Prudent monetary policy37

Figure

The Greenspan Era

12

38

This figure shows

annual data from

1984 to 2006 on the

unemployment rate

and on the inflation

rate (as measured by

the GDP deflator).

During most of this

period, Alan

Greenspan was

chairman of the

Federal Reserve.

Fluctuations in

inflation and

unemployment were

relatively small.



7/27/2012

20


• The Greenspan era

• 2001: recession

– Depressed aggregate demand

– Expansionary fiscal and monetary policy

• Bernanke’s challenges

– Ben Bernanke – chair, the Fed, 2006

–1995-2006: booming housing market

• New homeowners: subprime (high risk of default)

39



• 2006-2008: housing & financial crises

– Housing prices declined > 15%

• The new homeowners: underwater

– Value of house < balance on mortgage

– Mortgage defaults

– Home foreclosures

– Financial institutions – large losses – Depressing the aggregate demand

40



7/27/2012

21



• 2004-2008: rising commodity prices

– Increased demand from rapidly growing

emerging economies

– Prices of basic foods – rose significantly

• Droughts in Australia

• Demand increase from emerging economies

• Increased use of agricultural products – biofuels

– Contracting aggregate supply

41

Documents

Chapter 35 - The short-run treade-off between inflation and unemployment [Compatibility Mode].pdf