Inflation and Unemployememt

8/11/2019 Inflation and Unemployememt

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CHAPTER17

THESHORT-RUNTRADEOFFBETWEEN

INFLATIONANDUNEMPLOYMENT

Introduction

Introduces the Phillips Curve

Examines the theory and the historical record of

the tradeoff between inflation and unemployment

Explores the natural-rate hypothesis, sacrificeratio, and the theory of rational expectations.

The i!"r# ind"$

the rate of inflation added to the

unemployment rate

has been used as a measure of the health of the

economy.


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1%-1 T&" P&i''i(! Cur)"

Ori*in! o+ t&" P&i''i(! Cur)"

In !"# $.%. Phillips showed that wa&e rates, which

move closely with inflation, were related to

unemployment.

$merican economists 'uic(ly confirmed a similar

findin& for the ).*.

In years with low unemployment the inflation rates

seems hi&h and in years with hi&h unemployment the

inflation rate is lower.

*ociety faces a tradeoff between inflation andunemployment.

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or lower unemployment with hi&her inflation -

increase the money supply

increase &overnment spendin&

cut taxes

or lower inflation with hi&her unemployment -

decrease the money supply

decrease &overnment spendin&

raise taxes

In t&" N".!/ T&" E++"ct! o+ Lo. Un"('o#"nt

This article demonstrates that ti&hter labor mar(ets

demand hi&her wa&es, illustratin& the principle

underlyin& the Phillips Curve.

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1%-0 S&i+t! in t&" P&i''i(! Cur)"/ T&" Ro'" o+

E$("ct,tion!

T&" Lon*-Run P&i''i(! Cur)"

$ccordin& to Classical theory, the rate of money

&rowth determines inflation in the short-run but in the

lon& run has no impact on real variables.

riedman, and Edmund Phelps, concluded that there

is no reason to thin( that the rate of inflation would

be related to the rate of unemployment in the lon&

run.

This implies that the lon&-run Phillips curve is

vertical at the natural rate of unemployment.

*ee i&ure -/.

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*ince the 1natural1 rate of unemployment is simply

that rate to which the economy tends to move, it is

desirable to try to find ways to shift the lon&-run

Phillips curve to the left.

Policyma(ers should loo( to policies that improve the

functionin& of the labor mar(et.

Therefore, riedman concluded that monetary policy

could only be used in the short-run to pic( a point on

the Phillips curve.


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E$("ct,tion! ,nd t&" S&ort-Run P&i''i(! Cur)"

To explain the short-run and lon&-run relationship

between inflation and unemployment, riedman and

Phelps introduced a new variable into the analysis2

"$("ct"d in+',tion.

Expected inflation measures how much people expect

the overall price level to chan&e.

3ecause perceptions, wa&es, and prices will

eventually adust to the inflation rate, the lon&-run

a&&re&ate supply curve is vertical at the output level

associated with the natural rate of unemployment.

)nemployment rate 45atural 6ate of )nemployment

a 7$ctual inflation - Expected inflation8

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riedman ar&ued in the lon& run people come to

expect whatever inflation the ed actually produces.

Thus, actual inflation e'uals expected inflation, and

unemployment is at its natural rate.

riedman and Phelps concluded that even if

policyma(ers did face a short-run tradeoff between

inflation and unemployment and had tools to address

one or the other, that they shouldn:t.

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T&" N,tur,' E$("ri"nt +or t&" N,tur,'-R,t"

H#(ot&"!i!

The natural-rate hypothesis says that unemployment

eventually returns to its natural rate, re&ardless of the

rate of inflation.

The period from !9;-!9/ proved riedman and

Phelps:s theory was correct.

*ee i&ures - and -9.

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1%- T&" Ro'" o+ Su(('# S&oc2!

$fter the


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1%-3 T&" Co!t o+ R"ducin* In+',tion

In !9!, ed chairman Paul =olc(er decided to

pursue a policy of disinflation.

The ed would follow a contractionary monetary

policy to try to reduce inflation.

The short-run impact would be an increase in

unemployment because of low output.

T&" S,cri+ic" R,tio

Definition of the sacrifice ratio - the number of

percenta&e points of annual output lost in the process

of reducin& inflation by percenta&e point.

$ typical estimate is ".


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To try to decrease inflation by percent, you must be

willin& to sacrifice a five percent loss in output.

R,tion,' E$("ct,tion! ,nd t&" Po!!i4i'it# o+

Co!t'"!! Di!in+',tion

Definition of the theory of rational expectations -

people optimally use all available information,

includin& information about &overnment policy, when

formin& expectations.

The sacrifice ratio could be reduced if the

&overnment is resolute in its commitment to follow

the policy of inflation reduction consistently.

People would adust their expectations 'uic(ly and

the pain of unemployment could be shortened.

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In t&" N".!/ Un"('o#"nt ,nd It! N,tur,'

R,t"

In !!, the unemployment rate fell to ".@.

The ed had to decide if this was the natural rate or

not.

1%- Conc'u!ion

riedman2

AThere is a temporary tradeoff between inflation

and unemploymentB

AThere is no permanent tradeoffB

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Inflation and Unemployememt