Short Run Trade Off Between Inflation and Unemployment ETP Economics 102 Jack Wu

Short Run Trade Off Between Inflation and UnemploymentETP Economics 102Jack Wu

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.

Trade Off•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.

Phillips Curve

•The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2

Copyright © 2004 South-Western

AD, AS, and 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.

Quantityof Output

0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply

UnemploymentRate (percent)

0

InflationRate

(percentper year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregate

demand

Highaggregate demand

(output is8,000)

B

4

6

(output is7,500)

A

7

2

8,000(unemployment

is 4%)

106 B

(unemploymentis 7%)

7,500

102 A


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.

The Long-Run Phillips Curve

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

BHighinflation

Lowinflation

A

2. . . . but unemploymentremains at its natural ratein the long run.

1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .


Quantityof Output

Natural rateof output

Natural rate ofunemployment

0

PriceLevel

P

Aggregatedemand, AD

Long-run aggregatesupply

Long-run Phillipscurve


UnemploymentRate

0

InflationRate


2. . . . raisesthe pricelevel . . .

1. An increase in the money supplyincreases aggregatedemand . . .

AAD2

B

A

4. . . . but leaves output and unemploymentat their natural rates.

3. . . . andincreases theinflation rate . . .

P2B


Expectations and 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.

Formula

•Unemployment Rate=Natural Rate of Unemployment- a {Actual Inflation –Expected Inflation}

How Expected Inflation Shifts the Short-Run Phillips Curve

UnemploymentRate


InflationRate Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.

CB

A


Shifts in Short-Run Phillips Curve•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.

An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregatedemand


UnemploymentRate

0

InflationRate


3. . . . andraises the price level . . .

AS2 Aggregatesupply, AS

A

1. An adverseshift in aggregate supply . . .

4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


Cost of Reducing InflationTo reduce inflation, the Fed has to pursue contractionary

monetary policy 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.

Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate


InflationRate

Long-runPhillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.

BC

A


Sacrifice Ratio

•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.

Rational Expectations and Possibility of Costless Disinflation• 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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Short Run Trade Off Between Inflation and Unemployment ETP Economics 102 Jack Wu