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Copyright 2004 South-Western

35The Short-Run

Tradeoff betweenInflation and

Unemployment

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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 efficiencywages, and the effectiveness of job search.

The inflation rate depends primarily on growth

in the quantity of money, controlled by the Fed.

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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 costof higher inflation.

If they contract aggregate demand, they can

lower inflation, but at the cost of temporarilyhigher unemployment.

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THE PHILLIPS CURVE ThePhillips curve illustrates the short-run

relationship between inflation and

unemployment.

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Figure 1 The Phillips Curve

Unemployment

Rate (percent)

0

Inflation

Rate

(percent

per year)

Phillips curve

4

B6

7

A2


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Aggregate Demand, Aggregate Supply, andthe 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-runaggregate supply curve.

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7/42Copyright 2004 South-Western

Aggregate Demand, Aggregate Supply, andthe 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 levelof unemployment.

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Figure 2 How the Phillips Curve is Related toAggregate Demand and Aggregate Supply

Quantity

of Output

0

Short-run

aggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment

Rate (percent)

0

Inflation

Rate

(percentper year)

Price

Level

(b) The Phillips Curve

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


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SHIFTS IN THE PHILLIPS CURVE:THE ROLE OF EXPECTATIONS

The Phillips curve seems to offer policymakers

a menu of possible inflation and unemployment

outcomes.

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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 atthe natural rate of unemployment.

Monetary policy could be effective in the short run

but not in the long run.

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Figure 3 The Long-Run Phillips Curve

Unemployment

Rate0 Natural rate of

unemployment

Inflation

Rate Long-run

Phillips curve

BHigh

inflation

Low

inflation

A

2. . . . but unemployment

remains at its natural rate

in the long run.

1. When theFed increases

the growth rate

of the money

supply, the

rate of inflation

increases . . .


Fi 4 H th Philli C i R l t d t

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Figure 4 How the Phillips Curve is Related toAggregate Demand and Aggregate Supply

Quantity

of Output

Natural rate

of output

Natural rate of

unemployment

0

Price

Level

P

Aggregate

demand, AD

Long-run aggregate

supply

Long-run Phillips

curve


Unemployment

Rate

0

Inflation

Rate


2. . . . raises

the price

level . . .

1. An increase in

the money supply

increases aggregate

demand . . .

A

AD2

B

A

4. . . . but leaves output and unemployment

at their natural rates.

3. . . . and

increases the

inflation rate . . .P2

B


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Expectations and the Short-Run PhillipsCurve Expected inflation measures how much people

expect the overall price level to change.

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Expectations and the Short-Run PhillipsCurve 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.

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This equation relates the unemployment rate to

the natural rate of unemployment, actual

inflation, and expected inflation.

Expectations and the Short-Run PhillipsCurve

Natural rate of unemployment - a Actualinflation ExpectedinflationUnemployment Rate =

Fi 5 H E t d I fl ti Shift th Sh t

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Figure 5 How Expected Inflation Shifts the Short-Run Phillips Curve

Unemployment

Rate

0 Natural rate of

unemployment

Inflation

Rate Long-run

Phillips curve

Short-run Phillips curve

with high expected

inflation


with low expected

inflation

1. Expansionary policy moves

the economy up along the

short-run Phillips curve . . .

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

inflation rises, and the short-runPhillips curve shifts to the right.

CB

A


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The Natural Experiment for the Natural-RateHypothesis The view that unemployment eventually returns

to its natural rate, regardless of the rate of

inflation, is called the natural-rate hypothesis.

Historical observations support the natural-ratehypothesis.

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The Natural Experiment for the Natural RateHypothesis 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 highunemployment simultaneously.

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Figure 6 The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1968

1966

19611962

1963

1967

19651964


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Figure 7 The Breakdown of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1973

1966

1972

1971

19611962

1963

1967

1968

1969 1970

1965

1964


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SHIFTS IN THE PHILLIPS CURVE:THE ROLE OF SUPPLY SHOCKS

Historical events have shown that the short-runPhillips curve can shift due to changes in

expectations.

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The short-run Phillips curve also shifts becauseof shocks to aggregate supply.

Major adverse changes in aggregate supply can

worsen the short-run tradeoff betweenunemployment and inflation.

An adversesupply shock gives policymakers a less

favorable tradeoff between inflation and

unemployment.

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Asupply shock is an event that directly altersthe firms costs, and, as a result, the prices they

charge.

This shifts the economys aggregate supplycurve. . .

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

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Figure 8 An Adverse Shock to Aggregate Supply

Quantity

of Output

0

Price

Level

Aggregate

demand


Unemployment

Rate

0

Inflation

Rate


3. . . . and

raises

the price

level . . .

AS2 Aggregate

supply,AS

A

1. An adverse

shift in aggregate

supply . . .

4. . . . giving policymakers

a less favorable tradeoff

between unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve,P

C

2. . . . lowers output . . .

PC2

B


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In the 1970s, policymakers faced two choiceswhen OPEC cut output and raised worldwide

prices of petroleum.

Fight the unemployment battle by expandingaggregate demand and accelerate inflation.

Fight inflation by contracting aggregate demand

and endure even higher unemployment.

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Figure 9 The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1972

19751981

1976

1978

1979

1980

1973

1974

1977


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THE COST OF REDUCINGINFLATION

To reduce inflation, the Fed has to pursuecontractionary monetary 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.

Figure 10 Disinflationary Monetary Policy in the

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Figure 10 Disinflationary Monetary Policy in theShort Run and the Long Run

Unemployment

Rate

0 Natural rate of

unemployment

InflationRate

Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation


with low expectedinflation

1. Contractionary policy moves

the economy down along the

short-run Phillips curve . . .

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

inflation falls, and the short-run

Phillips curve shifts to the left.

BC

A


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To reduce inflation, an economy must endure aperiod 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.

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Thesacrifice ratio is the number of percentagepoints 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% in 1979-1981

to 4% would have required an estimated sacrifice of30% of annual output!

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Rational Expectations and the Possibility ofCostless Disinflation

The theory of rational expectations suggeststhat people optimally use all the information

they have, including information about

government policies, when forecasting thefuture.

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Rational Expectations and the Possibility ofCostless Disinflation 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 disappearsdepends on how quickly expectations adjust.

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Rational Expectations and the Possibility ofCostless Disinflation The theory of rational expectations suggests

that the sacrifice-ratio could be much smaller

than estimated.

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The Volcker Disinflation When Paul Volcker was Fed chairman in the

1970s, inflation was widely viewed as one of

the nations foremost problems.

Volcker succeeded in reducing inflation (from10 percent to 4 percent), but at the cost of high

employment (about 10 percent in 1983).

Fi 11 Th V l k Di i fl ti

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Figure 11 The Volcker Disinflation

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C


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The Greenspan Era Alan Greenspans term as Fed chairman began

with a favorable supply shock.

In 1986, OPEC members abandoned their

agreement to restrict supply. This led to falling inflation and falling

unemployment.

Fi 12 Th G E

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Figure 12 The Greenspan Era

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

Unemployment

Rate (percent)

Inflation Rate

(percent per year)

19841991

1985

19921986

19931994

1988

19871995

199620021998

1999

20002001

19891990

1997


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The Greenspan Era Fluctuations in inflation and unemployment in

recent years have been relatively small due to

the Feds actions.

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Summary The Phillips curve describes a negative

relationship between inflation and

unemployment.

By expanding aggregate demand, policymakerscan choose a point on the Phillips curve with

higher inflation and lower unemployment.

By contracting aggregate demand,policymakers can choose a point on the Phillips

curve with lower inflation and higher

unemployment.

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Summary The tradeoff between inflation and

unemployment described by the Phillips curve

holds only in the short run.

The long-run Phillips curve is vertical at thenatural rate of unemployment.

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Summary The short-run Phillips curve also shifts because

of shocks to aggregate supply.

An adverse supply shock gives policymakers a

less favorable tradeoff between inflation andunemployment.

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Summary When the Fed contracts growth in the money

supply to reduce inflation, it moves the

economy along the short-run Phillips curve.

This results in temporarily high unemployment. The cost of disinflation depends on how quickly

expectations of inflation fall.

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