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Chapter 16

Chapter 16. The Short-run Tradeoff Between Inflation and Unemployment. The Phillips Curve. It follows that, in the short run, there is a tradeoff between inflation & unemployment This short-run tradeoff is captured by a relation known as the Phillips Curve . A Hypothetical Phillips Curve.

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Chapter 16

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  1. Chapter 16 The Short-run Tradeoff Between Inflation and Unemployment

  2. The Phillips Curve • It follows that, in the short run, there is a tradeoff between inflation & unemployment • This short-run tradeoff is captured by a relation known as the Phillips Curve.

  3. A Hypothetical Phillips Curve Inflation Rate A High Inflation Phillips Curve B Low Inflation Low Unemployment High Unemployment Unemployment Rate

  4. The Aggregate Demand-Aggregate Supply Model and The Short-Run Phillips Curve • We have seen that, all else the same, the greater the aggregate demand for goods and services, the greater the economy’s output and the higher the overall price level. • We also know that the higher the level of output, the lower the unemployment rate.

  5. (a) The Model of AD and AS (b) Short-Run Phillips Curve Short-run AS Inflation Rate (percent per year) Price Level B 106 B 6 High AD 102 A A 2 Short-Run Phillips curve Low AD 8,000 0 7,500 7 0 4 Unemployment Rate (percent) The Short-Run Phillips Curve and the Model of Aggregate Demand and Aggregate Supply

  6. The Short-Run Phillips Curve • So you see, 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.

  7. The Short-Run Tradeoff Between Inflation and Unemployment • In the 1950s and 1960s, it was suggested that the Phillips Curve offers policymakers a “menu of possible economic outcomes.” • Policymakers thought they could take advantage of the tradeoff between inflation and unemployment.

  8. The Instability of the Short-Run Phillips Curve • But for the short-run Phillips Curve to be a reliable policy guide, it has to be stable. • The notion of a stable Phillips Curve broke down in the 1970s and early 1980s. • During the 70s and early 80s the economy experienced high inflation and high unemployment simultaneously, which is what we called stagflation.

  9. The Long-Run Phillips Curve • Two famous macroeconomist, Friedman and Phelps argued that inflation and unemployment are unrelated in the long run. • That is, the long-run Phillips Curve is vertical at the natural rate of unemployment • Thus monetary and fiscal policy could be effective in the short run but not in the long run.

  10. High inflation B 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases… 2. … but unemployment remains at its natural rate in the long run. Low inflation A The Long-Run Phillips Curve Inflation Rate Long-run Phillips curve Unemployment Rate 0 Natural rate of unemployment

  11. (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve Long-run aggregate supply Long-run Phillips curve Price Level Inflation Rate 3. …thus increasing the inflation rate… 1. An increase in the money supply increases aggregate demand… B P2 A P1 AD2 Aggregate demand, AD1 Natural rate of output Unemploy-ment Rate 0 0 Quantity of Output Natural rate of unemployment 2. …which raises the price level… 4. …but it leaves output and unemployment at their natural rates. The Long-Run Phillips Curve and the Model of Aggregate Demand and Aggregate Supply

  12. Shifts in the Short-Run Phillips Curve • As we saw earlier, historical events have shown that the short-run Phillips Curve is not stable. • It can shift due to the following factors: • 1. Expectations • 2. Supply Shocks

  13. 1. Shifts in the Short-run Phillips Curve: The Role of Expectations • Expected inflation measures how much people expect the overall price level to change. • Along any given short-run Phillips Curve, the expected inflation rate is constant. • An increase (decrease) in the expected inflation rate causes the short-run Phillips Curve to shift up (down).

  14. Changes in Expectations about Future Inflation Shift the Short-Run Phillips Curve Inflation Rate • • Pe1 > Pe0 • PC(Pe1) • PC(Pe0) Unemployment Rate

  15. Expectations and the Long-Run Phillips Curve • In the long-run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips Curve shifts. • Adjustment in inflation expectations in the long run result in a vertical long-run Phillips Curve whose intercept is at the natural rate of unemployment.

  16. Inflation Long-run Phillips curve Rate 2. …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B Short-run Phillips curve with high expected inflation 1. Expansionary policy moves the economy up along the short-run Phillips curve... A Short-run Phillips curve with low expected inflation 0 Unemployment Rate Natural rate of unemployment Changes in the Expected Inflation Shift the Short-Run Phillips Curve

  17. 1. The Long-Run Phillips Curve • Thus, in the long run, there is no tradeoff between inflation and unemployment. • In the long-run, the actual rate of inflation and unemployment will depend upon aggregate supply factors (real variables).

  18. The Natural-Rate Hypothesis • The view that in the long run unemployment eventually returns to its natural rate, regardless of the rate of inflation is called the natural-rate hypothesis. • Historical observations support the natural-rate hypothesis.

  19. 2. Shifts in the Phillips Curve Due to Supply Shocks • The short-run Phillips Curve also shifts because of shocks to aggregate supply. • An adverse supply shock, such as an increase in world oil prices, would shift the short-run Phillips Curve up. • Thus, an adverse supply shock worsens the short-run tradeoff between unemployment and inflation.

  20. (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve 4. …giving policymakers a less favorable tradeoff between unemployment and inflation. 3. …and raises the price level… Price Level Inflation Rate AS2 Aggregate supply, AS1 B P2 1. An adverse shift in aggregate supply… B A A P1 PC2 Aggregate demand Phillips curve, PC1 0 Y2 Y1 0 Quantity of Output Unemployment Rate 2. …lowers output… Adverse Supply Shocks Shift the Short-Run Phillips Curve and Worsens the Short-Run Tradeoff Between Inflation & Unemployment

  21. Inflation Rate (percent per year) 10 1981 1980 1975 1974 1979 8 1978 6 1977 1976 1973 4 1972 2 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) The Supply Shocks of the 1970s...

  22. The Cost of Reducing Inflation • To reduce inflation, the Fed has to pursue contractionary monetary policy (e.g., raising interest rates, etc.) • This would... • reduce the aggregate demand… • which would reduce the quantity of goods and services firms produce... • which would lead to a fall in employment and a rise in unemployment.

  23. The Cost of Reducing Inflation • Such an action by the Fed to combat inflation would move the economy down along the short-run Phillips Curve resulting in lower inflation but higher unemployment • It follows that if an economy is to reduce inflation in the short run, it must endure a period of high unemployment (sacrifice ratio).

  24. InflationRate 1. Contractionary policy moves the economy down along the short-run Phillips curve... Long-run Phillips curve A Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation 0 Natural rate of Unemployment unemployment Rate 2. ... but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left. Disinflationary Monetary Policy in the Short Run and Long Run

  25. Rational Expectations • We have seen that expected inflation is an important variable that 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.

  26. Rational Expectations -The theory of rational expectations suggests that people use all the information they have, including information about government policies, when forming their expectation of future inflation. -If so, the loss of output and employment associated with a disinflationary monetary policy could be much smaller than estimated.

  27. The Cost of Reducing Inflation The Volcker Disinflation • To reduce inflation from about 10% in 1979-81 to 4% required a sacrifice of 30 percent of annual output! • Paul Volcker (appt. by Carter in 1979) went public and created a recession… • And it worked.

  28. Inflation Rate (percent per year) 10 1980 1981 A 1979 8 1982 6 1984 B 4 1987 1983 1985 C 1986 2 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) The Volcker Disinflation...

  29. The Cost of Reducing Inflation The Greenspan Era • In 1986, OPEC abandoned their agreement to restrict supply, resulting in a favorable supply shock leading to falling inflation and falling unemployment. This marked the beginning of the Greenspan Era. • Fluctuations in inflation and unemployment have been relatively small due to Fed’s actions.

  30. Inflation Rate (percent per year) 10 8 6 1990 1991 1989 4 1984 1988 1985 1987 1992 1995 2 1994 1993 1986 0 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) The Greenspan Era...

  31. Evaluating Rational Expectations • Contracts may embody outdated expectations • Expectations adjust slowly • Wages tend to “catch up,” not precede inflation • Fighting inflation tends to be very costly.

  32. Gov’t should NOT prevent inflation • 1. Unemployment is more costly than inflation. • 2. Short-run Phillips curve is flat. • 3. Expectations react sluggishly. • 4. Self-correcting is slow and unreliable. • (Keynesian) Don’t “create a recession.”

  33. Gov’t SHOULD fight inflation • 1. Inflation is more costly than unemployment. • 2. Short-run Phillips curve is steep. • 3. People respond based on their expectations. • 4. Self-correcting works smoothly and relatively fast. • (Rational expectations)

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