Copyright © 2004 South-Western 22 The Short-Run Tradeoff between Inflation and Unemployment.

Copyright © 2004 South-Western

2222The Short-Run Tradeoff between

Inflation and Unemployment


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.


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 cost of higher inflation.

• If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.


THE PHILLIPS CURVE

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


Figure 1 The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2


Aggregate Demand, Aggregate Supply, and the 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.

• It is drawn for one level of AS. A shift of AS will generate a new level of the Phillips curve.


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

Quantityof Output

0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply


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


The Long-Run Phillips Curve

• Long-run Phillips curve is vertical

• It represents the natural rate of unemployment

• It may be shifted by changes in the labor market, such as increases in unemployment compensation, changes in minimum wage laws.


Figure 3 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 . . .


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

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


• This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.

Expectations and the Short-Run Phillips Curve

N atu ra l ra te o f u n em p lo y m en t - a A ctu a l in fla tio n

E x p ec ted in fla tio n

Unemployment Rate =


Figure 5 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


The Natural Experiment for the Natural-Rate Hypothesis

• 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-rate hypothesis.


Figure 6 The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

1968

1966

19611962

1963

1967

19651964


Figure 7 The Shift of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1973

1966

1972

1971

19611962

1963

1967

19681969 1970

19651964


SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

• 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.


Figure 8 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


Figure 9 The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1972

19751981

1976

1978

1979

1980

1973

1974

1977


THE COST OF REDUCING INFLATION

• To 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.


Figure 10 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


THE COST OF REDUCING INFLATION

• 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.


Rational Expectations and the Possibility of Costless 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 disappears depends on how quickly expectations adjust.


The Volcker Disinflation

• When Paul Volcker became Fed chairman in the 1980, inflation was widely viewed as one of the nation’s foremost problems.

• Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high unemployment (about 10 percent in 1983).


Figure 11 The Volcker Disinflation

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C


Figure 12 The Greenspan Era

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



19841991

1985

19921986

19931994

198819871995

199620021998

1999

20002001

19891990

1997


Positive changes in Aggregate Supply

• The best way to achieve low inflation and low unemployment is to experience an increase in the aggregate supply.

• Increase in AS moves Phillips curve to a lower level, giving the government a better trade-off between inflation and unemployment.

• Example: technological change in the 1990s.

• Problem: AS cannot be freely changed by government policy.

Copyright © 2004 South-Western 22 The Short-Run Tradeoff between Inflation and Unemployment.

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Transcript of Copyright © 2004 South-Western 22 The Short-Run Tradeoff between Inflation and Unemployment.