Inflation, Unemployment, and Central Banks’ Policy

Chapter Outline and Learning Objectives

17.1 The Discovery of the Short-Run Trade-off between Unemployment and Inflation

17.2 The Short-Run and Long-Run Phillips Curves

17.3 Expectations of the Inflation Rate and Monetary Policy

17.4 Central Banks’ Policy from the 1970s to the Present

• Monetary policy affects the performance of both new and used car companies.

• When the Federal Reserve raised interest rates in 2006 and kept them high through mid-2007, it meant higher costs for consumers who borrow money to buy cars and lower sales for car dealerships, such as CarMax, that sell them.

• By late 2008, the Fed had slashed the federal funds rate to near-zero levels and CarMax’s sales began to recover from the recession in 2009.

• Though interest rates remained low and incomes had risen in 2010 and 2011,unemployment remained high, consumer confidence was low, and CarMax’s sales began to slip again.

• AN INSIDE LOOK AT POLICY on page 600 discusses how the Fed attempts to reduce unemployment without causing a significant increase in inflation.

Why Does CarMax Worry about Monetary Policy?

Is It Wise to Delay a Job Search?

Your friend was recently laid off from her entry-level job as a business analyst.

You call to console her, but she does not seem very upset.

“Our state offers workers up to 99 weeks of unemployment compensation. I have almost two years before I have to find a new job. With my education and job experience, I should be able to find a new job by then without much trouble.”

Your friend did well in school, but you are not sure that waiting almost two years to find a new job is a good idea.

See if you can answer this question by the end of the chapter:

What advice would you give someone who has decided to wait nearly two years to look for a new job?

Economics in Your Life

Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

17.1 LEARNING OBJECTIVE

The Discovery of the Short-Run Trade-off between Unemployment and Inflation

There is a short-run trade-off between unemployment and inflation:

Higher unemployment is usually accompanied by lower inflation as aggregate demand decreases, and lower unemployment is usually accompanied by higher inflation as aggregate demand increases.

This trade-off, documented in the late 1950s by New Zealand economist A. W. Phillips as an inverse relationship between unemployment and inflation, exists in the short run—a period that may be as long as several years— but disappears in the long run.

Phillips Curve: A curve showing the short-run relationship between the unemployment rate and the inflation rate.

The Phillips curve has an advantage over the aggregate demand and aggregate supply model when we want to explicitly analyze changes in the inflation and unemployment rates.

Figure 17.1

The Phillips Curve

A.W. Phillips was the first economist to show that there is usually an inverse relationship between unemployment and inflation. Here we can see this relationship at work: In the year represented by point A, the inflation rate is 4 percent and the unemployment rate is 5 percent. In the year represented by point B, the inflation rate is 2 percent and the unemployment rate is 6 percent.

Figure 17.2 Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve

In panel (a), the economy in 2013 is at point A, with real GDP of $14.0 trillion and a price level of 100. If there is weak growth in aggregate demand, in 2014, the economy moves to point B, with real GDP of $14.3 trillion and a price level of 102. The inflation rate is 2 percent and the unemployment rate is 6 percent, which corresponds to point B on the Phillips curve in panel (b). If there is strong growth in aggregate demand, in 2014, the economy moves to point C, with real GDP of $14.6 trillion and a price level of 104. Strong aggregate demand growth results in a higher inflation rate of 4 percent but a lower unemployment rate of 5 percent. This combination of higher inflation and lower unemployment is shown as point C on the Phillips curve in panel (b).

Structural relationship A relationship that depends on the basic behavior of consumers and firms and that remains unchanged over long periods.

Is the Phillips Curve a Policy Menu?

Is the Short-Run Phillips Curve Stable?

During the 1960s, the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation.

Then in 1968, Milton Friedman argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation because a vertical long-run aggregate supply curve is inconsistent with a downward sloping long-run Phillips curve.

Because many economists and policymakers in the 1960s viewed the Phillips curve as a structural relationship, they believed it represented a permanent trade-off between unemployment and inflation.

Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

The Long-Run Phillips Curve

To understand Friedman’s argument, recall that the level of real GDP in the long run is also referred to as potential GDP, at which firms will operate at their full capacity and everyone who wants a job will have one, except the structurally and frictionally unemployed.

Friedman concluded that the long-run aggregate supply curve is a vertical line at potential real GDP, and the long-run Phillips curve is a vertical line at the natural rate of unemployment.

Figure 17.3 A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve

Milton Friedman and Edmund Phelps argued that there is no trade-off between unemployment and inflation in the long run. If real GDP automatically returns to its potential level in the long run, the unemployment rate must return to the natural rate of unemployment in the long run. In this figure, we assume that potential GDP is $14 trillion and the natural rate of unemployment is 5 percent.

The Role of Expectations of Future Inflation

If the long-run Phillips curve is a vertical line, no trade-off exists between unemployment and inflation in the long run.

Differences between the expected inflation rate and the actual inflation rate could lead the unemployment rate to rise above or dip below the natural rate.

Suppose that Ford and the United Auto Workers (UAW) agree on a wage of $31.50 per hour to be paid during 2015.

They both expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 percent.

We can calculate the real wage, which is the nominal wage corrected for inflation, that Ford expects to pay and the UAW expects to receive as follows:

30$100105

50.31$100level Price wageNominal wageReal

Table 17.1 The Effect of Unexpected Price Level Changes on the Real Wage

The following table shows the effect on the actual real wage if the actual inflation rate turns out to be higher or lower than the expected inflation rate of 5 percent:

Nominal Wage Expected Real Wage Actual Real WageExpected P2015 = 105 Actual P2015 = 102 Actual P2015 = 108

Expected inflation = 5% Actual inflation = 2% Actual inflation = 8%

$31.50 88.30$100102

50.31$ 17.29$100

10850.31$

30$100105

50.31$

Table 17.2 The Basis for the Short-Run Phillips Curve

If . . . then . . . and . . .actual inflation is less than expected inflation,

the actual real wage is greater than the expected real wage,

the unemployment rate rises.

actual inflation is greater than expected inflation,

the actual real wage is less than the expected real wage,

the unemployment rate falls.

An increase in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is unexpected.

A higher inflation rate can lead to lower unemployment if both workers and firms mistakenly expect the inflation rate to be lower than it turns out to be.

Workers often fail to realize that expected inflation increases the value of total production and the value of total income by the same amount.

Although not all wages will rise as prices rise, inflation will increase the average wage in the economy at the same time that it increases the average price.

If workers fail to understand this, then when inflation increases, in the short run,firms can increase wages by less than inflation without needing to worry about workers quitting or their morale falling, providing an explanation for a downward-sloping short-run Phillips curve.

Do Workers Understand Inflation?Making

theConnection

Explain the relationship between the short-run and long-run Phillips curves.17.2 LEARNING OBJECTIVE

The Short-Run and Long-Run Phillips Curves

Figure 17.4

The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve

In the late 1960s, U.S. workers and firms were expecting the 1.5 percent inflation rates of the recent past to continue. However, expansionary monetary and fiscal policies moved the short-run equilibrium up the short-run Phillips curve to an inflation rate of 4.5 percent and an unemployment rate of 3.5 percent.

The real interest rate is the nominal interest rate minus the expected inflation rate.

Figure 17.5

Expectations and the Short-Run Phillips Curve

By the end of the 1960s,workers and firms had revised their expectations of inflation from 1.5 percent to 4.5 percent. As a result, the short-run Phillips curve shifted up,which made the short-run trade-off between employment and inflation worse.

Shifts in the Short-Run Phillips Curve

The new, higher expected inflation rate can become embedded in the economy,meaning that workers, firms, consumers, and the government all take the inflation rate into account when making decisions.

Figure 17.6

A Short-Run Phillips Curve for Every Expected Inflation Rate

There is a different short-run Phillips curve for every expected inflation rate. Each short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate.

How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

By the 1970s, economists realized that the common view of the 1960s had been wrong:

It was not possible to buy a permanently lower unemployment rate at the cost of a permanently higher inflation rate.

In the long run, there is no trade-off between unemployment and inflation.

In the long run, the unemployment rate always returns to the natural rate, no matter what the inflation rate is.

Non-accelerating inflation rate of unemployment (NAIRU): The unemployment rate at which the inflation rate has no tendency to increase or decrease.

In the long run, the Federal Reserve can affect the inflation rate but not the unemployment rate.

Figure 17.7

The Inflation Rate and the Natural Rate of Unemployment in the Long Run

The inflation rate is stable only if the unemployment rate equals the natural rate of unemployment (point C). If the unemployment rate is below the natural rate (point A),the inflation rate increases, and, eventually, the short-run Phillips curve shifts up. If the unemployment rate is above the natural rate (point B),the inflation rate decreases,and, eventually, the short-run Phillips curve shifts down.

Does the Natural Rate of Unemployment Ever Change?

Makingthe

Connection

Your Turn: Test your understanding by doing related problems 2.9 and 2.10 at the end of this chapter.MyEconLab

Frictional or structural unemployment can change—thereby changing the natural rate—for several reasons:

• Demographic changes. An increase in the number of younger and less skilled workers, who typically have higher unemployment rates than do older and more skilled workers, can increase an economy’s natural rate of unemployment.

• Labor market institutions. Labor market institutions such as the unemployment insurance system, unions, and legal barriers to firing workers can increase the economy’s unemployment rate.

• Past high rates of unemployment. Evidence indicates that if high unemployment persists for a period of years, the natural rate of unemployment may increase.

Changing Views of the Phillips CurveSolved Problem 17.2

Writing in a Federal Reserve publication, Bennett McCallum, an economist at Carnegie Mellon University, argues that during the 1970s, the Fed was “acting under the influence of 1960s academic ideas that posited the existence of a long-run and exploitable Phillips-type tradeoff between inflation and unemployment rates.” What does McCallum mean by a “long-run and exploitable Phillips-type tradeoff”? How would the Fed have attempted to exploit this long-run tradeoff?

Solving the Problem

Step 1: Review the chapter material.

Step 2: Explain what a “long-run exploitable Phillips-type tradeoff” means.A “long-run exploitable Phillips-type tradeoff” means a Phillips curve that in the long run is downward sloping rather than vertical. An “exploitable” trade-off is one that the Fed could take advantage of to permanently reduce unemployment, at the expense of higher inflation, or to permanently reduce inflation, at the expense of higher unemployment.

Changing Views of the Phillips CurveSolved Problem 17.2

Step 3: Explain how the inflation rate will accelerate if the Fed tries to exploit a long-run trade-off between unemployment and inflation.As we have seen, during the 1960s, the Fed conducted expansionary monetary policies to move up what it thought was a stationary short-run Phillips curve. By the late 1960s, these policies resulted in very low unemployment rates. In the long run, there is no stable trade-off between unemployment and inflation. Attempting to permanently keep the unemployment rate at very low levels leads to a rising inflation rate, which is what happened in the late 1960s and early 1970s.

Your Turn: For more practice, do related problem 2.6 at the end of this chapter.MyEconLab

Writing in a Federal Reserve publication, Bennett McCallum, an economist at Carnegie Mellon University, argues that during the 1970s, the Fed was “acting under the influence of 1960s academic ideas that posited the existence of a long-run and exploitable Phillips-type tradeoff between inflation and unemployment rates.” What does McCallum mean by a “long-run and exploitable Phillips-type tradeoff”? How would the Fed have attempted to exploit this long-run tradeoff? What would be the consequences for the inflation rate?

Discuss how expectations of the inflation rate affect monetary policy.17.3 LEARNING OBJECTIVE

Expectations of the Inflation Rate and Monetary Policy

The experience in the United States over the past 60 years indicates that how workers and firms adjust their expectations of inflation depends on how high the inflation rate is.

There are three possibilities:

• Low inflation. When the inflation rate is low, as it was during most of the 1950s, the early 1960s, the 1990s, and the 2000s, workers and firms tend to ignore it.

• Moderate but stable inflation. For the four-year period from 1968 to 1971, the inflation rate in the United States stayed in the narrow range between 4 and 5 percent, which workers and firms could not ignore without seeing their real wages and profits decline.People are said to have adaptive expectations of inflation if they assume that future inflation rates will follow the pattern of recent inflation rates.

Rational expectations Expectations formed by using all available information about an economic variable.

• High and unstable inflation. Although it has been rare in U.S. history during peacetime, the inflation rate was above 5 percent every year from 1973 through 1982.

The inflation rate was also unstable during these years—rising from 6 percent in 1973 to 11 percent in 1974, before falling below 6 percent in 1976 and rising again to 13.5 percent in 1980.

In the mid-1970s, Nobel Laureates Robert Lucas and Thomas Sargent argued that the gains to accurately forecasting inflation had dramatically increased.

Workers and firms that failed to correctly anticipate the fluctuations in inflation during these years could experience substantial declines in real wages and profits.

The Effect of Rational Expectations on Monetary PolicyFigure 17.8

Rational Expectations and the Phillips Curve

If workers and firms ignore inflation, or if they have adaptive expectations, an expansionary monetary policy will cause the short-run equilibrium to move from point A on the short-run Phillips curve to point B;inflation will rise, and unemployment will fall.If workers and firms have rational expectations, an expansionary monetary policy will cause the short-run equilibrium to move up the long-run Phillips curve from point A to point C. Inflation will still rise, but there will be no change in unemployment.

If workers and firms have rational expectations, they will use all available information, including knowledge of the effects of Federal Reserve policy.

Is the Short-Run Phillips Curve Really Vertical?

An obvious objection to the argument of Lucas and Sargent was that the record of the 1950s and 1960s seemed to show that there was a short-run trade-off between unemployment and inflation and that the short-run Phillips curve was downward sloping rather than vertical.

Lucas and Sargent argued that the apparent short-run trade-off was actually the result of unexpected changes in monetary policy.

Because the Fed didn’t announce changes in policy during those years, workers, firms, and financial markets would be taken by surprise and their expectations of inflation would be too low, in which case an expansionary monetary policy might cause the unemployment rate to fall.

Many economists have remained skeptical of the argument that the short-run Phillips curve is vertical. The two main objections raised are that

(1) Workers and firms actually may not have rational expectations.

(2) The rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place.

Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP.

Real Business Cycle Models

During the 1980s, some economists argued that fluctuations in “real” factors, particularly technology shocks, which are changes to the economy that make it possible to produce either more output—a positive shock—or less output—a negative shock—with the same number of inputs, explain deviations of real GDP above or below its previous potential level.

The approaches of Lucas and Sargent and the real business cycle models are sometimes grouped together under the label the new classical macroeconomics because they share the assumptions that people have rational expectations, that wages and prices adjust rapidly, and that the economy will normally be at its potential level.

Some economists have begun to develop real business cycle models that may eventually converge with the approaches the Fed uses by allowing for the possibility that changes in the money supply may affect the level of real GDP.

Use a Phillips curve graph to show how the Federal Reserve can permanently lower the inflation rate.

17.4 LEARNING OBJECTIVE

Federal Reserve Policy from the 1970s to the Present

Figure 17.9 A Supply Shock Shifts the SRAS and the Short-Run Phillips Curve

When OPEC increased the price of a barrel of oil from less than $3 to more than $10, in panel (a), the SRAS curve shifted to the left.Between 1973 and 1975, real GDP declined from $4,917 billion to $4,880 billion, and the price level rose from 28.1 to 33.6.

Panel (b) shows that the supply shock shifted up the Phillips curve. In 1973, the U.S. economy had an inflation rate of about 5.5 percent and an unemployment rate of about 5 percent. By 1975, the inflation rate had risen to about 9.5 percent and the unemployment rate to about 8.5 percent.

Paul Volcker and DisinflationFigure 17.10

The Fed Tames Inflation, 1979–1989The Fed, under Chairman Paul Volcker, began fighting inflation in 1979 by reducing the growth of the money supply, thereby raising interest rates. By 1982, the unemployment rate had risen to 10 percent, and the inflation rate had fallen to 6 percent. As workers and firms lowered their expectations of future inflation, the short-run Phillips curve shifted down, improving the short-run trade-off between unemployment and inflation.This adjustment in expectations allowed the Fed to switch to an expansionary monetary policy,which by 1987 brought the economy back to the natural rate of unemployment, with an inflation rate of about 4 percent. The orange line shows the actual combinations of unemployment and inflation for each year from 1979 to 1989. Note that during these years, the natural rate of unemployment was estimated to be about 6 percent.

Don’t Let This Happen to YouDon’t Confuse Disinflation with DeflationDisinflation refers to a decline in the inflation rate. Deflation refers to a decline in the price level.The inflation rate fell from over 11 percent in 1979 to below 5 percent in 1984. Because the price level was still rising only at a slower rate, there was disinflation.The last period of significant deflation in the United States was in the early 1930s, during the Great Depression.The following table shows the consumer price index for each of those years:

Because the price level fell each year from 1929 to 1933, there was deflation.

Year Consumer Price Index Deflation Rate1929 17.1 —

1930 16.7 −2.3%

1931 15.2 −9.0

1932 13.7 −9.9

1933 13.0 −5.1

Your Turn: Test your understanding by doing related problem 4.5 at the end of this chapter.MyEconLab

Disinflation A significant reduction in the inflation rate.

Using Monetary Policy to Lower the Inflation RateSolved Problem 17.4

Consider the following hypothetical situation: The economy is currently at the natural rate of unemployment of 5 percent. The actual inflation rate is 6 percent, and, because it has remained at 6 percent for several years, this is also the rate that workers and firms expect to see in the future. The Federal Reserve decides to reduce the inflation rate permanently to 2 percent. How can the Fed use monetary policy to achieve this objective? Be sure to use a Phillips curve graph in your answer.

Solving the Problem

Step 1: Review the chapter material.

Step 2: Explain how the Fed can use monetary policy to reduce the inflation rate.To reduce the inflation rate significantly, the Fed will have to raise the target for the federal funds rate. Higher interest rates will reduce aggregate demand, raise unemployment, and move the economy’s equilibrium down the short-run Phillips curve.

Using Monetary Policy to Lower the Inflation RateSolved Problem 17.4

Step 3: Illustrate your argument with a Phillips curve graph.How much the unemployment rate would have to rise to drive down the inflation rate from 6 percent to 2 percent depends on the steepness of the short-run Phillips curve.Here we have assumed that the unemployment rate would have to rise from 5 percent to 7 percent.

Using Monetary Policy to Lower the Inflation RateSolved Problem 17.4

Step 4: Show on your graph the reduction in the inflation rate from 6 percent to 2 percent.For the decline in the inflation rate to be permanent, the expected inflation rate has to decline from 6 percent to 2 percent. We can show this decline on our graph.Once the short-run Phillips curve has shifted down, the Fed can use an expansionary monetary policy to push the economy back to the natural rate of unemployment. The downside to these policies of disinflation is that they lead to significant increases in unemployment.According to the new classical macroeconomics approach, however, the Fed’s policy announcement should cause people to revise downward their expectations of future inflation from 6 percent to 2 percent because the economy’s short-run equilibrium would move down the long-run Phillips curve by that amount, while keeping the unemployment rate constant at 5 percent.Still, many economists are skeptical that disinflation can be brought about so painlessly.

Your Turn: For more practice, do related problems 4.7 and 4.8 at the end of this chapter.MyEconLab

Alan Greenspan, Ben Bernanke, and the Crisis in Monetary Policy

Federal Reserve Chairman Term

Average Annual Inflation Rate During Term

William McChesney Martin April 1951–January 1970 2.2%

Arthur Burns February 1970–January 1978 6.5

G. William Miller March 1978–August 1979 9.1

Paul Volcker August 1979–August 1987 6.2

Alan Greenspan August 1987–January 2006 3.1

Ben Bernanke January 2006– 2.4Note: Data for Bernanke are through October 2011.

Table 17.3 The Record of Fed Chairmen and Inflation

Because Greenspan’s term was marked by only two short and mild recessions, in 1990–1991 and 2001, he was widely applauded by economists, policymakers, and the media when he left office.

But with the severity of the 2007–2009 recession, some critics questioned whether decisions made by the Fed under Greenspan’s leadership might have played a role in bringing on the crisis.

• The importance of Fed credibility. Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective.

Over the past two decades, the Fed has taken steps to ensure that announced changes in Fed policy have actually taken place by publicizing the target for the federal funds rate and the minutes of the FOMC meetings.

• Deemphasizing the money supply. Greenspan’s term was notable for the Fed’s continued movement away from using the money supply as a monetary policy target.

Instead of the Fed setting targets for M1 and M2, the Federal Open Market Committee (FOMC) has relied on setting targets for the federal funds rate to meet its goals of price stability and high employment.

We will discuss those arguments after briefly reviewing two other developments in monetary policy during the past 20 years:

The Decision to Intervene in the Failure of Long-Term Capital Management Hedge funds raise money, typically from wealthy investors, and use sophisticated investment strategies involving significant risk that generally rely heavily on borrowing in order to leverage their investments, thereby increasing potential returns.

During 2008, the Fed decided to help save the hedge fund Long-Term Capital Management (LTCM), which had suffered heavy losses on several of its investments.

Although some critics see the Fed’s actions in the case of LTCM as encouraging the excessive risk taking that helped result in the financial crisis of 2007–2009, other observers doubt that the behavior of managers of financial firms were much affected by the Fed’s actions.

The Decision to Keep the Target for the Federal Funds Rate at 1 Percent from June 2003 to June 2004 The Fed lowered the target for the federal funds rate from 6.5 percent in May 2000 to 1 percent in June 2003,where it remained until it was raised to 1.25 percent in June 2004.

At the time, the FOMC argued that although the recession of 2001 was mild,the very low inflation rates of late 2001 and 2002 raised the possibility that the U.S. economy could slip into a period of deflation.

Critics argued that by keeping interest rates low for an extended period, the Fed helped to fuel the housing bubble that eventually deflated beginning in 2006, with disastrous results for the economy.

The financial crisis of 2007–2009 led the Fed to move well beyond the federal funds rate as the focus of monetary policy, which had been driven to zero without much expansionary effect on the economy.

By 2011, the Fed’s extensive interventions in the financial system had led members of Congress to scrutinize—and in many cases, criticize—Fed policy to an unusual degree.

Some observers began to speak of a “crisis in monetary policy” and worried for the Fed’s freedom of action in the future.

Countries that keep central banks independent of the rest of the government do so to prevent it from furthering its own political interests and to avoid inflation.

Has the Fed Lost Its Independence?

Figure 17.11

The More Independent the Central Bank, the Lower the Inflation Rate

For 16 high-income countries, the greater the degree of central bank independence from the rest of the government, the lower the inflation rate.Central bank independence is measured by an index ranging from 1 (minimum independence) to 4 (maximum independence).During these years, Germany had a high index of independence of 4 and a low average inflation rate of just over 3 percent. New Zealand had a low index of independence of 1 and a high average inflation rate of over 7 percent.

Is It Wise to Delay a Job Search?

At the beginning of the chapter, we posed this question: What advice would you give someone who has decided to wait nearly two years to look for a new job.

As we discussed in the chapter, evidence shows that many of those who are unemployed for longer than a year or two find it more difficult to find new employment than if they searched for a new job soon after they were laid off.

The longer workers are unemployed, especially in a high-technology field, the more their skills deteriorate.

By delaying her job search, your friend risks being unemployed for longer than two years.

Eventually, she may have to be retrained or take additional courses in a different field in order to find a job. Tell your friend to start her job search right away!

Economics in Your Life

AN INSIDE

LOOK AT POLICY

Can the Fed Balance the Trade-Off between Unemployment and Inflation?

The short-run Phillips curve can be seen in the data for the period from July 2008to July 2011.