The Relationship Between Inflation and Unemployment•An inverse relationship between inflation and unemployment until the 1970s•1970s high inflation and unemployment•Is there still a relationship between inflation and unemployment?

The Relationship Between Inflation and Unemployment•An inverse relationship between inflation and unemployment until the 1970s•1970s high inflation and unemployment•Is there still a relationship between inflation and unemployment?

The Phillips Curve

The 1960s: A Policy Menu?

Explaining the Phillips Curve with Aggregate Demand

and Aggregate Supply Curves

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

As long as SRAS is stable, get Phillips Curve relation

1970s: Why did the Phillips curve vanish?higher oil prices … shift SRAS + inflation expectations…shift SRAS inflation became persistent and positive

1970s: Why did the Phillips curve vanish?higher oil prices … shift SRAS + inflation expectations…shift SRAS inflation became persistent and positive

Explaining the Phillips Curve with Aggregate Demand

and Aggregate Supply Curves

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

As long as SRAS is stable, get Phillips Curve relationIf people expect high inflation… Phillips curve shifts…

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, in his presidential address to the American Economic Association, Milton Friedman of the University of Chicago argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation.

The Long-Run Phillips Curve

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

The Long-Run Phillips Curve

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

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

The Role of Expectations of Future Inflation

The Basis for the Short-Run Phillips Curve

IF… THEN… AND…

actual inflation is greater than expected inflation,

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

labor is cheap …

the unemployment rate falls.

actual inflation is

less than expected inflation,

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

labor is dear …

the unemployment rate rises.

The Short-Run and Long-Run Phillips Curves

The Short-Run and Long-Run Phillips CurvesThe Inflation Rate and the Natural Rate of Unemployment in the Long Run

Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease.

Does the Natural Rate of Unemployment Ever Change?

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

• Demographic changes.

• Labor market institutions.

Strength of unions

Generous unemployment benefits

• Past high rates of unemployment.

• Other costs of production and the real wage

Oil price and the “natural rate”

• Low inflation stable expectations/ignore inflation.

• Moderate but stable inflation adaptive expectations.

• High and unstable inflation rational expectations.

Expectations of the Inflation Rate and Monetary Policy

Rational expectations Expectations formed by using all available information about an economic variable, including our model of the economy.

How workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities:

Rational expectations Expectations formed by using all available information about an economic variable, including what you’ve learned in college.

Expectations of the Inflation Rate and Monetary PolicyThe Effect of Rational Expectations on Monetary Policy

Rational expectations

Policy ineffectiveness Don’t bother with

expansionary policy

Laissez - faire

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

What if rational expectations are the rule?

Reasons to doubt that the short-run Phillips Curve is vertical:

(1) workers and firms actually may not have rational expectations, and

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

Is the Short-Run Phillips Curve Really Vertical?

How the Fed Fights InflationPaul Volcker and Disinflation

The Fed Tames Inflation, 1979–1989

FEDERAL RESERVE CHAIRMAN TERM

AVERAGE ANNUAL INFLATION RATE DURING TERM

William McChesney Martin April 1952-January 1970 2.0%

Arthur Burns February 1970-January 1978 6.5

G. William Miller March 1978-August 1979 9.2

Paul Volcker August 1979-August 1987 6.2

Alan Greenspan August 1987-(January 2006) 3.0

Ben Bernanke January 2006– 3.0

How the Fed Fights Inflation

De-emphasizing the Money Supply

The Fed learned an important lesson during the1970s:

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

How the Fed Fights InflationMonetary Policy Credibility after Greenspan

Central banks are more credible if they adopt and follow rules.

•Rules (e.g., Taylor Rule) vs. discretion

•A middle course between rules and discretion:

Inflation targeting.

The best way to achieve commitment to rules

remove political pressures on the central bank.

Crisis: the Bagehot Rule—Lend and lend freely!

The Fed Rethinks the Phillips Curve

Policy Makers at Fed Rethink Inflation’s Roots

The short- and long-run Phillips curves.

K e y T e r m s

Disinflation

Natural rate of unemployment

Nonaccelerating inflation rate of

unemployment (NAIRU)

Phillips curve

Rational expectations

Real business cycle models

Structural relationship