The Short-Run
Tradeoff between
Inflation and
Unemployment
Lecture 11
5.5.2015
Copyright © 2004 South-Western
• How monetary policy influences aggregate
demand
• Shifts in AD curve
• An increase in the money supply
• Shifts money supply curve to the right
• Interest rate must fall to induce people to hold additional
money that CB created
• The costs of borrowing and the return to saving are
reduced
• The demand for goods and services at given price level
increase
• The aggregate-demand curve shifts to the right.
Previous lecture
Copyright © 2004 South-Western
• How monetary policy influences aggregate
demand
• An increase in government purchases or a cut in
taxes shifts the aggregate-demand curve to the right.
• The shift in aggregate demand can be larger or
smaller than the fiscal change.
• 2 effects:
• The multiplier effect tends to amplify the effects of fiscal
policy on aggregate demand
• The crowding-out effect tends to dampen the effects of
fiscal policy on aggregate demand.
Previous lecture
Copyright © 2004 South-Western
Outline
• Inflation and unemployment
• How are these two measures of economic
performance related to each other?
• Society faces a short run trade-off between inflation
and unemployment
• The Philips curve
• The short-run and the long-run
• The role of expectations
• The role of supply shocks
Copyright © 2004 South-Western
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.
• In the long run – inflation and unemployment
are largely unrelated
Copyright © 2004 South-Western
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.
Copyright © 2004 South-Western
THE PHILLIPS CURVE
• The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.
Figure 1 The Phillips Curve
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Phillips curve
4
B6
7
A
2
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Copyright © 2004 South-Western
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.
Figure 2 How the Phillips Curve is Related to
Aggregate 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
(percent
per 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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Copyright © 2004 South-Western
Aggregate Demand, Aggregate Supply, and
the Phillips Curve
• The greater the aggregate demand for goods
and services, the greater is the economy’s
output, and the higher is the overall price level.
• A higher level of output results in a lower level
of unemployment.
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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 at
the natural rate of unemployment.
• Monetary policy could be effective in the short run
but not in the long run.
Figure 3 The Long-Run Phillips Curve
Unemployment
Rate
0 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 the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
Copyright © 2004 South-Western
Figure 4 How the Phillips Curve is Related to
Aggregate 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
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
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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Copyright © 2004 South-Western
Expectations and the Short-Run Phillips
Curve
• Expected inflation measures how much people
expect the overall price level to change.
• In the long run, expected inflation adjusts to
changes in actual inflation.
• The Fed’s 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.
Copyright © 2004 South-Western
• This equation relates the unemployment rate to
the natural rate of unemployment, actual
inflation, and expected inflation.
Expectations and the Short-Run Phillips
Curve
 Natural rate of unemployment -a Actual
inflation
Expected
inflation
Unemployment Rate =
Figure 5 How Expected Inflation Shifts the ShortRun
Phillips Curve
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate Long-run
Phillips curve
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
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-run
Phillips curve shifts to the right.
C
B
A
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Copyright © 2004 South-Western
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.
• A few years after Friedman and Phelps
proposed this hypothesis, monetary and fiscal
policy makers in the U.S. inadvertently created
a natural experiment to test it.
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
1961
1962
1963
1967
1965
1964
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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
1961
1962
1963
1967
1968
1969 1970
1965
1964
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Copyright © 2004 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• Historical events have shown that the short-run
Phillips curve can shift due to changes in
expectations.
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SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• The short-run Phillips curve also shifts because
of shocks to aggregate supply.
• A supply shock is an event that directly alters
the firms’ costs, and, as a result, the prices they
charge.
• This shifts the economy’s aggregate supply
curve. . .
• . . . and as a result, the Phillips curve.
Figure 8 An Adverse Shock to Aggregate Supply
Quantity
of Output
0
Price
Level
Aggregate
demand
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
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 unemployment
and inflation.
BP2
Y2
P
A
Y
Phillips curve,PC
2. . . . lowers output . . .
PC2
B
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Copyright © 2004 South-Western
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
• In the 1970s, policymakers faced two choices
when OPEC cut output and raised worldwide
prices of petroleum.
• Fight the unemployment battle by expanding
aggregate demand and accelerate inflation.
• Fight inflation by contracting aggregate demand
and endure even higher unemployment.
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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Copyright © 2004 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, the Fed has to pursue
contractionary 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
Short Run and the Long Run
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate
Long-run
Phillips curve
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
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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Copyright © 2004 South-Western
THE COST OF REDUCING
INFLATION
• To reduce inflation, an economy must endure a
period of high unemployment and low output
(point B).
• The size of this cost depends on
• the slope of Phillips curve
• and how quickly expectations of inflation adjust to
the new monetary policy.
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THE COST OF REDUCING
INFLATION
• The sacrifice ratio is the number of percentage
points of annual output that is lost in the
process of reducing inflation by one percentage
point.
• An estimate of the sacrifice ratio is five.
• To reduce inflation from about 10% in 1979-1981
to 4% would have required an estimated sacrifice of
30% of annual output!
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Rational Expectations and the Possibility of
Costless Disinflation
• The theory of rational expectations suggests
that people optimally use all the information
they have, including information about
government policies, when forecasting the
future.
• 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 nation’s foremost problems.
• Volcker succeeded in reducing inflation (from
10 percent to 4 percent), but at the cost of high
employment (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
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1980 1981
1982
1984
1986
1985
1979
A
1983
B
1987
C
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Copyright © 2004 South-Western
Most economist agree on:
• in “short run” Changes in AD
will change U and Y (higher
public budget deficits and higher
growth of MS will increase Y and
U)
• In the long run the economy stays
at the potential given by level of
technology and availability of
factors of production
• In the long run higher growth of
MS will only increase price level
and higher public budget deficits
will crowd out investment and
lower growth
Remaining disagreements:
• How long is “short run”?
• Role of policy:
• If “short run” is very short i.e.
economy comes back to potential
quickly, then macroeconomic
policies should be limited – there
should be binding rules which
limit public debt and set stable
increase in money supply
• If “short run” is relatively long,
then macroeconomic policies
should be more flexible
Macroeconomic policy – summing up
View of modern mainstream
Copyright © 2004 South-Western
Summary
• The Phillips curve
• describes a negative relationship between inflation
and unemployment.
• By expanding aggregate demand, policymakers can
choose a point on the Phillips curve with higher
inflation and lower unemployment.
• 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 the natural
rate of unemployment.
Copyright © 2004 South-Western
Summary
• The short-run Phillips curve also shifts because
of shocks to aggregate supply.
• 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.