MACROECONOMICS I
The Short-Run Trade-off
between Inflation and Unemployment
Lecture 11
May 13, 2022
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1
LOOK FOR THE ANSWERS TO THESE
QUESTIONS:
How are inflation and unemployment related in the
short run? In the long run?
What factors alter this relationship?
What is the short-run cost of reducing inflation?
Why were U.S. inflation and unemployment both so
low in the 1990s?
2
INTRODUCTION
In the long run, inflation & unemployment are
unrelated:
 The inflation rate depends mainly on growth in
the money supply.
 Unemployment (the “natural rate”) depends on
the minimum wage, the market power of unions,
efficiency wages, and the process of job search.
In the short run, society faces a trade-off between
inflation and unemployment.
3
THE PHILLIPS CURVE
Phillips curve, PC:
 Short-run trade-off between inflation and
unemployment
1958: A.W. Phillips
 Nominal wage growth was negatively
correlated with unemployment in the U.K.
1960: Paul Samuelson & Robert Solow
 Negative correlation between U.S. inflation &
unemployment
 Named it “the Phillips Curve.”
4
DERIVING THE PHILLIPS CURVE, PC
Suppose P = 100 this year.
The following graphs show two possible outcomes
for next year:
A. Aggregate demand low,
small increase in P (i.e., low inflation),
low output, high unemployment.
B. Aggregate demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.
5
DERIVING THE PHILLIPS CURVE
6
u-rate
inflation
PC
A. Low aggregate demand, low inflation, high u-rate
B. High aggregate demand, high inflation, low u-rate
Y
P
SRAS
AD1
AD2
Y1
103
A
105
Y2
B
6%
3% A
4%
5%
B
THE PHILLIPS CURVE: A POLICY MENU?
Since fiscal and monetary policy affect aggregate
demand,
 The PC appeared to offer policymakers a menu of
choices:
 Low unemployment with high inflation
 Low inflation with high unemployment
 Anything in between
1960s: U.S. data supported the PC
 Many believed the PC was stable and reliable
7
EVIDENCE FOR THE PHILLIPS CURVE?
8
0
2
4
6
8
10
0 2 4 6 8 10
During the 1960s,
U.S. policymakers
opted for reducing
unemployment
at the expense of
higher inflation
1961
63
65
62
64
66
67
68
Unemployment rate (%)
Inflation rate
(% per year)
THE VERTICAL LONG-RUN PHILLIPS CURVE
1968: Milton Friedman and Edmund Phelps
 Argued that the tradeoff was temporary
 Based on the classical dichotomy and the
vertical LRAS curve
Natural-rate hypothesis:
The claim that unemployment eventually returns
to its normal or “natural” rate, regardless of the
inflation rate
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THE VERTICAL LONG-RUN PHILLIPS CURVE
10
u-rate
inflation
In the long run, faster money growth only causes faster inflation.
Y
P
LRAS
AD1
AD2
Natural rate
of output
Natural rate of
unemployment
P1
P2
LRPC
low
infla-
tion
high
infla-
tion
RECONCILING THEORY AND EVIDENCE
Evidence (from 1960s):
 PC slopes downward
Theory (Friedman and Phelps):
 PC is vertical in the long run.
Friedman and Phelps, bridge the gap between theory
and evidence
 Introduced a new variable: expected inflation – a
measure of how much people expect the price level
to change
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THE PHILLIPS CURVE EQUATION
12
Short run
 The Fed can reduce u-rate below the natural u-rate by
making inflation greater than expected.
Long run
 Expectations catch up to reality, u-rate goes back to
natural u-rate whether inflation is high or low.
Unemp.
rate
Natural
rate of
unemp.
= – a Actual
inflation
Expected
inflation
–
HOW EXPECTED INFLATION SHIFTS THE PC
Initially, expected &
actual inflation = 3%,
unemployment =
natural rate (6%).
Fed makes inflation 2% higher
than expected, u-rate falls to 4%.
In the long run, expected inflation
increases to 5%, PC shifts upward,
unemployment returns to its
natural rate.
13
u-rate
inflation
PC1
LRPC
6%
3%
PC2
4%
5%
A
B C
14
ACTIVE LEARNING 1 A NUMERICAL EXAMPLE
Natural rate of unemployment = 5%
Expected inflation = 2%
In PC equation, a = 0.5
A. Plot the long-run Phillips curve.
B. Find the u-rate for each of these values of actual inflation:
0%, 6%. Sketch the short-run PC.
C. Suppose expected inflation rises to 4%.
Repeat part B.
D. Instead, suppose the natural rate falls to 4%.
Draw the new long-run Phillips curve, then repeat part B.
15
ACTIVE LEARNING 1 ANSWERS
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7 8
unemployment rate
inflationrate
LRPCA
An increase
in expected
inflation
shifts PC to
the right.
PCD
LRPCD
PCB
PCCA fall in the
natural rate
shifts both
curves
to the left.
0
2
4
6
8
10
0 2 4 6 8 10
THE BREAKDOWN OF THE PHILLIPS CURVE
16
Inflation rate
(% per year)
Unemployment
rate (%)
Early 1970s:
unemployment increased,
despite higher inflation.
Friedman &
Phelps’
explanation:
expectations
were catching
up with reality.
0
2
4
6
8
10
0 2 4 6 8 10
1961
63
65
62
64
66
67
68
69 70 71
72
73
ANOTHER PC SHIFTER: SUPPLY SHOCKS
Supply shock:
 An event that directly alters firms’ costs and
prices
 Shifting the AS and PC curves
Example: large increase in oil prices
17
HOW AN ADVERSE SUPPLY SHOCK SHIFTS THE PC
18
u-rate
inflation
SRAS shifts left, prices rise, output & employment fall.
Inflation & u-rate both increase as the PC shifts upward.
Y
P
SRAS1
AD PC1
PC2
A
B
SRAS2
A
Y1
P1
Y2
B
P2
THE 1970S OIL PRICE SHOCKS
The Fed chose to
accommodate the first shock
in 1973 with faster money
growth.
Result:
Higher expected inflation,
which further shifted PC.
1979:
Oil prices surged again,
worsening the Fed’s
tradeoff. 19
38.001/1981
32.501/1980
14.851/1979
10.111/1974
$ 3.561/1973
Oil price per barrel
Source: Dow Jones & Company
THE 1970S OIL PRICE SHOCKS
20
Inflation rate
(% per year)
Unemployment
rate (%)
0
2
4
6
8
10
Supply shocks &
rising expected
inflation
worsened the PC
tradeoff.
1972
73
74
75
76
77
78
79
80
81
THE COST OF REDUCING INFLATION
Disinflation:
 A reduction in the inflation rate
To reduce inflation,
 The Fed must slow the rate of money growth, which
reduces aggregate demand
Short run:
 Output falls and unemployment rises.
Long run:
 Output & unemployment return to their natural rates.
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DISINFLATIONARY MONETARY POLICY
Contractionary monetary
policy moves economy
from A to B.
Over time,
expected inflation falls,
PC shifts downward.
In the long run,
point C:
the natural rate
of unemployment,
lower inflation. 22
u-rate
inflation
LRPC
PC1
natural rate of
unemployment
A
PC2
C
B
THE COST OF REDUCING INFLATION
Sacrifice ratio:
 Percentage points of annual output lost
per 1 percentage point reduction in inflation
 Typical estimate: 5
➢ To reduce inflation rate 1%, must sacrifice 5% of a
year’s output.
 Can spread cost over time: to reduce inflation by 6%, can
either
➢ sacrifice 30% of GDP for one year
➢ sacrifice 10% of GDP for three years
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RATIONAL EXPECTATIONS, COSTLESS DISINFLATION?
Rational expectations:
Theory according to which people optimally use all
the information they have
Including info about government policies, when
forecasting the future
Early proponents: Robert Lucas, Thomas Sargent,
Robert Barro
Implied that disinflation could be much less costly…
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RATIONAL EXPECTATIONS, COSTLESS DISINFLATION?
Suppose the Fed convinces everyone it is
committed to reducing inflation.
 Then, expected inflation falls, the short-run PC
shifts downward.
 Result: disinflations can cause less
unemployment than the traditional sacrifice
ratio predicts.
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THE VOLCKER DISINFLATION
Fed Chairman Paul Volcker
Appointed in late 1979 under high inflation &
unemployment
Changed Fed policy to disinflation
1981–1984: Fiscal policy was expansionary
So Fed policy had to be very contractionary to reduce
inflation.
Success: Inflation fell from 10% to 4%,
but at the cost of high unemployment…
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THE VOLCKER DISINFLATION
27
Inflation rate
(% per year)
Unemployment
rate (%)
0
2
4
6
8
10
0 2 4 6 8 10
Disinflation turned out to be very costly
u-rate
near 10%
in 1982–83
1979
80
81
82
83
84
85
86
87
THE GREENSPAN ERA
1986: Oil prices fell 50%.
1989–90: Unemployment fell, inflation rose.
Fed raised interest rates, caused a mild recession
1990s: Unemployment and inflation fell.
2001:
Negative demand shocks created the first recession in a
decade.
Policymakers responded with expansionary monetary and
fiscal policy.
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THE GREENSPAN ERA
29
Inflation rate
(% per year)
Unemployment
rate (%)
0
2
4
6
8
10
0 2 4 6 8 10
Inflation and unemployment
were low during most of
Alan Greenspan’s years
as Fed Chairman.
1987
90
922000
949698
06
02
05
THE PHILLIPS CURVE DURING THE
FINANCIAL CRISIS
The early 2000s
 Housing market boom turned to bust in 2006
 Household wealth fell,
 Millions of mortgage defaults and foreclosures
 Heavy losses at financial institutions
Result:
 Sharp drop in aggregate demand, steep rise in
unemployment
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PHILLIPS CURVE DURING AND AFTER THE FINANCIAL CRISIS
31
2006
2007
2008
2009
2010
20112012
2013
2014
2015
0.0
2.0
4.0
6.0
8.0
10.0
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0
Inflationrate(%peryear)
2006-2009:
The financial crisis caused aggregate
demand to plummet, sharply increasing
unemployment and reducing inflation.
2010-2015:
A slow recovery reduced unemployment;
inflation remained between 1 and 2%
CONCLUSION
Theories in this chapter teach us that inflation and
unemployment are:
 Unrelated in the long run
 Negatively related in the short run
 Affected by expectations, which play an
important role in the economy’s adjustment
from the short-run to the long run
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SUMMARY
• The Phillips curve describes the short-run tradeoff
between inflation and unemployment.
• In the long run, there is no tradeoff:
inflation is determined by money growth,
while unemployment equals its natural rate.
• Supply shocks and changes in expected inflation shift
the short-run Phillips curve, making the tradeoff more
or less favorable.
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SUMMARY
• The Fed can reduce inflation by contracting the money
supply, which moves the economy along its short-run
Phillips curve and raises unemployment. In the long
run, though, expectations adjust and unemployment
returns to its natural rate.
• Some economists argue that a credible commitment to
reducing inflation can lower the costs of disinflation by
inducing a rapid adjustment of expectations.
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