Chapter 35
The Short-Run Tradeoff Between Inflation and Unemployment
In this chapter,
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?
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.
• One of the Ten Principles:
In the short run, society faces a trade-off
between inflation and unemployment.
The Phillips Curve
• Phillips curve: shows the short-run trade-off between inflation and
unemployment
• 1958: A.W. Phillips showed that
nominal wage growth was negatively
correlated with unemployment in the U.K.
• 1960: Paul Samuelson & Robert Solow found
a negative correlation between U.S. inflation
& unemployment, named it “the Phillips Curve.”
Deriving the Phillips Curve
• Suppose P = 100 this year.
• The following graphs show two possible outcomes for next year:
A. Agg demand low,
small increase in P (i.e., low inflation),
low output, high unemployment.
B. Agg demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.
Deriving the Phillips Curve
A. Low agg demand, low inflation, high u-rate
P inflation
SRAS
B B
5%
105
A
103 3% A
AD2
PC
AD1
Y1 Y2 Y 4% 6% u-rate
B. High agg demand, high inflation, low u-rate
The Phillips Curve: A Policy Menu?
• Since fiscal and mon policy affect agg 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 Phillips curve.
Many believed the PC was stable and reliable.
Evidence for the Phillips Curve?
Inflation rate
(% per year) During the 1960s, U.S.
policymakers opted
10
for reducing
8 unemployment
at the expense of
6 higher inflation
4 68
66
67
2 62
65
1961
64 63
0
0 2 4 6 8 10 Unemployment
rate (%)
The Vertical Long-Run Phillips Curve
• 1968: Milton Friedman and Edmund Phelps argued that the tradeoff
was temporary.
• Natural-rate hypothesis: the claim that unemployment eventually
returns to its normal or “natural” rate, regardless of the inflation rate
• Based on the classical dichotomy and the
vertical LRAS curve
The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes faster
inflation.
P inflation
LRAS LRPC
high
P2 infla-
tion
P1 AD2 low
infla-
AD1 tion
Y u-rate
Natural rate Natural rate of
of output unemployment
10
Reconciling Theory and Evidence
• Evidence (from ’60s):
PC slopes downward.
• Theory (Friedman and Phelps):
PC is vertical in the long run.
• To bridge the gap between theory and evidence, Friedman and Phelps
introduced a new variable: expected inflation – a measure of how
much people expect the price level to change.
The Phillips Curve Equation
Natural
Unemp. Actual Expected
= rate of – a –
rate inflation inflation
unemp.
Short run
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.
How Expected Inflation Shifts the PC
Initially, expected &
actual inflation = 3%,
inflation
unemployment = LRPC
natural rate (6%).
Fed makes inflation
2% higher than expected, B C
5%
u-rate falls to 4%.
3% A
In the long run,
expected inflation increases PC2
to 5%, PC1
PC shifts upward,
4% 6% u-rate
unemployment returns to
its natural rate.
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.
ACTIVE LEARNING 1
Answers LRPCD
PCB LRPCA
7
An increase
in expected 6
inflation
5
inflation rate
shifts PC to
the right. 4
PCD
3
A fall in the PCC
2
natural rate
1
shifts both
curves 0
to the left. 0 1 2 3 4 5 6 7 8
unemployment rate
The Breakdown of the Phillips Curve
Inflation rate
(% per year) Early 1970s:
unemployment increased,
10
Friedman &
despite higher inflation.
8 Phelps’
explanation:
6 73 expectations
69 70 71 were catching
4 68
66
72 up with reality.
67
2 62
65
1961
64 63
0
0 2 4 6 8 10 Unemployment
rate (%)
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
How an Adverse Supply Shock Shifts the PC
SRAS shifts left, prices rise, output & employment fall.
P inflation
SRAS2
SRAS1
B B
P2
P1 A A
PC2
AD PC1
Y2 Y1 Y u-rate
Inflation & u-rate both increase as the PC shifts upward.
The 1970s Oil Price Shocks
Oil price per barrel The Fed chose to accommodate
the
1/1973 $ 3.56 first shock in 1973
1/1974 10.11 with faster money growth.
1/1979 14.85 Result:
Higher expected inflation, which
1/1980 32.50 further shifted PC.
1/1981 38.00 1979:
Oil prices surged again,
worsening the Fed’s tradeoff.
The 1970s Oil Price Shocks
Inflation rate
(% per year) Supply
shocks &
10 81 75
74 rising
80 expected
8 79
78 inflation
6 77 worsened
73
76 the PC
4 1972 tradeoff.
0
0 2 4 6 8 10 Unemployment
rate (%)
The Cost of Reducing Inflation
• Disinflation: a reduction in the inflation rate
• To reduce inflation,
Fed must slow the rate of money growth,
which reduces agg demand.
• Short run:
Output falls and unemployment rises.
• Long run:
Output & unemployment return to their natural rates.
Disinflationary Monetary Policy
Contractionary monetary
policy moves economy from
A to B. inflation
LRPC
Over time,
expected inflation falls,
A
PC shifts downward.
In the long run, B
point C: C
the natural rate
of unemployment, PC1
lower inflation. PC2
u-rate
natural rate of
unemployment
The Cost of Reducing Inflation
• Disinflation requires enduring a period of
high unemployment and low output.
• Sacrifice ratio:
percentage points of annual output lost
per 1 percentage point reduction in inflation
• Typical estimate of the sacrifice ratio: 5
• To reduce inflation rate 1%,
must sacrifice 5% of a year’s output.
• Can spread cost over time, e.g.
To reduce inflation by 6%, can either
• sacrifice 30% of GDP for one year
• sacrifice 10% of GDP for three years
Rational Expectations, Costless Disinflation?
• Rational expectations: a theory according to which people optimally
use all the information they have, including info about govt policies,
when forecasting the future
• Early proponents:
Robert Lucas, Thomas Sargent, Robert Barro
• Implied that disinflation could be much less costly…
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.
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…
The Volcker Disinflation
Inflation rate Disinflation turned out to be very costly
(% per year)
10 81 u-rate
80
near 10% in
8 1979
1982–83
6 82
4 84
83
87 85
2 86
0
0 2 4 6 8 10 Unemployment
rate (%)
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. Alan Greenspan
Chair of FOMC,
• 2001: Negative demand shocks Aug 1987 – Jan 2006
created the first recession in a decade.
Policymakers responded with expansionary monetary and
fiscal policy.
The Greenspan Era
Inflation rate
(% per year) Inflation and unemployment
were low during most of
10
Alan Greenspan’s years
8 as Fed Chairman.
6
90
05
4
06 1987
2 2000 92
98 96 02 94
0
0 2 4 6 8 10 Unemployment
rate (%)
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
Ben Bernanke
• Result: Chair of FOMC,
Sharp drop in aggregate demand, Feb 2006 – present
steep rise in unemployment
The Phillips Curve During the
Financial Crisis
Inflation rate
(% per year)
10
The financial crisis caused
aggregate demand to plummet,
8 sharply increasing unemployment
and reducing inflation
6
4 2006
2007
2
2008 2009
0
0 2 4 6 8 10 Unemployment
rate (%)
CONCLUSION
• The theories in this chapter come from some of the greatest
economists of the 20th century.
• They 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
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.
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.