1 10. The Relationship between Unemployment and Inflation Abel, Bernanke and Croushore (chapter 12.1)

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10. The Relationship between Unemployment and Inflation

Abel, Bernanke and Croushore

(chapter 12.1)

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Syllabus Outline

1. Introduction to Macroeconomics

2. The measurement and structure of the national economy

3. Goods market equilibrium: the IS curve

4. Money market equilibrium: the LM curve

5. The IS-LM model

6. Demand-side policies in the IS-LM model (Keynesian Macroeconomics)

7. The Aggregate Supply curve

8. Classical Macroeconomics in the AD-AS model

9. Keynesian Macroeconomics in the AD-AS model

10. The relationship between Unemployment and Inflation

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Goals of the chapter

A) Why study unemployment and inflation together?

1. The most important macroeconomic problems2. Phillips curve relationship

B) Study relationship between inflation and unemployment

1. Has it changed over time?2. Is there a trade-off between inflation and unemployment?

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A) Many people think there is a trade-off between inflation and unemployment1. The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain2. Since then economists have looked at the relationship between unemployment and price inflation (Samuelson and Solow, 1960)3. In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables4. The United States appears to be on one Phillips curve in the 1960s (text Figure 12.1)5. This suggested that policymakers could choose the combination of unemployment and inflation they most desired6. But the relationship fell apart in the following three decades (text Figure 12.2)7. The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve

Unemployment and Inflation: Is There a Trade-off? (Sec. 12.1)

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Figure 12.1 The Phillips curve and the U.S. economy during the 1960s

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Figure 12.2 Inflation and unemployment in the United States, 1970–2002

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B) The expectations-augmented Phillips curve1. Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation)

a. This theory was made before the Phillips curve began breaking down in the 1970s

b. It suggests that the relationship between inflation and the unemployment rate

isn’t stable

2. How does this work in the extended classical model?

Unemployment and Inflation: Is There a Trade-off?

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B) The expectations-augmented Phillips curve (cont.)2. How does this work in the extended classical model?

a. First case: anticipated increase in money supply (text Figure 12.3)


(1) AD shifts up and SRAS shifts up, with no misperceptions

(2) Result: P rises, Y unchanged

(3) Inflation rises with no change in unemployment

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B) The expectations-augmented Phillips curve (cont.) 2. How does this work in the extended classical model?

b. Second case: unanticipated increase in money supply (text Figure 12.4)


(1) AD expected to shift up to AD2, old (money supply expected to rise 10%), but unexpectedly money supply rises 15%, so AD shifts further up to AD2, new

(2) SRAS shifts up based on expected 10% rise in money supply

(3) Result: P rises and Y rises as misperceptions occur

(4) So higher inflation occurs with lower unemployment

(5) Long run: P rises further, Y declines to full-employment level

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B) The expectations-augmented Phillips curve (cont.) 2. How does this work in the extended classical model?

c. Expectations-augmented Phillips curve:

e – h(u – u ) (12.1)

(1) When e, u u

(2) When < e, u > u

(3) When > e, u < u

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C) The shifting Phillips curve1. The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment

2. Changes in the expected rate of inflation (text Figure 12.5) u

a. For a given expected rate of inflation, the Phillips curve shows the trade-off between cyclical unemployment and actual inflation

b. The Phillips curve is drawn such that = e when u =

c. Higher expected inflation implies a higher Phillips curve

u

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C) The shifting Phillips curve (cont.) 3. Changes in the natural rate of unemployment (text Figure 12.6)

a. For a given natural rate of unemployment, the Phillips curve shows the trade-off between unemployment and unanticipated inflation

b. A higher natural rate of unemployment shifts the Phillips curve to the right

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C) The shifting Phillips curve (cont.)4. Supply shocks and the Phillips curve

a. A supply shock increases both expected inflation and the natural rate of unemployment

(1) A supply shock in the classical model increases the natural rate of unemployment, because it increases the mismatch between firms and workers

(2) A supply shock in the Keynesian model reduces the marginal product of labor and thus reduces labor

demand at the fixed real wage, so the natural unemployment rate rises

b. So an adverse supply shock shifts the Phillips curve up and to the right

c. The Phillips curve will be unstable in periods with many supply shocks

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C) The shifting Phillips curve (cont.)5. The shifting Phillips curve in practice

a. Why did the original Phillips curve relationship apply to many historical cases?

(1) The original relationship between inflation and unemployment holds up as long as

expected inflation and the natural rate of unemployment are approximately constant

(2) This was true in the United States in the 1960s, so the Phillips curve appeared to be stable

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C) The shifting Phillips curve (cont.)5. The shifting Phillips curve in practice

b. Why did the U.S. Phillips curve disappear after 1970?(1) Both the expected inflation rate and the natural rate of unemployment varied considerably more in the 1970s than they did in the 1960s

(2) Especially important were the oil price shocks of 1973– 1974 and 1979–1980

(3) Also, the composition of the labor force changed in the 1970s and there were other structural changes in the economy as well, raising the natural rate of unemployment

(4) Monetary policy was expansionary in the 1970s, leading to high and volatile inflation

(5) Plotting unanticipated inflation against cyclical unemployment shows a fairly stable relationship since 1970 (text Figure 12.7)

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Figure 12.7 The expectations-augmented Phillips curve in the United States, 1970–2002

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D) Macroeconomic policy and the Phillips curve1. Can the Phillips curve be exploited by policymakers?

Can they choose the optimal combination of unemployment and inflation?

a. Classical model: NO(1) The unemployment rate returns to its natural level

quickly, as people’s expectations adjust

(2) So unemployment can change from its natural level only for a very brief time

(3) Also, people catch on to policy games; they have rational expectations and try to anticipate policy changes, so

there is no way to fool people systematically

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D) Macroeconomic policy and the Phillips curve1. Can the Phillips curve be exploited by policymakers?

Can they choose the optimal combination of unemployment and inflation?

b. Keynesian model: YES, temporarily(1) The expected rate of inflation in the Phillips curve is

the forecast of inflation at the time the oldest sticky prices were set

(2) It takes time for prices and expected prices to adjust, so unemployment may differ from the natural rate for some time

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D) Macroeconomic policy and the Phillips curve2. Box 12.1: The Lucas critique

a. When the rules of the game change, behavior changes

b. For example, if batters in baseball were called out after two strikes instead of three, they’d swing more often when they have one strike than they do now

c. Lucas applied this idea to macroeconomics, arguing that historical relationships between variables won’t hold up if there’s been a major policy change

d. The Phillips curve is a good example—it fell apart as soon as policymakers tried to exploit it

e. Evaluating policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary

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E)The long-run Phillips curve1. Long run: u = for both Keynesians and classicals

2. The long-run Phillips curve is vertical, since when

(text Figure 12.8)

u e, u u

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E)The long-run Phillips curve

3. Changes in the level of money supply have no long-run real effects; changes in the growth rate of money supply have no long-run real effects, either

4. Even though expansionary policy may reduce unemployment only temporarily, policymakers may want to do so if, for example, timing economic booms right before elections helps them

(or their political allies) get reelected

Documents

1 10. The Relationship between Unemployment and Inflation Abel, Bernanke and Croushore (chapter 12.1)