The Trade-Off between Inflation and Unemployment 17

The Trade-Off between Inflation and Unemployment

17

Inflation vs. Unemployment

• High-growth policies that reduce unemployment tend to raise inflation

• Slow-growth policies that reduce inflation tend to raise unemployment

• Tradeoff –• is different in the short run than in long run

2

Demand Side vs. Supply Side Inflation

• Two sources of inflation• Demand-side inflation

• Rise in the price level caused by rapid growth of aggregate demand (demand-pull)

• Supply-side inflation• Rise in the price level caused by slow growth (or

decline) of aggregate supply (cost-push)

3

Inflation from the Demand Side

4

Pric

e Le

vel

Real GDP

D1

D1

S

S

D0

D0

A

B

Inflation from the Supply Side

5

Pric

e Le

vel

Real GDP

S0

S0

D0

D0

A

S1

S1

B

Origins of the Phillips Curve

• Suppose most business fluctuations come from demand• Inverse relationship between unemployment and

inflation• Faster growth of real output, faster growth in the

number of jobs so lower unemployment• Slower growth of real output, slower growth in

the number of jobs so higher unemployment

6


7

Infla

tion

Rat

e

0

Unemployment rate

9%8%

1

2

10%

3A

B

C


• Does the data support the theory?• A.W. Phillips compared wages and

unemployment for Britain

8

The original Phillips Curve

9


• Phillips curve• Depicts the rate of unemployment on the

horizontal axis• Either the rate of inflation or the rate of change

of money wages on the vertical axis• Normally downward sloping

• Higher inflation rates are associated with lower unemployment rates

• Phillips curve for the U.S.

10

A Phillips Curve for the United States, 1954–1969

11

A Phillips Curve for the United States?

12

1970 – 1983What

happened?

Supply-Side Inflation• Inflation 1970 – 1983

• Adverse supply shocks• Crop failures 1972-1973• Oil price increases: 1973-1974, 1979-1980

• Costs increase, prices rise, output falls, unemployment increases

13

1961

1958 1962 1954

1959

1963 1960

1964 1967

1957 1965 1955 1956

1966

1969

1968

1978 1973

1979

1974 1980

1981 1975

1983

1982

1977

1971

1970 1972

1984

1976

12%

11

10

9

8

7

6

5

4

3

2

10 9 8 7 6 5 4 3 2 0 1

Infl

ati

on

Ra

te

1

Unemployment Rate in Percent

The Phillips Curve: A Historical Perspective 1960’s and 1970-80’s

Supply-side Inflation

• 1996-1998, favorable supply shocks• Lower oil prices, advances in technology

• Both aggregate demand and supply increase• But aggregate supply shifted more• Rapid growth, lower unemployment, and

lower inflation

15

Favorable Supply Shock

16

What the Phillips Curve Is and Is Not

• Phillips curve• Is a statistical relationship between inflation and

unemployment• Holds if business cycle fluctuations arise mainly

from demand and AS is stable• If AS shifts, the Phillips curve shifts• During 1970s, 1980s, incorrectly seen as

alternative equilibrium points from which policy makers could choose. AS was not stable.

17

The Phillips Curve is Not Stable

• Self-correcting mechanism• Refers to the way money wages respond to

recessionary or expansionary gaps• Wage changes shift the aggregate supply

curve• Effecting equilibrium real GDP and the

price level• The Phillips curve shifts

18

The Elimination of a Recessionary Gap: As the AS curve shifts down the Phillips curve shifts down

19

Real GDP

Pric

e Le

vel

Potential GDP

AS0

AS0

D

D

AS1

AS1

AS2

AS2

A

B

C

The Vertical Long-Run Phillips Curve

20

2 3 40 5 6


7 8 9

C1

2

3

4

5

Infla

tion

Rat

e

7

6

8%

A

PC0

PC2

The Natural Rate of Unemployment is 5%.

What the Phillips Curve is Not

• Recessionary gap points (a)• Low inflation and high unemployment• Lead to falling inflation and falling unemployment• The Phillips curve shifts down to point (c).

• Inflationary gap points (d)• High inflation and low unemployment• Lead to rising unemployment and rising inflation• The Phillips curve shifts up to point (f).

21


22

d

2 3 40 5 6


7 8 9

e

1

2

3

4

5

Infla

tion

Rat

e

7

6

8%f

PC0

PC2



• Natural Rate of Unemployment; pts c, e, and f• The unemployment rate achieved through the self-

correction mechanism• Consistent with full unemployment at the natural

rate of unemployment

• Vertical (long-run) Phillips curve• There is no trade-off between inflation and

unemployment in the long run• Some economist argue there is no trade-off in the

short run.

23

Trade-off: inflation & unemployment

• Short run: Trade-off• Policy makers can attempt to “Ride up the Phillips

curve”• Stimulate AD to reduce unemployment below the natural

rate

• Policy makers can attempt to “Ride down the Phillips curve”

• Restrict growth of AD to lower inflation

• Long run: No trade-off• Self-correcting mechanism ensures get back to the

natural rate• Faster (slower) growth of demand leads to higher (lower)

inflation and no permanent change in the natural rate of unemployment 24


25

d

2 3 40 5 6


7 8 9

e

c1

2

3

4

5

Infla

tion

Rat

e

7

6

8%f

a


Fighting Unemployment with Policy

• Should the government manage aggregate demand to fight unemployment?

• Great Recession, 2007-2009• Started in December 2007: Unemployment rate: 5% at

the natural rate.• By October 2009, 10.1%• Why didn’t we simply let the economy recover?

26

Fighting Unemployment

• Monetary policy• Federal Reserve started cutting interest rates in 2008

• Fiscal policy • Fiscal stimulus package (almost $900 billion), early 2009,

and December 2010

• Result• Faster (maybe) recovery from the 2007–2009 recession• Probably a higher inflation rate

• The cost of reducing unemployment more rapidly using expansionary fiscal and monetary policy is a permanently higher inflation rate (than it would be otherwise)

27

Fighting Unemployment

28

d

2 3 40 5 6


7 8 9

e

c1

2

3

4

5

Infla

tion

Rat

e

7

6

8%f

a

Allow the economy to self correct: Long and painful

Expansionary policy reduces unemployment but leads to higher inflation compared to point “c”

What Should Be Done ?• How do policymakers decision between

unemployment and inflation?• Costs of inflation and unemployment

• Controversy over the costs and benefits of using demand management to fight unemployment

• Policy makers that feel inflation is costly will not accept the inflationary cost of reducing unemployment faster.

• Slope of short run Phillips curve• The steeper the curve, the higher the inflationary cost of

reducing unemployment• The flatter the curve, the lower the inflationary cost of

reducing unemployment

29

Slope of Short Run Phillips curve

30

2 3 40 5 6


7 8 9

1

2

3

4

5

Infla

tion

Rat

e

7

6

8% Flatter Phillips curve, lower inflation cost to reduce unemployment.

What Should Be Done ?

• Efficiency of economy’s self-correcting mechanism• If fast and reliable: high unemployment will not

last very long• Small costs of waiting

• If wage inflation responds slowly to unemployment• Large costs of waiting

31

Inflationary Expectations

• Recall why the aggregate supply curve slopes upward?• From chapter 10: businesses purchase labor and

other inputs under long-term contracts• As P increases

• Real cost of labor (real wages) decrease and profits increases

• Business firms expand employment and output

32

Money and Real Wages under Unexpected Inflation

33

Inflation erodes workers’ purchasing power, so worse off.

What if workers can see inflation coming?

Money and Real Wages under Expected Inflation

34

Contracts would stipulate that wages increase by the expected inflation rate.

If workers see inflation coming and they receive compensation for it

• Real wages remain the same• Firms will not increase production• Aggregate supply curve is a vertical line at potential GDP

A Vertical Aggregate Supply Curve and the Corresponding Vertical Phillips Curve are possible in the SR

35

Real GDP

Pric

e Le

vel

S

AS

(a)

Unemployment Rate

Infla

tion

Rat

e

(b)

Vertical aggregate supply curve

5%

Vertical short-run Phillips curve

PC

Most Economist agree that the AS Curve and the Phillips Curve are vertical in the long-run

Vertical long-run Phillips curve

Infl

ati

on

Ra

te

(b)

Unemployment Rate

Vertical long-run aggregate supply curve P

ric

e L

ev

el

(a)

Real GDP U* Yf

AS

How Expected Inflation Shifts the Short-Run Phillips Curve

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.

FD

E

Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate

0 Natural rate ofunemployment

InflationRate

Long-runPhillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.

AC

E

An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregatedemand

(a) The Model of Aggregate Demand and Aggregate Supply

UnemploymentRate

0

InflationRate

(b) The Phillips Curve

3. . . . andraises the price level . . .

AS2 Aggregatesupply, AS

A

1. An adverseshift in aggregate supply . . .

4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B

Rational Expectations and the Possibility of Costless Disinflation

• Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run.

• How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.

The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

Rational Expectations - Vertical short- run Phillips Curve

41

d

2 3 40 5 6


7 8 9

e

c1

2

3

4

5

Infla

tion

Rat

e

7

6

8%f

a

Suppose we want to go from point e to point c.With rational expectations the only has to say they will reduce the inflation rate and the economy goes from e to c directly

PC0

PC2

Inflationary Expectations

• Is this realistic? • No. People often fail to anticipate inflation correctly

• Aggregate supply• Vertical when inflation is predicted accurately• Upward sloping when inflation is underestimated• Unexpected higher inflation will raise output• Unexpected decline in inflation will lead to a

recession

42

Theory of Rational Expectations

• Most reject the extreme rational expectations position• Old contacts – outdated expectations. 2008

contracts with 3.3% inflation turned out to be wrong because of the recession (inflation actually 1.4%)

• Expectations may adjust slowly• Wages change after the fact, not in response to

inflation• Facts do not support rational expectations

43

Why Economists Disagree

• Should the government take strong actions to prevent or reduce inflation?• Yes, if you believe in rational expectations

because:• Believe that inflation more costly than

unemployment• Short-run Phillips curve steep• Expectations adjust quickly• Self-correcting mechanism of economy works

smoothly and rapidly

44


• Should the government take strong actions to prevent or reduce inflation?• No, if you are a Keynesian because:

• Unemployment more costly than inflation• Short-run Phillips curve flat• Expectations adjust slowly• Self-correcting mechanism is slow and

unreliable

45


• Should you use demand side management to end recession?• Yes if you are a Keynesian economist• No if you believe in rational expectations

46

Natural Rate of Unemployment• Why would it be beneficial to have a lower natural

rate?• A lower natural rate of unemployment, lowers

unemployment without higher inflation

• How can we reduce the natural rate of unemployment?• Education, training, job placement• Problems

• People trained for jobs that don’t exist when done• High costs restricts number of programs and number

of workers accommodated

47

Natural Rate of Unemployment

• Natural rate may have risen in the U.S.• Due to long term unemployment, workers have

built up less work experience• Skill mismatch, less productive, which increases

natural rate

48

THE COST OF REDUCING INFLATION

• To reduce inflation, an economy must endure a period of high unemployment and low output.

• When the Fed combats inflation, the economy moves down the short-run Phillips curve.

• The economy experiences lower inflation but at the cost of higher unemployment.

The Volcker Disinflation

• When Paul Volcker became Fed chairman in 1979, 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 unemployment (about 10 percent in 1983).


1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

UnemploymentRate (percent)

Inflation Rate

(percent per year)

1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C

Copyright © 2004 South-Western


1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate

(percent per year)

1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C


The Greenspan Era

• Alan Greenspan’s term as Fed chairman (1987) began with a favorable supply shock.

– In 1986, OPEC members abandoned their agreement to restrict supply.

– This led to falling inflation and falling unemployment.

The Greenspan Era

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

19841991

1985

19921986

19931994

198819871995

199620021998

1999

20002001

19891990

1997


Documents

The Trade-Off between Inflation and Unemployment 17