The Short-Run Trade-off Between Inflation and Unemployment and the Phillips Curve – Ch. 35 Mankiw 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? Understanding why inflation & unemployment were both low in the 1990s is not, in fact, a major learning objective of this chapter. However, it’s a nice application of factors that shift the Phillips curve, and understanding these factors is a major learning objective. CHAPTER 35 THE SHORT-RUN TRADE-OFF

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. CHAPTER 35 THE SHORT-RUN TRADE-OFF

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.” CHAPTER 35 THE SHORT-RUN TRADE-OFF

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. “Suppose P = 100 this year” provides an anchor to the analysis in the graphs on the following slide. At this point, remind students that output and unemployment are negatively related over business cycles (one of the “three facts about economic fluctuations” from the chapter entitled “aggregate demand and aggregate supply”). CHAPTER 35 THE SHORT-RUN TRADE-OFF

Deriving the Phillips Curve A. Low agg demand, low inflation, high u-rate Y P u-rate inflation AD2 SRAS PC 4% 5% B 105 Y2 B AD1 Y1 103 A 6% 3% A Assume P = 100 this year. If aggregate demand next year is low – reflecting, for example, slow money growth – then outcome A will occur next year. In outcome A, P = 103 next year, so the inflation rate from this year to next equals 3%. Output (Y1) is relatively low, so unemployment is relatively high at 6%. Instead, if aggregate demand next year is high – reflecting, for example, rapid money growth – then outcome B will occur next year. In outcome B, P = 105 next year, so the inflation rate from this year to next equals 5%. Output (Y2) is higher, so unemployment is lower (4%). B. High agg demand, high inflation, low u-rate CHAPTER 35 THE SHORT-RUN TRADE-OFF

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 In the face of what many considered overwhelming evidence for the stability of the downward-sloping Phillips curve, Friedman and Phelps (working separately) boldly asserted that any tradeoff would be purely temporary. Their logic? The Classical Dichotomy and the vertical LRAS curve. CHAPTER 35 THE SHORT-RUN TRADE-OFF

The Vertical Long-Run Phillips Curve In the long run, faster money growth only causes faster inflation. Y P u-rate inflation LRAS LRPC AD2 high infla-tion P2 AD1 P1 low infla-tion The greater the expansion of the money supply, the faster AD will shift to the right, resulting in a larger increase in prices – i.e. higher inflation. But this higher inflation will not produce lower unemployment: in the long run, unemployment always goes to its natural rate, whether inflation is high or low. In the long run, faster money growth only causes faster inflation. natural rate of output natural rate of unemployment CHAPTER 35 THE SHORT-RUN TRADE-OFF

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. u-rate inflation LRPC 6% PC2 PC1 B C 4% 5% A 3% When people adjust their inflation expectations upward, then the PC shifts up: each value of the u-rate is associated with a higher inflation rate. Of course, we can extrapolate this: Suppose the Fed wants to PERMANENTLY keep unemployment at 4%. It must continually raise inflation above expectations. Expectations will keep adjusting upward, so the Fed will have to keep raising the inflation rate faster than expectations are adjusting. Inflation spirals upward as a result of the attempt to keep unemployment at 4%. Before long, people will come to expect not only higher inflation, but ever-increasing inflation, and they will factor this into their contracts. It will be extremely difficult for the Fed to continue this game. Ultimately, unemployment has to return to the natural rate, yet the economy will end up with something approaching hyperinflation, and the costs it imposes on society. CHAPTER 35 THE SHORT-RUN TRADE-OFF

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. CHAPTER 35 THE SHORT-RUN TRADE-OFF

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, and lower inflation. u-rate inflation LRPC PC1 PC2 A B C natural rate of unemployment CHAPTER 35 THE SHORT-RUN TRADE-OFF

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. CHAPTER 35 THE SHORT-RUN TRADE-OFF