1 Chapter 21 The Short-Run Tradeoff between Inflation and Unemployment The Phillips Curve Shifts in the Phillips Curve: the role of expectations Shifts in the Phillips Curve: the role of Supply Shocks The Cost of Reducing Inflation

2 Two closely watched indicators of economic performance are inflation and unemployment. How are these two measures of economic performance related to each other? We saw that the natural rate of unemployment depends on various features of the labour market, such as minimum wage laws, the generosity of Employment Insurance, the market power of unions, the role of efficiency wages, and the effectiveness of job search. The inflation rate depends primarily on growth in the money supply, which a nation’s central bank controls. In the long run, therefore, inflation and unemployment are largely unrelated problems. In the short run, the opposite is true. The society faces a short-run trade off between inflation and unemployment.

3 The Phillips Curve Macroeconomics focuses on three primary areas of our economy — output, prices, and unemployment. – If policy-makers expand aggregate demand, they can lower unemployment, in the short-run, but only at the cost of higher inflation. – If they contract aggregate demand, they can lower inflation, but at the cost of higher unemployment. The Phillips curve illustrates the tradeoff between inflation and unemployment — a short-run negative relationship. See Figure The greater the aggregate demand for goods and services, the greater is the economy’s output and the higher the overall price level. Imagine that the price level, such as CPI, equals 100 in the year Figure 21-2 shows two possible outcomes,

4 CPI=102 or CPI=106, that might occur in year If the AD for goods and services is relatively low, the economy experiences outcome A. The economy produces output of 7500 and the price level is 102. By contrast, if AD is relatively high, the economy experiences outcome B. The economy produces output of 8000 and the price level is 106. Thus, higher AD moves the economy to an equilibrium with higher output and a higher price level. Because firms need more workers when they produce a greater outcome of goods and services, unemployment is lower when output is higher. So, a higher level of output results in a lower level of unemployment. Monetary and fiscal policy can shift the aggregate demand curve, thus moving the economy along the Phillips curve. Summary: The Phillips Curve relates inflation and unemployment in the short-run as shifts occur in the

5 aggregate demand and aggregate supply. Policy-makers face a tradeoff between inflation and unemployment, and the Phillips Curve illustrates that tradeoff. – Okun’s Law: the number of percentage points the unemployment rate increases when GDP falls by 1 percentage point. – So, Okun’s law tells us that greater output means a lower rate of unemployment but at a higher overall price level. See Figure 21-6, the Phillips curve in the 1950s and 1960s. See Figure 21-7, the breakdown of the Phillips Curve

6 It has been suggested that the Phillips curve offers policy- makers a “menu of possible economic outcomes.” Historical events have shown that the Phillips Curve can shift due to the following factors: – Expectations – Supply Shocks The concept of a stable Phillips Curve broke down in the 1970s and 1980s. During the 70s and 80s the economy experienced high inflation and high unemployment simultaneously. Economists determined that monetary policy was effective in the short-run in picking a combination of inflation and unemployment, but not in the long-run

7 Shifts in the Phillips Curve: The role of expectations In the long-run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips Curve shifts. – Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. – As a result, the long-run Phillips Curve is vertical at the natural rate of unemployment. See Figure 21-3 In the long-run, with a vertical Phillips Curve at the natural rate of unemployment, the actual rate of inflation and unemployment will depend upon aggregate supply factors and the fiscal and monetary policies pursued by the government. See Figure 21-4.

8 How expected inflation shifts the short-run Phillips Curve See Figure 21-5 The higher the expected rate of inflation, the higher the short-run tradeoff between inflation and unemployment. At Point A, expected inflation are actual inflation are both low, and unemployment is at its natural rate. If the B of C pursues an expansionary monetary policy, the economy moves from point A to point B in the short run. Why? At Point B, expected inflation is still low, but actual inflation is high. Unemployment is below its natural rate. In the long run, expected inflation rises and the economy moves to Point C. At this point, expected inflation and actual inflation are both high and unemployment is back to its natural rate. The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation is called the natural-rate hypothesis.

9 Shifts in the Phillips Curve: the role of Supply Shocks The short-run Phillips Curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives policy-makers a less favorable tradeoff between inflation and unemployment. See Figure 21-8 When the AS shifts to left, the equilibrium price level rises and quantity of output falls. The adverse shift in AS moves the economy from a point with lower unemployment and lower inflation to a point with higher unemployment and higher inflation. Major changes in aggregate supply can “worsen” the short- run tradeoff between unemployment and inflation.

10 Example: 1974 OPEC actions. OPEC in the 1970s (1) cut output and (2) raised prices. The tradeoff in this situation resulted in two choices: –Fight the unemployment battle with monetary expansion (and accelerate inflation). –Stand firm against inflation (but endure even higher unemployment). See Figure 21-9 Increases in the world price of oil in the early 1970s and again in 1979 caused large jumps in the rate of inflation and caused the short-run Phillips curve to shift to the right. In between these two oil price shocks, tight monetary policy and wage and price controls caused Canada to slide down a temporarily stable short-run curve.

11 The Cost of Reducing Inflation To reduce inflation, the B of C has to pursue contractionary monetary policy (e.g. raising interest rates, etc.). When the B of C slows the rate of money growth: – It contracts the aggregate demand, which reduces the quantity of goods and services that firms produce, which leads to a fall in employment. Given the actions of the B of C in combating inflation, the economy moves along (downward) the short-run Phillips Curve, resulting in lower inflation but higher unemployment. If an economy is to reduce inflation it must endure a period of high unemployment and low output. See Figure The economy moves from point A to B. Over time, expected inflation falls and the short-run Phillips curve shifts downward. When the economy reaches point C,unemployment is back to its natural rate.

12 The sacrifice ratio is the number of percentage points of one year’s output that is lost in the process of reducing inflation by one percentage point. A typical estimate of the sacrifice ratio is between 2 and 5 percentage points. We can also express the sacrifice ratio in terms of unemployment. Reducing inflation by 1 percentage point requires a sacrifice of between 1 and 2.5 percentage points of unemployment. In some years (e.g. 1979) the sacrifice ratio was very large indicating a high level of unemployment was to be experienced in order to reduce inflation to acceptable levels. To reduce inflation from about 10% in 1979 to 4% would require an estimated sacrifice of 30 percent of one year’s output and 15 percentage points of unemployment.

13 Rational Expectations The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. The theory of rational expectations suggested that the time and therefore the sacrifice-ratio, could be shorter and lower than estimated. Expected inflation is an important variable that 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.

14 Disinflation in the 1980s When the B o C at the beginning of the 1980s faced the prospect of reducing inflation from its peak of about 11%, the economics profession offered two conflicting predictions. One group of economists offered estimates of the sacrifice ratio and concluded that reducing inflation would have great cost in terms of lost output and high unemployment. Another group offered the theory of rational expectations and concluded that reducing inflation could be much less costly and perhaps could even have no cost at all. See Figure Disinflation in the 1980s. Inflation did decrease from almost 11% in 1980/1981 to about 2.5% in 1985/1986. At the same time, the production of goods and services, real GDP was well below its trend level.

15 The disinflation of the early 1980s produced the deepest recession in Canada since the Great Depression of the 1930s. Does this experience refute the possibility of costless disinflation as suggested by the rational-expectations theorists? Some economists have argued that the answer to this question is a resounding yes. The estimate of the sacrifice ration for the period of 1981 to 1988 is 2.3. This is at the upper end of estimates of the sacrifice ratio suggested by those economists who argued that reducing inflation could come only at a great cost in terms of lost output and high unemployment. For those economists, then, the claims of rational-expectations theorists that less costly disinflation was possible seemed to carry little weight.

16 The zero-inflation target In 1988, then Governor of the B of C, John Crow, made a speech known as the Hanson lecture. In it he asserted that the sole goal of the B of C would thereafter be to achieve and maintain a stable price level and zero inflation. The Bank’s target was reached by 1992 by which time the unemployment rate had increased to over 11 percent. See Figure It shows that the unemployment rate increased from 7.5% in 1989 to 11.4% in 1993, while inflation rate fell from 4.% to 1.5%. From 1993 to 1999, the inflation rate averaged just over 1%, so that the target was successfully maintained.

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