The Relationship Between Inflation and Unemployment An inverse relationship between inflation and unemployment until the 1970s 1970s  high inflation and unemployment Is there still a relationship between inflation and unemployment? The Relationship Between Inflation and Unemployment An inverse relationship between inflation and unemployment until the 1970s 1970s  high inflation and unemployment Is there still a relationship between inflation and unemployment? The Phillips Curve

The 1960s: A Policy Menu?

Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves Phillips curve A curve showing the short- run relationship between the unemployment rate and the inflation rate. As long as SRAS is stable, get Phillips Curve relation

1970s: Why did the Phillips curve vanish? higher oil prices … shift SRAS + inflation expectations…shift SRAS  inflation became persistent and positive

Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves Phillips curve A curve showing the short- run relationship between the unemployment rate and the inflation rate. As long as SRAS is stable, get Phillips Curve relation If people expect high inflation… Phillips curve shifts…

Is the Phillips Curve a Policy Menu? Is the Short-Run Phillips Curve Stable? During the 1960s, the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation. Then in 1968, in his presidential address to the American Economic Association, Milton Friedman of the University of Chicago argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. The Long-Run Phillips Curve Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

The Long-Run Phillips Curve A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP.

The Role of Expectations of Future Inflation The Basis for the Short-Run Phillips Curve IF…THEN…AND… actual inflation is greater than expected inflation, the actual real wage is less than the expected real wage, labor is cheap … the unemployment rate falls. actual inflation is less than expected inflation, the actual real wage is greater than the expected real wage, labor is dear … the unemployment rate rises.

The Short-Run and Long-Run Phillips Curves

The Inflation Rate and the Natural Rate of Unemployment in the Long Run Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease.

Does the Natural Rate of Unemployment Ever Change? Frictional or structural unemployment can change— thereby changing the natural rate—for several reasons: Demographic changes. Labor market institutions. Strength of unions Generous unemployment benefits Past high rates of unemployment. Other costs of production and the real wage Oil price and the “natural rate”

Low inflation  stable expectations/ignore inflation. Moderate but stable inflation  adaptive expectations. High and unstable inflation  rational expectations. Expectations of the Inflation Rate and Monetary Policy Rational expectations Expectations formed by using all available information about an economic variable, including our model of the economy. How workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities:

Rational expectations Expectations formed by using all available information about an economic variable, including what you’ve learned in college. Expectations of the Inflation Rate and Monetary Policy The Effect of Rational Expectations on Monetary Policy Rational expectations  Policy ineffectiveness  Don’t bother with expansionary policy  Laissez - faire Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP. What if rational expectations are the rule?

Reasons to doubt that the short-run Phillips Curve is vertical: (1)workers and firms actually may not have rational expectations, and (2)the rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place. Is the Short-Run Phillips Curve Really Vertical?

How the Fed Fights Inflation Paul Volcker and Disinflation The Fed Tames Inflation, 1979–1989

FEDERAL RESERVE CHAIRMAN TERM AVERAGE ANNUAL INFLATION RATE DURING TERM William McChesney MartinApril 1952-January % Arthur BurnsFebruary 1970-January G. William MillerMarch 1978-August Paul VolckerAugust 1979-August Alan GreenspanAugust 1987-(January 2006)3.0 Ben BernankeJanuary 2006–3.0 How the Fed Fights Inflation De-emphasizing the Money Supply The Fed learned an important lesson during the1970s: Workers, firms, and investors in stock and bond markets have to view Fed announcements as credible if monetary policy is to be effective.

How the Fed Fights Inflation Monetary Policy Credibility after Greenspan Central banks are more credible if they adopt and follow rules. Rules (e.g., Taylor Rule) vs. discretion A middle course between rules and discretion: Inflation targeting. The best way to achieve commitment to rules  remove political pressures on the central bank. Crisis : the Bagehot Rule—Lend and lend freely!

The Fed Rethinks the Phillips Curve Policy Makers at Fed Rethink Inflation’s Roots The short- and long-run Phillips curves.

K e y T e r m s Disinflation Natural rate of unemployment Nonaccelerating inflation rate of unemployment (NAIRU) Phillips curve Rational expectations Real business cycle models Structural relationship