Recall that inflation is a sustained increase in the ave. prices of goods and services  We want to examine the following issues : What are the costs of inflation? Is there a tradeoff between inflation and unemployment? Assuming there is a tradeoff between inflation and unemployment, can unemployment be “too low”? Why is it that once inflation starts, it tends to persist? Is monetary expansion to blame for inflation?

Unemployment rate (%) Inflation rate (%) The Phillips curve is named for A.W. Phillips, who identified an inverse correlation between inflation and unemployment in the U.K. Note the shape of the curve implies a policy trade-off.

Unemployment rate (%) Inflation rate (%) Critics such as Professors Friedman and Lucas argue there is no “stable” trade-off between inflation and unemployment. Data for the U.S. appears to support their view

NAIRU is an acronym for “non-accelerating inflation rate of unemployment.” Unemployment rate (%) Inflation rate (%) U*  Below U*(also called the natural rate, the inflation rate will accelerate-- that’s the theory

Some advocates of the NAIRU assert that any trade-off between inflation and unemployment will “blow up” as household and firms “catch up” to a change in prices of goods and services

Let:  denote the inflation rate.  e t is the expected inflation rate in month t.  a t is the actual inflation rate in month t.  For the sake of simplicity, we assume:  e t =  a t -1 People are assumed to extrapolate based on the inflation in the most recent month

Hours per week Money wage (w) N s (P e = 1.00) $10 $12 N s (P e = 1.20) 4045 A failure to perceive that the value of money has changed Mistakenly thinking the real wage increased, Bobby worked 5 more hours per week

unemployment  U* 0 Long-run Phillips curve U0U0  e = 0  e = 3%  e = 7% 3 7  A,B, and C are short-run curves corresponding to inflationary expectations A B C

The effort by policy makers to drive unemployment below the NAIRU works in the short-term but is doomed to fail in the long-run. Moreover, the attempt to exploit the short-run relation has damaging effects in terms of inflationary expectations

Long-run Phillips curve  e = 13.5% U* 7.6 unemployment  Once inflationary expectations take hold, then it is possible to overestimate inflation. The result is stagflation

Just a few years ago, estimates of the NAIRU ranged from 5.5% to 6.5%. Those estimates appear off base in light of recent experience