© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. Fernando & Yvonn Quijano Prepared by: Chapter 28 Inflation, Unemployment, and Federal Reserve Policy

© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 2 of 30 Why Does Whirlpool Care about Monetary Policy? 28.1Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation. 28.2Explain the relationship between the short-run and long-run Phillips curves. 28.3Discuss how expectations of the inflation rate affect monetary policy. 28.4Use a Phillips curve graph to show how the Federal Reserve can permanently lower the inflation rate. Learning Objectives In 2007, Whirlpool, headquartered in Benton Harbor, Michigan, had 73,000 employees and $19 billion in annual sales. In 2001 and the following years, Whirlpool clearly benefited from the effects of monetary policy.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 3 of 30 Phillips curve A curve showing the short- run relationship between the unemployment rate and the inflation rate. Learning Objective 28.1 The Discovery of the Short-Run Trade-off between Unemployment and Inflation FIGURE 28.1 The Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 4 of 30 Learning Objective 28.1 Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves FIGURE 28.2 Using Aggregate Demand and Aggregate Supply to Explain the Phillips Curve The Discovery of the Short-Run Trade-off between Unemployment and Inflation

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 5 of 30 Structural relationship A relationship that depends on the basic behavior of consumers and firms and remains unchanged over long periods. Learning Objective 28.1 Is the Phillips Curve a Policy Menu? The Discovery of the Short-Run Trade-off between Unemployment and Inflation 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.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 6 of 30 Natural rate of unemployment The unemployment rate that exists when the economy is at potential GDP. Learning Objective 28.1 The Long-Run Phillips Curve The Discovery of the Short-Run Trade-off between Unemployment and Inflation

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 7 of 30 Learning Objective 28.1 The Long-Run Phillips Curve The Discovery of the Short-Run Trade-off between Unemployment and Inflation FIGURE 28.3 A Vertical Long-Run Aggregate Supply Curve Means a Vertical Long-Run Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 8 of 30 Learning Objective 28.1 The Role of Expectations of Future Inflation The Discovery of the Short-Run Trade-off between Unemployment and Inflation NOMINAL WAGEEXPECTED REAL WAGEACTUAL REAL WAGE Expected P 2012 = 105 Expected Inflation = 5% Actual P 2012 = 102 Actual Inflation = 2% Actual P 2012 = 108 Actual Inflation = 8% $31.50 Table 28-1 The Impact of Unexpected Price Level Changes on the Real Wage

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 9 of 30 Learning Objective 28.1 The Role of Expectations of Future Inflation The Discovery of the Short-Run Trade-off between Unemployment and Inflation Table 28-2 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, the unemployment rate falls. actual inflation is less than expected inflation, the actual real wage is greater than the expected real wage, the unemployment rate rises.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 10 of 30 Learning Objective 28.1 Do Workers Understand Inflation? Making the Connection Will her wage increases keep up with inflation?

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 11 of 30 Learning Objective 28.2 The Short-Run and Long-Run Phillips Curves FIGURE 28.4 The Short-Run Phillips Curve of the 1960s and the Long-Run Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 12 of 30 Learning Objective 28.2 The Short-Run and Long-Run Phillips Curves FIGURE 28.5 Expectations and the Short-Run Phillips Curve Shifts in the Short-Run Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 13 of 30 Learning Objective 28.2 The Short-Run and Long-Run Phillips Curves FIGURE 28.6 A Short-Run Phillips Curve for Every Expected Inflation Rate Shifts in the Short-Run Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 14 of 30 Learning Objective 28.2 The Short-Run and Long-Run Phillips Curves FIGURE 28.7 The Inflation Rate and the Natural Rate of Unemployment in the Long Run How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 15 of 30 Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease. Learning Objective 28.2 The Short-Run and Long-Run Phillips Curves How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 16 of 30 Learning Objective 28.2 Does the Natural Rate of Unemployment Ever Change? Making the Connection What makes the natural rate of unemployment increase or decrease? Frictional or structural unemployment can change— thereby changing the natural rate—for several reasons: Demographic changes. Labor market institutions. Past high rates of unemployment.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 17 of 30 Solved Problem 28-2 Changing Views of the Phillips Curve Learning Objective 28.2 Writing in a Federal Reserve publication, Bennett McCallum, an economist at Carnegie Mellon University, argues that during the 1970s, the Fed was “acting under the influence of 1960s academic ideas that posited the existence of a long-run and exploitable Phillips-type tradeoff between inflation and unemployment rates.”

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 18 of 30 Low inflation. Moderate but stable inflation. High and unstable inflation. Learning Objective 28.3 Expectations of the Inflation Rate and Monetary Policy Rational expectations Expectations formed by using all available information about an economic variable. The experience in the United States over the past 50 years indicates that how workers and firms adjust their expectations of inflation depends on how high the inflation rate is. There are three possibilities:

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 19 of 30 Learning Objective 28.3 Expectations of the Inflation Rate and Monetary Policy The Effect of Rational Expectations on Monetary Policy FIGURE 28.8 Rational Expectations and the Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 20 of 30 Learning Objective 28.3 Expectations of the Inflation Rate and Monetary Policy Many economists have remained skeptical of the argument that the short-run Phillips curve is vertical. The two main objections raised are that (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? Real business cycle models Models that focus on real rather than monetary explanations of fluctuations in real GDP. Real Business Cycle Models

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 21 of 30 Learning Objective 28.4 How the Fed Fights Inflation The Effect of a Supply Shock on the Phillips Curve FIGURE 28.9 A Supply Shock Shifts the SRAS and the Short-Run Phillips Curve

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 22 of 30 Learning Objective 28.4 How the Fed Fights Inflation Paul Volcker and Disinflation FIGURE The Fed Tames Inflation, 1979–1989

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 23 of 30 Learning Objective 28.4 Disinflation A significant reduction in the inflation rate. Paul Volcker and Disinflation Don’t Let This Happen to YOU! Don’t Confuse Disinflation with Deflation YEARCONSUMER PRICE INDEXDEFLATION RATE % How the Fed Fights Inflation

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 24 of 30 Solved Problem 28-4 Using Monetary Policy to Lower the Inflation Rate Learning Objective 28.4

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 25 of 30 Learning Objective 28.4 How the Fed Fights Inflation Alan Greenspan and the Importance of a Credible Monetary Policy 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 Ben BernankeJanuary 2006–3.0 Table 28-3 The Record of Fed Chairmen and Inflation

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 26 of 30 Learning Objective 28.4 How the Fed Fights Inflation De-emphasizing the Money Supply The Importance of Fed Credibility 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.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 27 of 30 Learning Objective 28.4 How the Fed Fights Inflation Monetary Policy Credibility after Greenspan Debate continues over policies to increase the Fed’s credibility. Some economists and policymakers believe that central banks are more credible if they adopt and follow rules. Economists and policymakers who oppose the rules strategy support a discretion strategy for monetary policy Many economists believe a middle course between a rules strategy and a discretion strategy is desirable. Most economists believe the best way to achieve commitment to rules is to remove political pressures on the central bank.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 28 of 30 Learning Objective 28.4 How the Fed Fights Inflation Federal Reserve Policy and Whirlpool’s “Pricing Power” The success of any firm, particularly a firm like Whirlpool that produces consumer durables, will be determined partly by its ability to compete against rival firms and partly by macroeconomic conditions.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 29 of 30 An Inside LOOK The Fed Rethinks the Phillips Curve Policy Makers at Fed Rethink Inflation’s Roots The short- and long-run Phillips curves.

Chapter 28: Inflation, Unemployment, and Federal Reserve Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 30 of 30 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