Copyright © 2010 Cengage Learning 10 The Short-Run Trade-Off between Inflation and Unemployment

Copyright © 2010 Cengage Learning Unemployment and Inflation What are the determinants of the natural rate of unemployment? The natural rate of unemployment is determined by minimum wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. What is the determinant of the inflation rate? The inflation rate depends primarily on growth in the quantity of money, controlled by the central bank.

Copyright © 2010 Cengage Learning Unemployment and Inflation Society faces a short-run trade-off between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. This lecture considers the following issues: Why policymakers face the short-run trade-off between unemployment and inflation? Why it disappears in the long run? How can supply shocks shift the trade-off? What is the short-run cost of reducing the rate of inflation? How the policy-makers’ credibility affects the cost of reducing inflation?

Figure 1 The Phillips Curve Unemployment Rate (percent) 0 Inflation Rate (percent per year) Phillips curve 4 B 6 7 A 2 Copyright©2010 South-Western

Copyright © 2010 Cengage Learning Aggregate Demand, Aggregate Supply, and the Phillips Curve The Phillips curve illustrates the short-run relationship between inflation and unemployment. The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. A higher level of output results in a lower level of unemployment.

Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output 0 Short-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (percent) 0 Inflation Rate (percent per year) Price Level (b) The Phillips Curve Phillips curve Low aggregate demand High aggregate demand (output is 8,000) B 4 6 (output is 7,500) A 7 2 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7, A Copyright©2010 South-Western

Copyright © 2010 Cengage Learning The Long-Run Phillips Curve The Phillips curve seems to offer policy makers a menu of possible inflation and unemployment outcomes. In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. Monetary policy could be effective in the short run but not in the long run.

Figure 3 The Long-Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve B High inflation Low inflation A but unemployment remains at its natural rate in the long run. 1. When the central bank the growth rate of the money supply, the rate of inflation increases... increases Copyright©2010 South-Western

Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply Quantity of Output Natural rate of output Natural rate of unemployment 0 Price Level P Aggregate demand,AD Long-run aggregate supply Long-run Phillips curve (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve raises the price level An increase in the money supply increases aggregate demand... A AD 2 B A but leaves output and unemployment at their natural rates and increases the inflation rate... P2P2 B Copyright©2010 South-Western

Copyright © 2010 Cengage Learning Expectations and the Short-Run Phillips Curve Expected inflation measures how much people expect the overall price level to change. In the long run, expected inflation adjusts to changes in actual inflation. The central bank’s ability to create unexpected inflation exists only in the short run. Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. Unemployment Rate Natural Rate of Unemployment = ―

Figure 5 How Expected Inflation Shifts the Short- Run Phillips Curve Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Expansionary policy moves the economy up along the short-run Phillips curve but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B A Copyright©2010 South-Western

Copyright © 2010 Cengage Learning The Natural Experiment for the Natural-Rate Hypothesis The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. Historical observations support the natural-rate hypothesis. The stable Phillips curve relationship between inflation and unemployment broke down in the in the early ’70s. During the ’70s and ’80s, many economies experienced high inflation and high unemployment simultaneously.

Figure 6 The Breakdown of the Phillips Curve Copyright©2010 South-Western

Copyright © 2010 Cengage Learning SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS Historical events have shown that the short-run Phillips curve can shift due to changes in expectations. The short-run Phillips curve also shifts because of shocks to aggregate supply. Major adverse changes in aggregate supply can worsen the short-run trade-off between unemployment and inflation. An adverse supply shock gives policy makers a less favourable trade-off between inflation and unemployment.

Copyright © 2010 Cengage Learning SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. This shifts the economy’s aggregate supply curve and as a result, the Phillips curve.

Figure 7 An Adverse Shock to Aggregate Supply Quantity of Output 0 Price Level Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 Inflation Rate (b) The Phillips Curve and raises the price level... AS 2 Aggregate supply,AS A 1. An adverse shift in aggregate supply giving policymakers a less favourable trade-off between unemployment and inflation. B P2P2 Y2Y2 P A Y Phillips curve,PC lowers output... PC 2 B Copyright©2010 South-Western

Copyright © 2010 Cengage Learning SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of oil. Fight the unemployment battle by expanding aggregate demand and accelerate inflation. Fight inflation by contracting aggregate demand and endure even higher unemployment.

Figure 8 The Supply Shocks of the 1970s Copyright©2010 South-Western

Copyright © 2010 Cengage Learning THE COST OF REDUCING INFLATION policyTo reduce inflation, the central bank has to pursue contractionary monetary policy. When the central bank slows the rate of money growth, it contracts aggregate demand. This reduces the quantity of goods and services that firms produce. This leads to a rise in unemployment.

Figure 9 Disinflationary Monetary Policy in the Short Run and the Long Run Unemployment Rate 0Natural rate of unemployment Inflation Rate Long-run Phillips curve Short-run Phillips curve with high expected inflation Short-run Phillips curve with low expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve but in the long run, expected inflation falls, and the short-run Phillips curve shifts to the left. B C A Copyright©2010 South-Western

Copyright © 2010 Cengage Learning THE COST OF REDUCING INFLATION To reduce inflation, an economy must endure a period of high unemployment and low output. When the central bank combats inflation, the economy moves down the short-run Phillips curve. The economy experiences lower inflation but at the cost of higher unemployment. The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. A typical estimate of the sacrifice ratio is around 3 to 5. To reduce inflation from about 22% in early 1980 to 5% would have required an estimated sacrifice of more than 40% of annual output!

Copyright © 2010 Cengage Learning Rational Expectations and the Possibility of Costless Disinflation The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future. Expected inflation 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 trade-off disappears depends on how quickly expectations adjust. The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.

Copyright © 2010 Cengage Learning The Thatcher Disinflation When Margaret Thatcher was elected Prime Minister of the UK in 1979, inflation was widely viewed as one of the nation’s foremost problems. Inflation was reduced from almost 20 per cent in 1980 to about 5 per cent in 1983, but at the cost of high unemployment (about 11 per cent in 1982 and 1983 ).

Figure 10 The Thatcher Disinflation Copyright©2010 South-Western

Copyright © 2010 Cengage Learning INFLATION TARGETING The Thatcher government in the early 1980s announced a credible commitment to achieving targets for the growth of money supply. However, a series of financial sector reforms that the government introduced at the same time made the achievement of these targets much more difficult than anticipated. Towards the end of the 1980s the government began to think of other indicators of the tightness of monetary policy, such as the exchange rate. In 1990 the UK joined the exchange rate mechanism (ERM). In 1992, the UK was forced to withdraw from the ERM, following a massive speculative attack on the pound. As a result, the government had to re-assess the tools and indicators of monetary policy it should use.

Copyright © 2010 Cengage Learning INFLATION TARGETING The level of the money supply and the exchange rate can be thought of as intermediate targets of monetary policy. The only final target of monetary policy is inflation. Neither the money supply or the exchange rate are under the direct control of the government. The implication is that the government should target the rate of inflation directly and use interest rates to achieve the target.

Copyright © 2010 Cengage Learning INFLATION TARGETING Because it takes time for a change in interest rates to affect the rate of inflation, the future rate of inflation must be forecast and interest rate changes made in advance of rises in inflation. This is the approach adopted in the UK in late 1992.

Copyright © 2010 Cengage Learning Summary The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policy makers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate demand, policy makers can choose a point on the Phillips curve with lower inflation and higher unemployment. The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run. The long-run Phillips curve is vertical at the natural rate of unemployment.

Copyright © 2010 Cengage Learning Summary The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock gives policy makers a less favorable trade-off between inflation and unemployment. When the central bank contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve. This results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall.