PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Trade-off between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER

Inflation vs. Unemployment High-growth policies –Reduce unemployment –Tend to raise inflation Slow-growth policies –Reduce inflation –Tend to raise unemployment Aggregate supply curve –Fairly flat in short run –Quite steep in long run 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflation Demand-side inflation –Rise in the price level – caused by rapid growth of aggregate demand Rapid growth of real GDP Supply-side inflation –Rise in the price level – caused by slow growth (or decline) of aggregate supply Stagnant or even falling GDP 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 Inflation from the Demand Side 4 Price Level Real GDP D1D1 D1D1 S S D0D0 D0D0 A B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 Inflation from the supply side 5 Price Level Real GDP S0S0 S0S0 D0D0 D0D0 A S1S1 S1S1 B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Origins of the Phillips Curve Business fluctuations – from demand –Inverse relationship between unemployment and inflation Faster growth of real output –Faster growth in the number of jobs –Lower unemployment Slower growth of real output –Slower growth in the number of jobs –Higher unemployment 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 Origins of the Phillips Curve 7 Inflation Rate 0 Unemployment rate 9% 8% % 3 A B C © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Origins of the Phillips Curve Phillips curve - a graph –Depicting the rate of unemployment on the horizontal axis –And either the rate of inflation or the rate of change of money wages on the vertical axis –Normally downward sloping: higher inflation rates are associated with lower unemployment rates 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 4 The original Phillips Curve 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Origins of the Phillips Curve Phillips curve –Short-run trade-off between inflation and unemployment –Fits data U.S. post WWII 1960s and 1970s –Doesn’t fit data: 1970s, 1980s High unemployment High inflation 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 5 A Phillips Curve for the United States, 1954– © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 6 A Phillips Curve for the United States? 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply-side Inflation Inflation 1972 – 1982 –Adverse supply shocks Crop failures Oil price increases – – –Prices rise –Output falls Rise in unemployment 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply-side Inflation Fluctuations in economic activity – from the supply side –Higher rates of inflation Associated with higher rates of unemployment –Lower rates of inflation Associated with lower rates of unemployment 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply-side Inflation , favorable supply shocks Oil prices – plummeted Advances in technology Value of U.S. dollar – rise –Aggregate demand – shift outward –Aggregate supply – shift outward more –Rapid growth –Reduce unemployment –Lower inflation 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 7 The Effects of a Favorable Supply Shock 16 Real GDP Price Level S0S0 S0S0 D0D0 D0D0 A D1D1 D1D1 S1S1 S1S1 B C Normal growth of aggregate supply Effect of favorable supply shock © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What the Phillips Curve is Not Phillips curve –Statistical relationship between inflation and unemployment –That we expect to emerge if business cycle fluctuations arise mainly from demand –1970s, 1980s Misinterpretation Alternative equilibrium points from which policy makers could choose 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What the Phillips Curve is Not Self-correcting mechanism –No government intervention –Corrects inflationary gap Inward shift – aggregate supply –Corrects recessionary gap Outward shift – aggregate supply 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 8 The Elimination of a Recessionary Gap 19 Real GDP Price Level Potential GDP S0S0 S0S0 D D S1S1 S1S1 S2S2 S2S2 A B C © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What the Phillips Curve is Not Inflationary gap points, Phillips curve diagram –High inflation and low unemployment –Cannot be maintained indefinitely –Lead to rising unemployment and rising inflation 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What the Phillips Curve is Not Recessionary gap points, Phillips curve diagram –Low inflation and high unemployment –Cannot be maintained indefinitely –Lead to falling inflation and falling unemployment 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 9 The Vertical Long-Run Phillips Curve 22 d Unemployment Rate in Percent e c g Inflation Rate 7 6 8% f a © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What the Phillips Curve is Not Economy’s self-correcting mechanism –Push unemployment rate Toward a specific rate of unemployment “Natural rate of unemployment” Vertical (long-run) Phillips curve –Points: inflation and unemployment Choices available to society in long run –Vertical straight line At natural rate of unemployment 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trade-off: inflation & unemployment Short run –“Ride up the Phillips curve” Lower levels of unemployment Stimulate aggregate demand –“Ride down the Phillips curve” Lower rates of inflation Restrict growth of aggregate demand 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trade-off: inflation & unemployment Short run –Trade-off between unemployment and inflation –Stimulate demand Lower unemployment Worsen inflation –Restricting demand Lower inflation Worsen unemployment problem 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trade-off: inflation & unemployment Long run: No trade-off –Economy’s self-correcting mechanism Unemployment - Natural rate –Faster growth of demand Higher inflation Not lower unemployment –Slower growth of demand Lower inflation Not higher unemployment 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fighting Unemployment Fighting unemployment with fiscal and monetary policy Great Recession, –Started in December 2007 Unemployment rate: 5%, estimates of the natural rate of unemployment –Unemployment rate increased 6% - summer of % - May % - October © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fighting Unemployment Do nothing, economy’s self- correcting mechanism –Would have gradually eroded the recessionary gap –Both unemployment and inflation would have declined gradually –Return to natural rate of unemployment –Inflation would have fallen –But it may take an agonizingly long time to get there 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fighting Unemployment Monetary policy –The Federal Reserve started cutting interest rates aggressively in 2008 Fiscal policy –Large fiscal stimulus package, early 2009 –Smaller fiscal stimulus package, December © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fighting Unemployment Result –Faster recovery from the 2007–2009 recession –Probably a higher inflation rate The cost of reducing unemployment more rapidly –By expansionary fiscal and monetary policies –Is a permanently higher inflation rate 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Should Be Done ? Costs of inflation and unemployment –Controversy over the costs and benefits of using demand management to fight unemployment Slope of short run Phillips curve –Steeper: higher inflationary cost of reducing unemployment 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Should Be Done ? Efficiency of economy’s self-correcting mechanism –If it is fast and reliable: high unemployment will not last very long Small costs of waiting –If wage inflation responds only slowly to unemployment Enormous costs of waiting 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflationary Expectations Inflationary expectations and the Phillips curve Aggregate supply curve – slopes upward –Business – fixed inputs cost (money) Long-term contacts: labor, inputs –Prices of goods – rise Real wages – fall Labor – cheaper in real terms –Expand employment and output 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 1 Money and Real Wages under Unexpected Inflation 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflationary Expectations Fixed money wage – long-term contract –Inflation: Lower real wage –Firms: increase production and employment Compensation for inflation –Increasing real wage –Firms: no incentive to increase production –Aggregate supply: vertical line Potential GDP 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 2 Money and Real Wages under Expected Inflation 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 10 A Vertical Aggregate Supply Curve and the Corresponding Vertical Phillips Curve 37 Real GDP Price Level S S (a) Unemployment Rate Inflation Rate (b) Vertical aggregate supply curve 5 Vertical short-run Phillips curve © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflationary Expectations Vertical aggregate supply curve –Leads to a vertical Phillips curve Short-run Phillips curve - vertical If inflation is predicted accurately –Short-run aggregate supply curve is vertical 38 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflationary Expectations If inflation is underestimated –Aggregate supply curve – upward sloping –Unexpectedly high inflation Reduce real wages and raise output –Unexpected decline in inflation: recession People often fail to anticipate inflation correctly –Phillips curve slopes downward in the short run and is vertical in the long run 39 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Theory of Rational Expectations Rational expectations –Forecasts Not necessarily correct Best that can be made –Given the available data –Cannot err systematically –Forecasting errors are pure random numbers 40 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Theory of Rational Expectations Rational expectations –Optimal use of all the available information If expectations are rational Inflation – Expected inflation = A random number –Inflation can be reduced without a period of high unemployment Because the short-run Phillips curve will be vertical 41 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Theory of Rational Expectations Reject the extreme rational expectations position –In favor of the trade-off between inflation and unemployment in the short run –Reasons Old contacts – outdated expectations Expectations – adjust slow Wages – catch up with inflation Facts 42 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Why Economists Disagree Why economists (and politicians) disagree Believers in rational expectations –Inflation - more costly than unemployment –Short-run Phillips curve – steep –Expectations react quickly –Self-correcting mechanism of economy Works smoothly and rapidly 43 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Why Economists Disagree Keynesian economists –Unemployment - more costly than inflation –Short-run Phillips curve – flat –Expectations react sluggishly –Self-correcting mechanism Slow and unreliable 44 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Why Economists Disagree Believers in rational expectations –Government intervention Prevent / reduce inflation –Don’t want to fight recessions Keynesian economists –No government intervention Prevent / reduce inflation (inflationary gap) –Eager to fight recessions 45 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dilemma of Demand Management Shifts of aggregate supply curve –Inflation and unemployment Rise or fall together –Can destroy the statistical Phillips curve relationship 46 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dilemma of Demand Management Monetary and fiscal policy –Shifts aggregate demand curve –Unemployment and inflation Move in opposite directions Monetary and fiscal policy authorities –Disagreeable trade-off between inflation and unemployment 47 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Natural Rate of Unemployment Attempts to reduce the natural rate of unemployment Reduce natural rate of unemployment –Lower unemployment without higher inflation –Education, training, job placement Problems: look better on paper and high cost –Work experience –Indexing 48 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Natural Rate of Unemployment Indexing - provisions in a law / contract –Monetary payments Automatically adjusted When the price index changes –Escalator clauses Wage rates, pensions, Interest payments on bonds, income taxes –Seeks to reduce: social costs of inflation 49 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.