The Trade-Off between Inflation and Unemployment 17

Inflation vs. Unemployment High-growth policies that reduce unemployment tend to raise inflation Slow-growth policies that reduce inflation tend to raise unemployment Tradeoff – is different in the short run than in long run 2

Demand Side vs. Supply Side Inflation Two sources of inflation Demand-side inflation Rise in the price level caused by rapid growth of aggregate demand (demand-pull) Supply-side inflation Rise in the price level caused by slow growth (or decline) of aggregate supply (cost-push) 3

Inflation from the Demand Side 4 Price Level Real GDP D1D1 D1D1 S S D0D0 D0D0 A B

Inflation from the Supply Side 5 Price Level Real GDP S0S0 S0S0 D0D0 D0D0 A S1S1 S1S1 B

Origins of the Phillips Curve Suppose most business fluctuations come from demand Inverse relationship between unemployment and inflation Faster growth of real output, faster growth in the number of jobs so lower unemployment Slower growth of real output, slower growth in the number of jobs so higher unemployment 6

Origins of the Phillips Curve 7 Inflation Rate 0 Unemployment rate 9% 8% % 3 A B C

Origins of the Phillips Curve Does the data support the theory? A.W. Phillips compared wages and unemployment for Britain 8

The original Phillips Curve 9

Origins of the Phillips Curve Phillips curve Depicts the rate of unemployment on the horizontal axis 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 Phillips curve for the U.S. 10

A Phillips Curve for the United States, 1954–

A Phillips Curve for the United States? – 1983 What happened? 1970 – 1983 What happened?

Supply-Side Inflation Inflation 1970 – 1983 Adverse supply shocks Crop failures Oil price increases: , Costs increase, prices rise, output falls, unemployment increases 13

% Inflation Rate 1 Unemployment Rate in Percent The Phillips Curve: A Historical Perspective 1960’s and ’s

Supply-side Inflation , favorable supply shocks Lower oil prices, advances in technology Both aggregate demand and supply increase But aggregate supply shifted more Rapid growth, lower unemployment, and lower inflation 15

Favorable Supply Shock 16

What the Phillips Curve Is and Is Not Phillips curve Is a statistical relationship between inflation and unemployment Holds if business cycle fluctuations arise mainly from demand and AS is stable If AS shifts, the Phillips curve shifts During 1970s, 1980s, incorrectly seen as alternative equilibrium points from which policy makers could choose. AS was not stable. 17

The Phillips Curve is Not Stable Self-correcting mechanism Refers to the way money wages respond to recessionary or expansionary gaps Wage changes shift the aggregate supply curve Effecting equilibrium real GDP and the price level The Phillips curve shifts 18

The Elimination of a Recessionary Gap: As the AS curve shifts down the Phillips curve shifts down 19 Real GDP Price Level Potential GDP AS 0 D D AS 1 AS 2 A B C

The Vertical Long-Run Phillips Curve Unemployment Rate in Percent C Inflation Rate 7 6 8% A PC0 PC2 The Natural Rate of Unemployment is 5%.

What the Phillips Curve is Not Recessionary gap points (a) Low inflation and high unemployment Lead to falling inflation and falling unemployment The Phillips curve shifts down to point (c). Inflationary gap points (d) High inflation and low unemployment Lead to rising unemployment and rising inflation The Phillips curve shifts up to point (f). 21

The Vertical Long-Run Phillips Curve 22 d Unemployment Rate in Percent e Inflation Rate 7 6 8% f PC0 PC2 The Natural Rate of Unemployment is 5%.

The Vertical Long-Run Phillips Curve Natural Rate of Unemployment; pts c, e, and f The unemployment rate achieved through the self- correction mechanism Consistent with full unemployment at the natural rate of unemployment Vertical (long-run) Phillips curve There is no trade-off between inflation and unemployment in the long run Some economist argue there is no trade-off in the short run. 23

Trade-off: inflation & unemployment Short run: Trade-off Policy makers can attempt to “Ride up the Phillips curve” Stimulate AD to reduce unemployment below the natural rate Policy makers can attempt to “Ride down the Phillips curve” Restrict growth of AD to lower inflation Long run: No trade-off Self-correcting mechanism ensures get back to the natural rate Faster (slower) growth of demand leads to higher (lower) inflation and no permanent change in the natural rate of unemployment 24

The Vertical Long-Run Phillips Curve 25 d Unemployment Rate in Percent e c Inflation Rate 7 6 8% f a The Natural Rate of Unemployment is 5%.

Fighting Unemployment with Policy Should the government manage aggregate demand to fight unemployment? Great Recession, Started in December 2007: Unemployment rate: 5% at the natural rate. By October 2009, 10.1% Why didn’t we simply let the economy recover? 26

Fighting Unemployment Monetary policy Federal Reserve started cutting interest rates in 2008 Fiscal policy Fiscal stimulus package (almost $900 billion), early 2009, and December 2010 Result Faster (maybe) recovery from the 2007–2009 recession Probably a higher inflation rate The cost of reducing unemployment more rapidly using expansionary fiscal and monetary policy is a permanently higher inflation rate (than it would be otherwise) 27

Fighting Unemployment 28 d Unemployment Rate in Percent e c Inflation Rate 7 6 8% f a Allow the economy to self correct: Long and painful Expansionary policy reduces unemployment but leads to higher inflation compared to point “c”

What Should Be Done ? How do policymakers decision between unemployment and inflation? Costs of inflation and unemployment Controversy over the costs and benefits of using demand management to fight unemployment Policy makers that feel inflation is costly will not accept the inflationary cost of reducing unemployment faster. Slope of short run Phillips curve The steeper the curve, the higher the inflationary cost of reducing unemployment The flatter the curve, the lower the inflationary cost of reducing unemployment 29

Slope of Short Run Phillips curve Unemployment Rate in Percent Inflation Rate 7 6 8% Flatter Phillips curve, lower inflation cost to reduce unemployment.

What Should Be Done ? Efficiency of economy’s self-correcting mechanism If fast and reliable: high unemployment will not last very long Small costs of waiting If wage inflation responds slowly to unemployment Large costs of waiting 31

Inflationary Expectations Recall why the aggregate supply curve slopes upward? From chapter 10: businesses purchase labor and other inputs under long-term contracts As P increases Real cost of labor (real wages) decrease and profits increases Business firms expand employment and output 32

Money and Real Wages under Unexpected Inflation 33 Inflation erodes workers’ purchasing power, so worse off. What if workers can see inflation coming?

Money and Real Wages under Expected Inflation 34 Contracts would stipulate that wages increase by the expected inflation rate. If workers see inflation coming and they receive compensation for it Real wages remain the same Firms will not increase production Aggregate supply curve is a vertical line at potential GDP

A Vertical Aggregate Supply Curve and the Corresponding Vertical Phillips Curve are possible in the SR 35 Real GDP Price Level S AS (a) Unemployment Rate Inflation Rate (b) Vertical aggregate supply curve 5% Vertical short-run Phillips curve PC

Most Economist agree that the AS Curve and the Phillips Curve are vertical in the long-run Vertical long-run Phillips curve Inflation Rate (b) Unemployment Rate Vertical long-run aggregate supply curve Price Level (a) Real GDP U* Yf AS

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. F D E

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. A C E

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 favorable tradeoff between unemployment and inflation. B P2P2 Y2Y2 P A Y Phillips curve,PC lowers output... PC 2 B

Rational Expectations and the Possibility of Costless Disinflation 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 tradeoff disappears depends on how quickly expectations adjust. The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

Rational Expectations - Vertical short- run Phillips Curve 41 d Unemployment Rate in Percent e c Inflation Rate 7 6 8% f a Suppose we want to go from point e to point c. With rational expectations the only has to say they will reduce the inflation rate and the economy goes from e to c directly PC0 PC2

Inflationary Expectations Is this realistic? No. People often fail to anticipate inflation correctly Aggregate supply Vertical when inflation is predicted accurately Upward sloping when inflation is underestimated Unexpected higher inflation will raise output Unexpected decline in inflation will lead to a recession 42

Theory of Rational Expectations Most reject the extreme rational expectations position Old contacts – outdated expectations contracts with 3.3% inflation turned out to be wrong because of the recession (inflation actually 1.4%) Expectations may adjust slowly Wages change after the fact, not in response to inflation Facts do not support rational expectations 43

Why Economists Disagree Should the government take strong actions to prevent or reduce inflation? Yes, if you believe in rational expectations because: Believe that inflation more costly than unemployment Short-run Phillips curve steep Expectations adjust quickly Self-correcting mechanism of economy works smoothly and rapidly 44

Why Economists Disagree Should the government take strong actions to prevent or reduce inflation? No, if you are a Keynesian because: Unemployment more costly than inflation Short-run Phillips curve flat Expectations adjust slowly Self-correcting mechanism is slow and unreliable 45

Why Economists Disagree Should you use demand side management to end recession? Yes if you are a Keynesian economist No if you believe in rational expectations 46

Natural Rate of Unemployment Why would it be beneficial to have a lower natural rate? A lower natural rate of unemployment, lowers unemployment without higher inflation How can we reduce the natural rate of unemployment? Education, training, job placement Problems People trained for jobs that don’t exist when done High costs restricts number of programs and number of workers accommodated 47

Natural Rate of Unemployment Natural rate may have risen in the U.S. Due to long term unemployment, workers have built up less work experience Skill mismatch, less productive, which increases natural rate 48

THE COST OF REDUCING INFLATION To reduce inflation, an economy must endure a period of high unemployment and low output. When the Fed combats inflation, the economy moves down the short-run Phillips curve. The economy experiences lower inflation but at the cost of higher unemployment.

The Volcker Disinflation When Paul Volcker became Fed chairman in 1979, inflation was widely viewed as one of the nation’s foremost problems. Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high unemployment (about 10 percent in 1983).

The Volcker Disinflation Unemployment Rate (percent) Inflation Rate (percent per year) A 1983 B 1987 C Copyright © 2004 South-Western

The Volcker Disinflation Unemployment Rate (percent) Inflation Rate (percent per year) A 1983 B 1987 C Copyright © 2004 South-Western

The Greenspan Era Alan Greenspan’s term as Fed chairman (1987) began with a favorable supply shock. In 1986, OPEC members abandoned their agreement to restrict supply. This led to falling inflation and falling unemployment.

The Greenspan Era Unemployment Rate (percent) Inflation Rate (percent per year) Copyright © 2004 South-Western