The Short-run Tradeoff Between Inflation and Unemployment Chapter 16 The Short-run Tradeoff Between Inflation and Unemployment

The Phillips Curve It follows that, in the short run, there is a tradeoff between inflation & unemployment This short-run tradeoff is captured by a relation known as the Phillips Curve.

A Hypothetical Phillips Curve Inflation Rate A High Inflation Phillips Curve Low Inflation B Low Unemployment High Unemployment Unemployment Rate

The Aggregate Demand-Aggregate Supply Model and The Short-Run Phillips Curve We have seen that, all else the same, the greater the aggregate demand for goods and services, the greater the economy’s output and the higher the overall price level. We also know that the higher the level of output, the lower the unemployment rate.

The Short-Run Phillips Curve and the Model of Aggregate Demand and Aggregate Supply (b) Short-Run Phillips Curve Inflation Rate (percent per year) Unemployment Rate (percent) (a) The Model of AD and AS Price Level Low AD High AD B 4 6 A 7 2 7,500 102 8,000 106 Short-run AS Key diagram – be able to relate points and changes on this diagram The short run phillips curve is literally a “mirror image” of the Short run aggregate supply curve

The Short-Run Phillips Curve So you see, 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 Short-Run Tradeoff Between Inflation and Unemployment In the 1950s and 1960s, it was suggested that the Phillips Curve offers policymakers a “menu of possible economic outcomes.” Policymakers thought they could take advantage of the tradeoff between inflation and unemployment.

The Instability of the Short-Run Phillips Curve But for the short-run Phillips Curve to be a reliable policy guide, it has to be stable. The notion of a stable Phillips Curve broke down in the 1970s and early 1980s. During the 70s and early 80s the economy experienced high inflation and high unemployment simultaneously, which is what we called stagflation.

The Ph. Curve became unreliable in the 70s

The Long-Run Phillips Curve Two famous macroeconomist, Friedman and Phelps argued that inflation and unemployment are unrelated in the long run. That is, the long-run Phillips Curve is vertical at the natural rate of unemployment Thus monetary and fiscal policy could be effective in the short run but not in the long run.

The Long-Run Phillips Curve Inflation Rate Long-run Phillips curve B High inflation 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases… 2. … but unemployment remains at its natural rate in the long run. A Low inflation Unemployment Rate Natural rate of unemployment

The Long-Run Phillips Curve and the Model of Aggregate Demand and Aggregate Supply Natural rate of unemployment Long-run Phillips curve (b) The Phillips Curve Inflation Rate A Natural rate of output P1 Aggregate demand, AD1 Long-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level 4. …but it leaves output and unemployment at their natural rates. P2 2. …which raises the price level… Quantity of Output Unemploy-ment Rate 1. An increase in the money supply increases aggregate demand… AD2 B 3. …thus increasing the inflation rate… “long-run monetary impotence”

Shifts in the Short-Run Phillips Curve As we saw earlier, historical events have shown that the short-run Phillips Curve is not stable. It can shift due to the following factors: 1. Expectations 2. Supply Shocks Reasons that short-run curve in unstable- the short run curve supposes people have a consistent expectation of inflation

1. Shifts in the Short-run Phillips Curve: The Role of Expectations Expected inflation measures how much people expect the overall price level to change. Along any given short-run Phillips Curve, the expected inflation rate is constant. An increase (decrease) in the expected inflation rate causes the short-run Phillips Curve to shift up (down).

Changes in Expectations about Future Inflation Shift the Short-Run Phillips Curve Rate • • Pe1 > Pe0 • PC(Pe1) Expectations of inflation change, leading to a worse tradeoff: to create jobs, you have to make even higher inflation because people were already expecting some inflation • PC(Pe0) Unemployment Rate

Expectations and the Long-Run Phillips Curve In the long-run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips Curve shifts. Adjustment in inflation expectations in the long run result in a vertical long-run Phillips Curve whose intercept is at the natural rate of unemployment.

Changes in the Expected Inflation Shift the Short-Run Phillips Curve Unemployment Rate Natural rate of unemployment Inflation Rate C B Long-run Phillips curve A 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... 2. …but in the long-run, expected inflation rises, and the short-run Phillips curve shifts to the right.

1. The Long-Run Phillips Curve Thus, in the long run, there is no tradeoff between inflation and unemployment. In the long-run, the actual rate of inflation and unemployment will depend upon aggregate supply factors (real variables). Fiscal policy does have some long-run effects– if the money is spent on things like infrastructure, education, etc.- the spending can influence the long-run aggregate supply curve. Monetary policy cannot do this, though. Problem- politics is myopic, they look at election cycles.

The Natural-Rate Hypothesis The view that in the long run 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.

2. Shifts in the Phillips Curve Due to Supply Shocks The short-run Phillips Curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, would shift the short-run Phillips Curve up. Thus, an adverse supply shock worsens the short-run tradeoff between unemployment and inflation.

(a) The Model of Aggregate Demand and Aggregate Supply Adverse Supply Shocks Shift the Short-Run Phillips Curve and Worsens the Short-Run Tradeoff Between Inflation & Unemployment AS2 1. An adverse shift in aggregate supply… Quantity of Output Price Level P1 Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate (b) The Phillips Curve A Inflation Rate Phillips curve, PC1 Aggregate supply, AS1 Y1 P2 3. …and raises the price level… B 2. …lowers output… Y2 4. …giving policymakers a less favorable tradeoff between unemployment and inflation. PC2 (stagflation)

The Supply Shocks of the 1970s... Inflation Rate (percent per year) Unemployment Rate (percent) 1 2 3 4 5 6 7 8 9 10 1972 1975 1981 1976 1978 1979 1980 1973 1974 1977 You can see clearly the supply shocks of 73 and 79

The Cost of Reducing Inflation To reduce inflation, the Fed has to pursue contractionary monetary policy (e.g., raising interest rates, etc.) This would... reduce the aggregate demand… which would reduce the quantity of goods and services firms produce... which would lead to a fall in employment and a rise in unemployment. The loss of output is called the “sacrifice ratio”

The Cost of Reducing Inflation Such an action by the Fed to combat inflation would move the economy down along the short-run Phillips Curve resulting in lower inflation but higher unemployment It follows that if an economy is to reduce inflation in the short run, it must endure a period of high unemployment (sacrifice ratio).

Disinflationary Monetary Policy in the Short Run and Long Run Short-run Phillips curve with high expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve... Unemployment Rate Natural rate of unemployment Inflation Rate Long-run Phillips curve C B with low expected 2. ... but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left. The two questions are how far out is b? how long will it take to get back to C?

Rational Expectations We have seen that expected inflation is an important variable that 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. This theory says the sacrifice ratio is low. The minute you tell people you are fighting inflation, rational expectations change, people reduce expected inflation and there is not much loss of output.

Rational Expectations -The theory of rational expectations suggests that people use all the information they have, including information about government policies, when forming their expectation of future inflation. -If so, the loss of output and employment associated with a disinflationary monetary policy could be much smaller than estimated.

The Cost of Reducing Inflation The Volcker Disinflation To reduce inflation from about 10% in 1979-81 to 4% required a sacrifice of 30 percent of annual output! Paul Volcker (appt. by Carter in 1979) went public and created a recession… And it worked. Volcker (appt. 79 by Carter) went public, created a recession– but it worked.

The Volcker Disinflation... Unemployment Rate (percent) Inflation Rate (percent per year) 1 2 3 4 5 6 7 8 9 10 1979 1980 1983 1981 1982 1984 1986 1987 1985 A B C So it took 8 years

The Cost of Reducing Inflation The Greenspan Era In 1986, OPEC abandoned their agreement to restrict supply, resulting in a favorable supply shock leading to falling inflation and falling unemployment. This marked the beginning of the Greenspan Era. Fluctuations in inflation and unemployment have been relatively small due to Fed’s actions. Bob Woodward’s book “Maestro” all about Greenspan

The Greenspan Era... Unemployment Rate (percent) 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Inflation Rate (percent per year) 1984 1991 1985 1992 1993 1986 1994 1988 1987 1995 1989 1990

Evaluating Rational Expectations Contracts may embody outdated expectations Expectations adjust slowly Wages tend to “catch up,” not precede inflation Fighting inflation tends to be very costly.

Gov’t should NOT prevent inflation 1. Unemployment is more costly than inflation. 2. Short-run Phillips curve is flat. 3. Expectations react sluggishly. 4. Self-correcting is slow and unreliable. (Keynesian) Don’t “create a recession.”

Gov’t SHOULD fight inflation 1. Inflation is more costly than unemployment. 2. Short-run Phillips curve is steep. 3. People respond based on their expectations. 4. Self-correcting works smoothly and relatively fast. (Rational expectations)