1. Tradeoff: inflation & unemployment
Historical data of UK showed tradeoff between unemployment and inflation.
The relationship is called Phillips curve. It has also been verified by data from other countries.
This relationship seemed irrefutable.
price
inflation AS B B A A
AD’ AD
Phillips Curve
output
unemployment
Principles of Economics 2015

2. Tradeoff: inflation & unemployment
SR Phillips curve is a mirror image of SR supply curce!
price
inflation AS B B A A
AD’ AD
Phillips Curve
output
employment
Principles of Economics 2015

3. Figure 3 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 . . .
but unemployment
remains at its natural rate
in the long run.
Low
inflation A
Natural rate of
Unemployment
unemployment
Rate
Copyright © South-Western

4. Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price
Long-run aggregate
Inflation
Long-run Phillips
Level
Rate
supply
curve
1. An increase in
the money supply
increases aggregate
demand . . .
and
increases the
inflation rate . . .
AD2 P2 B B
raises
the price
level . . . A P A
Aggregate
demand, AD
Natural rate
Quantity
Natural rate of
Unemployment
of output
of Output
unemployment
Rate
but leaves output and unemployment
at their natural rates.
Copyright © South-Western

5. Long-run Phillips curve by Friedman
Friedman argued such relationship does not exist, and LR Phillips curve is vertical, as is LR aggregate supply curve.
SR Phillips curves depend on expected inflation rate, as do SR AS on price level.
As time goes by, people change their expectation, and the curve shifts to the right. We are back to B! Phillips curves are mirror images of AS curves.
price
LR Phillips Curve
LR AS
SR AS’
inflation
SR AS B B A’ A’ A
SR PC’ A
AD’ AD
SR PC
output
unemployment
Principles of Economics 2015

6. Principles of Economics 2015
How Expected Inflation Shifts the Short-Run Phillips Curve (only the Phillips Curve part from the previous slide)
but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Inflation
Rate
Long-run
Short-run Phillips curve
with high expected
inflation
Phillips curve C
Short-run Phillips curve
with low expected
inflation B
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . . A
Natural rate of
Unemployment
unemployment
Rate
Principles of Economics 2015
Copyright © South-Western

7. What if Long-run Supply moves at the same time?
What about the historical data?
If productivity sufficiently increased in between times, then we may observe the traditional Phillips Curve.
price
LR Phillips Curve’
LR AS’
LR AS
inflation
LR Phillips Curve
SR AS A’ A’ A A
AD’ AD
SR PC
output
unemployment
Principles of Economics 2015

8. A bold prediction without evidence…
Natural experiment was under way during the late 60s: discretionary expansion!!
Expansionary fiscal policy was followed by increase in money supply to suppress interest rate. The result was inflation and high rate of unemployment!
Inflation persisted, and people formed expectation on inflation.
Principles of Economics 2015

9. The Phillips Curve in the 1960s
Principles of Economics 2015

10. The Breakdown of the Phillips Curve
Principles of Economics 2015

11. Principles of Economics 2015
Another experiment came from oil shock.
As oil price increased, AS shifted to the left, and SR Phillips curve to the right. We experienced stagflation.
price
AS’
inflation AS B B A A
SR PC’
AD’ AD
SR PC
output
unemployment
Principles of Economics 2015

12. The Supply Shocks of the 1970s
Recession was mild by expansionary monetary policy; but high inflation persisted!
Principles of Economics 2015

13. Sacrifice ratio and Rational Expectation
How quickly does expectation change to new monetary policy?
Sacrifice ratio: % in output decrease to decrease inflation by 1%.
If the ratio is 5, then 6% reduction in inflation required 30% decrease in output.
Emergence of Rational Expectations Theory
People adjust quickly, and sacrifice ratio would be rather small. It could even be zero. What is most important is the credibility of the policy.
Volcker disinflation took several years of deep recession.
The cost was not as large as many economists claimed. Volcker’s tough stand might have had some direct effect on expectations.
Still many did not believe him, and expectation did not change as quickly.
No definite conclusion on Rational Expectations Theory, yet.
Principles of Economics 2015

14. Disinflationary Monetary Policy in the Short Run and Long Run
Principles of Economics 2015

15. The Volcker Disinflation
Principles of Economics 2015