2. Recall that inflation is a sustained increase in the ave. prices of goods and services  We want to examine the following issues : What are the costs of inflation? Is there a tradeoff between inflation and unemployment? Assuming there is a tradeoff between inflation and unemployment, can unemployment be “too low”? Why is it that once inflation starts, it tends to persist? Is monetary expansion to blame for inflation?

3. Unemployment rate (%) Inflation rate (%) 01 2345 2 4 6 8 10 The Phillips curve is named for A.W. Phillips, who identified an inverse correlation between inflation and unemployment in the U.K. Note the shape of the curve implies a policy trade-off.

4. Unemployment rate (%) Inflation rate (%) 1980-83 1986-95 1960-69 Critics such as Professors Friedman and Lucas argue there is no “stable” trade-off between inflation and unemployment. Data for the U.S. appears to support their view 5 6 12 0 10

5. NAIRU is an acronym for “non-accelerating inflation rate of unemployment.” Unemployment rate (%) Inflation rate (%) U*  Below U*(also called the natural rate, the inflation rate will accelerate-- that’s the theory

6. Some advocates of the NAIRU assert that any trade-off between inflation and unemployment will “blow up” as household and firms “catch up” to a change in prices of goods and services

7. Let:  denote the inflation rate.  e t is the expected inflation rate in month t.  a t is the actual inflation rate in month t.  For the sake of simplicity, we assume:  e t =  a t -1 People are assumed to extrapolate based on the inflation in the most recent month

8. Hours per week Money wage (w) N s (P e = 1.00) $10 $12 N s (P e = 1.20) 4045 A failure to perceive that the value of money has changed Mistakenly thinking the real wage increased, Bobby worked 5 more hours per week

9. unemployment  U* 0 Long-run Phillips curve U0U0  e = 0  e = 3%  e = 7% 3 7  A,B, and C are short-run curves corresponding to inflationary expectations A B C

10. The effort by policy makers to drive unemployment below the NAIRU works in the short-term but is doomed to fail in the long-run. Moreover, the attempt to exploit the short-run relation has damaging effects in terms of inflationary expectations

11. Long-run Phillips curve  e = 13.5% U* 7.6 unemployment  0 13.5 10.3 1981 Once inflationary expectations take hold, then it is possible to overestimate inflation. The result is stagflation

12. Just a few years ago, estimates of the NAIRU ranged from 5.5% to 6.5%. Those estimates appear off base in light of recent experience