1. 16 The Trade-off Between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER The Trade-off Between Inflation and Unemployment We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER

2. ●Demand-Side Inflation versus Supply-Side Inflation: A Review ●Origins of the Phillips Curve ●Supply-Side Inflation and the Collapse of the Phillips Curve ●What the Phillips Curve Is Not ●Demand-Side Inflation versus Supply-Side Inflation: A Review ●Origins of the Phillips Curve ●Supply-Side Inflation and the Collapse of the Phillips Curve ●What the Phillips Curve Is Not Contents Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

3. ●Fighting Unemployment with Fiscal and Monetary Policy ●What Should Be Done? ●Inflationary Expectations and the Phillips Curve ●The Theory of Rational Expectations ●Why Economists (and Politicians) Disagree ●Fighting Unemployment with Fiscal and Monetary Policy ●What Should Be Done? ●Inflationary Expectations and the Phillips Curve ●The Theory of Rational Expectations ●Why Economists (and Politicians) Disagree Contents (continued) Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

4. ●The Dilemma of Demand Management ●Attempts to Reduce the Natural Rate of Unemployment ●Indexing ●The Dilemma of Demand Management ●Attempts to Reduce the Natural Rate of Unemployment ●Indexing Contents (continued) Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

5. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  AD  ♦  prices ♦  output ●  AS  ♦  prices ♦  output ●  AD  ♦  prices ♦  output ●  AS  ♦  prices ♦  output Demand-Side Inflation versus Supply-Side Inflation

6. FIGURE 1: Inflation from the Demand Side Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. S S D 0 D 0 Price Level Real GDP A D 1 D 1 B

7. FIGURE 2: Inflation from the Supply Side Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP A S 1 S 1 B

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Origins of the Phillips Curve ●If  GDP are primarily caused by  AD: ♦Higher rates of inflation will be associated with lower rates of unemployment ♦Lower rates of inflation will be associated with higher rates of unemployment ●The U.S. data for 1954-1969 show such a relationship. ●If  GDP are primarily caused by  AD: ♦Higher rates of inflation will be associated with lower rates of unemployment ♦Lower rates of inflation will be associated with higher rates of unemployment ●The U.S. data for 1954-1969 show such a relationship.

9. FIGURE 3: Origins of the Phillips Curve Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. 3% 1% 2% 6% A B Inflation Rate 5%4% C Unemployment Rate

10. FIGURE 5: A Phillips Curve for the U.S., 1954-1969 Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. 7% 6 5 4 3 2 1098765432 1961 1958 1962 1954 1959 1963 1960 1964 1967 1957 1965 1955 1956 1966 1969 1968 01 Inflation Rate 1 Unemployment Rate in Percent

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Supply-Side Inflation and the Collapse of Phillips Curve ●If  GDP are primarily caused by  AS: ♦Higher rates of inflation will be associated with higher rates of unemployment ♦Lower rates of inflation will be associated with lower rates of unemployment ●The U.S. data for 1972-1974 and 1978-1980 show such a relationship. ●If  GDP are primarily caused by  AS: ♦Higher rates of inflation will be associated with higher rates of unemployment ♦Lower rates of inflation will be associated with lower rates of unemployment ●The U.S. data for 1972-1974 and 1978-1980 show such a relationship.

12. FIGURE 6: A Phillips Curve for the U.S.? Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. 1961 1958 1962 1954 1959 1963 1960 1964 1967 1957 1965 1955 1956 1966 1969 1968 19781973 1979 1974 1980 1981 1975 1983 1982 1977 1971 1970 1972 1984 1976 12% 11 10 9 8 7 6 5 4 3 2 9876543201 Inflation Rate 1 Unemployment Rate in Percent

13. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Supply-Side Inflation and the Collapse of Phillips Curve ●Explaining the Fabulous 1990s ♦Favorable supply shock  AS curve shifts out ♦Characterizes the U.S. economy from 1996 to 1998 ■GDP grew rapidly ■Both inflation and unemployment fell ●Explaining the Fabulous 1990s ♦Favorable supply shock  AS curve shifts out ♦Characterizes the U.S. economy from 1996 to 1998 ■GDP grew rapidly ■Both inflation and unemployment fell

14. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 7: The Effects of a Favorable Supply Shock Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Price Level Real GDP Effect of favorable supply shock Normal growth of aggregate supply D 0 D 0 S 0 S 0 D 1 D 1 S 1 S 1 B C A

15. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●Phillips Curve = curve showing a short-run trade-off between unemployment and inflation ♦Only applies if  AD ♦Not a stable, long-run menu of choices ●Phillips Curve = curve showing a short-run trade-off between unemployment and inflation ♦Only applies if  AD ♦Not a stable, long-run menu of choices

16. FIGURE 8: The Elimination of a Recessionary Gap Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Price Level Real GDP S 0 S 0 S 2 S 2 S 1 S 1 D D A B Potential GDP C

17. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●In the long run,  AD  : ♦  inflation ♦ But  AD does not   unemployment ●Long-run effects due to the self-correcting mechanism of the economy ●In the long run,  AD  : ♦  inflation ♦ But  AD does not   unemployment ●Long-run effects due to the self-correcting mechanism of the economy

18. FIGURE 9: The Vertical Long-Run Phillips Curve Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Inflation Rate Unemployment Rate in Percent g c f e 8% a d 7 6 5 4 3 2 1 76.543.565.554.5

19. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●Natural rate of unemployment = level of unemployment that is sustainable in the long run ●Corresponds to the “full-employment” unemployment rate ●Natural rate of unemployment = level of unemployment that is sustainable in the long run ●Corresponds to the “full-employment” unemployment rate

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fighting Unemployment with Fiscal and Monetary Policy ●Policy choices if high unemployment: ♦Use expansionary fiscal and monetary policy ■  unemployment ■  inflation ♦Rely on economy’s self-correcting mechanism ■  unemployment without  inflation ■Problem: may take a long time to reduce unemployment ●Policy choices if high unemployment: ♦Use expansionary fiscal and monetary policy ■  unemployment ■  inflation ♦Rely on economy’s self-correcting mechanism ■  unemployment without  inflation ■Problem: may take a long time to reduce unemployment

21. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. What Should be Done? ●Active versus passive monetary and fiscal policy ♦How the public rates the relative costs of unemployment and inflation ♦Slope of the short-run Phillips curve ♦Efficiency of the economy’s self-correcting mechanism ●Active versus passive monetary and fiscal policy ♦How the public rates the relative costs of unemployment and inflation ♦Slope of the short-run Phillips curve ♦Efficiency of the economy’s self-correcting mechanism

22. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Inflationary Expectations and the Phillips Curve ●Inflation does not erode real wages if: ♦Workers can see inflation coming ♦They receive compensation for it ●But if real wages do not fall, firms have no incentives to increase production. ●Inflation does not erode real wages if: ♦Workers can see inflation coming ♦They receive compensation for it ●But if real wages do not fall, firms have no incentives to increase production.

23. TABLE 1: Money & Real Wages under Unexpected Inflation Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

24. TABLE 2: Money and Real Wages under Expected Inflation Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

25. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●When inflation is predicted accurately: ♦The short-run AS curve is vertical at potential GDP ♦The short-run Phillips curve is vertical at the natural rate of unemployment ●When inflation is underestimated: ♦ The short-run AS curve and the short-run Phillips curve slope upward ●When inflation is predicted accurately: ♦The short-run AS curve is vertical at potential GDP ♦The short-run Phillips curve is vertical at the natural rate of unemployment ●When inflation is underestimated: ♦ The short-run AS curve and the short-run Phillips curve slope upward Inflationary Expectations and the Phillips Curve

26. FIGURE 10: Vertical AS Curve and the Vertical Phillips Curve Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Vertical short-run Phillips curve Inflation Rate (b) Unemployment Rate Vertical aggregate supply curve Price Level (a) Real GDP 5 S S

27. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Rational expectations = forecasts that are the best that can be made given the available data ♦Not necessarily correct ♦No systematic errors ●Rational expectations = forecasts that are the best that can be made given the available data ♦Not necessarily correct ♦No systematic errors The Theory of Rational Expectations

28. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●If expectations of inflation are rational: ♦The short-run Phillips Curve is vertical ♦Inflation can be reduced without the need for a period of high unemployment ●If expectations of inflation are rational: ♦The short-run Phillips Curve is vertical ♦Inflation can be reduced without the need for a period of high unemployment

29. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●Reasons that expectations are not completely rational ♦Contracts may embody outdated expectations ♦Expectations may adjust slowly ♦Workers likely receive compensation for inflation after the fact ●Reasons that expectations are not completely rational ♦Contracts may embody outdated expectations ♦Expectations may adjust slowly ♦Workers likely receive compensation for inflation after the fact

30. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●In the long run, expectations should be rational. ♦People should not cling to incorrect expectations indefinitely. ●In the long run, expectations should be rational. ♦People should not cling to incorrect expectations indefinitely.

31. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Economists (and Politicians) Disagree ●Why Keynesians and liberals are more eager to fight unemployment ♦Unemployment is more costly than inflation ♦The short-run Phillips Curve is flat ♦Expectations react sluggishly ♦The self-correcting mechanism is slow or unreliable ●Why Keynesians and liberals are more eager to fight unemployment ♦Unemployment is more costly than inflation ♦The short-run Phillips Curve is flat ♦Expectations react sluggishly ♦The self-correcting mechanism is slow or unreliable

32. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Economists (and Politicians) Disagree ●Why rational expectations, adherents, and conservatives are more eager to fight inflation ♦Inflation is more costly than unemployment ♦The short-run Phillips curve is steep ♦Expectations react quickly ♦The economy’s self-correcting mechanism works smoothly and rapidly ●Why rational expectations, adherents, and conservatives are more eager to fight inflation ♦Inflation is more costly than unemployment ♦The short-run Phillips curve is steep ♦Expectations react quickly ♦The economy’s self-correcting mechanism works smoothly and rapidly

33. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Dilemma of Demand Management ●Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment. ♦True whether inflation is due to a shock to AD or AS ♦Government only has control over AD curve ●Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment. ♦True whether inflation is due to a shock to AD or AS ♦Government only has control over AD curve

34. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Attempts to Reduce Natural Rate of Unemployment ●The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment. ♦Education ♦Training ♦Job placement services ●The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment. ♦Education ♦Training ♦Job placement services

35. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Attempts to Reduce Natural Rate of Unemployment ●Problems ♦Training and placement programs often look better on paper than they do in practice, where they achieve only modest successes. ♦The high cost of these programs restricts the number of workers that can be accommodated, even when they work. ●Problems ♦Training and placement programs often look better on paper than they do in practice, where they achieve only modest successes. ♦The high cost of these programs restricts the number of workers that can be accommodated, even when they work.

36. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Indexing ●Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes ♦Wages ♦Pensions ♦Interest payments on bonds ♦Income taxes ●Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes ♦Wages ♦Pensions ♦Interest payments on bonds ♦Income taxes

37. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Indexing ●Indexing protects people from the costs of inflation. ●But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it. ●Indexing protects people from the costs of inflation. ●But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it.