1. Lecture 4. The Short-Run Tradeoff between Inflation and Unemployment

2. Agenda n Unemployment and inflation. n The Phillips Curve n Aggregate Demand, Aggregate Supply, and the Phillips Curve n Shifts in the Phillips Curve: The Role of Expectations n The Cost of Reducing Inflation n Thr Role of Rational Expectations.

3. Unemployment and Inflation u The natural rate of unemployment depends on various features of the labor market. u Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search.

4. Unemployment and Inflation u The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed. u The misery index, one measure of the “health” of the economy, adds together the inflation rate and unemployment rate.

5. Unemployment and Inflation u Society faces a short-run tradeoff between unemployment and inflation. u If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. u If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

6. The Phillips Curve The Phillips curve illustrates the short-run relationship between inflation and unemployment.

7. The Phillips Curve... Unemployment Rate (percent) 0 Inflation Rate (percent per year) 4 B 6 A 7 2 Phillips curve

8. Aggregate Demand, Aggregate Supply, and the Phillips Curve u 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.

9. Aggregate Demand, Aggregate Supply, and the Phillips Curve u The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. u A higher level of output results in a lower level of unemployment.

10. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply... Phillips curve 0 (b) The Phillips Curve Inflation Rate (percent per year) Unemployment Rate (percent) 0 (a) The Model of AD and AS Price Level Low AD High AD B 4 6 (output is 8,000) A 7 2 (output is 7,500) A 7,500 102 (unemployment is 7%) B 8,000 106 (unemployment is 7%) Short-run AS

11. Shifts in the Phillips Curve: The Role of Expectations The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

12. The Long-Run Phillips Curve u In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. u As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. u Monetary policy could be effective in the short run but not in the long run.

13. The Long-Run Phillips Curve... Unemployment Rate 0 Natural rate of unemployment 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

14. Expectations and the Short-Run Phillips Curve Expected inflation measures how much people expect the overall price level to change.

15. Expectations and the Short-Run Phillips Curve u In the long run, expected inflation adjusts to changes in actual inflation. u The central bank’s ability to create unexpected inflation exists only in the short run. u Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

16. Expectations and the Short-Run Phillips Curve Unemployment Rate = Natural rate of unemployment Actual Expected inflation inflation - ()a- This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.

17. How Expected Inflation Shifts the Short-Run Phillips Curve... Unemployment Rate 0 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.

18. The Natural-Rate Hypothesis u The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. u Historical observations support the natural-rate hypothesis.

19. The Natural Experiment for the Natural Rate Hypothesis u The concept of a stable Phillips curve broke down in the in the early ’70s. u During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

20. The Phillips Curve in the 1960s... Unemployment Rate (percent) Inflation Rate (percent per year) 012345678910 2 4 6 8 1968 1966 1961 1962 1963 1967 1965 1964

21. The Breakdown of the Phillips Curve... Unemployment Rate (percent) Inflation Rate (percent per year) 012345678910 2 4 6 8 1973 1971 1969 1970 1968 1966 1961 1962 1963 1967 1965 1964 1972

22. Shifts in the Phillips Curve: The Role of Supply Shocks u Historical events have shown that the short-run Phillips curve can shift due to changes in expectations.

23. Shifts in the Phillips Curve: The Role of Supply Shocks u The short-run Phillips curve also shifts because of shocks to aggregate supply. u Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. u An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

24. Shifts in the Phillips Curve: The Role of Supply Shocks u A supply shock is an event that directly affects firms’ costs of production and thus the prices they charge. u It shifts the economy’s aggregate supply curve... u … and as a result, the Phillips curve.

25. Shifts in the Phillips Curve: The Role of Supply Shocks u In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. u Fight the unemployment battle by expanding aggregate demand and accelerate inflation. u Fight inflation by contracting aggregate demand and endure even higher unemployment.

26. Inflation Rate (percent per year) Unemployment Rate (percent) 012345678910 2 4 6 8 The Supply Shocks of the 1970s... 1972 1975 1981 1976 1978 1979 1980 1973 1974 1977

27. The Cost of Reducing Inflation u To reduce inflation, the Fed has to pursue contractionary monetary policy. u When the Fed slows the rate of money growth, it contracts aggregate demand. u This reduces the quantity of goods and services that firms produce. u This leads to a rise in unemployment.

28. The Cost of Reducing Inflation u To reduce inflation, an economy must endure a period of high unemployment and low output. u When the central bank combats inflation, the economy moves down the short-run Phillips curve. u The economy experiences lower inflation but at the cost of higher unemployment.

29. The Cost of Reducing Inflation u The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. u An estimate of the sacrifice ratio is five. u To reduce inflation from about 10% in 1979- 1981 to 4% would have required an estimated sacrifice of 30% of annual output!

30. Rational Expectations The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

31. Rational Expectations u Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run. u How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.

32. Rational Expectations u The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.

33. Summary u The Phillips curve describes a negative relationship between inflation and unemployment. u By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. u By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.

34. Summary u The tradeoff between inflation and unemployment described by the Phillips curve holds only in the short run. u The long-run Phillips curve is vertical at the natural rate of unemployment.

35. Summary u The short-run Phillips curve also shifts because of shocks to aggregate supply. u An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

36. Summary u When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve. u This results in temporarily high unemployment. u The cost of disinflation depends on how quickly expectations of inflation fall.

37. Summary u Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy. u Changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment.

38. Graphical Review

39. The Phillips Curve... Unemployment Rate (percent) 0 Inflation Rate (percent per year) 4 B 6 A 7 2 Phillips curve

40. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply... Phillips curve 0 (b) The Phillips Curve Inflation Rate (percent per year) Unemployment Rate (percent) 0 (a) The Model of AD and AS Price Level Low AD High AD B 4 6 (output is 8,000) A 7 2 (output is 7,500) A 7,500 102 (unemployment is 7%) B 8,000 106 (unemployment is 7%) Short-run AS

41. The Long-Run Phillips Curve... Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve B High inflation 1. When the central bank 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

42. How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply… Natural rate of unemployment Long-run Phillips curve 0 (b) The Phillips Curve Inflation Rate A Natural rate of output 0 P1P1 Aggregate demand, AD 1 Long-run aggregate supply (a) The Model of Aggregate Demand and Aggregate Supply Price Level 4. …but leaves output and unemployment at their natural rates. P2P2 2. …raises the price level… Quantity of Output Unemploy- ment Rate 1. An increase in the money supply increases aggregate demand… AD 2 B 3. …and increases the inflation rate…

43. How Expected Inflation Shifts the Short-Run Phillips Curve... Unemployment Rate 0 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.

44. The Phillips Curve in the 1960s... Unemployment Rate (percent) Inflation Rate (percent per year) 012345678910 2 4 6 8 1968 1966 1961 1962 1963 1967 1965 1964

45. The Breakdown of the Phillips Curve... Unemployment Rate (percent) Inflation Rate (percent per year) 012345678910 2 4 6 8 1973 1971 1969 1970 1968 1966 1961 1962 1963 1967 1965 1964 1972

46. An Adverse Shock to Aggregate Supply... AS 2 1. An adverse shift in aggregate supply… Quantity of Output 0 Price Level P1P1 Aggregate demand (a) The Model of Aggregate Demand and Aggregate Supply Unemployment Rate 0 (b) The Phillips Curve A Inflation Rate Phillips curve, PC 1 Aggregate supply, AS 1 A Y1Y1 P2P2 3. …and raises the price level… B 2. …lowers output… Y2Y2 B 4. …giving policymakers a less favorable tradeoff between unemployment and inflation. PC 2

47. The Supply Shocks of the 1970s... Inflation Rate (percent per year) Unemployment Rate (percent) 012345678910 2 4 6 8 1972 1975 1981 1976 1978 1979 1980 1973 1974 1977

48. A Short-run Phillips curve with high expected inflation 1. Contractionary policy moves the economy down along the short-run Phillips curve... Unemployment Rate 0 Natural rate of unemployment Inflation Rate Long-run Phillips curve C B Short-run Phillips curve with low expected inflation 2.... but in the long run, expected inflation falls and the short-run Phillips curve shifts to the left. Disinflationary Monetary Policy in the Short Run and the Long Run...

49. The Volcker Disinflation... Unemployment Rate (percent) Inflation Rate (percent per year) 012345678910 2 4 6 8 1979 1980 1983 1981 1982 1984 1986 1987 1985 A B C

50. The Greenspan Era... Unemployment Rate (percent) 0123456789100 2 4 6 8 Inflation Rate (percent per year) 1984 1991 1985 1992 1993 1986 1994 1988 1987 1995 1989 1990