2. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 16: The Short-run Tradeoff Between Inflation and Unemployment

3. Econ 202 Dr. Ugur Aker 2 Long-run Unemployment The natural rate of unemployment (the long- run unemployment rate) depends on the characteristics of the labor market. –Effectiveness of job search. –Skill gaps between labor demand and labor supply. –Efficiency wages. –Union power. –Minimum wage laws.

4. Econ 202 Dr. Ugur Aker 3 Long-run Inflation Inflation in the long-run is strictly a monetary phenomenon. Classical “Quantity Theory” works in the long run. In the long-run, inflation and unemployment are unrelated. –A country can have any inflation rate at the natural rate of unemployment.

5. Econ 202 Dr. Ugur Aker 4 Short Run In the short run, aggregate supply is upward sloping. –Long run aggregate supply is a vertical line. Any shift in the aggregate demand curve will affect unemployment and inflation in opposite directions initially. After the adjustment of prices, unemployment will reach the natural rate.

6. Econ 202 Dr. Ugur Aker 5 Short-run AD1 LRAS SRAS P* Y* AD2 Y2 P2 An increase in C or I or G or NX will shift the AD to the right. In the short run, GDP will increase but so will the price level. The economy will experience a drop in the unemployment rate but a positive inflation rate. If the AD had shifted to the left, inflation would have fallen, but unemployment would have risen. AD3 Y3 P3

7. Econ 202 Dr. Ugur Aker 6 Keynesian Theory The negative connection between inflation and unemployment is the logical conclusion of Keynesian theory. –Prices and wages are constant in the short run. –An increase in money supply, increases the GDP. –But an increase in GDP (a fall in unemployment) will usher in an increase in the price level.

8. Econ 202 Dr. Ugur Aker 7 Phillips Curve In 1958, A. W. Phillips published an article showing the relationship between nominal wages and unemployment rates in Britain for a century. When one took the average of the observations, i.e., when one tried to fit a single line to summarize the observations, the line was downward sloping. This relationship is termed Phillips curve since.

9. Econ 202 Dr. Ugur Aker 8 Phillips Curve for the US Samuelson and Solow showed the same relationship for the US (1960). They used inflation rate instead of the nominal wage increase. Once this relationship is established, it made sense in the sixties to talk about the choice a government had. –Low inflation and high unemployment –High inflation and low unemployment

10. Econ 202 Dr. Ugur Aker 9 Unemployment and Inflation

11. Econ 202 Dr. Ugur Aker 10 Unemployment and Inflation

12. Econ 202 Dr. Ugur Aker 11 Objections to Phillips Curve By the end of the sixties, Friedman and Phelps questioned the wisdom of viewing unemployment and inflation trade-off in the long-run. They emphasized the classical dichotomy. –Real variables cannot be influenced by monetary factors. –Monetary policy will affect nominal variables. In the long-run, Phillips curve is vertical at the natural unemployment rate.

13. Econ 202 Dr. Ugur Aker 12 Long Run Y P Infl. rate Unemp. rate LRAS AD SRAS Y* U* P* AD SRAS Long run Phillips curve

14. Econ 202 Dr. Ugur Aker 13 How To Reconcile Phillips Curves The data showed downward sloping Phillips curve. The theory claimed vertical Phillips curve. In the short-run Phillips curves are downward sloping. However, there is not one but many Phillips curves, each one indicating a different expected inflation rate.

15. Econ 202 Dr. Ugur Aker 14 Short Run and Long Run Y P Infl. rate Unemp. rate LRAS AD SRAS Y* U* P* AD SRAS Long run Phillips curve SRPhC 3% 5% Expected inflation on the white SRPhC is 3%. When expected inflation rises to 5%, SRPhC shifts to the blue one.

16. Econ 202 Dr. Ugur Aker 15 How the Fed Can Fuel Inflation LRPhC 2% 6% 1 1 P e =2% 4% 2 P e =4% 3 7% 45 P e =7%

17. Econ 202 Dr. Ugur Aker 16 Inflation-Unemployment in the 1960s

18. Econ 202 Dr. Ugur Aker 17 Unemployment-Inflation 1961-73

19. Econ 202 Dr. Ugur Aker 18 Cost of Production Increase A shock to the economy that raises the cost of production in general, will shift the SRAS to the left. At the same inflation level unemployment rises, shifting SRPhC to the right. Oil price shocks of 1973 and 1980 had this influence on the economy. Oil price collapse of 1985 had the opposite result.

20. Econ 202 Dr. Ugur Aker 19 Oil Price Shock LRAS AD SRAS Y* P* LRPhC P e =3% 3% U* SRAS Y P U 5% 6% P e =6% P e =5% SRAS

21. Econ 202 Dr. Ugur Aker 20 Unemployment-Inflation 1972-81

22. Econ 202 Dr. Ugur Aker 21 Oil Price Collapse LRAS SRAS AD Y* P U* LRPhC SRPhC 4% SRAS Y P 3% U SRPhC SRAS

23. Econ 202 Dr. Ugur Aker 22 Unemployment-Inflation 1979-87

24. Econ 202 Dr. Ugur Aker 23 Unemployment-Inflation 1984-95

25. Econ 202 Dr. Ugur Aker 24 Cost of Reducing Inflation Suppose the economy is in long-run equilibrium with 10% inflation. Draw it. Suppose the Fed wants to reduce the inflation. What should the Fed do? What would be the cost to the society?

26. Econ 202 Dr. Ugur Aker 25 Cost of Reducing Inflation SRAS LRAS AD Y* P 10% P e =10% LRPhC U* AD

27. Econ 202 Dr. Ugur Aker 26 Unemployment-Inflation 1979-87

28. Econ 202 Dr. Ugur Aker 27 Cost of Reducing Inflation The sacrifice the society has to go through is the high unemployment rate it has to endure until inflationary expectations are lowered to acceptable levels. The Volcker years of the Fed were severe unemployment period but inflation was lowered from two digit levels down to 4%. The cost was supposed to be 5% drop of GDP per one percent of inflation drop. Perhaps because of rational expectations the cost was lower.