1. R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN FIFTH EDITION © 2015 Pearson Education, Inc..

2. 2 of 36 © 2015 Pearson Education, Inc. Chapter Outline and Learning Objectives 17.1 The Discovery of the Short- Run Trade-off between Unemployment and Inflation 17.2 The Short-Run and Long- Run Phillips Curves 17.3 Expectations of the Inflation Rate and Monetary Policy 17.4 Federal Reserve Policy from the 1970s to the Present CHAPTER 17 CHAPTER Inflation, Unemployment, and Federal Reserve Policy

3. LEARNING OBJECTIVE 3 of 36 © 2015 Pearson Education, Inc. The Discovery of the Short-Run Trade-off between Unemployment and Inflation 17.1 Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

4. 4 of 36 © 2015 Pearson Education, Inc. Unemployment and Inflation The two great macroeconomic problems that the Fed deals with (in the short run) are unemployment and inflation. But these two are related in an important way: higher levels of inflation are associated with lower levels of unemployment, and vice versa. This relationship is known as the Phillips curve, after economist A.W. Phillips, the first to identify this relationship. Phillips curve: A curve showing the short-run relationship between the unemployment rate and the inflation rate. The Phillips curveFigure 17.1

5. 5 of 36 © 2015 Pearson Education, Inc. Why Does the Phillips Curve Exist? In the AD-AS model, a small aggregate demand increase leads to low inflation and high unemployment. A stronger AD increase results in lower unemployment but more inflation—the short run Phillips curve relationship. Using aggregate demand and aggregate supply analysis to explain the Phillips curve Figure 17.2

6. 6 of 36 © 2015 Pearson Education, Inc. Is the Phillips Curve a Policy Menu? During the 1960s, some economists argued that the Phillips curve was a structural relationship: a relationship that depends on the basic behavior of consumers and firms, and that remains unchanged over long period. In the 1960s, this relationship had appeared to be quite stable. If this was true, policy-makers could choose a point on the curve: trading permanently higher inflation for lower unemployment, or vice versa. But this turned out not to be true: allowing more inflation doesn’t lead to permanently lower unemployment. That is, the short-run Phillips curve moves over time.

7. 7 of 36 © 2015 Pearson Education, Inc. The Long-Run Phillips Curve By the late 1960s, most economists agreed that the long-run aggregate supply curve was vertical. Is a vertical long-run AS curve compatible with a downward- sloping long-run Phillips curve? Economists Milton Friedman and Edmund Phelps argued that this implied the long-run Phillips curve was also vertical: in the long run, employment is determined by output, which in the long run does not depend on the price level. A vertical long-run aggregate supply curve means a vertical long-run Phillips curve Figure 17.3a

8. 8 of 36 © 2015 Pearson Education, Inc. Natural Rate of Unemployment Since employment was determined by potential GDP, so must be unemployment. Unemployment, in the long run, goes to its natural rate, when the output returns to potential GDP. Natural rate of unemployment: The unemployment rate that exists when the economy is at potential GDP. At this output level, there is no cyclical unemployment; but there does remain structural and frictional unemployment. These latter two are not predictably affected by inflation. A vertical long-run aggregate supply curve means a vertical long-run Phillips curve Figure 17.3b

9. 9 of 36 © 2015 Pearson Education, Inc. The Role of Expectations of Future Inflation However this conclusion contradicted the experience of the 1950s and 1960s, during which time a stable trade-off seemed to exist between unemployment and inflation. The short-run trade-off appears to exist because workers and firms sometimes expect the inflation rate to be either higher or lower than it turns out to be. Suppose Ford and the United Auto Workers (UAW) agree to a wage of $34.65 per hour for 2016. They expect the price level to increase from 110.0 in 2015 to 115.5 in 2015: 5% inflation. Then $34.65 represents a real wage of $30.00:

10. 10 of 36 © 2015 Pearson Education, Inc. The Role of Expectations of Future Inflation—cont. If the expectations about inflation are correct, the real wage will be $30 as expected; Ford will hire its planned number of workers. But: The effect of unexpected price level changes on the real wage Table 17.1 Nominal WageExpected Real WageActual Real Wage Expected P 2016 = 115.5 Expected inflation = 5% $34.65 Actual P 2016 = 118.8 Actual inflation = 8% Actual P 2016 = 112.2 Actual inflation = 2% Friedman: “There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade- off comes not from inflation per se, but from unanticipated inflation.” The basis for the short-run Phillips curve Table 17.2 If…then…and... actual inflation is greater than expected inflation, the actual real wage is less than the expected real wage the unemployment rate falls actual inflation is less than expected inflation the actual real wage is greater than the expected real wage the unemployment rate rises

11. 11 of 36 © 2015 Pearson Education, Inc. Making the Connection Do Workers Understand Inflation? Most economists believe an increase in inflation will quickly lead to an increase in wages. However workers tend not to believe this, expecting that inflation will decrease their purchasing power for years, or even permanently. This has an important consequence: since workers do not expect their wages to increase with inflation, firms can increase wages by less than inflation (i.e. decrease real wages) without worrying about workers quitting or their morale falling. This gives a further reason why higher inflation will lead to lower (short-run) unemployment.

12. LEARNING OBJECTIVE 12 of 36 © 2015 Pearson Education, Inc. The Short-Run and Long-Run Phillips Curves 17.2 Explain the relationship between the short-run and long-run Phillips curves.

13. 13 of 36 © 2015 Pearson Education, Inc. The Phillips Curves in the 1960s Throughout the early 1960s, inflation was low—about 1.5%. Firms and workers expected this rate to continue, but inflation was higher in the late 1960s, about 4.5%, due to expansionary monetary and fiscal policies. Because this was unexpected, the economy moved along the short-run Phillips curve, resulting in low unemployment of 3.5%. The short-run Phillips curve of the 1960s and the long-run Phillips curve Figure 17.4

14. 14 of 36 © 2015 Pearson Education, Inc. Shifts in the Short-Run Phillips Curve Eventually, firms and workers adjusted their expectations to the inflation rate of 4.5%. Workers demanded higher wages to compensate for the increased inflation, and the economy returned to potential GDP, with unemployment at its natural rate of 5%. The “new normal” inflation rate of 4.5% became embedded in the economy, in the form of the short- run Phillips curve shifting to the right. 3.5% unemployment would require another unexpected increase in the rate of inflation. Expectations and the short-run Phillips curve Figure 17.5

15. 15 of 36 © 2015 Pearson Education, Inc. A Short-Run Phillips Curve for Every Expected Inflation Rate Each expected inflation rate generates a different short-run Phillips curve. In each case, when the inflation rate is actually at the expected level, the unemployment level is at its natural rate—i.e. the long-run Phillips curve. A short-run Phillips curve for every expected inflation rate Figure 17.6

16. 16 of 36 © 2015 Pearson Education, Inc. Implications for Monetary Policy By the 1970s, most economists agreed that the long-run Phillips curve was vertical; it was not possible to “buy” a permanently lower unemployment rate at the cost of permanently higher inflation. In order to keep unemployment lower than the natural rate, the Fed would need to continually increase inflation. Or it could decrease inflation, at the cost of a temporarily higher unemployment rate. The inflation rate and the natural rate of unemployment in the long run Figure 17.7

17. 17 of 36 © 2015 Pearson Education, Inc. Implications for Monetary Policy Since any rate of unemployment other than the natural rate results in the rate of inflation increasing or decreasing, the natural rate of unemployment is sometimes referred to as the non-accelerating inflation rate of unemployment, or NAIRU. The inflation rate and the natural rate of unemployment in the long run Figure 17.7

18. 18 of 36 © 2015 Pearson Education, Inc. Making the Connection Does the Natural Rate of Unemployment Ever Change? The natural rate of unemployment might change if the amount of frictional or structural unemployment changed. Possible reasons for this include: Demographic changes: younger and less skilled workers have higher unemployment rates. Changes in labor market institutions: a change in the availability of unemployment insurance, the prevalence of unions, or legal barriers to firing workers. Past high rates of unemployment: during long periods of unemployment, workers’ skills may deteriorate, or they may become dependent on the government for support.

19. LEARNING OBJECTIVE 19 of 36 © 2015 Pearson Education, Inc. Expectations of the Inflation Rate and Monetary Policy 17.3 Discuss how expectations of the inflation rate affect monetary policy.

20. 20 of 36 © 2015 Pearson Education, Inc. How Long Does It Take to Get to the Long Run? How long can the economy remain off the long-run Phillips curve? It depends on how fast workers and firms adjust their expectations about future inflation. This depends on inflation itself. The U.S. has seen three types of inflation of the last several decades: Low inflation: slow adjustment, since workers and firms seem to ignore inflation Moderate but stable inflation: quick adjustment; stable but noticeable inflation is easily incorporated into expectations High and unstable inflation: quick adjustment again, but for a different reason: forming rational expectations about inflation becomes very important, so workers and firms pay a lot of attention to forecasting inflation Rational expectations: Expectations formed by using all available information about an economic variable.

21. 21 of 36 © 2015 Pearson Education, Inc. The Effect of Rational Expectations on Monetary Policy If workers and firms have adaptive expectations, expecting inflation to be the same as it was last period, then expansionary monetary policy can increase employment. But if they have rational expectations, workers and firms will anticipate the Fed’s policies, and adjust their expectations about inflation accordingly. Then the policy would have no effect on employment: the short-run Phillips curve would be vertical also. Rational expectations and the Phillips curve Figure 17.8

22. 22 of 36 © 2015 Pearson Education, Inc. Is the Short-Run Phillips Curve Really Vertical? This idea of rational expectations and a vertical short-run Phillips curve was proposed by Nobel Laureates Robert Lucas and Thomas Sargent. Their critics argued that the 1950s and 1960s showed an obvious short-run trade-off between unemployment and inflation. Lucas and Sargent: This happened because the Fed was secretive, not announcing changes in policy. If the Fed announces its policies, people will correctly anticipate inflation. Critics: Workers and firms still cannot correctly anticipate inflation; their expectations are not rational. Besides, wages and prices don’t adjust fast enough anyway; so even if people anticipated the inflation, they couldn’t do enough about it to make the short-run Phillips curve vertical.

23. 23 of 36 © 2015 Pearson Education, Inc. Real Business Cycle Models The conclusion from Lucas and Sargent was the Fed could affect output and employment; but only through unexpected changes to the money supply. During the 1980s, a different mechanism for explaining changes in real GDP: technology shocks—increases or decreases in productive ability—might push real GDP above or below its (previous) potential level. Since this was based on real (not monetary) factors, models based on this became known as real business cycle models. Real business cycle models: Models that focus on real rather than monetary explanations of the fluctuations in real GDP. These models assume rational expectations and quickly-adjusting prices, as did Lucas and Sargent; collectively, these two approaches are known as the new classical macroeconomics.

24. LEARNING OBJECTIVE 24 of 36 © 2015 Pearson Education, Inc. Federal Reserve Policy from the 1970s to the Present 17.4 Use a Phillips curve graph to show how the Federal Reserve can permanently lower the inflation rate.

25. 25 of 36 © 2015 Pearson Education, Inc. Oil Price Shocks in the 1970s The graphs show the U.S. economy in 1973: moderate but anticipated inflation, hence unemployment at its natural rate. In 1974, OPEC caused oil prices to rise dramatically. This was a supply shock, decreasing short-run aggregate supply. Unemployment rose but so did people’s expectations of inflation— a higher short-run Phillips curve. A supply shock shifts the SRAS curve and the short-run Phillips curve Figure 17.9

26. 26 of 36 © 2015 Pearson Education, Inc. The Fed’s Response What could the Fed do? It wanted to fight both inflation and unemployment, but the short-run Phillips curve makes clear that improving one worsens the other. The Fed chose expansionary monetary policy: reducing unemployment, at the cost of even more inflation. A supply shock shifts the SRAS curve and the short-run Phillips curve Figure 17.9

27. 27 of 36 © 2015 Pearson Education, Inc. High Inflation: Must It Continue? The newly high inflation was incorporated into people’s expectations and became self- reinforcing. The Fed’s new chairman, Paul Volcker, wanted inflation lower, believing high inflation was hurting the economy. So Volcker announced and enacted a contractionary monetary policy. If people believed the announcement, they would adjust down to a lower Phillips curve. But for several years, the Phillips curve appeared not to move. The Fed tames inflation, 1979-1989 Figure 17.10

28. 28 of 36 © 2015 Pearson Education, Inc. Did Rational Expectations Fail? Does this prove people were not forming their expectations about inflation rationally? Not necessarily. The Fed had a credibility problem: it had previously announced contractionary policies but allowed inflation to occur anyway. Eventually, several years of tight money convinced people that inflation would be lower. Prices fell, and so did expectations about inflation: a new, lower short-run Phillips curve. This was disinflation: a significant reduction in the inflation rate. The Fed tames inflation, 1979-1989 Figure 17.10

29. 29 of 36 © 2015 Pearson Education, Inc. Fed Chairmen and Inflation Fed policies in the 1970s resulted in high inflation. Volcker, Greenspan, and Bernanke were all determined to keep inflation low. The record of Fed chairmen and inflation Table 17.3 Federal Reserve Chairman Term Average Annual Inflation Rate During Term William McChesney MartinApril 1951–January 19702.2% Arthur BurnsFebruary 1970–January 19786.5 G. William MillerMarch 1978–August 19799.1 Paul VolckerAugust 1979–August 19876.2 Alan GreenspanAugust 1987–January 20063.1 Ben BernankeJanuary 2006–January 20142.3

30. 30 of 36 © 2015 Pearson Education, Inc. Alan Greenspan at the Helm When he left the Fed, Alan Greenspan’s term appeared very successful: Low inflation Only two recessions—both short and mild (1990-1991, 2001) Increased Fed credibility (following through on announced actions) Increased Fed transparency (since 1994, federal funds rate target has been made public) Greenspan also oversaw the deemphasizing of the money supply as a Fed monetary policy target, and the increased interest rates—the federal funds rate, in particular.

31. 31 of 36 © 2015 Pearson Education, Inc. Alan Greenspan at the Helm: LTCM With hindsight, two Fed actions during Greenspan’s tenure appear to have worsened the 2007-2009 recession: 1.Saving hedge fund Long-Term Capital Management (LTCM) LTCM suffered heavy investment losses in 1998. Owing money to other firms, it was going to have to sell off its investments quickly to repay debts. Rather than causing the prices to fall in this manner, the Fed intervened and helped LTCM make arrangements with its creditors to unwind its investments slowly. This action set the precedent for helping over-leveraged financial firms, and may have encouraged financial firms to take too many risks, exacerbating the financial crisis.

32. 32 of 36 © 2015 Pearson Education, Inc. Alan Greenspan at the Helm: Federal Funds Rate With hindsight, two Fed actions during Greenspan’s tenure appear to have worsened the 2007-2009 recession: 2.Keeping the federal funds rate at 1% from June 2003 to June 2004 In 2001, the economy experienced a recession. By 2003, the recession was long over, but the Fed kept interest rates low anyway. This encouraged borrowing and may have exacerbated the housing bubble.

33. 33 of 36 © 2015 Pearson Education, Inc. Making the Connection The Debate over Quantitative Easing Beginning in November 2008, Fed Chairman Ben Bernanke instituted a policy of quantitative easing (QE): Fed purchased long-term Treasuries and mortgage-backed securities to reduce long-term interest rates. Critics of QE have said it could result in: Speculative asset price bubbles Excessive financial risk-taking Unfavorable changes in savings behavior A credibility problem for the Fed, due to its deviation from rules-based monetary policy.

34. 34 of 36 © 2015 Pearson Education, Inc. Central Bank Independence and Inflation In 1993, economists Alberto Alesina and Larry Summers demonstrated an important link between the inflation rate in high- income countries and the degree of independence their central banks had from the rest of the government. They concluded that, in order to continue to fight inflation, the Fed would need to maintain its independence. The more independent the central bank, the lower the inflation rate Figure 17.11

35. 35 of 36 © 2015 Pearson Education, Inc. Has the Fed Lost Its Independence? The financial crisis of 2007-2009, and the Fed’s extraordinary actions resulting from it, have prompted much political attention for the Fed. While typically the Fed has taken actions independently of the Treasury Department, during the crisis the two worked closely together. Also, by keeping interest rates low, the Fed has made it easier for the federal government to run large deficits. Ultimately, time will tell whether this apparent decrease in independence will have negative consequences for the U.S. economy.

36. 36 of 36 © 2015 Pearson Education, Inc. Common Misconceptions to Avoid Inflation and “expectations about inflation” are different but related concepts. Changes in current inflation cause movements along the short-run Phillips curve, changes in expectations about inflation cause shifts of the short-run Phillips curve. Disinflation and deflation are not the same; disinflation refers to significantly reducing the inflation rate, whereas deflation is a negative inflation rate. Remember that as long as the short-run Phillips curve is not vertical, the Fed can improve inflation or unemployment but not both simultaneously.