Transcript Mankiw: Brief Principles of Macroeconomics, Second Edition

Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 16: The Short-run Tradeoff
Between Inflation and
Unemployment
Long-run Unemployment
• The natural rate of unemployment (the longrun 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.
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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.
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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.
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Short-run
LRAS
SRAS
P3
P2
AD3
P*
AD2
AD1
Y* Y2 Y3
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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.
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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.
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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.
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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
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Unemployment and Inflation
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Unemployment and Inflation
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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.
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Long Run
P
Infl.
rate
LRAS
SRAS
Long run
Phillips curve
SRAS
AD
P*
AD
Y*
Y
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U*
Unemp.
rate
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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.
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Short Run and Long Run
P
Infl.
rate
LRAS
SRAS
SRAS
5%
3%
AD
P*
AD
Y*
SRPhC
Long run
Phillips curve
Y
U*
Expected inflation on the white SRPhC is 3%.
When expected inflation rises to 5%, SRPhC shifts to the blue one.
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Unemp.
rate
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How the Fed Can Fuel Inflation
LRPhC
7%
4
5
Pe=7%
2
4%
3
Pe=4%
11
2%
Pe=2%
4%
6%
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Inflation-Unemployment in the 1960s
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Unemployment-Inflation 1961-73
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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.
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Oil Price Shock
LRAS
SRAS
P
P*
LRPhC
SRAS
SRAS
6%
5%
3%
Pe=6%
Pe=5%
Pe=3%
AD
U* U
Y Y*
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Unemployment-Inflation 1972-81
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Oil Price Collapse
LRPhC
LRAS
SRAS
SRAS
P
P
SRAS
4%
SRPhC
3%
SRPhC
SRPhC
AD
Y* Y
U U*
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Unemployment-Inflation 1979-87
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Unemployment-Inflation 1984-95
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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?
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Cost of Reducing Inflation
LRAS
LRPhC
Pe=10%
SRAS
10%
P
AD
AD
Y*
U*
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Unemployment-Inflation 1979-87
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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.
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