Transcript Inflation – Unemployment Tradeoff

The Short-Run
Tradeoff between
Inflation and
Unemployment
Chapter 33
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Unemployment and Inflation
 The
natural rate of unemployment
depends on various features of the labor
market.
 Examples include minimum-wage laws,
the market power of unions, the role of
efficiency wages, and the effectiveness
of job search.
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Unemployment and Inflation
 The
inflation rate depends primarily
on growth in the quantity of money,
controlled by the Fed.
 The
misery index, one measure of the
“health” of the economy, adds together
the inflation rate and unemployment
rate.
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Unemployment and Inflation
 Society
faces a short-run tradeoff between
unemployment and inflation.
 If policymakers expand aggregate
demand, they can lower unemployment,
but only at the cost of higher inflation.
 If they contract aggregate demand, they
can lower inflation, but at the cost of
temporarily higher unemployment.
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The Phillips Curve
The Phillips curve illustrates the
short-run relationship between
inflation and unemployment.
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The Phillips Curve...
Inflation
Rate
(percent
per year)
B
6
A
2
Phillips curve
0
4
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7
Unemployment
Rate (percent)
Aggregate Demand, Aggregate
Supply, and the Phillips Curve
 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.
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Aggregate Demand, Aggregate
Supply, and the Phillips Curve
 The
greater the aggregate demand for
goods and services, the greater is the
economy’s output, and the higher is the
overall price level.
 A higher level of output results in a lower
level of unemployment.
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How the Phillips Curve is Related to the Model
of Aggregate Demand and Aggregate Supply...
(a) The Model of AD and AS
Price Level
Short-run
AS
102
0
Inflation Rate
(percent per
year)
B
106
A
7,500
(unemployment
is 7%)
(b) The Phillips Curve
High AD
6
Low AD
2
8,000
(unemployment
is 7%)
0
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B
A
Phillips curve
7
4
(output is (output is
8,000)
7,500)
Unemployment
Rate (percent)
Shifts in the Phillips Curve:
The Role of Expectations
The Phillips curve seems to offer
policymakers a menu of possible
inflation and unemployment outcomes.
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The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps
concluded that inflation and
unemployment are unrelated in the long
run.
 As
a result, the long-run Phillips curve is
vertical at the natural rate of
unemployment.
 Monetary policy could be effective in the
short run but not in the long run.
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The Long-Run Phillips Curve...
Inflation
Rate
1. When the
Fed increases
the growth
rate of the
money
supply, the
rate of
inflation
increases…
High
inflation
Low
inflation
0
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Long-run
Phillips curve
B
A
Natural rate of
unemployment
2. … but
unemployment
remains at its
natural rate
in the long run.
Unemployment
Rate
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How the Phillips Curve is Related to the
Model of Aggregate Demand and
Aggregate Supply…
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
Long-run aggregate
supply
(b) The Phillips Curve
Inflation
Rate
P2
1. An increase in the
money supply increases
aggregate demand…
P1
AD2
0
2. …raises the
price level…
Natural rate of
output
Aggregate
demand, AD1
Quantity of
Output
Long-run Phillips
curve
B
3. …and
increases the
inflation rate…
A
0
Natural rate of
unemployment
4. …but leaves output and unemployment
at their natural rates.
Unemployment Rate
Expectations and the
Short-Run Phillips Curve
Expected inflation measures
how much people expect the
overall price level to change.
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Expectations and the
Short-Run Phillips Curve
 In
the long run, expected inflation adjusts
to changes in actual inflation.
 The Fed’s ability to create unexpected
inflation exists only in the short run.
 Once
people anticipate inflation, the only
way to get unemployment below the natural
rate is for actual inflation to be above the
anticipated rate.
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Expectations and the
Short-Run Phillips Curve
Unemployment
=
Rate
Natural rate of
unemployment
-
Actual
a ( inflation
-
Expected
inflation )
This equation relates the unemployment rate
to the natural rate of unemployment, actual
inflation, and expected inflation.
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How Expected Inflation Shifts the
Short-Run Phillips Curve...
Inflation
Rate
Long-run
Phillips curve
B
1. Expansionary
policy moves
the economy up
along the shortrun Phillips
curve...
0
2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
curve shifts to the right.
C
Short-run Phillips curve with
high expected inflation
A
Short-run Phillips curve with
low expected inflation
Natural rate of
unemployment
Unemployment
Rate
The Natural-Rate Hypothesis
 The
view that unemployment
eventually returns to its natural rate,
regardless of the rate of inflation, is
called the natural-rate hypothesis.
 Historical observations support the
natural-rate hypothesis.
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The Natural Experiment for the
Natural Rate Hypothesis
 The
concept of a stable Phillips curve
broke down in the in the early ’70s.
 During the ’70s and ’80s, the economy
experienced high inflation and high
unemployment simultaneously.
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The Phillips Curve in the 1960s...
Inflation Rate
(percent per year)
10
8
6
1968
4
1967
1966
1962
1965
1964
2
0
1
1963
1961
2
3
4
5
6
7
8
Unemployment Rate (percent)
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9
10
The Breakdown of the Phillips Curve...
Inflation Rate
(percent per year)
10
8
1973
6
1969
1968
4
1967
1971
1970 1972
1966
1962
1965
1964
2
0
1
1963
1961
2
3
4
5
6
7
8
Unemployment Rate (percent)
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9
10
Shifts in the Phillips Curve:
The Role of Supply Shocks
 Historical
events have shown that the
short-run Phillips curve can shift due to
changes in expectations.
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Shifts in the Phillips Curve:
The Role of Supply Shocks
 The
short-run Phillips curve also shifts
because of shocks to aggregate supply.
 Major
adverse changes in aggregate supply
can worsen the short-run tradeoff between
unemployment and inflation.
 An adverse supply shock gives policymakers
a less favorable tradeoff between inflation
and unemployment.
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Shifts in the Phillips Curve:
The Role of Supply Shocks
 A supply
shock is an event that directly
affects firms’ costs of production and
thus the prices they charge.
 It shifts the economy’s aggregate supply
curve...
 … and as a result, the Phillips curve.
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An Adverse Shock to Aggregate
Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
3. …and raises the
price level…
AS2
P2
Inflation
Rate
Aggregate
supply, AS1
A
A
PC2
Aggregate
demand
0
Y2
Y1
Quantity of
Output
2. …lowers output…
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4. …giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
1. An adverse
shift in aggregate
supply…
B
P1
(b) The Phillips Curve
0
Phillips curve, PC1
Unemployment Rate
Shifts in the Phillips Curve:
The Role of Supply Shocks
 In
the 1970s, policymakers faced two
choices when OPEC cut output and
raised worldwide prices of petroleum.
 Fight
the unemployment battle by expanding
aggregate demand and accelerate inflation.
 Fight inflation by contracting aggregate
demand and endure even higher
unemployment.
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The Supply Shocks of the 1970s...
Inflation Rate
(percent per year)
10
1980
1974
8
6
1975
1979
1978
1977
1973
4
1981
1976
1972
2
0
1
2
3
4
5
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6
7
8
9 10 Unemployment
Rate (percent)
The Cost of Reducing Inflation
 To
reduce inflation, the Fed has to pursue
contractionary monetary policy.
 When the Fed slows the rate of money
growth, it contracts aggregate demand.
 This reduces the quantity of goods and
services that firms produce.
 This leads to a rise in unemployment.
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Disinflationary Monetary Policy in the
Short Run and the Long Run...
Inflation
Rate
Long-run
Phillips curve
A
1. Contractionary policy
moves the economy
down along the short-run
Phillips curve...
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
Rate
2. ... but in the long run, expected inflation falls
and the short-run Phillips curve shifts to the left.
The Cost of Reducing Inflation
 To
reduce inflation, an economy must
endure a period of high unemployment
and low output.
 When
the Fed combats inflation, the
economy moves down the short-run Phillips
curve.
 The economy experiences lower inflation but
at the cost of higher unemployment.
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The Cost of Reducing Inflation
 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.
 An
estimate of the sacrifice ratio is five.
 To reduce inflation from about 10% in
1979-1981 to 4% would have required an
estimated sacrifice of 30% of annual
output!
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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.
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Rational Expectations
 Expected
inflation explains why there is a
tradeoff between inflation and
unemployment in the short run but not in
the long run.
 How quickly the short-run tradeoff
disappears depends on how quickly
expectations adjust.
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Rational Expectations
 The
theory of rational expectations
suggests that the sacrifice-ratio could be
much smaller than estimated.
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The Volcker Disinflation
 When
Paul Volcker was Fed chairman in
the 1970s, inflation was widely viewed as
one of the nation’s foremost problems.
 Volcker succeeded in reducing inflation
(from 10% to 4%), but at the cost of high
employment (about 10% in 1983).
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The Volcker Disinflation...
Inflation Rate
(percent per year)
10
A
1980 1981
1979
8
1982
6
1984
B
1987
1983
1985
C
1986
4
2
0
1
2
3
4
5
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6
7
8
9 10 Unemployment
Rate (percent)
The Greenspan Era
 Alan
Greenspan’s term as Fed chairman
began with a favorable supply shock.
 In
1986, OPEC members abandoned their
agreement to restrict supply.
 This led to falling inflation and falling
unemployment.
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The Greenspan Era...
Inflation Rate
(percent per year)
10
8
6
1990 1991
1989
1984
1988
1985
1987
1992
1995
1994 1993
1986
4
2
00
1
2
3
4
5
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6
7
8
9 10
Unemployment
Rate (percent)
The Greenspan Era
 Fluctuations in
inflation and
unemployment in recent years have been
relatively small due to the Fed’s actions.
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Summary
 The
Phillips curve describes a negative
relationship between inflation and
unemployment.
 By expanding aggregate demand,
policymakers can choose a point on the
Phillips curve with higher inflation and lower
unemployment.
 By contracting aggregate demand,
policymakers can choose a point on the
Phillips curve with lower inflation and higher
unemployment.
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Summary
 The
tradeoff between inflation and
unemployment described by the Phillips
curve holds only in the short run.
 The long-run Phillips curve is vertical at
the natural rate of unemployment.
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Summary
 The
short-run Phillips curve also shifts
because of shocks to aggregate supply.
 An adverse supply shock gives
policymakers a less favorable tradeoff
between inflation and unemployment.
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Summary
 When
the Fed contracts growth in the
money supply to reduce inflation, it
moves the economy along the short-run
Phillips curve.
 This results in temporarily high
unemployment.
 The cost of disinflation depends on how
quickly expectations of inflation fall.
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Summary
 Because
monetary and fiscal policy can
influence aggregate demand, the
government sometimes uses these policy
instruments in an attempt to stabilize the
economy.
 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.
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Graphical
Review
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The Phillips Curve...
Inflation
Rate
(percent
per year)
B
6
A
2
Phillips curve
0
4
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7
Unemployment
Rate (percent)
How the Phillips Curve is Related to the Model
of Aggregate Demand and Aggregate Supply...
(a) The Model of AD and AS
Price Level
Short-run
AS
102
0
Inflation Rate
(percent per
year)
B
106
A
7,500
(unemployment
is 7%)
(b) The Phillips Curve
High AD
6
Low AD
2
8,000
(unemployment
is 7%)
0
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B
A
Phillips curve
7
4
(output is (output is
8,000)
7,500)
Unemployment
Rate (percent)
The Long-Run Phillips Curve...
Inflation
Rate
1. When the
Fed increases
the growth
rate of the
money
supply, the
rate of
inflation
increases…
High
inflation
Low
inflation
0
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Long-run
Phillips curve
B
A
Natural rate of
unemployment
2. … but
unemployment
remains at its
natural rate
in the long run.
Unemployment
Rate
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How the Phillips Curve is Related to the
Model of Aggregate Demand and
Aggregate Supply…
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
Long-run aggregate
supply
(b) The Phillips Curve
Inflation
Rate
P2
1. An increase in the
money supply increases
aggregate demand…
P1
AD2
0
2. …raises the
price level…
Natural rate of
output
Aggregate
demand, AD1
Quantity of
Output
Long-run Phillips
curve
B
3. …and
increases the
inflation rate…
A
0
Natural rate of
unemployment
4. …but leaves output and unemployment
at their natural rates.
Unemployment Rate
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How Expected Inflation Shifts the
Short-Run Phillips Curve...
Inflation
Rate
Long-run
Phillips curve
B
1. Expansionary
policy moves
the economy up
along the shortrun Phillips
curve...
0
2. …but in the long-run,
expected inflation rises,
and the short-run Phillips
curve shifts to the right.
C
Short-run Phillips curve with
high expected inflation
A
Short-run Phillips curve with
low expected inflation
Natural rate of
unemployment
Unemployment
Rate
The Phillips Curve in the 1960s...
Inflation Rate
(percent per year)
10
8
6
1968
4
1967
1966
1962
1965
1964
2
0
1
1963
1961
2
3
4
5
6
7
8
Unemployment Rate (percent)
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
9
10
The Breakdown of the Phillips Curve...
Inflation Rate
(percent per year)
10
8
1973
6
1969
1968
4
1967
1971
1970 1972
1966
1962
1965
1964
2
0
1
1963
1961
2
3
4
5
6
7
8
Unemployment Rate (percent)
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9
10
An Adverse Shock to Aggregate
Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level
3. …and raises the
price level…
AS2
P2
Inflation
Rate
Aggregate
supply, AS1
A
A
PC2
Aggregate
demand
0
Y2
Y1
Quantity of
Output
2. …lowers output…
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4. …giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
B
1. An adverse
shift in aggregate
supply…
B
P1
(b) The Phillips Curve
0
Phillips curve, PC1
Unemployment Rate
The Supply Shocks of the 1970s...
Inflation Rate
(percent per year)
10
1980
1974
8
6
1975
1979
1978
1977
1973
4
1981
1976
1972
2
0
1
2
3
4
5
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6
7
8
9 10 Unemployment
Rate (percent)
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Disinflationary Monetary Policy in the
Short Run and the Long Run...
Inflation
Rate
Long-run
Phillips curve
A
1. Contractionary policy
moves the economy
down along the short-run
Phillips curve...
Short-run Phillips curve
with high expected
inflation
C
B
Short-run Phillips curve
with low expected
inflation
0
Natural rate of
unemployment
Unemployment
Rate
2. ... but in the long run, expected inflation falls
and the short-run Phillips curve shifts to the left.
The Volcker Disinflation...
Inflation Rate
(percent per year)
10
A
1980 1981
1979
8
1982
6
1984
B
1987
1983
1985
C
1986
4
2
0
1
2
3
4
5
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6
7
8
9 10 Unemployment
Rate (percent)
The Greenspan Era...
Inflation Rate
(percent per year)
10
8
6
1990 1991
1989
1984
1988
1985
1987
1992
1995
1994 1993
1986
4
2
00
1
2
3
4
5
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
6
7
8
9 10
Unemployment
Rate (percent)