chapter 35 the short-run tradeoff between inflation and unemployment

Chapter 35

The Short-Run Tradeoff between Inflation and

Unemployment

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.

• The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.

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.

35.1 THE PHILLIPS CURVE

35.1 THE PHILLIPS CURVE

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

35.1.1 Origins of the Phillips Curve• In 1958,economist A.W.Phillips published an

article in the British journal Economica that would make him famous. The article was titled “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861-1957.” In it, Phillips showed a negative correlation between the rate of unemployment and the rate of inflation.

• That is, Phillips showed that years with low unemployment tended to have high inflation, and years with high unemployment tend to have low inflation.

35.1.1 Origins of the Phillips Curve

• Although Phillips discovery was based on data for the United Kingdom, researchers quickly extended his finding to other countries.

• Two years after Phillips published his article, economists Paul Samuelson and Robert Solow published an article in the American Economic Review called “Analytics of Anti-inflation Policy” in which they showed a similar negative correlation between inflation and unemployment in data for the US.

35.1.1 Origins of the Phillips Curve

• Economists Paul Samuelson and Robert Solow reasoned that this correlation arose because low unemployment was associated with high aggregate demand, which in turn puts upward pressure on wages and prices throughout the economy. Paul Samuelson and Robert Solow dubbed the negative association between inflation and unemployment the Phillips curve.

• Paul Samuelson and Robert Solow were interested in the Phillips curve because they believed that it held important lessons for policymakers.

Figure 1 The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2

35.1.2 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.


• 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.

Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply


0

InflationRate

(percentper year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregate

demand

Highaggregate demand

(output is8,000)

B

4

6

(output is7,500)

A

7

2

8,000(unemployment

is 4%)

106 B

(unemploymentis 7%)

7,500

102 A

Notice: AD shifts toward right whilst AS holds constant.


• Monetary and fiscal policy can shift the aggregate demand curve. Therefore monetary and fiscal policy can move the economy along the Phillips curve.

• Increase in the money supply, increases in government spending, or cuts in taxes expand aggregate demand and move the economy to a point on the Phillips curve with lower unemployment and higher inflation.

• Decrease in the money supply, cuts in government spending, or increases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment.

35.2 SHIFTS IN THE PHILLIPS

CURVE: THE ROLE OF EXPECTATIONS

35.2 SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF

EXPECTATIONS• The Phillips curve seems to offer policymakers

a menu of possible inflation and unemployment outcomes.

35.2.1 The Long-Run Phillips Curve

• In the 1960s, Milton Friedman and Edmund 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.

• The vertical long-run Phillips curve illustrates the conclusion that unemployment does not depend on money growth and inflation in the long run.

Figure 3 The Long-Run Phillips Curve

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

BHighinflation

Lowinflation

A

2. . . . but unemploymentremains at its natural ratein the long run.

1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .

Figure 4 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

Natural rateof output

Natural rate ofunemployment

0

PriceLevel

P

Aggregatedemand, AD

Long-run aggregatesupply

Long-run Phillipscurve


UnemploymentRate

0

InflationRate


2. . . . raisesthe pricelevel . . .

1. An increase in the money supplyincreases aggregatedemand . . .

AAD2

B

A

4. . . . but leaves output and unemploymentat their natural rates.

3. . . . andincreases theinflation rate . . .

P2B

35.2.1 The Long-Run Phillips Curve

• The vertical long-run Phillips curve is, in essence, one expression of the classical idea of monetary neutrality.

• As figure 4 illustrates, the vertical long-run Phillips curve and the vertical long-run AS curve are two sides of the same coin. In panel (a) of this figure, an increase in the money supply shifts the AD curve to the right from AD1 to AD2 . As a result of this shift, the long-run equilibrium moves from point A to point B. The price level rises from P1 to P2 , but because the AS curve is vertical, output remains the same.

35.2.1 The Long-Run Phillips Curve• In panel (b), more rapid growth in the money supply

raises the inflation rate by moving the economy from point A to point B. But because the Phillips curve is vertical, the rate of unemployment is the same at these two points. Thus, the vertical long-run AS curve and the vertical long-run Phillips curve both imply that monetary policy influences nominal variables (the price level and the inflation rate) but not real variables (output and unemployment).

• Regardless of the monetary policy pursued by the Fed, output and unemployment are, in the long run, at their natural rates.

Appendix: Okun’s law

• Okun’s law states that for every 2 percent that GDP falls relative to potential GDP, the unemployment rate rises about 1 percent point.

.10*

*),(

:'

　潜在失业率，

实际失业率，潜在产出，实际产出，其中，

　　　　　

u

uyy

uuy

yy

LawsOkun

f

f

f

Appendix: Okun’s law

• One important consequence of Okun’s Law is that actual GDP must grow as rapidly as potential GDP just to keep the unemployment rate from rising. In a sense, GDP has to keep running just to keep unemployment in the same place. Moreover, if you want to bring the unemployment rate down, actual GDP must be growing faster than potential GDP.

(Samuelson, Economics, 17th edition, p670.)

35.2.2 Expectations and the Short-Run Phillips Curve

• Expected inflation measures how much people expect the overall price level to change.


• 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.

• This equation relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation.


－a －Natural rate of unemployment

Unemploymentrate

Actualinflation

Expectedinflation=

Figure 5 How Expected Inflation Shifts the Short-Run Phillips Curve

UnemploymentRate


InflationRate Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.

CB

A

Figure 5: How expected inflation shifts the short-run Phillips curve• The higher the expected rate of inflation, the higher

the short-run tradeoff between inflation and unemployment. At point A, expected inflation and actual inflation are both low, and unemployment is at in its natural rate. If the Fed pursues an expansionary monetary policy. The economy moves from point A to point B in the short run. At point B, expected inflation is still low, but actual inflation is high. Unemployment is below its natural rate. In the long run, expected inflation rises, and the economy moves to point C. At point C, expected inflation and actual inflation are both high, and unemployment is back to its natural rate.

35.2.3 The Natural Experiment for the Natural-Rate Hypothesis

• Friedman and Phelps had made a bold prediction in 1968: If policymakers try to take advantage of the Phillips curve by choosing higher inflation in order to reduce unemployment, they will succeed at reducing unemployment only temporarily.

• 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.

35.2.3 The Natural Experiment for the Natural Rate Hypothesis

• The concept of a stable Phillips curve broke down in the in the early 1970s.

• During the 1970s and 1980s, the economy experienced high inflation and high unemployment simultaneously.

35.2.3 The Natural Experiment for the Natural Rate Hypothesis

• Figure 7 displays the history of inflation and unemployment from 1961 to 1973. It shows that the simple negative relationship between these two variables started to break down around 1970. In particular, as inflation remained high in the early 1970s, people’s expectations of inflation caught up with reality, and the unemployment rate reverted to the 5 percent to 6 percent range that had prevailed in the early 1960s. Notice that history illustrated in Figure 7 closely resembles the theory of a shifting short-run Phillips curve shown in Figure 5. By 1973, policymakers had learned that Friedman and Phelps were right: There is no tradeoff between inflation and unemployment in the long run.

Figure 6 The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

1968

1966

19611962

1963

1967

19651964

Figure 7 The Breakdown of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1973

1966

1972

1971

19611962

1963

1967

19681969 1970

19651964

35.3 SHIFTS IN THE PHILLIPS

CURVE: THE ROLE OF SUPPLY SHOCKS

35.3 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.


SHOCKS• The short-run Phillips curve also shifts because

of shocks to aggregate supply 总供给冲击 . – 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.


SHOCKS• A supply shock is an event that directly alters the

firms’ costs, and, as a result, the prices they charge.

• This shifts the economy’s aggregate supply curve. . .

• . . . and as a result, the Phillips curve.

Figure 8 An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregatedemand


UnemploymentRate

0

InflationRate


3. . . . andraises the price level . . .

AS2 Aggregatesupply, AS

A

1. An adverseshift in aggregate supply . . .

4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


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.

Figure 9 The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1972

19751981

1976

1978

1979

1980

1973

1974

1977

35.4 THE COST OF REDUCING

INFLATION

35.4 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.

Figure 10 Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate


InflationRate

Long-runPhillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.

BC

A


• 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.


• 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!

Country Ratio,% Country Ratio,%

Australia 1.00 Japan 0.93

Canada 1.50 Switzerland 1.57

France 0.75United Kingdom

0.79

Germany 2.92 United States2.39

Italy 1.74

Table1. Estimated Average Sacrifice Ratios

35.4.2 Rational Expectations and the Possibility of Costless Disinflation

• Just as Paul Volcker was pondering how costly reducing inflation might be, a group of economics professors was leading an intellectual revolution that would challenge the conventional wisdom on the sacrifice ratio. This group included such prominent economists as Robert Lucas, Thomas Sargent, and Robert Barro.

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


• 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.

• Proponents of rational expectations built on the Friedman-Phelps analysis to argue that when economic policies change, people adjust their expectations of inflation accordingly.


• According to Sargent, the sacrifice ratio could be much smaller than suggested by previous estimates. Indeed, in the most extreme case, it could be zero. If the government made a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately. The short-run Phillips curve would shift downward, and the economy would reach low inflation quickly without the cost of temporarily high unemployment and low output.

35.4.3 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 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).

Figure 11 The Volcker Disinflation

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C

35.4.4 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.

Figure 12 The Greenspan Era

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



19841991

1985

19921986

19931994

198819871995

199620021998

1999

20002001

19891990

1997

35.4.4 The Greenspan Era

• Fluctuations in inflation and unemployment in recent years have been relatively small due to the Fed’s actions.

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.

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.

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.

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.

复习题1. 画出通货膨胀与失业之间的短期权衡取舍。美联储如何使经济从这条曲线上的一点移动到另一点？

2. 画出通货膨胀与失业之间的长期权衡取舍。解释短期与长期权衡取舍如何相互关联。

3. 什么是自然失业率？为什么各国的自然失业率不同？4. 假设干旱摧毁了农作物并使食物价格上升。这对通货膨胀与失业之间的短期权衡取舍有什么影响？

5. 美联储决定降低通货膨胀。用菲利普斯曲线说明这种政策的短期与长期影响。如何减少短期的代价？

• (Mankiw, Chapter35 inflation and unemployment, p805, Question 1.) Suppose the natural rate of unemployment is 6 percent. On one graph, draw two Phillips curves that can be used to describe the four situations listed here. Label the point hat shows the position of the economy in each case:

• a. Actual inflation is 5 percent and expected inflation is 3 percent.

• b. Actual inflation is 3 percent and expected inflation is 5 percent.

• c. Actual inflation is 5 percent and expected inflation is 5 percent.

• d. Actual inflation is 3 percent and expected inflation is 3 percent.

Short-run Phillips curvewith 3% expected

inflation

Short-run Phillips curvewith 5% expected

inflation

Natural rate ofunemployment

unemployment rate

InflationRate

3%

5%A

D

C

B

Mankiw,ch35 inflation and unemployment,question1

• (Mankiw, Chapter35 inflation and unemployment, p805, Question

2.) Illustrate the effects of the following developments on both the short-run and the long-run Phillips curves. Give the economic reasoning underlying your answers

• a. a rise in the natural rate of unemployment

• b. a decline in the price of imported oil

• c. a rise in government spending

• d. A decline in expected inflation

chapter 35 the short-run tradeoff between inflation and unemployment

Documents

unemployment unemployment

higher unemployment

aggregate demand curve

high unemployment

lower unemployment

low unemployment

phillips curve35

phillips curvein